Remarks to the International Swaps and Derivatives
Energy and Developing Products Conference
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.