Thank you, Laura Kodres, for that kind introduction. It is a pleasure for me to come to the IMF to share some of my thoughts on energy futures markets. Laura asked me to give you my perspective on the important functions of futures markets and what we do at the Commodity Futures Trading Commission (CFTC) to ensure that the markets function properly. I was also asked to comment on the position data the CFTC receives, and whether we should require and possibly publish more information, either from futures, OTC, or foreign markets, to detect or prevent manipulation. Before I begin, let me say that the comments I offer today are derived from my own perspective on markets and therefore, do not necessarily reflect those of the other Commissioners or staff.
As regulators, our charge is to ensure that the markets operate with integrity, free from fraud and manipulation, efficiently pricing the underlying assets on which the contracts are based. Futures markets serve many important functions, but today I want to focus on two: risk management and price discovery.
Futures and other derivatives like forwards, options, and swaps allow commercial market participants a means to manage the risks they face in their business. They allow hedgers to shift unwanted risks from themselves to other market participants who are willing to assume it. To illustrate, consider the case of an oil refiner. When looking at oil companies, many often assume that these are enterprises that simply pump oil out of the ground, refine it, and sell gasoline and other products for as profitable a price as possible. But if we examine these enterprises more carefully, we see that they are much more complex and face multiple risks throughout the production process.
Focusing on the oil refining process, the goal of a refiner is to purchase crude oil for as little as possible, turn it into refined products, mainly gasoline and distillate, and sell those products for as high a price as the market will bear. The difference between the value of the crude purchased and the price for which refined products is sold is what is known as the crack spread. Thus, a refinery is interested in maximizing its crack spread. In a sense, the refiner is less interested in the actual price of oil or the actual price of the products it sells than it is with the spread between those prices.
The refiner has a couple of options when it endeavors to capture the crack spread. It can simply take its chances in the market by buying crude oil at the current spot price of oil, and then sell its refined product at spot prices; or it can manage this risk. That is, it can hedge the crack spread. Again, it can do this in several ways, one of which is to use the futures market. To lock in the crack spread, the refiner would typically buy three crude oil futures contracts, and sell two gasoline and one heating oil futures contracts. This combination of contracts is commonly known as the NYMEX 3-2-1 Crack Spread, and reflects the fact that three barrels of oil will produce approximately two barrels of gasoline and one barrel of heating oil, or distillate. For the refiner that chooses to lock in this hedge, the price risk that it faces during the refining process is substantially decreased.
But not only do the futures market allow refiners—or for that matter, any commercial enterprise in any market for which futures exist—to lock in prices or price spreads, they also provide critical information that allow them to plan for the future. Again, looking at the oil industry, oil companies can look into the future, in some cases the distant future, to see what the market’s assessment is for future profitability. This is vitally important, since prices drive decisions related to exploration and development, to expansion of refining capacity. For example, there is a fair amount of liquidity for oil futures going out to December 2011, which currently shows a futures price of about $67 per barrel. The heating oil and gasoline contracts do not trade actively out that far, but the nearer months and the OTC markets nonetheless provide valuable information on the crack spread to oil companies considering whether or not to expand refining capacity. In essence, these prices tell companies what the market is demanding in terms of future service levels and capacity. If the future crack spread is high, the market is signaling for more capacity. Conversely, if it is low, then the market is signaling that excess capacity currently exists in the industry.
While I am on the topic of price signals, the question is often raised as to why futures prices typically do not end up being what the spot price is for the commodity. Well, in one sense futures prices do end up being what the spot price is and in one sense they do not. Let me explain. At any point in time, what the futures price reflects is the market’s best prediction as to what the spot price will be at the expiration date of the futures contract. So, for example, I mentioned that the current futures price for crude oil in December 2011 is $67.00 per barrel. Does that mean that the price of oil in December of 2011 will be $67? This is unlikely. Supply and demand patterns are not static and new information will always come to the market that will change the actual or “realized spot prices”. The futures price only reflects that the market, given the information that is currently available to traders, expects the future price of oil to be $67.
However, while futures prices typically will not precisely equal the realized spot price, as time passes, and the possibility for new information to change expectations starts to shrink, the futures price will arrive at equivalence to the spot price. That will happen when the contract approaches expiration. At that point the information being reflected in the futures price will be the same as that reflected in the spot market and prices will converge. This convergence is very important to the risk management process since a hedger wanting to lock in that $67 per barrel price of oil for purchase in December of 2011 can do so today. There are a variety of OTC contracts, including forwards and swaps, which allow the hedger to set the price based on the settlement prices of the futures markets. To hedge the risk directly using futures markets, a refiner may sell a futures contract for $67 today. In 2011, let’s say that the spot price of oil is $100 per barrel. Because the futures price converges to the spot price, the refiner will be able to buy back the futures contract at $100 per barrel, making a profit of $33. That $33 can then be used to offset the purchase price of $100 per barrel to create and an effective price of $67 per barrel for the oil. So if you think about it in that way, the price of a futures contract today does equal the future spot price, at least in terms of what a hedger pays.
These examples of how the futures markets function demonstrate the need for government regulation to assure that the markets are functioning properly and are free from distortion, either because of the way in which the markets are designed or because of the behavior of participants in the market. At the CFTC, we appreciate the value and role that the futures markets play in the economy and make it a priority to assure that the markets are fair and able to do their job in discovering prices so that the signals sent to the market are clear. The main way that we accomplish this is through our market oversight and surveillance programs.
The CFTC’s market oversight staff continuously monitors the terms and conditions of contracts being offered by the exchanges and considers underlying market factors that may affect the functioning of a contract. For example, the staff of our Division of Market Oversight will look at the expected level of deliverable supplies and market infrastructure at the delivery points of a contract to assure that conditions do not exist that would allow a contract to be easily cornered or squeezed. If such conditions should exist, the staff will work with the exchanges to develop remedies to the situation.
It is also the case that staff continuously evaluates market conditions and structures related to contracts. Back in the 1990’s, for instance, staff became concerned with the available delivery stocks for corn and soybeans at the Chicago Board of Trade delivery points in Chicago and Toledo, Ohio. Over time, less of these commodities naturally moved through these points and as a result, the only reason why these commodities moved at all to warehouses in these markets was to serve the futures market. As a result, contract expirations increasingly experienced problems in these commodities such that futures prices were not converging cleanly to spot market prices. When prices do not converge, it increases risk to hedgers who are not able to lock in prices with certainty. To resolve the problem, Commission staff worked with the Chicago Board of Trade to introduce delivery through shipping certificates, which better conformed to the natural flow of these commodities in the cash market. This illustrates how the Commission works with the industry at the contract design level to assure well structured markets.
In the energy markets, we have also recently worked with the exchanges to devise more efficient and effective means to help prevent and detect manipulation. For example, hard-wired market constraints like speculative position limits and price limits can sometimes distort the convergence process that I just outlined in addition to creating costs for market users who find themselves unable to adjust their positions as a result. An alternative approach, which I have strongly advocated, is a policy of “position accountability.” With position accountability, traders are not arbitrarily limited on the size of positions they take, but when they pass a certain level, the exchange and the Commission are afforded the opportunity to inquire as to the intent of the party -- whether they have product available for delivery, whether they are taking a view on prices and what the basis for that view is, etc. If the exchange or the Commission deems that the large position could give rise to congestion or could have a detrimental price impact, the position holder can be required to liquidate their position down to the accountability level. With position accountability, the levels serve as a “trigger” for increased monitoring of positions. In this way, the Commission and the exchanges are able to monitor markets in a proactive way, without interfering unduly in the hedging and price discovery function process.
The application of position limits has become directly relevant in the ongoing competition between NYMEX, a US floor-based futures exchange, and ICE Futures, a UK domiciled, FSA regulated electronic market. As I mentioned, position limits can constrain users of the markets from attaining their optimal hedge or can force mechanical liquidations as expiration approaches. NYMEX officials have complained that the limits put them at a disadvantage to ICE Futures, which offers a cash settled contract similar to the NYMEX West Texas Intermediate (WTI) Crude Oil contract that has been able to garner significant volume from US based customers. I agree that the speculative position limit currently in effect should be modified. This situation has led NYMEX to work with the CFTC staff to develop a position accountability approach that will wed their GLOBEX-based electronic contract to their physically delivered contract, and do so in a way that unburdens the markets while ensuring our goals to detect and prevent manipulation are achieved.
On a day-to-day basis, the market surveillance program of the Commission bears responsibility for monitoring trading activity. The market surveillance section employs a staff of about 45 economists and analysts who continually monitor activity on the futures exchanges. The heart of the program relies on what we refer to as the Large Trader Reporting System. This system captures the end-of-day position of every trader who has a reportable position. For example, the reporting level for natural gas is 200 contracts. That means that every trader in the natural gas market that has a position that is equal to or greater than 200 contracts will have his position reported to the Commission. While the reporting levels are fixed from one day to the next, they are adjusted periodically to assure that the CFTC captures from 70 to 90 percent of all positions in a particular market.
Using these reports, the surveillance staff looks for unusual concentrations or the coordination of trading by groups of traders who may be attempting to manipulate the markets. The surveillance staff will also focus on the largest of the traders in the markets as trading nears expiration to assure that the markets are liquidating in an orderly fashion. For example, if the staff notices that a large trader is holding on to a position by not liquidating the positions, they may contact the trader to find out his intentions. Is the position a hedge? Does it make economic sense to hold the position? Are there other reasons why the trader may be unable or unwilling to liquidate the position?
In addition to the staff collecting this information and contacting traders in the markets, the staff routinely reports its findings to the Commission. Every week the staff identifies those commodities deserving the most attention and briefs the Commission on activities in the markets. As you may well guess, over the past couple of years, the oil and gas markets have garnered the most attention. Other contracts that have involved close monitoring were the expiration of some of the treasury-note futures contracts and price movements around the announcements of mad cow disease in Canada and United States.
During the weekly surveillance briefings, the staff presents an analysis of current market conditions, including physical market activity related to such things as storage and usage figures, imports and exports, production expectations, weather forecasts—whatever information may be important to understanding current price trends in the markets. Also, they will review the large trader reports and present any other relevant information regarding the intentions of the major players in the markets. With the growth of hedge funds and other large speculators, the staff has also begun to more closely track activity by this group to ascertain what impact these participants as a group may be having on the markets. To date, the staff’s findings have shown that these large speculators as a group tend to inject liquidity into the markets rather than having an undue impact on price movements.
From the information we collect from our surveillance function, the CFTC has for many years published on a weekly basis an aggregated version of trader activity known as the Commitments of Traders, or COT, 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. Recently, there has been a call by some to provide a greater breakout with respect to the composition of 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. Some market users have expressed their desire to see the non-traditional group be broken out, and at the behest of the Chairman, the Commission staff is currently evaluating the desirability of doing so.
Many have suggested that the increased participation of commodity index investors and the swaps dealers who serve them has had a distorting effect on the markets and has led to high prices. Engaging in a dime store economic analysis, they see the high prices, particularly in the energy complex, and the increased participation of the swaps dealers and funds, and they assert that the funds are the probable cause. The reason that the index money is particularly suspected in the energy complex is because many index funds, like the Goldman Sachs Commodity Index Fund, or GSCI, has a high concentration of energy commodities in their portfolio.
As someone who has been closely monitoring these data and market activity for going on four years, I would like to set the record straight: the increased participation of commodity index investors and the swaps dealers has actually had a stabilizing effect on the price process. Since these position holders take large positions, and generally roll them from one contract month to the next in a very deliberate and transparent fashion, their net positions are a flat line over time, with very little variation. Breaking them out as a separate category would do little to increase the informativeness or trading value of the COT data, but would potentially expose these traders to increased risk that they would be front run by others in the market.
I also believe, and this is my personal view as a financial economist, that these market participants are appropriately classified as commercials. The underlying motivation for entering the market and investing in commodities through these indexes is to attain increased diversification of one’s portfolio and to hedge systematic commodity exposure that underlies all commercial activity. Further, the swaps dealers who sell these swaps to accommodate the demand for commodity exposure and then turn around and hedge it in the futures market are most certainly engaged in the reduction of risk in the conduct and management of its commercial enterprise. This activity comports with the regulatory definition of bona fide hedging and forms the basis for my conclusion that this type of trader is appropriately categorized as a commercial trader.
While I believe that the staff review at this time is fine, I think that moving to revealing more information about trader’s positions and activity creates a risk of giving away the information that market participants collected and brought to the market. And if traders can no longer profit from the information they have collected, they lose their incentive to collect information and 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 that it if it helped me do my job or policing 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 whether a moral hazard is created. The moral hazard is created when market participants begin to rely on the government’s efforts to police bilateral commercial 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 will become 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 reporting requirements that would place greater reporting requirements on exempt OTC 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, like that of the Intercontinental Exchange, or ICE, 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 OTC markets could be moved to voice brokered markets or offshore, where again they become less visible to front-line regulators and the market.
In the case of OTC markets, contracts 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 execute and possibly of very limited value.
Instead of attempting to design an expensive surveillance program to monitor markets as diverse and fragmented as the OTC markets, I believe that we need to better appreciate the current regulatory and enforcement model we have in place. 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 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. 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 and that the price discovery process is not being harmed. To ensure this is the case, through the authority granted to the Commission by Congress, we are able to access a great deal of information on OTC and the physical markets as a result of the informational and arbitrage linkage to the futures markets.
I would add that in linked foreign and electronic markets, we have engaged in information sharing and routine discussions between our partner regulatory authorities to ensure there are no holes in regulatory coverage. In my view, it is important to avoid regulatory duplication and to rely upon our regulatory partners before asserting jurisdiction over appropriately regulated foreign entities. True global competition is important to inspiring innovation and bringing down prices. As policy makers, we should do everything we can to encourage it within the framework of our shared regulatory principles of fair and efficient markets.
Thank you for the attention you have given me today. As I said at the outset, it is my pleasure to be here at the International Monetary Fund and I welcome any questions you may have.
Last Updated: April 18, 2007