"A Brief Legislative History of the Regulation of Significant Price Discovery Contracts”
Statement of Dan M. Berkovitz, General Counsel on Meeting to Consider Significant Price Discovery Contract Determinations
April 27, 2010
This testimony briefly discusses the legislative history of the provisions in the Commodity Exchange Act (“CEA”) related to significant price discovery contracts (“SPDCs”). This history includes:
• the creation of a new type of market—the Exempt Commercial Market (“ECM”)—under the Commodity Futures Modernization Act (“CFMA”);
• the evolving role of ECMs in the energy derivative markets, leading to an increased need for regulation and oversight of ECMs; and
• the CFTC Reauthorization Act of 2008, which provided the Commission with authority to regulate the trading of contracts on ECMs that perform a significant price discovery function.
Commodity Futures Modernization Act of 2000
The CFMA amended the Commodity Exchange Act (“CEA”)1 to establish new categories of regulated and regulated markets, codify a number of exemptions and exclusions from regulation for certain swaps and other off-exchange transactions, and provide “legal certainty” that such swap transactions were not illegal or prohibited under the CEA.2 Generally, the CFMA established a tiered regulatory structure for commodities, with the degree of regulation dependent upon the type of commodity (i.e. financial, agricultural, or energy or metal), the type of market (i.e. futures exchange, bilateral negotiation, multilateral negotiation, or electronic exchange), and size and degree of sophistication of the participants in the market (i.e. retail customer, financial institution, or commercial enterprise). The exemptions and exclusions for off-exchange or over-the-counter (“OTC”) transactions reflected the view that sophisticated counterparties who are trading amongst themselves do not require the same types of protections—and hence the same type of regulatory oversight—as in the case of the retail public trading futures contracts on a futures exchange.
The CFMA added Section 2(h)(3) to the CEA to exempt from the provisions of the Act—other than the anti-fraud and anti-manipulation provisions—the trading of contracts in “exempt commodities” on an electronic trading facility by large, sophisticated parties, known as “eligible commercial entities” (“ECEs”).3 Because these electronic markets for large, sophisticated commercial entities were exempted from virtually all regulation, they have become to be called “Exempt Commercial Markets.” An “exempt commodity” is any commodity that is not an excluded commodity (primarily financial commodities) or an agricultural commodity, meaning therefore, energy commodities, such as crude oil, natural gas, heating oil and gasoline, as well as metal commodities, chemicals, and emission allowances.4
Trading in these exempt markets is restricted to large, sophisticated commercial market participants. The term ECE includes companies with significant assets that regularly enter into transactions to purchase or sell the commodity or derivative contracts in the commodity. An eligible commercial entity is also a large company that, in connection with its business, either (i) has the ability to make or take delivery of the underlying commodity, (ii) incurs some commodity risk beyond price risk, or (iii) is a dealer in the underlying commodity.5
Although the Commission’s generic anti-fraud and anti-manipulation authority applied to transactions on an ECM, the facilities themselves were exempt from all substantive provisions of the CEA and Commission regulations applicable to regulated exchanges. ECMs were not required to comply with any of the core principles that applied to designated contracts markets (“DCMs”) that traded contracts for future delivery. Thus, for example, ECMs were not required to adopt position limits or accountability rules to address the potential for manipulation, establish compliance and surveillance programs, monitor trading or undertake any other self-regulatory responsibilities. Similarly, because ECMs were exempt from the licensing and registration requirements of the CEA, the CFTC did not have general oversight or regulatory authority over trading on or the operation of these facilities.
An ECM trading a contract that performed a significant price discovery function was required to publicly disseminate certain basic information -- such as contract terms and conditions and daily trading volume, open interest, and opening and closing prices or price ranges. Hence, although the CFMA provided the Commission with the authority to determine whether an ECM performs a significant price discovery function for transactions in an underlying cash market, under the CFMA such a determination did not trigger any self-regulatory responsibilities for the ECM or confer any additional oversight authority on the Commission.
Significant Growth in OTC Energy Markets: 2001-2007
At the time that the CFMA was enacted, most ECMs were simple trading platforms, resembling in many ways commercial-to-commercial trade matching facilities, with trading volumes that were small relative to DCMs. The first ECMs did not offer centralized clearing. Early ECM contracts were not linked to contracts listed on DCMs.
Subsequent to the CFMA, trading in the OTC market, especially the natural gas and other energy derivatives markets, expanded exponentially, in a manner and to an extent that was unforeseen in 2000. In just a few years, ECMs dramatically changed and took on many of the attributes of a DCM. Most notably, ECMs began to offer “look-alike” swap contracts that were linked to the settlement prices of their exchange-traded counterparts. Several of these look-alike contracts began to garner significant trading volumes. Traders on ECMs began to include non-commercial entities, such as large hedge funds and exchange floor traders. Some ECMs also started to offer centralized clearing for their contracts – an option widely utilized by their customers.
The evolution of ECMs, beyond the simple trading platforms in existence at the time the CFMA was enacted, raised issues regarding whether ECM trading activity could impact trading of similar contracts traded on DCMs and whether the Commission had adequate authority to address that impact and protect markets from manipulation and other market abuse. Of special concern was the existence of the ECM cash-settled look-alike contracts that were economically equivalent to futures contracts for risk-management purposes. The trading of these look-alike contracts on ECMs could provide persons trading on the ECM with the ability to affect—perhaps even manipulate—the settlement price of an underlying DCM futures contract in order to benefit positions in the look-alike contract traded on the ECM, or vice versa. These concerns increased following the collapse of the Amaranth hedge fund, which was a very large trader in both natural gas futures contracts on the regulated NYMEX market and in natural gas swaps on an unregulated ECM operated by the Intercontinental Exchange (“ICE”).6
The recognition that certain ECMs (particularly ICE) and DCMs were offering virtually identical or linked contracts and functioning as a single market, together with the fact that major traders on ECMs were also the major traders on DCMs, spurred the Commission itself to reexamine the oversight of ECMs. A series of Commission staff studies and special calls culminated in a public hearing on the subject. In October 2007, based on the information developed through these studies and its public hearing, the Commission published its findings in a report entitled ‘‘Report on the Oversight of Trading on Regulated Futures Exchanges and Exempt Commercial Markets.’’7
In the report, the Commission found that, to the extent that trading volume on an ECM contract remained low and its prices were not significantly relied upon by other markets, the existing level of regulation remained appropriate. However, the Commission concluded that when an ECM contract began to serve a significant price discovery function, the contract warranted increased oversight to deter and prevent manipulation or other market disruptions -- on the ECM itself and in any DCM trading a related contract. The Commission reasoned that greater oversight was necessary “in order to effectuate the CEA’s mandate that the Commission deter and prevent price manipulation or any other disruptions to market integrity. . . . Without some increased oversight of trading in relevant mature ECM contracts, the Commission cannot adequately police the trading of DCM contracts to detect and deter price manipulation and other trading abuses.”8 It also advised that any changes be prudently targeted so as not to adversely affect the ability of ECMs to innovate and grow.9
CFTC Reauthorization Act of 2008
Consistent with the Commission’s recommendations for improving oversight of ECMs, the CFTC Reauthorization Act of 2008, which was included as part of the 2008 Farm Bill, added a new section 2(h)(7) to the CEA to provide a more comprehensive regulatory scheme for those contracts traded on ECMs.10 The new section provided a regulatory regime for contracts traded on ECMs that perform a significant price discovery function (SPDCs) that is comparable to that provided for futures contracts that are traded on a DCM.
The Reauthorization Act directed the Commission to review contracts traded on ECMs to identify those that serve a significant price discovery function, based on the following criteria:
• Price Linkage—the extent to which the contract uses or otherwise relies on a daily or final settlement price, or other major price parameter, of a contract traded on a DCM or derivatives transaction execution facility (“DTEF”), or a SPDC traded on an ECM, to value a position, transfer or convert a position, cash or financially settle a position, or close out a position.
• Arbitrage—the extent to which the price for the contract is sufficiently related to the price of a contract traded on a DCM or DTEF, or a SPDC traded on an ECM, so as to permit market participants to effectively arbitrage between the markets.
• Material price reference —the extent to which, on a frequent and recurring basis, bids, offers or transactions in a commodity are directly based on, or are determined by referencing or consulting, the prices generated by contracts being traded or executed on the ECM.
• Material liquidity—the extent to which the volume of contracts in a commodity being traded on the electronic trading facility is sufficient to have a material effect on other contracts traded on a DCM, DTEF or ECM.
Not all criteria must be present to support a determination that a particular contract performs a significant price discovery function. The contract may be determined to perform a significant price discovery function even if one or more criteria may be inapplicable to a particular contract. Moreover, the statutory language neither prioritizes the criteria nor specifies the degree to which a SPDC must conform to the various criteria.
In the Guidance on this matter in Appendix A to Part 36, the Commission stated that certain factors, by themselves, such as the price linkage factor, may not be sufficient to support a finding that a contract performs a significant price discovery function.11 The Commission nonetheless emphasized, “These factors do not lend themselves to a mechanistic checklist or formulaic analysis.”
If the Commission finds that a contract serves a SPDC function, the SPDC contract is subject to similar types of regulations and oversight that apply to DCMs. Specifically, for contracts that are determined by the Commission to be a SPDC, the Act requires that the ECM comply with nine core principles, derived from selected DCM core principles and designation criteria set forth in the Act. These core principles include the obligation to adopt and maintain position and accountability limits for SPDCs; monitor trading in SPDCs to prevent manipulation and price distortion; provide for emergency authority to liquidate open positions and to suspend trading in SPDCs; and publish daily trading information on price and volume.
Congress did not apply all 18 of the DCM core principles to ECMs since ECM participation is limited to eligible commercial entities, who are sophisticated and well-capitalized market participants; hence many of the core principles that provide protection to retail investors were not applied to these markets. At the same time, however, Congress recognized that, regardless of the type of participants in the market, the trading of any contract that performs a significant price discovery function warrants a heightened level of oversight to detect and prevent manipulation and to protect the price discovery and settlement process.
The Reauthorization Act amended section 4i of the CEA to authorize the Commission to require large trader reports for SPDCs traded on ECMs, and amended section 8a(9) to provide the Commission with comparable authority to take emergency actions with respect to SPDCs as it has with respect to contracts for future delivery. Finally, the Act amended the CEA to include SPDCs within the definition of “registered entity,” thus fully incorporating those entities into the regulatory structure for regulated markets.12
The legislation directed the Commission to issue rules implementing the provisions of new section 2(h)(7) of the CEA. Consistent with this directive, in March 2009, the Commission issue a final rule to amend Part 36 of the Commission’s regulations to address the criteria on which the Commission will rely in making a determination that a contract is a SPDC, the factors that will trigger an ECM’s obligation to notify the Commission of a possible SPDC; the procedures the Commission will follow in reaching its determination whether a contract is a SPDC; and the procedures, standards and timetables by which an ECM with a SPDC must demonstrate compliance with the core principles.
The testimony of Mr. Shilts provides a summary of the Commission’s rules in Part 36 that address these matters.
1 7 U.S.C. §1 et seq.
2 Pub. L. No. 106-554, 114 Stat. 2763 (2000). In this context, “legal certainty” means that the parties that enter into a swap transaction have certainty that the swap transaction is not illegal because it was not entered into or executed in accordance with the exchange-trading requirement for contracts for future delivery in section 4(a) of the CEA.
3 7 U.S.C. §2(h)(3).
4 7 U.S.C. §1a(14).
5 7 U.S.C. §1a(11).
6 See, e.g., Excessive Speculation in the Natural Gas Market, Hearing Before the Senate Permanent Subcommittee on Investigations, 110th Cong., 1st Sess., June 25 and July 6, 2007.
7 See Commodity Futures Trading Commission, Report on the Oversight of Trading on Regulated Futures Exchanges and Exempt Commercial Markets (October 2007) (“ECM Report”), http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/pr5403-07_ecmreport.pdf, for a comprehensive report of the Commission’s findings following its September 2007 hearing.
8 Id. at 19.
9 Id. p.18-20. As the Commission noted in its ECM Report, there was little support for eliminating the ECM provisions, §§ 2(h)(3)-(5) from the Act.
10 Incorporated as Title XIII of the Food, Conservation and Energy Act of 2008, Pub. L. No. 110-246, 122 Stat. 1624 (June 18, 2008).
11 17 C.F.R. Part 36, Appendix A, Guidance on Significant Price Discovery Contracts (2009).
12 7 U.S.C. §1(a(29)(E).
Last Updated: January 24, 2011