November 30, 2011
Good afternoon. Thank you for inviting me here today to discuss my perspective on CFTC policy issues that may affect the electric industry as well as the markets the Commission regulates. Much of what we have focused on over the last year directly relates to implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. It has been a very complex process involving a great deal of coordination with other U.S. and foreign regulators. The further along we get in the implementation process, the more complex it is has become. Since September 2010, the Commission has held 20 public meetings to vote on various Dodd-Frank matters and has issued nearly 60 proposed rules, notices, or other requests seeking public comment, and 22 final rules, interim final rules, and exemptions. We have two more public meetings scheduled for December, and four meetings scheduled for early 2012.
Before addressing the details of the policy agenda going forward and the CFTC’s new authority over swaps markets, I think it would be helpful to step back and give a history of the CFTC.
The Commodity Futures Trading Commission was created by Congress as an independent agency in 1974 to replace the Commodity Exchange Administration that resided within the U.S. Department of Agriculture. At that time, most futures contracts were based on agricultural commodities. In 1975, the first financial futures contracts began trading when the CFTC approved the Chicago Board of Trade’s futures contract based on Ginnie Maes, and within months approved the Chicago Mercantile Exchange’s 90-day Treasury bill futures contract. The advent of financial futures contracts would forever change the futures and options industry.
In addition to the transformation brought about by financial futures, in 1978 home heating oil futures contracts began trading, in 1983 WTI crude oil futures contracts began trading, and in 1990 Henry Hub natural gas futures contracts began trading. The success of these contracts continued the evolution of the industry toward non-agricultural contracts.
With the passage of the Commodity Futures Modernization Act of 2000, exempt commercial markets were born, drastically changing the way energy contracts were traded. Particularly, the rapid growth of the Intercontinental Exchange, or ICE, provided energy market participants with additional trading opportunities and a more transparent view into trading activity in many markets.
The CFTC currently regulates 17 designated contracts markets, 14 derivatives clearing organizations (DCOs) and 123 active futures commission merchants (FCMs) or intermediaries. There are over 2,400 actively traded futures contracts listed on the exchanges we regulate.
The Futures Industry Association reports that in 2010 the total volume in U.S. futures and options markets was 3.222 billion contracts and globally the total number of contracts traded on derivatives exchanges around the world reached a new all-time record of 22.3 billion.
When I arrived at the CFTC in August of 2007, we employed approximately 440 FTEs and our appropriation for FY 2008 was $112,000,000. The 2011 spending plan accommodated 720 FTEs, an increase of 280 FTEs in just 4 years. On November 18, our appropriation for FY 2012 was signed by President Obama at $205,000,000, which is over a $100 million less than the President had in his budget for us but is still a slight increase over our FY 2011 number. With passage of the Dodd-Frank Act, there is no doubt that Congress expanded the mission and scope of the agency. We were given broad authority to regulate swap transactions, swap markets and swap market participants. However, I believe it is premature for us to assume that the agency will need to increase both our staff and our budget by more than three fold in order to implement the new authority. When we finish writing the rules and definitions, the agency should have a much better understanding of how much money it will take for technology and staff to regulate these markets and market participants. And until then, we should feel lucky that our budget was not cut in the current fiscal environment.
There are a number of different issues that we are considering that are likely of interest to power market participants but I will start with jurisdiction.
For quite some time, there have been questions about whether or not certain power market transactions were subject to the Commodity Exchange Act (CEA or Act) and Commission regulations. Given those questions, the Dodd-Frank Act added section 4(c)(6) to the CEA, which states that if the Commission determines it is in the public interest and consistent with the purposes of the Act, the Commission shall exempt from the requirements of the CEA an agreement, contract, or transaction that is entered into pursuant to a tariff or rate schedule approved or permitted to take effect by FERC or the regulatory authority of a State or municipality, or entered into between entities described in section 210(f) of the Federal Power Act.
Our staff has been analyzing these markets and public interest concerns, and has been meeting with the ISOs and RTOs to evaluate how best to give effect to this new statutory provision. The process for granting exemptions would involve a person or entity formally requesting an exemption pursuant to Section 4(c)(6) of the CEA, the Commission publishing the request in the Federal Register for public comment, and the Commission determining whether to grant the exemption. While I expect this process to begin in the coming months, I cannot pinpoint a specific date upon which any requests for exemption will be filed with the Commission.
Regardless of when or whether exemptions are granted for certain transactions, power market participants should be very interested in how their other transactions may be classified – that is, whether certain of their nonexempt transactions fall within the definition of “swap.” If certain transactions are classified as swaps, entities will need to evaluate whether they are required to clear them, or whether they are entitled to claim the end-user exemption from mandatory clearing. In addition, they will need to determine whether their level of swap activity will require registration as a swap dealer or major swap participant, and how their swap activity will be treated for purposes of speculative position limits. The regulatory requirements and potential costs associated with each of these issues are not insignificant.
Last December the Commission proposed rules outlining the end-user exemption. Generally, the Dodd-Frank Act makes it unlawful for any person to engage in a swap unless that person submits the swap for clearing to a DCO if the swap is required to be cleared. However, an election can be made not to clear that swap if least one party to the swap is not a “financial entity,” is using the swap to hedge or mitigate commercial risk, and a notice is provided to the Commission regarding how the person or entity generally meets its financial obligations associated with entering into non-cleared swaps. Some have argued that the Commission’s proposed end-user exemption is not sufficiently broad and does not provide the necessary certainty to end-users. In my view, the exemption should be as broad as possible to protect end-users from additional costs associated with mandatory clearing. If an end-user chooses to clear its transactions, that’s great. However, Congress explicitly left that choice to the end-user, not to the Commission.
As I mentioned, power market participants may also potentially need to evaluate whether their activity makes them a swap dealer or major swap participant if their transactions are not exempted. Last December, the Commission proposed joint rules with the SEC that define the term “swap dealer” as any person who: (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps. In that same proposed rule, the Commission and the SEC define the term “major swap participant” as: (i) a person who maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan; (ii) a person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets”; or (iii) any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories.
As with the end-user exemption, the de minimus exemption has been criticized as being too narrow. I do not disagree with that assessment. The purpose of registration as a swap dealer, or a major swap participant for that matter, is to ensure that regulators have oversight over swap transaction activity that is concentrated in such a manner that it creates, or has the real potential to create, systemic risk. Our goal should not be to regulate merely for the sake of regulating. It is my hope that when the Commission and the SEC finalize the definitions of swap dealer, major swap participant, and the de minimus exemption, the scope of the definitions are rationally related to achieving the regulatory goal of identifying and diminishing system risk. I am still hopeful that those definitions will be finalized early in 2012.
I am sure some of you have heard the arguments dating back to 2007 that speculators are driving up the prices of energy, food, and metals, and if their trading activity was limited, prices would surely drop. I do not believe position limits will diminish market volatility and lead to lower food and energy costs. The Commission finalized the rules implementing position limits in October and I believe those rules may actually have the potential to do the exact opposite. When Congress directed the Commission to set speculative position limits, it also directed that position limits would not apply to producers, purchasers, sellers, middlemen, and users of a commodity or a product derived from a commodity, who are commonly referred to as bona-fide hedgers. Congress’s directive specifically allows bona-fide hedgers to hedge their legitimate anticipated business needs irrespective of whether their hedging transactions exceed position limits. Congress recognized that appropriate hedging reduces the risk associated with exposing a bona-fide hedger’s business operations to commodity price fluctuations.
The Commission’s final rules narrow the circumstances under which bona-fide hedgers can hedge their price risk, make it more inefficient for them to hedge in certain circumstances, and increase the reporting burdens of hedging. As a result, the likelihood exists that bona-fide hedgers will incur increased costs. Increased costs for bona-fide hedgers will probably lead to increased costs for consumers—a result that is at complete odds with the stated goals of Dodd-Frank.
Another aspect of the position limit rule is the required aggregation of positions among affiliated entities. This may be particularly troubling for energy companies and the way they currently do business. If affiliated entities do not meet the rigid “independent account controller” exemption, the entities must aggregate their positions for position limits purposes unless they file a notice with the Commission, along with a written opinion of legal counsel, substantiating that the sharing of information between affiliates would violate Federal law or regulations. There is no exemption if the sharing of information would violate state law, or the law of a foreign jurisdiction. The consequences of the required aggregation, and the rigid and limited exemptions for affiliated entities have not been fully thought through. I have started hearing from market participants who have grave concerns about compliance. I voted against the final rules but would like to see the agency keep the commitment made by Commissioners at the time of the vote that if we got it wrong, we will amend the rule. If there are legal barriers to compliance, the Commission must immediately move to resolve any unintended consequences resulting from the final rules.
International issues are important me as I chair the Global Markets Advisory Committee and have participated for the last three years in the Technical Committee meetings of the International Organization of Securities Commissions (IOSCO). Last month a number of key proposals made incremental progress through the EU system.
EMIR: On October 4, 2011, the Council adopted its version of EMIR, the European Market Infrastructure Regulation. The Regulation introduces a reporting obligation for all derivatives, a clearing obligation for eligible OTC derivatives, measures to reduce risk for uncleared OTC derivatives, and common rules for central counterparties (CCPs) and for trade repositories. This legislation could impact US power companies that do business in the EU. Specifically, the EU may subject transactions entered into by non-EU entities to the clearing and risk mitigation requirements of EMIR if these transactions have a “direct, substantial and foreseeable effect within the EU or where such obligations are necessary or appropriate to prevent the evasion of any provisions of this Regulation.” This legislation is expected to come into effect in 2012.
Additionally in October, the European Commission also issued proposals to amend both the Markets in Financial Instruments Directive (MiFID) and Markets in Financial Instruments Regulation (MiFIR).
MiFIR sets requirements on:
All three of these proposals are the EU’s responses to the commitments made by G-20 leaders in 2009 to address less regulated parts of the financial system, such as OTC derivatives, and to improve the oversight and transparency of commodity derivative markets. They are expected to be adopted by the G-20 deadline of end of 2012.
MAD/MAR: The European Commission has also proposed regulations to increase the number of commodity derivatives and OTC derivatives that are covered by the market abuse regime. The proposals extend the market manipulation prohibition to instruments whose value relates to exchange traded instruments. So for instance an OTC derivative referenced to a contract traded on ICE Futures Europe would fall within the new Directive. These updated regulations now include prohibitions against attempted manipulation where the old rules only covered actual manipulation. I should note to you that the new anti-manipulation regulation does contain a carve out for spot market wholesale energy products. Finally, the regulation gives the member states more enforcement tools and criminalizes certain insider trading and market manipulation offenses. These proposals are also expected to be considered in 2012.
Our staff has been in constant contact with our counterparts in the European Union and in many other jurisdictions around the world to ensure we are harmonizing our rules to the greatest extent possible. As required by Dodd-Frank, and in keeping with the commitments reached by the G-20, this coordination is necessary for ensuring that we accomplish the overall objectives of reducing systemic risk and limiting opportunities for regulatory arbitrage.
The CFTC also co-chairs the IOSCO’s Task Force on OTC Derivatives, along with the SEC, the UK FSA, and the Securities and Exchange Board of India. The task force is tackling issues such as analyzing the benefits, costs, and challenges associated with transitioning standardized derivatives products onto exchanges and electronic trading platforms, along with data reporting and aggregation, and international standards. These issues are very complex, and the possibility of divergent views among international regulators is very real. The challenge lies in building a consistent philosophy for how the regulatory frameworks of many nations fit together to ensure that cross-border swap activities are not disrupted.
After all of those important issues, it is hard to believe that I have only covered a small slice of what is currently on the CFTC agenda. Next week the Commission will consider final rules relating to investment of customer funds; registration of foreign boards of trade; as well as two proposals. I expect data recordkeeping and reporting; real time reporting; joint entity definitions with the SEC; external and internal business conduct standards; and the scope of the end-user exemption to be on the agenda in the coming weeks.
I must admit that the significance and complexity of the issues can become overwhelming, but it is a real honor for me to serve in my current role with all of the talented staff at the CFTC. And it has been a pleasure to be here today to speak to such a distinguished group of professional woman.
Thank you for having me.
Last Updated: November 30, 2011