Remarks to the International Swaps and Derivatives
Association
Energy and Developing Products
Conference
Houston, Texas
Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
March 26, 2003
Good morning. It is a pleasure to be invited to talk about the current
state of energy markets, post-Enron, from the perspective of a regulator. I
am especially pleased to be speaking before the International Swaps and
Derivatives Association. Looking back to the early days of the swaps
industry, when the over-the-counter (OTC) market for foreign exchange and
interest rate swaps was fledgling, the industry and regulators were being
assailed in a manner not dissimilar to what we see today in the energy
markets.
There were clearly big debacles then, too. The prominent, highflying firm,
Bankers Trust, was charged with wrongdoing. Municipalities, retirement
funds, and corporations including, among others, Gibson Greetings, Proctor
and Gamble, and Dell Computers, incurred large derivatives-related losses.
Back then, ISDA played an important role in restoring confidence to the OTC
derivatives industry by educating the public on derivatives, and developing
and advocating best practices and standard agreements. Today we are faced
with some of the same challenges in the energy sector. Again I am pleased
that ISDA and its professional membership are stepping up to restore public
and industry credibility to this market.
Before I get too far along, I should note that the thoughts and views I
express do not necessarily represent those of the Commodity Futures Trading
Commission (CFTC). My remarks are from the perspective of one Commissioner
whose background includes an education in economics, with a strong
public-policy orientation.
That said, let me begin by summarizing my thoughts. First is the
observation that, as usual, derivatives are a convenient scapegoat when
investors lose money. As Claude Rains said to the policeman, “round up
the usual suspects.” Second, it is my opinion that prescriptive
regulation cannot address the problems being experienced by the energy
sector, and in fact, may exacerbate an already
“liquidity-challenged” market by creating regulatory and legal
uncertainty. Third, I believe that effective regulation must be efficient
and targeted.
The appeal of the Commodity Futures Modernization Act (CFMA) is that it
allows the Commission to more effectively target regulation, as needed and
appropriate. That is to say that it permits regulators to be more
prescriptive where markets involve less sophisticated participants or
commodities that are more susceptible to manipulation and market abuses.
Additionally, it provides the flexibility to be more deterrence-based when
regulating professional commercial markets or broad and diverse markets in
which a prescriptive approach is not meaningful or effective.
Recently, certain individuals have been anxious to hang the blame for
Enron, and the general contraction of the energy markets, on derivatives.
But neither logic, nor evidence, validates the supposition that derivatives,
whether traded by exchange or over-the-counter, were to blame for market
declines experienced by specific companies or the markets, in general. In
fact, the current crisis in the energy markets has nothing to do with
derivatives contracts, per se. There were no large positions that suddenly
soured; no rogue traders accumulating massive losing positions; no
misunderstanding of the risk of a particular position. In that respect, the
recent problems in the energy markets are dissimilar to past events, where
traders and companies found themselves holding portfolios of derivatives
that suddenly soured. This is an important observation. I believe it shows
that derivatives users are increasingly sophisticated and savvy; not only in
their use of these instruments, but also in their understanding that
derivative contracts and OTC derivative markets, which were brought online
in recent years, are not to blame for the crisis.
Very simply, the current crisis stems from improper behavior, on the part
of companies and individuals, including improper accounting practices, the
reporting of fictitious trades and prices, and “gaming” of
poorly structured cash markets that almost seemed designed to invite
strategic, opportunistic, if not fraudulent, behavior. Furthermore, the
accusation that derivatives are unregulated, looming like a black hole in an
otherwise peaceful universe of regulated securities markets, is a
regrettable misrepresentation of reality.
Perhaps derivatives are a convenient scapegoat because of their relative
complexity, or because of their contrast in purpose to common asset classes,
such as stocks and bonds. Derivatives are designed to help individuals and
firms manage price risks at low cost. Exchanges and intermediaries have
devised contracts and structured markets primarily to affect that purpose.
Contracts can be standardized, allowing maximum liquidity and transparency
for a basic risk, or tailored to the particular principals or risks
involved. In the latter case, contracts can become quite customized and
sophisticated. Considering the diversity and the unique features of the
exchange-traded markets, dealer markets, and over-the-counter markets, I
believe effective regulation of the markets begins with an understanding of
these operational and structural differences.
I have and continue to look hard at what has occurred, and I must emphasize
that it has not been demonstrated that the market for energy derivatives
suffered from a market failure or a paucity of regulation. From my
perspective, it is not clear that new or additional layers of regulation are
called for unless we establish that existing regulation failed in the first
place. Speaking generally, I believe that in many high-profile cases
existing laws were broken, ethical standards of business practice were
breached, and existing regulations were violated. It is prudent, then, to
allow a number of investigations being conducted by the CFTC, as well as
other federal and state agencies, to be completed before we rush to strap on
prescriptive-style regulation.
The CFTC has been actively pursuing violators and working with other
agencies and criminal authorities to identify and punish wrongdoers.
Recently the Commission filed a complaint against Enron, charging the
company and a trader with manipulating prices at the Henry Hub natural gas
market. We also entered into a five million dollar settlement with Dynegy
over charges they falsely reported prices and trades to the trade press.
Also, as previously noted by Chairman Newsome, the Commission announced this
morning a twenty million dollar settlement with El Paso over similar charges
of false price and transaction reporting. As we continue to uncover abuses,
it is my philosophy that we should deal harshly with wrongdoers to deter
others that may be tempted to abuse the markets. By dealing with abuses on a
case-by-case basis we are able to deal directly with issues in the market,
without burdening participants who play by the rules.
An alternative approach that has been suggested to deal with the current
crisis is to adopt a prescriptive regulatory structure. Such an approach
would establish a set of requirements for dealers and covered entities;
essentially adopting a “hold-every-hand” approach. My primary
concern is that, in an effort to appear proactive and responsive to
political pressures, we would launch a program of regulation and legislation
that is inappropriate for the types of markets we are considering. It is my
view that prescriptive regulation cannot address the problems being
experienced by the energy sector, and may exacerbate a liquidity shortage in
the energy complex by unnecessarily imposing costs on industry participants,
and creating regulatory and legal uncertainty.
Without question, the energy markets are suffering a crisis of confidence
driven by a lack of liquidity and the realization that credit risk may have
been higher than realized. Prescriptive approaches to these problems
generally include mandates for increased transparency and minimum capital
requirements. Since the current version of Senate Bill 509, the Energy
Market Oversight Act, contains similar proposals, I would like to outline
some of the difficulties and costs associated with these mandates.
Increased market transparency is often held out as a quick-fix solution to
market problems, even though there are different levels or types of
appropriate transparency depending on the kind of market and the instrument
being traded. Clearly there must be transparency and integrity in the
accounting and financial statements of firms. Publicly-traded companies are
required to ensure disclosures accurately reflect the financial condition of
the firm, in accordance with accepted accounting principles. Failure to do
so is not only a violation of existing laws, it is not in the best interest
of the economy, or the self-interest of companies that choose to violate
them. As one example, Enron proved to be a house of cards that, inevitably,
could not stand.
The extent to which the details of individually negotiated or private
transactions should be made public is less clear-cut. Proposed legislation
suggests that covered entities, including certain electronic markets, as
well as dealer markets, should make information, such as volume, settlement
prices, open interest, and opening and closing price ranges, public as
appropriate. While I can appreciate the intentions of specific language
granting the CFTC discretion in this regard, it appears to force
exchange-style transparency onto bilateral and proprietary OTC
markets.
My concerns with these prescriptive approaches are that they are
operationally difficult to implement, and could do significant harm to the
markets if implemented without regard to market structure. Making
transaction data, including price, volume, and open interest, public is
operationally problematic in over-the-counter markets since, as I stated
before, many contracts are complex, customized, or traded in a variety of
venues. Accordingly, some concepts like open interest and volume have little
meaning in the OTC markets. Therefore, it is not clear that this information
can be aggregated to serve a useful regulatory purpose, without significant
cost at the industry level, and at the CFTC.
Whether contracts are principal-to-principal, proprietary, or transacted on
a “one-off” basis, it is also not clear how the public might
benefit from transaction information since it is specific to the contract
and participant in question. Since intermediaries designing these contracts
do so competitively, requiring disclosure of contract terms may be akin to
disclosing trade secrets. Regulators must be careful not to give competitors
a free ride. Otherwise, innovation and liquidity provision will be
discouraged.
Responsive to concerns about credit risk in the energy markets, the current
bill requires covered entities to “maintain sufficient capital,
commensurate with risk.” Setting aside for a moment the fact that
covered entities may not be engaging in the transactions themselves, but
rather simply providing a trading platform, how would risk-linked capital
requirements be operationalized in these markets? While capital requirements
might result in some level of credit enhancement, from an economics
perspective, it is an inefficient model for credit mitigation since, at
inception, derivatives have zero intrinsic value, and price movement defines
the inherent risks.
Capital requirements have the potential to raise transactions costs to such
an extent that markets would experience extreme illiquidity. As a result,
only the largest participants could use these markets, and even then they
would likely seek other, less costly alternatives. Banks might address this
problem, except they already have capital requirements imposed by their
regulators. Worst of all, imposing capital requirements could result in
significant risks going unhedged, resulting in more volatile energy
prices.
More effective alternatives to capital requirements include novation and
clearing-type arrangements for OTC transactions. Clearing has been used for
more than a century to mitigate credit risk in the futures industry through
a number of mechanisms. More specifically, through membership criteria,
guarantee funds, margin requirements, position limits, and default
procedures.
Recently I had the pleasure of participating in a joint conference,
sponsored by the CFTC and the Federal Energy Regulatory Commission, which
considered how clearing might be applied to the energy industry. A primary
message that came out of the conference was that clearing, as it exists for
exchange-traded instruments, is probably not suited for OTC markets, without
modifications. That is not to say that particular aspects of clearing cannot
be adapted and applied to these markets. In this regard, I have every
confidence that market realities and incentives will guide members of the
clearing industry to work with participants in the energy industry towards
crafting sound solutions to the credit risk problem.
I also feel compelled to lightly touch on the jurisdictional issues raised
by the legislation. Certain language appears to run counter to the
CFTC’s exclusive jurisdiction. Since exclusive jurisdiction is an
important feature of the 1974 Commodity Exchange Act, as well as a key to
the legal certainty enjoyed by our exchanges, this language is of concern to
me.
Probably the greatest risk associated with proposed legislation is the
creation of legal and regulatory uncertainty at a time when the markets need
the opposite. While we at the CFTC stand ready to work with Congress, I
believe we already have significant legal authority to deal with issues and
violations that have arisen. Furthermore, Senate Bill 509, as currently
drafted, is potentially damaging to the market and the economy.
Another caution that I raise as a US regulator is that we not devise costly
and ineffective regulation; the inevitable effect would be to drive
participants offshore. Keeping market participants here, under our
regulatory umbrella, is vital to maintaining our economy.
The OTC markets are big and diverse, and not well suited to traditional
prescriptive regulation borrowed from the exchange model. The intention of
the CFMA was to create a more flexible structure, not because those who
authored it were laissez faire, but because they knew that effective
regulation is efficient and targeted.
In conclusion, I believe that legislative and regulatory responses have to
provide a direct hit on actual problems and misdeeds in the markets.
Regulators have been criticized for not moving quickly enough, yet, I
believe acting without good information, or a complete understanding of the
markets, poses greater risks. “Knee-jerk” responses are not
helpful in solving real or perceived problems, but rather create significant
costs, not only for the industry, but also for government and taxpayers.
Moreover, if the regulatory response is to kill the market, this will deny
vital risk management tools to this industry, punish the innocent by
curtailing legitimate business activity, and ultimately, the economy will
suffer.