Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Maguire Oil and Gas Institute: Energy Policy Symposium
"Managing Risk in Energy Markets"
March 7, 1997
I appreciate the opportunity to address such a distinguished group of energy experts, policy makers and industry leaders. As you know, I came here from the nation's capital and I want to assure you that Washington is vitally concerned with energy issues. In fact, top government scientists inside the beltway are currently working to develop a virtually inexhaustible supply of cheap power by harnessing the wasted energy from partisan bickering.
The working sessions of this conference are covering the nuts and bolts of energy risk management, so let me give you a regulator's perspective on a few "big picture" issues -- the commoditization of the energy markets, regulatory safeguards for exchange-traded derivatives, and the importance of international cooperation among derivatives regulators.
Commoditization of the Energy Markets
We are all familiar with the transition of energy markets from a price-controlled structure to a free market environment, where energy derivatives are traded in the open market like corn or cotton futures. We've seen it happen with oil, we've seen it happen with natural gas, and now we're seeing the same phenomenon with electricity. I'd like to take a moment to look beyond the mechanics of this process and enumerate the factors necessary for the creation of a successful futures market.
There are many prerequisites to a successful futures market: a well-developed cash market trading a standardized unit or grade of commodity that lends itself to futures-style delivery; commercial hedgers with risk management needs (due, for example, to uncertainty concerning available supplies); speculators to provide market depth and liquidity; and a free market structure that allows prices to fluctuate. But the most important factor -- the basic element without which no futures market can survive -- the underlying condition that creates a need for futures trading -- is price volatility.
Volatility often gives rise to a chicken vs. egg debate. Does price volatility heighten the need for futures trading or does futures trading cause price volatility? The latter theory, quite understandably, is more often held by producers -- at least with respect to some volatility. The producer of any commodity traded on a futures market -- whether it is corn, copper or crude oil -- tends to have a bifurcated view of volatility. Price increases are caused by natural market forces. Price declines are caused by greedy futures speculators.
In fact, we can thank one group of producers for giving us a test case to help decide the volatility debate. Back before the CFTC was created -- when its predecessor, the Commodity Exchange Authority, regulated only agricultural futures -- onion producers prevailed upon Congress to include in the Commodity Exchange Act a prohibition against futures trading in onions. This had the twin effects of killing the onion futures market, which the producers so hated, and giving futures economists a perfect test case. When those economists later studied this case, they found more cash market volatility in onion prices before and after the period of futures trading than there was while the onion futures market was operating. In other words, futures markets don't cause volatility, they respond to and decrease volatility.
The creation of new futures markets as a response to volatile prices is actually quite a well known fact. We can see it in 1971, when the collapse of the Bretton Woods system of fixed exchange rates allowed foreign exchange rates to float. This created much greater volatility in currencies and prompted the creation of a large and very successful foreign currency futures market. We can see it a few years later when increasing interest rate volatility opened the door for a whole variety of interest rate and other financial futures. And we can see the very same process at work in the energy markets.
The introduction of the New York Mercantile Exchange's highly successful crude oil futures contract in 1983 was made possible by a variety of structural changes in the world crude oil market over the preceding years, which combined to create a more open, competitive and volatile marketplace. These structural changes included: (1) growth in the market power of state-owned oil production companies -- from controlling six percent of production in 1970, to 55 percent in 1979; (2) a corresponding decline in ownership of crude oil sources by the "seven sisters" -- from 61 percent to 25 percent over the same period; (3) US crude oil price deregulation and the elimination of the entitlements program in 1981; and (4) growth in the crude oil spot market, with an increased market role for independent producers and crude oil brokers.
NYMEX crude oil futures began trading in March 1983. According to CFTC statistics, which are kept by fiscal years, volume for FY 1983, the first full year of trading, was 1.4 million contracts. By FY 1996, combined futures and options volume in the NYMEX sweet crude contract had grown to over 28 million contracts. The major oil companies, which initially resisted futures trading as a threat to their price setting power, have come to depend on the futures market for both hedging and price basing.
The growth of natural gas futures experienced a somewhat similar pattern. Deregulation of prices pursuant to the Natural Gas Policy Act of 1978 gave rise to an active spot market, the entry of new marketing firms into the business and considerable price volatility, which created a need for the kind of hedging protection a futures market can provide. There was, however, less resistance to natural gas futures than we saw in the crude oil market. Many of the players were already active in crude oil futures and had learned the twin lesson that, in a highly volatile pricing environment, futures trading carries with it not only great commercial utility, but also a certain inevitability.
Natural gas futures began trading in April 1990. In the contract's first full fiscal year, FY 1991, it traded 338,000 contracts. By FY 1996, combined futures and options volume in natural gas was nearly 10 million contracts.
It remains to be seen whether electricity futures trading can mimic this remarkable record of success. There are certainly many parallels to its crude oil and natural gas predecessors. Deregulation is becoming a reality under the 1978 Public Utility Regulatory Policy Act, the Energy Policy Act of 1992, and FERC rules requiring open access to transmission facilities and otherwise promoting competition in the nation's wholesale bulk power markets. Significant technological changes in generation and transmission have made possible lower-cost producers with surplus power that can be economically transmitted over long distances, and a certain amount of price volatility. A growing spot market in bulk electrical power has developed. New faces have entered the marketplace, including a growing number of non-utility electricity producers and wholesale bulk power marketers.
On the other hand, there is considerable resistance to futures trading from those who have a vested interest in the old way of doing things -- or simply the normal, human resistance to radical changes in a familiar and comfortable system. Investor-owned utilities, which account for about 75 percent of US generating capacity, and the public utility commissions, which set their rates, are often uncomfortable with changes in the marketplace and are especially leery of the new and unfamiliar world of derivatives trading.
The first two electricity futures contracts began trading on March 29, 1996, with options trading following in April. Both contracts have gotten off to a respectable start over their first eleven months. By the end of February, the California Oregon Border (COB) contract traded 62,463 futures and 8,262 options and the Palo Verde contract traded 26,216 futures and 5,142 options over the same period. In the long run, however, the marketplace is the final judge of each new futures contract. I believe that, for electricity futures, that ultimate judgment is likely to be positive. I see it as a matter of simple economics. Deregulation begets competition. Competition engenders price volatility. Price volatility creates the demand for risk management. And an active futures market is one of the most efficient and effective way to fill that demand.
Regulatory Safeguards for Exchange-Traded Derivatives
The same deregulation of pricing, which leads to increased volatility and creates the need for futures trading, also creates a demand for regulation of a different kind. By analogy, safer cars and better roads may justify less restrictive speed limits, but you still need traffic cops. In the case of futures trading, the traffic cops are the Commodity Futures Trading Commission. Congress created the CFTC in 1974, and gave it exclusive jurisdiction over futures trading, because futures markets perform two vital economic functions -- risk transferal (hedging) and price basing -- and there is a national public interest in assuring that those functions are performed fairly.
I would note, as an aside, that Congress is currently considering amendments to the Commodity Exchange Act. The Commission has testified that certain of those amendments, as currently proposed, would seriously compromise our ability to protect customers and preserve market integrity. However, the legislative process is far from over. I am hopeful that reason will ultimately prevail -- as it somehow usually does in our legislative system -- and that the final legislation will preserve the regulatory protections which market users have come to expect and rely upon. With that hope in mind, let me use the example of a typical futures order to illustrate some of the protections available under the current regulatory system.
Before the customer ever places the order, we know that several protections are already in place. We know that the futures or option contract which is the subject of that order has passed a CFTC review to assure that it is not readily susceptible to manipulation. We know that the customer has received a disclosure statement describing the generic risks of futures trading. Further, if the customer has delegated trading authority to a commodity trading advisor (CTA), or has pooled funds with other customers through a commodity pool operator (CPO), we know that the customer has also received disclosure information concerning the CTA's or CPO's performance history.
When the customer calls his or her broker to place the order, we know the account executive who takes the order is registered with the CFTC as an Associated Person -- that means he or she has been subject to a background review, including a fingerprint check by the FBI, and has complied with competency testing and ethics training requirements. The firm the AP works for is registered with the CFTC as a futures commission merchant (FCM), or possibly as an introducing broker. In either event, the firm and its principals have also been subject to background checks. The same holds true of the commodity trading advisors and pool operators I mentioned earlier. The FCM firm itself is subject to minimum net capital requirements, and the customer's funds on deposit with the firm, as well any market positions in the customer's account, are segregated from the firm's funds and proprietary positions. Thus, the customer is protected if the firm experiences financial difficulties and the marketplace is insulated from the domino effects of individual defaults.
When the AP takes the order, it is tagged with the customer's account number (to prevent improper allocation of trades), time stamped and transmitted to the FCM's order desk on the exchange floor. At the FCM's floor order desk, the customer's order is time stamped again -- part of a comprehensive audit trail that applies throughout the life of the order to help deter and detect possible abusive trading practices. The order is then transmitted to a floor broker in the trading pit where, again, the participants -- both floor brokers executing customer trades and "locals" trading only for their own accounts -- are registered with the Commission. Trading activity in the pit is subject to surveillance by both exchange and Commission market surveillance staffs.
Once the order is executed in the pit, information on the size and price of the transaction (though not the identity of the parties) is added to the data stream made public by these fully transparent markets. The order itself is submitted for clearing to the exchange clearing house. That clearing house acts as the buyer to all sellers and the seller to all buyers, thus protecting the customer from counter-party credit risk. The financial integrity of the clearing house is, in turn, secured by substantial guarantee funds and other protections set out in the exchange's rules, and is also subject to Commission oversight.
Throughout this process, the exchange is required not only to follow the CFTC's regulations, but to enforce its own rules as well -- and the Commission conducts periodic rule enforcement reviews to see if these duties are being carried out. But the ultimate weapon to assure that exchanges and commodity market professionals follow the rules is the Commission's Division of Enforcement, which investigates and prosecutes violations of the Commodity Exchange Act and CFTC regulations. The penalties imposed can include civil injunctions, registration revocations, permanent trading bans and fines of up to one million dollars per violation.
International Regulatory Cooperation
My final topic is international regulatory cooperation -- an absolute necessity in today's global marketplace. Whether you look at financial instruments or physical commodities, every day the global marketplace becomes more tightly integrated. Cargoes of crude change course in mid-ocean as energy prices fluctuate from destination to destination. Capital moves from country to country, time zone to time zone, with the tap of a computer key as international conglomerates seek the best returns. And just as capital knows no boundaries, neither does systemic risk and neither does fraud.
To understand systemic risk, picture any nation's economic system as a house. At some earlier point in history, you might argue it was a detached home. In today's global marketplace, there's no question that we all live in row houses. You might have the world's best sprinkler system and a smoke detector in every room, but if the house on the other side of the common wall burns down, you will suffer too. With respect to fraud, the Fortune 500 don't have an exclusive license to employ sophisticated information technology or a monopoly on global operations. Following close behind the legitimate businesses are the crooks and con artists devising ever more sophisticated schemes of cross-border fraud.
If regulators are to keep pace with these developments -- if they wish to protect their economies from systemic risk and their citizens from fraud -- they must cooperate with regulators, and with industry self-regulatory bodies, in other countries. The CFTC's cooperative efforts in this area have included both bilateral and multilateral initiatives. Bilaterally, over the past ten years we have entered into some 25 agreements for enforcement cooperation and/or financial information sharing with regulators in 15 other jurisdictions. Multilaterally, we are an active member of the International Organization of Securities Commissions (IOSCO), the most prominent international forum for cooperation among financial regulators. Of equal importance, the CFTC has taken a leading role in more targeted cooperative efforts arising out of recent international market crises. I am referring specifically to the Barings and Sumitomo affairs.
The collapse two years ago of the British merchant bank, Barings Plc., posed a serious threat to the international financial system -- a threat that was averted only by heroic efforts, including midnight phone calls and ad hoc cooperation among regulators. The crisis gave rise to the May 1995 Windsor Conference at which regulators from 16 countries agreed upon an impressive array of concrete steps to enhance regulatory safeguards and minimize the systemic effects of any future market disruptions. These included: large exposure information sharing; market crisis procedures; enhanced transparency of market protection and procedures; and client asset protection measures.
With respect to Sumitomo, the activities of confessed rogue trader, Yasuo Hamanaka, and the resultant impact on copper users and producers, are still being investigated. No one can deny, however, that the Sumitomo events had a major market impact -- a fact most easily illustrated by the magnitude of Sumitomo's $2.6 billion loss. Because Sumitomo involved a physical commodity and a physical delivery market, it brought to light a number of unique problems not contemplated under pre-existing cooperative agreements, which were designed in response to financial market events. We found that international arrangements designed for financial instruments delivered via wire transfer don't always work as well in situations where delivery involves warehouses, railroads, trucks and boats. In response, the CFTC, the UK's Securities and Investments Board, and the Japanese Ministry of International Trade and Industry invited regulators of physical delivery markets from 15 other jurisdictions around the world to a conference in London in November, 1996. The London Conference produced a consensus among regulators of physical delivery markets to work together in three key areas: (1) contract design, so that commodity contract terms will correspond with cash market customs, making the contracts less susceptible to manipulation; (2) market surveillance, so that regulators will have in place appropriate market oversight mechanisms to detect and prevent manipulation; and (3) information sharing, so that regulators will have in place effective systems for sharing market data when events in one market have the potential to affect other markets.
In closing, let me mention the most recent crisis to shake the global futures markets -- last week's multi-million dollar default by Rose Trading, Inc., a clearing member of the New York Mercantile Exchange with large positions in both S&P 500 stock index and crude oil futures. I see a lot of puzzled looks around the room. The reason you haven't heard about this latest crisis is simple. It was imaginary -- a hypothetical default formulated by US and British regulators to provide a cross-border "stress test" of our emergency management system. The "default" involved a hypothetical holding company with both US and UK operating subsidiaries and market exposure on multiple exchanges in both countries. The nine organizations participating in the February 28 stress test included regulators, exchanges, and clearing houses in both the US and the UK.
Exercises like this are sometimes characterized as "war games," and their purpose is just as serious as that of their namesake. The weeks of planning going into such an event prove invaluable as they help regulators and exchanges to spot weaknesses in emergency response systems -- ranging from issues as simple as a wrong phone number for an emergency contact to something as complex as how to determine the true amount of capital available to a corporation entangled in web of interlocking subsidiaries and affiliates.
The time and effort devoted to the February 28 cross-border stress test are a clear signal that the participating regulators and exchanges recognize the highly integrated nature of the global financial marketplace, the dangers of systemic risk, and the crucial importance of international regulatory cooperation. The stated objectives in responding to last week's hypothetical crisis -- and to the real thing when and if it happens -- are fourfold: (1) to minimize potential market over-reaction; (2) to protect customers' funds and positions; (3) to minimize the threat to related financial markets and firms; and (4) to maintain clear communications among regulators and with the public. The larger goal is to isolate and contain any market crisis so as to avoid a panic situation that could lead to financial gridlock or a market meltdown.
I hope these remarks provided you with a better understanding of the issues confronting energy derivatives and their regulators in today's global marketplace. I'll be happy to take a few questions if time permits.