Overview of the North American Energy, Commodities and Developing
Sharon Brown-Hruska, Acting Chairman
U.S. Commodity Futures Trading Commission
International Swaps and Derivatives Association (ISDA)
New York, November 17, 2004
It is a pleasure to have been invited here to New York to address you today. The last time I had spoken to an ISDA event on energy markets, it was in early 2003, and the Commodity Futures Trading Commission was deep into a number of investigations into allegations of manipulation and false price reporting in the energy sector that were spawned by revelations that began to be uncovered when Enron imploded. Today, I thought it might be valuable to survey how the energy industry and the commodities derivatives business as a whole have adapted and what challenges lay ahead, from both a markets and regulatory perspective.
Although we have taken our share of criticism, as I scan the Commission’s regulatory involvement in these markets, I am pleased we have acted decisively without over-reacting. We have resisted the temptation to resort to over-reaching or prescriptive solutions that are so often called for by legislators and regulators, and have continued to embrace principles-based and targeted approaches that have proven efficient and effective. As a result, I believe confidence in the integrity of the energy markets has risen and this has contributed to increased liquidity and growth in the markets.
No doubt, the energy markets have experienced some trauma in the last couple of years. After quite an extended period of certainty and calm in the energy markets, we moved rather quickly into a period of uncertainty driven by fundamental supply and demand factors including those related to energy supplies, the political situation in many of the OPEC countries, and the potential rise of the Chinese and Indian economies as substantial consumers of energy. These events combined to raise prices and the volatility of prices to levels not seen since the early 1980’s. And while prices did not reach the peak real price levels we saw in the late 70’s and early 80’s, the relative quickness with which they rose from relatively low levels certainly caught the attention of consumers, regulators, and politicians.
Before I get started, let me begin by telling you a little about myself and the Commodity Futures Trading Commission, but also let me state that the opinions and views I express here today are my own and do not necessarily represent those of the Commission or its staff. As for myself, prior to joining the Commission, I was an assistant professor of finance at George Mason University, and prior to that, Tulane University. In 2002, President Bush asked me to serve as a Commissioner at the CFTC, and I was confirmed by the Senate and began work in August 2002. Upon the departure of Chairman James Newsome this summer, the President designated me as Acting Chairman, and I have enjoyed serving in that role since July of this year. Actually, this is my second tour at the Commission. While finishing my PhD, I worked at the Commission as a research economist for five years before moving into academia.
As a college professor and economist, my interests have always been the markets. Markets make a compelling subject of study. Seemingly on their own, markets allocate resources by matching buyers with sellers at prices each side is willing to accept – this is what Adam Smith called the “invisible hand.” And what is truly remarkable is that for the most part they do so exceedingly well without a regulator or some other operator there to lord over every price and every allocation of a resource. In fact, as the Russian, the Chinese, the North Korean, and every other centrally planned economy has shown, efficient resource allocation breaks down when planners get involved.
So as a regulator, and as an economist, I see my role as both a protector and promoter of markets. Unfortunately when prices or price volatility increases, such as has occurred with energy prices, there are often calls for the government to “do something.” And by doing something that usually means interfering with the market process. We hear this today as some politicians and market commentators call for the government to do something about energy prices. Fortunately, cooler heads have prevailed thus far and we have avoided the disastrous economic experiment of price controls that we saw in the 1970’s. But even so, the mere fact that we hear these continual calls to “do something” tells me that we need to be vigilant to ensure that wrongheaded policies do not creep into legislation or regulation that impede market users and prevents markets from doing their job.
Alternatively, if we must to “do something,” the most effective thing we can do is to promote markets and innovations that allow them to operate more efficiently. The futures markets are important price discovery markets because they can price commodities out into the future, which helps companies plan their investments. In fact, Federal Reserve Board Chairman Alan Greenspan has repeatedly cited the forward futures prices for crude and natural gas as providing important guidance regarding expectations and information that are vital to sending investment and exploration signals to companies who develop and utilize energy resources.
But having forecasts of prices is one thing, as we all know price volatility is another thing. And that is where derivatives markets again come into play. The existence of futures, options, and swaps markets allow companies to lock in those forward prices and to make investments knowing that the financial results will be more certain. An article in the New York Times a few months back noted that Southwest Airlines has 80 percent of its fuel needs hedged for this year and 2005, and 30 percent for 2006 at prices below $30 a barrel. Similarly, Alaska Air has 40 percent of this and next year’s fuel consumption hedged at $25 to $27 a barrel. So we see that when we have innovative markets and innovative companies, “something” can be done. Both Southwest Airlines and Alaska Air have “done something” about the high cost of oil—they have avoided it. And they have avoided high prices without the government having to step in to “do something.”
Now of course there are those critics out there who would maintain that it is in fact these markets that have caused or at least exacerbated high prices in the energy markets. Some market commentators have alluded to the trading of funds, a term these days used to refer to speculators, as a source for high prices. While it is true that currently the funds are more actively involved in trading energy commodities, I challenge the assertion that these funds are somehow artificially inflating prices. Hedge funds, like any other participant, bring information and liquidity to markets whenever they trade. When they are speculating, they seek to make money for their clients by making predictions of market trends and movements, and trading on that basis. If funds do a bad job of predicting the markets, then they will inevitably lose money and find themselves out of the market. If they do a good job of predicting the markets, they inherently make the markets more efficient by their trading, thus improving certain aspects of market quality.
As for monitoring fund activity, like any other large trader in the markets we regulate, the CFTC monitors on a daily basis positions and price moves. In addition, the Commission is able to track the activity of funds as a group and to see how their positions add up on a gross or net basis. Finally, if we do see something unusual or which gives us cause for concern, the Commission is often in contact with these traders to the extent that any positions they hold would appear to be interfering with the smooth operation of the market. Our analysis indicates that funds are not driving prices, but instead, by bringing information into the markets, which is a crucial part of the price discovery process, they bring vital liquidity to the markets. Thus, I believe that the funds represent an important and fundamental part of the futures markets.
When it comes to markets, I am unapologetic in my support for open and competitive markets. That said, it is not always the case that markets or participants in the markets function as we would like. We know that markets dominated by monopolies and oligopolies are not always conducive to efficient resource allocation. We also know that at times individuals may attempt to manipulate prices in their favor. Manipulated prices in the futures markets reduce the efficiency of hedges, meaning that risk managers are less able to insulate themselves from volatile prices. Oftentimes the markets themselves will discipline the would-be manipulators, but at other times regulators must step in to ensure market integrity. And let me stress this point. When regulators “do something” about markets it should be to ensure integrity and not to affect prices. The markets will take care of prices as long as we take care of the markets.
Recently the Commission faced a situation where we felt it necessary to protect the markets from false price reporting and the attempted manipulation of natural gas prices. The Commission has aggressively pursued companies and individuals who manipulated or attempted to manipulate natural gas prices. Since 2002, we have investigated over 40 major energy companies and a number of individuals for alleged violations. Thus far, the Commission has filed 20 actions and collected over one-quarter billion dollars in civil monetary penalties. In some cases we found that traders were misreporting or engaging in wash trades to directly boost their personal profits. In other cases, traders were found to be attempting to manipulate the price indices to benefit the value of their company’s position. In still other cases, traders indicated that they were pursuing a “defensive” strategy to counter the perceived manipulation of indices by other traders.
Regardless of the source or rationale for misreporting, it became apparent that something needed to be done to restore confidence in these markets. In cooperation with the Federal Energy Regulatory Commission and the Department of Justice, the Commission took action under provisions of the Commodity Exchange Act to penalize those entities and individuals who took part in the misreporting.
While the transactions in question did not involve futures contracts, the markets for OTC and futures are linked in important ways. Traders in one market tend to be aware of what is happening in related markets and incorporate the information they see in one market into the prices of other markets. In addition, traders at times hedge their market risk in one market with positions in the other. Thus, it is natural that the Commission took an interest in what was occurring in the OTC natural gas markets due to the potential that those prices could have affected natural gas futures.
The exchange-traded market, the OTC markets, and the cash markets are all linked together, financially and informationally. Thus, the Commission is given jurisdiction over the manipulation and false reporting of commodity prices, regardless of whether those prices are futures or otherwise. With respect to false reporting, the Commodity Exchange Act applies to “the price of any commodity in interstate commerce, or for future delivery on or subject to the rule of any registered entity.” With respect to manipulation, the classic strategy involves intentionally creating artificial prices in one market to create a profit on a position in another market. Thus, Congress was judicious and clear in the Act in their intention that the Commission’s jurisdiction included not only futures prices, but any and all commodity prices.
Finally, because of the fallout from the Enron debacle along with the false reporting claims, the market for OTC energy contracts had collapsed from a perceived lack of integrity. We at the Commission felt that to restore integrity, we needed to act to assure market participants that market abuses would not be tolerated and that these markets were safe for participants who have legitimate and vital business to transact. Many companies have come forward to report the findings of their own internal investigations and have cooperated with the Commission to determine whether wrongdoing occurred. This demonstrates that companies are anxious to put this chapter behind them, and get on with business.
As for our progress, I am happy to report that 97% of the energy investigations we opened in 2002 have been resolved. Furthermore, the remaining investigations that were spin-off corporate investigations from those in 2002 should be completed shortly. In my mind, this era in which many acted with a lack of integrity and violated the law will soon be a part of history – one that will not be repeated as a result of our enforcement actions.
In addition to our enforcement actions, the Commission along with Federal Energy Regulatory Commission has sought other means to restore confidence in the energy markets. In the wake of the misreporting scandal and the collapse of Enron, two things came to light, and let me deal with them in turn. First, with respect to price reporting, we found that internal controls at companies involved in energy trading and the procedures at price reporting firms were often weak or even nonexistent. For example, prices were often reported directly by the traders. Such a situation tends to create an inherent conflict of interest when a trader realizes he has an opportunity to influence the indices on which his position will settle. In other cases, price reporting firms asked traders for the “sense of the trades” they were seeing in the markets. While there is nothing inherently wrong with providing a sense of the market, such market views come with limitations and caveats and should not be passed off as true market transactions, as they were in some cases.
To deal with the price reporting problems, there have been those who have called for an invasive government presence in the price reporting business. Some have called for the creation of a centralized data hub to which all natural gas, and possibly electricity prices would be reported. Under some proposals this would be a government-sanctioned entity with the power to force companies to report prices. In other scenarios, advocated by some in Congress, the hub would be a government regulator. As one can imagine, such an endeavor would be a huge undertaking as the regulator/data hub sought to ensure the integrity of prices in a widely diverse market. As an alternative I supported, and still do support, an industry initiative such as that proposed by the Committee of Chief Risk Officers, that establishes guidelines for reporting prices. I believe that such industry initiatives can be very effective in stemming the price reporting problems in a less costly fashion than by interposing a regulator into a job that the market can perform itself.
The second problem that became apparent with the collapse of Enron was the issue of credit risk. Prior to its collapse Enron was viewed as one of the better risks in the energy business. Following the collapse, not only did the industry realize that Enron’s credit was worthless, but it suddenly cast a pall on the creditworthiness of many within the industry.
Following the Enron collapse the CFTC and FERC held several public meetings to discuss the problem of credit risk in the OTC markets and the possibility of a clearing solution similar to that used in futures markets. As commercial participants in the energy industry considered clearing of OTC trades, I know many are skeptical that an exchange-based clearing model could work in the OTC energy markets. OTC markets are often not as liquid, contracts not as fungible, and quick settlements put strain on cash flows. Although a widely accepted clearing model has not yet emerged, there has been some progress towards clearing for OTC products and we continue to see innovation to provide solutions.
To date, we have seen clearing introduced for OTC swaps by the NYMEX and the Intercontinental Exchange, or ICE. Not surprisingly, however, the types of transactions that are eligible for clearing tend to be standardized contracts such as a Henry Hub natural gas swap. We also have begun to see some innovative solutions which rely on more sophisticated financial engineering to mitigate credit risk. This may involve the management of price risks through portfolio techniques or structured products that allow clearing houses to sell off the price risks much as Fannie Mae or Freddie Mac are able to sell off mortgage risks through the sale of securitized assets. Other approaches, like the North American Energy Credit and Clearing Corporation, seek to integrate the physical and financial energy markets to reduce collateral requirements and eliminate receivable risk from pooled energy markets.
Now while credit risk and clearing solutions do not directly prevent manipulation or market abuses, these solutions do help create liquid markets. And ultimately it is liquidity that is the most effective preventative defense against manipulation. That said, it is often the case that OTC markets involve customized transactions, so in a sense they are relatively illiquid in that there may be fewer counterparties with whom to trade, and to exit a contract one may have to return to the original counterparty to change terms. However, the markets for such contracts tend not to be considered susceptible to manipulation since prices for such contracts relate more specifically to the contract itself rather than to the broader market. These are bilateral deals between relatively large and sophisticated counterparties, and their proprietary nature means that the public interest here is limited.
One of the centerpieces of the Commodity Futures Modernization Act, which amended the statute of the Commodity Futures Trading Commission in 2000, was to set up a regulatory scheme that was more flexible in dealing with the varied types of commodities and assets traded as well as the sophistication of parties entering into these contracts. The CFMA generally followed the recommendations of the President’s Working Group on Financial Markets.
As a result, when one now looks at the Act it is written more in terms of who is trading and what is traded, rather than trying to fit all participants and commodities through the same filter. In general, as the level of sophistication of participants rises as well as the ability to manipulate a commodity falls, the market is subject to less regulation. Alternatively for commodities perceived to be more vulnerable to manipulation and where a more retail clientele exists, the level of regulatory scrutiny rises.
We must continue to be vigilant to ensure that we are not forced to turn back on the legal certainty and appropriate regulatory approach that the CFMA enabled. There were a series of proposals put forth in Washington that I believed would create a circumstance where firms would face additional costs as a result of duplicative and ambiguous regulatory structures. Senator Feinstein put forth proposals to revise the CFTC’s jurisdiction to more broadly and prescriptively regulate the over-the-counter energy markets. Senator Cantwell proposed an amendment that was billed as prohibiting Enron-type manipulation strategies, but was similarly overbroad, lacking specific parameters on what constitutes manipulation and creating potential overlap of authority between the CFTC and the FERC.
In my view, duplicative and prescriptive regulation is neither necessary nor well-suited to address the problems being experienced in the energy sector, and instead may exacerbate a liquidity shortage in the energy complex by unnecessarily imposing costs on industry participants, and creating regulatory and legal uncertainty. As a result, in our effort to squelch illegal behavior, we may end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets. In my view, the true enemy of manipulation and market power is competition and liquid markets.
The energy bill worked out in conference and passed by the U.S. House, but which stalled in the Senate, contained several provisions that directly affected the CFTC’s oversight responsibilities. Changes proposed to Section 4b of the Commodity Exchange Act sought to expand the Commission’s authority to bring anti-fraud actions in off-exchange principal-to-principal futures transactions. This revision would have enabled the CFTC to go after illegal conduct that were alleged to have occurred in an Enron-Online type environment, where transactions are not intermediated but where fraud may be present. Frankly, given some of the earlier proposals and language I had seen, I was relieved to see that the CFTC was not drafted into regulating a wider swath of territory that would expand our jurisdiction beyond the fraud and manipulation authority that I believe we already have.
In the wake of the Enron collapse, just as was the case with the August blackout, there has been a “knee-jerk” call to increase the CFTC’s regulatory authority. As all of you know, Enron was a large promoter and user of derivative contracts. I would note, however, that the CFTC successfully pursued a complaint against Enron for attempted manipulation of the natural gas markets, subsequently settling for a civil monetary penalty of $35 million dollars. As mentioned, after its collapse, liquidity in many wholesale energy markets suffered because of a concern about the credit risk of industry participants. But widespread defaults on contracts did not occur. With regard to the financial integrity of the markets we regulate, regulation worked.
Many have proposed re-imposing a wide range of regulatory prescriptions on OTC markets that would provide little protective benefit to the markets and its participants, while imposing high costs. The enforcement actions that the CFTC has and continues to take against natural gas traders who have misreported prices and transactions, or attempted to manipulate markets, have been prudent and effective as a deterrent to further abuses. Attempts to layer on additional reporting and disclosure burdens and capital requirements on innocent industry participants seem to be more an effort to demonstrate that lawmakers are “doing something” rather than actually addressing a problem.
That said, we need to be vigilant not to allow those who would turn back elements of this smart and progressive regulatory approach to accommodate their own competitive interests or to accomplish their own political agendas. This is particularly true of the OTC energy markets, where a variety of proposals have been made and unsupportable revisions have been circulated to modify CFTC jurisdiction to a more prescriptive regulatory model and to expand CFTC jurisdiction in such a way that might jeopardize the legal certainty afforded to the principal-to-principal swaps markets.
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 must be efficient and targeted. In this regard, we will use our resources most efficiently to ensure that our enforcement against fraud and manipulation is swift and painful to violators.
As we approach Congressional reauthorization for the Commission next year, I am committed to working to ensure that the intent of Congress and many of the accomplishments of the Modernization Act are not put in jeopardy. I look forward to working with the members and leadership at ISDA to ensure the markets continue to recover in an atmosphere of competition, innovation, and integrity.