Address by Chairman James E. Newsome
of the Commodity Futures Trading Commission
to the Global Energy Management Institute
University of Houston
July 9, 2003
Thank you Mark for that kind introduction. I am pleased to be here this morning to discuss the Commission’s role in overseeing derivatives activity in the energy markets. For those of you who may not be familiar with the Commodity Futures Modernization Act of 2000, I would like to highlight some of the important things that Congress did through the CFMA that relate to energy trading. I will also touch on various issues that have been raised by recent events in the energy sector, and the Commission’s response to those events. First, however, since some of you may not be familiar with Commission itself, I would like to give you a brief overview of our mission and how we operate.
The Commission was established in 1974 as an independent federal regulatory agency to oversee trading in futures contracts, and later to oversee options trading. It is comprised of up to five Commissioners appointed by the President, with the advice and consent of the Senate, and is governed by the Commodity Exchange Act. Typically, there are two Democratic commissioners, two Republicans, and a Chairman who represents the party of the President. As an independent agency, however, I am proud to say that the Commission has operated relatively free of partisanship. We currently have four commissioners on board – Barbara Holum, Walt Lukken, Sharon Brown-Hruska, and myself.
The Commission has two regulatory units. The Division of Market Oversight, which is comprised primarily of economists, conducts ongoing market surveillance to detect and prevent price distortion and manipulation, and also performs other key functions such as processing applications from new exchanges and reviewing new contracts and exchange rules. Our other regulatory unit, the Division of Clearing and Intermediary Oversight, employs auditors and other staff who monitor the financial and operational integrity of the clearinghouses and intermediaries, to ensure that customer funds are protected and that safeguards are in place to prevent the financial problems of a single entity from spreading throughout the system. This division also oversees the registration of futures commission merchants, commodity pool operators, and commodity trading advisors. Supplementing the expertise of these two divisions is our Chief Economist’s Office, which conducts research on important policy issues facing the Commission and provides expert economic analysis to the Commission and the other divisions. Our Division of Enforcement is charged with investigating potential violations of our Act and regulations and with prosecuting wrongdoers in administrative actions before the agency and in federal court proceedings. In addition, as in other agencies, we have an Office of General Counsel, an Office of External Affairs, and an Office of the Executive Director.
In addition to its individual efforts, the Commission works cooperatively with other financial regulators and criminal enforcement authorities. As Chairman of the CFTC, I sit on the President’s Corporate Fraud Taskforce, a group initiated by President Bush to coordinate investigations and enforcement actions among independent agencies, U.S. attorney’s offices, and the Justice Department. I also serve as a member of the President’s Working Group on Financial Markets, with the Secretary of the Treasury and the Chairmen of the Federal Reserve Board and the Securities and Exchange Commission. Over the past year or so, the Commission has also worked closely with the Federal Energy Regulatory Commission to seek solutions to problems in the energy sector.
The Commission’s mission is twofold: to foster competitive and financially sound markets and to protect market users and the public from fraud, manipulation and abusive trading practices. In seeking to fulfill that mission, the Commission focuses on issues of market integrity. We seek to protect the economic integrity of the markets so that they may operate free from manipulation; we seek to protect the financial integrity of the markets so that the insolvency of a single participant does not become a systemic problem affecting other market participants; and we seek to protect the operational integrity of the markets so that transactions are executed fairly and that proper disclosures are made to existing and prospective customers.
While a substantial portion of the Commission’s resources are devoted to the day-to-day oversight of registered exchanges, intermediaries, and derivatives clearing organizations, equally important is the CFTC’s role as a civil enforcement agency. If any indication of fraud or manipulation within our jurisdiction is found, the Commission will investigate and prosecute the parties involved. Our Enforcement Division, which makes up almost half of our staff, typically has over one hundred investigations open at any particular time. Over the years, the Commission has brought a number of actions for manipulations or attempted manipulations of commodity prices. The Sumitomo copper case and the Hunt brothers silver case are well-known examples. A variety of administrative sanctions are available to us, such as bans on futures trading, civil monetary penalties, and restitution orders. The Commission may also seek federal court injunctions, asset freezes, and orders to disgorge ill-gotten gains. If evidence of criminal activity is found, matters can and will be referred to state or federal authorities for prosecution under criminal statutes.
The Commission oversees the on-exchange trading of energy-related futures and option contracts based on products such as crude oil, natural gas, heating oil, propane, gasoline, and coal. Several U.S. exchanges are designated to trade energy products, but the overwhelming majority of on-exchange energy transactions are executed on the New York Mercantile Exchange. And, while the Commission does not directly regulate the OTC energy markets, we do have authority to prosecute fraud and manipulation occurring in those markets.
In 1974, when the Commission was founded, the vast majority of futures trading took place in the agricultural sector. These contracts gave farmers, ranchers, distributors, and end-users of everything from corn to cattle an efficient and effective set of tools to hedge against price volatility. Over the years, as the value of the risk management tools afforded by the futures markets became apparent, trading in financial, metal, and energy futures began, as manufacturers started using futures contracts to plan their raw material costs and to reduce uncertainty over the prices they received for finished products sold overseas. Mutual fund managers can now use stock index futures to protect against market volatility and to effectively put a floor on portfolio losses. And electric power generators can use futures contracts to secure stable pricing for their coal and natural gas needs. Although farmers and ranchers continue to use the futures markets as actively as ever to effectively lock in prices for their crops and livestock months before they come to market, financial contracts based on such things as interest rates, foreign currencies, treasury bonds, and stock market indices, have now far outgrown agricultural contracts in trading volume. Our latest statistics show that currently, approximately five percent of on-exchange derivatives activity is in the agricultural sector, while financial derivatives make up approximately eighty-six percent, and other contracts, such as those on metals and energy products make up about nine percent.
As these new on-exchange markets were developing, privately negotiated risk management arrangements between commercial counterparties became more prevalent off-exchange. Because these off-exchange arrangements contained elements similar to those found in futures contracts, which by law were required to be conducted on regulated exchanges, legal uncertainty arose over their status under the Commodity Exchange Act. The Commission responded to this uncertainty by providing exemptions from the on-exchange requirement for privately negotiated swaps and for certain energy contracts related to commercial delivery systems.
Nevertheless, the issue of legal uncertainty persisted. In 1999, the President’s Working Group on Financial Markets addressed the problem in a report on the OTC markets. The PWG recognized that this “cloud of legal uncertainty” – if not resolved by Congress – could discourage innovation and growth and damage U.S. leadership in these important markets by driving transactions off-shore. The PWG recommended, among other things, that Congress amend the Commodity Exchange Act to specifically exclude from the Commission’s jurisdiction certain types of OTC derivatives activity conducted by sophisticated counterparties, and it advised Congress to retain the exemptions from the Act that the Commission had previously granted, including those related to energy trading. In December 2000, after careful consideration of the issues in numerous public hearings, Congress did so in the CFMA.
The CFMA provided a new, flexible regulatory environment for on-exchange activity, and much-needed legal certainty for off-exchange activity. Marketplaces can now choose to operate under one of several levels of Commission oversight, depending on the products traded, the system in which they are traded, and the sophistication of the market participants. At each level of oversight for registered exchanges, prescriptive rules have been replaced by core principles governing operational integrity. For off-exchange activity, the CFMA established that the requirements of the Commodity Exchange Act do not apply to transactions in non-agricultural commodities when they are individually negotiated between eligible contract participants and are not executed on a trading facility. It also cleared the way for multilateral trading in energy products conducted between eligible commercial entities on electronic trading facilities, provided that that the trading facility complies with, among other things, certain notification requirements. The Commission refers to these trading facilities as exempt commercial markets, and the transactions conducted on them remain subject to the anti-fraud and anti-manipulation sections of our Act. Importantly, the CFMA provides that the failure of an exempt commercial market to properly comply with the requirements for operation cannot affect the legality, validity, or enforceability of the transactions conducted on the facility, or cause a participant on the system to be in violation of the Act. These important clarifications have provided market participants with greater certainty that their risk management agreements will be respected and enforceable, and that they cannot be voided under an argument that the transaction does not comply with the law.
I fully supported the CFMA because I believe in providing the most flexible and responsive regulatory regime possible for the legitimate efforts of market participants who, through innovation and fair competition, bring to the marketplace greater liquidity, more useful risk management tools, a better use of technology, more efficient pricing, and enhanced customer service. For those who choose to ignore the rules, however, or attempt to engage in fraud or manipulation, I can promise prompt investigations and an aggressive exercise of our enforcement authority under the Commodity Exchange Act. The derivatives markets are too important to the countless producers, distributors and end-users that rely upon them to manage their risks, and too important for the growth, stability, and resiliency of the economy as a whole, to tolerate any activity that would threaten their efficiency and reliability, or undermine trust in their integrity.
Some have argued that the flexible regulatory structure provided by the CFMA should be altered in light of recent events in the OTC energy markets, and various legislative proposals to do so have been advanced. While these market events have presented the Commission with a number of challenges, I have yet to see anything that changes my belief that the Commission already possesses the tools it needs to address misconduct occurring within its jurisdiction. In my opinion, the proper deterrent to such misconduct is a vigorous use of our enforcement authority, rather than the imposition of additional, prescriptive, or burdensome regulations that could adversely affect legitimate activity. I have said before that a regulatory structure that replicates the exchange-traded model is not appropriate for principal-to-principal trading between institutional counterparties, and we should approach any changes to the legal certainty in place for these specialized marketplaces with extreme caution. I would also like to point out that I am not alone among the federal financial regulators in believing that the legislative proposals that have been advanced could result in significant, negative unintended consequences for the risk management markets. On June 11th of this year, in response to a letter from Senators Crapo and Miller, the President’s Working Group on Financial Markets reiterated its unanimous view that, as demonstrated by actions taken by the CFTC, the SEC, FERC, and the Justice Department, wrongdoers in the energy markets are within the grasp of federal regulators, and that new legislation at this time would not be justified or advisable.
When the financial condition of Enron rapidly deteriorated a year and a half ago, there was immediate concern over whether the exchange-traded energy markets would suffer excessive price volatility, or reduced liquidity, if Enron’s large exchange-traded positions had to suddenly be unwound. As the Commission carefully monitored the situation and Enron voluntarily closed out its positions, these deep, liquid markets coped well. Prices did not spike and liquidity did not dry up. But, the difficulties of any large market participant will raise concerns about the ability of intermediaries carrying that trader’s positions to successfully manage them if the trader fails to meet margin calls. In the Enron situation, the Commission worked closely with the NYMEX clearinghouse and the affected FCMs to ensure that the winding down of Enron’s positions was accomplished quickly and smoothly. The system of financial controls in place was successful. There were no disruptions to the system of clearance and settlement, and each trader met its obligations.
Although I am keenly aware of the challenges facing users of OTC risk management tools, I would like to note some positive developments in the energy sector. In February of this year, the Commission jointly hosted a conference with FERC to consider possible solutions to credit risk problems. One potential solution discussed was the clearing of OTC energy derivatives by futures clearinghouses, which was made possible by the CFMA. The Commission has been working since early last year on efforts in this area. I also applaud efforts that have made within the industry to adopt new codes of ethics and best practices. There are other indications of movement toward improving systems to better detect wash trades and to establish dedicated compliance functions. I welcome such initiatives and encourage all market participants, especially operators of trading systems, to continue to pursue these and other efforts to restore confidence in the use of risk management mechanisms in the energy sector. I would also like to acknowledge recent efforts made by FERC and the industry to find solutions to the current problems associated with price reporting. I believe that these market initiatives, coupled with the appropriate use of the Commission’s enforcement authority, are critical to restoring confidence in the marketplace.
As most of you know, the Commission has opened a number of investigations relating to misconduct in the OTC energy markets, and has filed several enforcement actions. Two of those cases have been settled and resulted in significant monetary penalties. I am fully committed to resolving our other investigations as expeditiously as possible, so that wrongdoers are appropriately punished, and those that were not involved are exonerated.
In closing, I would like to emphasize that I firmly believe that legal and regulatory certainty is crucial to the effective operation of the derivatives markets. Unclear laws, regulations, or enforcement policies can result in inefficiencies, missed opportunities, and the misallocation of resources by market participants, who must factor such uncertainty into their business decisions. If Commission statements or actions fail to clearly present the Commission’s goals, policies, or positions, we would appreciate hearing from market participants and will carefully consider ways to provide additional clarity. Going forward, the Commission will continue its aggressive efforts in the enforcement area, so that those who operated outside of the law are identified and sanctioned, and just as importantly, so that companies that followed the rules are identified as well. In my opinion, that is not only our responsibility, but also the appropriate role for the CFTC. I encourage those of you in the industry to continue your efforts to reach consensus solutions to the challenges before you today.