Keynote Address to the Cornerstone Research Conference
Market Manipulation in the Energy Markets
Commissioner Sharon Brown-Hruska
October 2, 2003
Thank you for the opportunity to share with you my thoughts on market manipulation in the energy markets. Let me just say from the outset -- I know this notable audience of economic and legal scholars and practitioners will appreciate this -- that the views I express are my own and, therefore, do not necessarily represent the official position of the Commodity Futures Trading Commission (CFTC), the views of other Commissioners, or the staff. The observations I make today are those of one Commissioner with a perspective that derives from my economics background and personal interest and research in the law and economics of regulation.
The CFTC is an independent agency created in 1974 to regulate the futures and options exchanges in the United States. In our authorizing statute, the Commodity Exchange Act, Congress recognized that these markets are important to our economy, and that fraud and manipulation impinged upon the market’s ability to perform vital functions of price discovery and risk management. Hence, the primary role of the Commission is to assure price integrity in the markets and to protect customers. By implication, our mission is affirmative as well, in that, as we perform our mission effectively, we must provide necessary assurance to market participants, investors, and consumers that the markets are competitive and fair.
As a doctoral student, a staff economist at the CFTC early in my career, and a college professor in finance, I have observed and studied manipulation for some time. Now, as a Commissioner at the CFTC, I am called upon to deal with it. While I cannot discuss any specific cases that the CFTC is litigating or investigating, I can speak generally to give you some insight as to how the cases in the energy area differ conceptually from what we have seen in the past, and how I believe an agency like the CFTC can and should handle these matters.
I believe firmly that we as regulators have a role to play in instilling credibility in the markets while minimizing legal uncertainty. By providing direct and unqualified assurance that criminal and fraudulent behavior by market participants will not be tolerated, we can help restore integrity to the energy markets and bring legitimate, honest dealing back. At the same time, I believe we must not become overzealous in our efforts to rid the markets of manipulative behavior to the point that we severely stifle legitimate activity merely to achieve political purposes. Fortunately, we have the law and economic sensibility to guide us.
As I am sure you are aware, federal and state authorities, led by the CFTC, have initiated a number of investigations and enforcement actions against companies and traders that focus on allegations of manipulative activities in the energy markets. We have initiated or are currently investigating 32 companies (including employees of those companies) to determine whether violations of the Commodity Exchange Act occurred including wash trading, manipulation, and false reporting.
The manipulative acts that are the focus of these enforcement actions are not the classic market “squeezes” of commodities, such as the Hunt brothers’ efforts to corner the market for silver. Rather, they seem designed to affect settlement prices through the manipulation of price indices. In other cases, they involve schemes to create the appearance of volume and price volatility and an illusion of liquidity in new markets. These novel acts raise the issue of what constitutes a manipulation under the Commodity Exchange Act?
Under the law, manipulation is treated in a similar fashion to a violation of our antitrust laws. Indeed, manipulation is considered to be an illegal restraint on trade. This explains why manipulation cases have frequently been brought under the Sherman Act as well as the Commodity Exchange Act. Proof of manipulation involves elements similar to those found in antitrust law--i.e., domination of relevant market, whether trading practices were inconsistent with competitive behavior, and ability to leverage across markets. That is, both require a showing of monopoly power in the relevant market and intentional anticompetitive conduct. Proving these elements requires a blend of both legal and economic analysis.
Our law defines a manipulative act as one that is inherently capable of causing an artificial price. This definition is well suited for the classic forms of manipulation that we saw in the past, such as attempts to manipulate the price of a commodity by cornering the deliverable supply. But it applies with equal force to more contemporary forms of manipulation involving attempts to influence the prices reported on published indexes.
In addition to proving that a manipulative act occurred which created artificial prices, it must be shown that the respondent intended to create that result—a showing of “specific intent” that by itself presents evidentiary problems of proof. Yet, even as this element raises difficult issues of proof, our Division of Enforcement is fond of stating, “intent is the essence of manipulation.” In my view, the intent requirement necessary to prove manipulation is the safe harbor that legitimate users of markets can and should be able to rely upon when they trade in the markets. In a liquidity challenged market, and in markets that have been characterized by fairly large players, both circumstances that have typified the energy markets, it is not unusual to see prices bend as a result of one market participant’s trading.
Finally, it must be demonstrated that the alleged manipulative act was in fact the actual cause of the artificial price. Proving actual causation may also be difficult, as the Division must establish that artificiality was actually caused by the respondent's actions, and not by the occurrence of simultaneous or intervening causes. This element is also a crucial protection to ensure that legitimate market participants are not deterred from providing liquidity or from making markets, since when those intervening causes do come into play, such as when information hits the markets unexpectedly creating market palpitations, we do not want to discourage necessary risk taking or arbitrage that may help bring prices back in line.
It is not an understatement to say that proving all of these elements is a formidable task. Judging by the number of press announcements of enforcement actions released by the CFTC in the past year, however, it should be evident that we believe the elements can be identified and cases can be successfully prosecuted. While these more recent examples differ from the more classic instances of attempts to corner a market in that they instead seek to affect a specific price index relied upon by market participants, the basic legal elements of proof for both forms of manipulation, nonetheless, are the same. In these more recent cases, it is still the government’s obligation to prove that the respondent acted with the purpose or conscious design to cause or affect an “artificial” price or price trend in the market--one that did not reflect the legitimate forces of supply and demand.
Many have raised concerns that the legal definition of manipulation is too limiting and the requirements for proof of manipulation under the law are too extensive to prosecute, much less deter illicit behavior. They suggest numerous remedies, from extensive rulemakings imposing requirements or limits on market participants, to wholesale legislative solutions designed to discourage market “strategies” that are alleged to be manipulative. Before I discuss the proposed remedies, let me again suggest that our laws must serve to protect those engaging in legitimate business activity from frivolous regulatory or legal action.
With regard to energy, many trading strategies that have been much discussed in the press would not satisfy a legal or economic definition of manipulation. In the case of electricity, inconsistent regulatory treatment led to strategic behavior by the companies and utilities participating in them. In California, for example, methods mandated for price aggregation and artificial transmission constraints ignored market reality and forced separation of the day-ahead energy market from real-time transmission supply and demand. This led to opportunities for arbitraging price differences ostensibly created by regulation.
Indeed, many strategies employed in California were regulatory arbitrage in the classic sense. We’re talking buy low, sell high – buy the low price-capped power in California, sell the power back via a loophole allowing out-of-state power to be priced without caps; buy the low priced power in the day-ahead market, taking the risk that you can then sell the high priced power in the real-time market that had regulatory incentives that gave rise to distortions in supply. While the cash power markets are outside the jurisdiction of the CFTC, it seems these activities would not likely satisfy any standard for an actionable case of manipulation, much less meet our standard for manipulation.
Since December of last year, the CFTC has entered into six settlements with a number of very prominent energy companies and power merchants, collecting a total of $96 million in civil money penalties for attempting to manipulate the prices reported on energy indexes. In all of these matters, the Commission has alleged that the firms used basically the same modus operandi to carry out their manipulation--by knowingly delivering false or misleading or knowingly inaccurate and, in effect, artificial trade prices and volumes in an attempt to skew those indexes for their financial benefit. That is, the manipulation, or attempt at manipulation, was carried out through false reporting, which itself is a separate violation of our Act. Just this week, the CFTC announced the filing of a complaint in federal district court against another major power company for attempting to manipulate natural gas prices in a similar manner.
In short, I believe our cases in this area demonstrate not only that we have significant authority to bring cases of manipulation in the energy sector, but also that we are prepared to exercise that authority. In my view, calls for additional authority for the CFTC in the OTC energy markets based on the premise that they are unregulated does not square with the strong action the CFTC has taken in these markets.
One public policy issue I want to address is the proposition that it is possible to design a preemptive regulatory scheme that could prevent manipulation from occurring in the OTC markets. Prescriptive measures have been proposed that include some form of daily government monitoring of market participants and their positions, some level of public disclosure of aggregated position information, and constraints on market activity in the form of position and accountability limits. While these approaches are established protocol in the exchange-traded market, and we might quibble on the effectiveness and the cost relative to the benefits of these approaches in that microstructure, I would suggest that these prophylactic measures would be particularly bad public policy in the OTC markets.
At the CFTC, the surveillance group spends significant resources monitoring large traders in particular, and all manner of cash market fundamentals, to determine when a trader or traders may be assuming positions of such a size and proportion as to cause congestion or price movement. If they find such a position, they then seek to determine the economic purpose of the position, whether it is a hedge or whether it is consistent with the trader’s business given the market conditions at the time. If staff determines that a trader’s position is not consistent with economic conditions or its business plan, they will seek to persuade that trader to liquidate the position in an orderly fashion.
You will notice if you study early legislative and regulatory policy in the futures markets that the proposed solutions for dealing with manipulation are typically to either outright ban trading or to severely curtail speculative participation in the markets. In fact one vestige of those efforts remains with us today in the form of speculative position limits. Never mind that speculative trading provides the liquidity that oils the markets and is potentially as much a source for fundamental market information as hedging, the fact is that if a speculative trader’s position rises above some arbitrarily defined limit, they will have been found to be in violation of Section 4a of the Commodity Exchange Act.
When you study attempts to deal with manipulation you will also notice a tendency for a correlation to exist between price levels and the call for regulatory or legislative action. That is, usually when prices move significantly, we hear that prices are being manipulated and regulation should be implemented to prevent this. While we are quick to investigate the circumstances that may have given rise to such price moves, particularly with an eye toward economic conditions, extreme price movement is not a prima facie case for manipulation. Again, our laws and our conscience should prevent us from defaming those who happened to be in the market during the time the prices experienced significant change.
Very simply, the fact that prices spike or plunge is not sufficient evidence that the markets have been manipulated. In my view, we must be vigilant not to equate unpopular price moves to manipulative behavior and throttle the market’s ability to serve its national public interest of providing a means for managing and assuming price risks, discovering prices, and disseminating pricing information.
As part of our affirmative obligation to regulate these markets, we must also provide assurance that we will follow due process in our investigations and in our pursuit of wrongdoing in the markets. To this end, I believe that we should not make public pronouncements or release staff studies that allege manipulation when we do not have sufficient evidence or a viable case to support it. As we investigate, we are also bound by our statute in Section 8 of the Commodity Exchange Act to protect proprietary or sensitive information that we acquire in our investigations. We have worked hard to establish relationships with other regulatory agencies to try to avoid subjecting respondents to unnecessary and duplicative regulatory scrutiny or double jeopardy.
Some of you may be asking why the CFTC has an interest in these transactions? After all, the misreported prices were for OTC transactions between private counterparties, not futures prices. Very simply, the Commodity Exchange Act recognizes the integral link between the physical and futures markets and the potential for the manipulation of prices in one market to effect prices in the other. As a result, Congress granted the CFTC authority to take action against manipulators of any price of a commodity in interstate commerce.
My primary concern has been that in an effort to solve the problems and respond to political pressures, a program of regulation and legislation is proposed that is prescriptive and inappropriate for the type of markets we are considering. It is my view that prescriptive regulation cannot address the problems being experienced by the energy sector, but may exacerbate a liquidity shortage in the energy complex by unnecessarily imposing costs on industry participants, and creating regulatory and legal uncertainty. In this sense, in our effort to squelch manipulative behavior, we may end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets. The true enemy of manipulation is competition and liquid markets.
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 disclosure. Increased market transparency is often held out as a quick-fix solution to market problems, even though there are different types of transparency and different levels are appropriate 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 accurately reflect the financial condition of the firm and must do so according to accepted principles. Failure to do so is not only a violation of law, it is not in the best interest of the economy or the self-interest of companies that chose to violate them. Witness that Enron had become 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. One proposed amendment to the Energy Policy Act suggests that covered entities, including certain electronic markets as well as dealer markets, make public such information as volume, settlement prices, open interest, and opening and closing price ranges, and make available to the CFTC large trader position reports as appropriate. While I appreciate that the proposal gives the government discretion in this regard, it appears to want 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 they are done without regard to market structure. Where the contracts are principal-to-principal, proprietary, or done on a one-off basis, it is also not clear how release of this information would deter manipulation, but it certainly might deter participation in the markets. Since the intermediaries that design 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 would be discouraged.
The Commission continues to investigate numerous companies and individuals in the energy sector to ascertain those who should be prosecuted, and those who are innocent of allegations. Many companies have come forward to report the findings of their own internal investigations and have been cooperative in helping the Commission determine whether wrongdoing occurred. This demonstrates that companies are anxious to put this chapter behind them, and get on with business. For our part, we are working hard to complete our energy market investigations by the end of the year.
To summarize, I believe that legislative and regulatory remedies for purported manipulation have to provide a direct hit on actual problems and misdeeds we see in the markets. We have been criticized for not moving quickly enough, but I think the greater risk is in acting without good information and understanding of the markets, in a “knee-jerk” response that does not solve problems. To do so would create significant costs, not only for the industry, but also for government and the taxpayers. Moreover, if the regulatory response is to “chill or kill” the market, this will deny vital risk management tools to this industry, punish the innocent, and ultimately the economy will suffer.
There are many challenging issues here, and I would note that I am not only addressing you, but I am also attending this conference. I am open to your insight and I would welcome your questions and thoughts as we consider the options put before us.
 See United States v. Patten, 226 U.S. 525, 541-542 (1913) (conspiracy to run a corner that was specifically intended to raise prices artificially falls within the purview of Section 1 of the Sherman Act, which prohibits a conspiracy in restraint of trade); Peto v. Howell, 101 F.2d 353, 362 (7th Cir. 1938) (cornering violates Section 2 of the Sherman Act, which prohibits monopolization in restraint of trade); Apex Oil Co. v. DiMaturo, 822 F.2d 246, 252-53 (2d Cir. 1987) (squeezing is actionable under Section 2 of the Sherman Act, which prohibits conspiracy to monopolize in restraint of trade). See also, Strob v. New York Mercantile Exch., 768 F.2d 22, 28-29 (2d Cir.), cert. denied, 106 S. Ct. 527 (1985) (the reach of antitrust law, with respect to manipulation claims, is not preempted by the Commodity Exchange Act because the policies of both are consistent with one another).
 See In re Nelson Bunker Hunt, CFTC Docket No. 85-12 (the "CFTC Action"). The CFTC action arose out of events in the market for silver and silver futures contracts during the period from September 1979 through mid-March 1980. At that time, the price of silver and silver futures contracts rose to unprecedented levels. The CFTC action alleged that respondents were members of a conspiracy to manipulate the price of silver and silver futures contracts in violation of the Commodities Exchange Act.
 In re Indiana Farm Bureau Cooperative Assn., [1982-1984 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 21,796 at 27,281 (CFTC Dec. 17, 1982).