Commissioner Thomas J. Erickson
Commodity Futures Trading Commission
Code of Conduct Conference for Power Trading
Western Power Trading Forum
July 16, 2002
Santa Clara, California
Good morning. Thank you for inviting me to participate in the Western Power Trading Forum’s conference on potential codes of conduct for the energy industry. This conference is particularly timely given recent events in energy markets and current debates on the appropriate level of regulatory oversight of these markets. As some of you may know, I testified before the Senate’s Agriculture Committee last week at a hearing that examined the Commodity Futures Trading Commission’s (CFTC’s or Commission’s) existing authority over markets in over-the-counter (OTC) derivatives and, more importantly, whether Congress should restore to the Commission its authority to address fraud and manipulation in these markets.
Before we turn to a broader discussion of codes of conduct, I’d like to provide you with a few general observations as well as an overview on the existing oversight of energy derivatives markets and share some of my thoughts on the legislative debate about the appropriateness of our current regulatory framework.
First, the general observations. Over the past year, I have had the pleasure of sharing my views about the appropriate oversight of commodity derivatives transactions with many commercial energy groups like this one. Through these discussions, I have learned much more about energy commodities. For example, I’ve learned about the complex interaction between cash and derivatives transactions as well as the equally complex array of regulatory interests in your markets. As a result of this complexity, I’ve noted the tendency of speakers to blur the distinctions between these two markets when discussing them. With that in mind, I’d like to move on to an overview of existing oversight on the derivatives side.
Passage of the Commodity Futures Modernization Act, or CFMA, in December of 2000 brought sweeping change to the regulation of derivatives in the United States – both on- and off-exchange. Nowhere was the change in the law more dramatic than in its effect on OTC derivatives, more commonly referred to as swaps. Many of the CFMA’s changes to the Commodity Exchange Act (Act) were based on the recommendations of the President’s Working Group on Financial Markets (PWG). Although the PWG Report recommended that bilateral swap transactions in financial commodities be excluded from the CFTC’s jurisdiction, it concluded that the same case could not be made for physical commodities. The PWG unanimously agreed that the exclusion should not extend beyond financial commodities.
The CFMA adopted a variant of the PWG recommendations and created three categories of commodities. Each category defines the CFTC’s regulatory interest in derivative instruments, including swaps. Generally, financial commodities are excluded from the CFTC’s jurisdiction; agricultural commodities are included in the CFTC’s jurisdiction; and all other commodities – including energy – are exempted from the CFTC’s jurisdiction. What this means in application is not so simple.
In part, the complexity stems from the fact that the regulatory framework hangs on the distinction between “excluded” and “exempted” commodities. An excluded commodity, transaction, or market indicates that the Commission has no jurisdictional interest. An exempted commodity, transaction, or market, means that the Commission retains a jurisdictional interest, but that the law limits its application.
Ostensibly, under the CFMA, the CFTC retains anti-fraud and anti-manipulation jurisdiction over exempt commodities. However, through other provisions in the law, the vast majority of OTC swap transactions in energy commodities become excluded. As a result, they are not subject to the Commission’s fraud or manipulation authorities.
Thus, we have a gap in the oversight of exempt commodity transactions. On the one hand, the Act expects full prosecution of manipulations of exempt commodities in regulated exchange markets. On the other hand, the regulatory regime turns a blind eye to the manipulation of these very same commodities, if effected through OTC derivatives transactions.
From a practical perspective, the Commission’s own experience has yielded some significant results in this area – results that would be difficult, if not impossible, to replicate under current law. For example, the Commission in 1998 reached a settlement with Sumitomo Corporation for the manipulation of global copper prices. The Commission found that the manipulation imposed enormous costs on traders, manufacturers, retailers, and consumers of copper. More recently, the Commission settled with Avista Energy, Inc. for the manipulation of the Palo Verde and California-Oregon-Border electricity futures contract. Interestingly, the Commission found that the manipulation created artificial settlement prices in futures contracts and was done to enhance the value of Avista’s OTC swap positions.
I am skeptical that the Commission could replicate these cases in today’s market environment. As the Avista settlement underscores, commodity markets – cash, futures and options, and OTC swaps – are increasingly linked. We now know that wash transactions in unregulated swaps occur, and in certain cases send price signals that raise manipulation concerns. Thus, if we are serious about detecting and deterring fraud and manipulation, these authorities must apply to all derivatives transactions.
Derivatives markets bring unquestionable efficiencies to cash commodity markets. The consequent benefits extend not only to market users, but also to consumers. Thus, I believe that if Congress were to restore to the Commission its fraud and manipulation authorities, it must also provide the Commission with the tools to enforce these authorities. Derivatives marketplaces like electronic swap exchanges should adhere to certain, minimal regulatory obligations: among them are transparency, disclosure, and reporting.
Our experience with the futures markets has shown us that measures designed to increase market transparency instill confidence in markets, attract speculative liquidity, and increase market integrity by providing regulators with the means to monitor for fraud and manipulation. I believe application of these principles to derivatives markets generally is sound public policy, prudent business practice, and common sense. Unfortunately, we are presently witnessing some of the best arguments in favor of reinstating these principles in our markets.
U.S. energy markets are suffering a crisis in confidence. Six months ago we could define the scope of the crisis by the tens of millions of energy consumers in western states who believed the markets had been manipulated. To date, none of our federal regulators have been able to assure them that this was, or was not, the case, and it is not even clear which regulator should be answering the question. More recent revelations of wash sales by numerous commercial market participants have expanded the scope of this crisis – eroding the trust and confidence firms have in each other. In this environment, liquidity dries up and the market efficiencies created by all derivatives are put at risk. I believe this crisis in confidence is shaking the very foundation of our energy markets. Modest legislation would be a good first step toward restoring this lost confidence and returning energy markets to a path of growth and efficiency.
As I testified last week, legislation previously introduced by Senator Dianne Feinstein would address the essential concerns I have outlined. Moreover, the bill would hew more closely to the PWG’s recommendations. Importantly, the bill recognizes the benefits of market innovation by preserving the long-sought legal certainty for swaps. At the same time, however, the bill ensures that all derivatives transactions are subject to the Commission’s fraud and manipulation authorities. It would not require the registration of swap counterparties, but would require that they maintain books and records of transactions – something that should be routine practice in the industry. Finally, the legislation recognizes that all exchange markets serve price discovery and hedging purposes by imposing modest transparency, disclosure, and reporting obligations.
Consumers are the ultimate beneficiaries of properly functioning derivatives markets, whether those markets are private – like EnronOnline – or public – like the New York Mercantile Exchange. By the same token, consumers are the ultimate victims when markets are manipulated, or otherwise affected by unlawful behavior.
Whether there is ever anything found in current investigations of energy markets is irrelevant. We have a hole in our regulatory regime that allows for fraud and manipulation to operate free from sanction. We have markets experiencing a crisis in confidence. Modest legislation amending the commodities laws is appropriate in my view to restore confidence and build integrity.
Finally, I would like to make a few points about codes of conduct, or – as you will hear from representatives of the NFA and NASDR – self-regulation.
First, from an historical perspective, codes of conduct or, more broadly, rules for trading in a centralized market are always beneficial. Second, self-regulation must be real. Third, never blend your cash and derivatives market rules.
As to the first point, the evolution of commodity markets may be a helpful example. Well over 150 years ago, we saw in the United States the establishment of centralized cash markets as farmers brought storable, perishable commodities, such as grain, to merchant centers. Over time, markets developed formal rules for trading which, in turn, led to forward contracting and, eventually, to futures. For years marketplaces accommodated both cash and derivatives transactions. In fact, you can still get a glimpse of this at the Minneapolis Grain Exchange, where cash and derivative contracts trade side-by-side, albeit in different pits. The futures market is overseen by the CFTC, and cash contracts are traded pursuant to separate exchange rules and without direct federal oversight. The point here is that cash and derivative markets can co-exist under different, but complimentary, regulatory schemes.
Second, to be effective, regulation must be real and not illusory. Today, you will hear about self-regulatory efforts in securities and futures markets. In each instance, a federal regulator with separate enforcement abilities oversees the SRO system. I believe this kind of oversight enhances market integrity. Moreover, without benefit of a regulatory environment, self-regulatory efforts may well draw additional scrutiny from an antitrust perspective.
Third, and finally, I think it is important to maintain separate, market-appropriate rules for different types of markets. Cash and derivatives markets are unique and distinct from one another and should not be treated the same. By way of example, I have heard from several sources that it is possible to report energy swap transactions into a cash market index survey. This should not occur. Cash prices reflect current supply and demand while swaps price market expectations at a date in the future.
I hope this perspective from the derivatives side has been helpful and will advance your discussion this afternoon regarding codes of conduct. Thank you again for asking me to join you this morning, and I look forward to the discussion.