Remarks of Chairman Timothy Massad before the Natural Gas Roundtable (Washington, D.C.)
May 26, 2015
As Prepared For Delivery
Good afternoon, everyone. David, thank you for the kind introduction. And, thank you to the Natural Gas Roundtable for inviting me today. I am pleased to be here to discuss the energy markets and the work of the CFTC.
When it comes to managing market risk, I suspect there are few industries that have faced more challenge than the oil and gas industry in recent years. The changes in supply and demand that all of you must contend with have been significant. The shale revolution has had dramatic effects on price and changed fundamental assumptions about our domestic production capabilities. Five or six years ago, there was hardly any shale production in the Marcellus region, and in April it was over 16 billion cubic feet per day. And you have always faced the challenges created by the basic structure of the gas market, such as the fact that it is largely domestic and demand can vary significantly depending on the unpredictable effects of weather.
I know also that regulatory change is a challenge for you. As someone who spent many years advising businesses trying to plan investments and strategies, I appreciate the value of predictability and certainty in regulation. I am committed to trying to provide that as much as possible.
This is not easy, of course, given the challenges that face us. We must implement a significant change to the regulatory landscape, and that is, to bring oversight and transparency to the over-the-counter swaps market. This is a market that became global before it was regulated. As with the futures market which we have traditionally overseen, the swaps market has served the needs of commercial end users very well. But we saw in 2008 how certain parts of the swaps market generated excessive risks that were not well understood, and that contributed to the intensity of the worst financial crisis since the Great Depression. Our country lost eight million jobs and thousands of businesses were shuttered. I spent five years helping our nation recover from that crisis. It staggers my mind, even today, that the U.S. government had to commit $182 billion to prevent the collapse of one company, AIG, as a result of its excessive swap risk.
Commercial end users were not responsible for that crisis. And our challenge today is to implement this new regulatory framework in a way that achieves the important goals of bringing some transparency, sensible oversight, and prevention of excessive risk, while making sure that these markets still function effectively and efficiently for the many commercial firms that depend on them. After all, that should be the ultimate purpose of the derivatives markets – to help commercial companies manage their risks.
Today I want to discuss a few of our priorities and some of the specific agenda items we are working that I believe will be of particular interest to you. First, I’d like to briefly review some of the steps we have taken to address the concerns of commercial end users. Then I want to discuss our work in finishing the rules that Congress has required we implement; in particular with respect to position limits. And finally I would like to discuss the issue of benchmarks and price indices. I then would be happy to take your questions.
Addressing Concerns of Commercial End Users
One of my priorities since taking office has been to address concerns of commercial end-users, to make sure they can continue to hedge risk effectively in these markets. We have taken several actions in this area. Let me note some specifics.
Embedded Volumetric Optionality: Last month, the Commission voted to finalize a proposal we made in November regarding contracts with embedded volumetric optionality – a contractual right to receive more or less of a commodity at the negotiated contract price. Specifically, we proposed to clarify when a contract with embedded volumetric optionality will be excluded from being considered a swap. I know contracts with this feature are important to many of you.
Trade Options: Also last month, the Commission voted to issue a proposed rule revising the rules regarding trade options, which are a subset of commodity options. Among the changes we have proposed is to eliminate Form TO, which will reduce reporting burdens. These products are commonly used by commercial participants, so this action should help those participants continue to do so cost-effectively.
Utility Special Entities: Last fall, we made it easier for local utility companies to access the energy swaps market. These companies, which keep the lights on in many homes across the country, must access these markets efficiently in order to provide reliable, cost-effective service to their customers.
Reporting of Illiquid Swaps: CFTC staff also granted relief from the real-time reporting requirements for certain less liquid, long-dated swap contracts—specifically long-term jet fuel swaps. The staff did so because it recognized that in a very illiquid market, immediate reporting can undermine a company’s ability to hedge.
Treasury Affiliates: The Commission staff has also taken action to make sure that end-users can use the Congressional exemptions given to them regarding clearing and swap trading if they enter into swaps through a treasury affiliate.
Customer Protection/Margin Collection: In March, the Commission unanimously approved a final rule to modify what is known as our “residual interest” rule. This rule can affect when customers must post collateral with clearing members.
Special Calls: The Commission also recently revised its procedures concerning special calls. We actually make two types of requests for information that are called special calls. Some are truly special – infrequent requests triggered by unusual market activity or some other event observed by our surveillance team. Another is a more routine request automatically triggered when a market participant trades above set levels, in which case we ask for very limited information to help us reconcile transactions with position data. We discovered our system for making these latter requests was generating too many of them. So we notified some who received these requests that they did not need to complete them, and we made adjustments to fix the problem going forward.
We have also worked with FERC to exempt from our regulations several electric industry participants—that is, regional transmission organizations and independent system operators—because they are already subject to FERC regulation.
And we have proposed to modify reporting and record keeping requirements for commercial end-users.
We will continue to look at ways that we can make sure commercial end-users can use these markets effectively and to make sure that the new regulatory framework for swaps does not impose unintended consequences or burdens for them.
Finishing the Remaining Rules
Another priority is finishing the few remaining rules required under Dodd-Frank for the new swaps regulatory framework. Our proposed position limits rule is one.
Regarding position limits, the law mandates that the agency adopt limits to address the risk of excessive speculation. A rule was proposed by the commission in the fall of 2013. And it is the task of the current commission—three of us have joined since that vote—to adopt a final rule.
Now I first want to emphasize the phrase “excessive speculation.” We recognize these markets depend on speculators. Our responsibility is to address excessive speculation.
This is not a new concept. Let’s remember that our markets have had position limits in place for many years. We have had federal limits for 9 agricultural commodities for decades, and exchange-imposed limits in other commodities.
So we are directed by Congress to extend the federal scheme to other commodities, most or all of which are currently subject to exchange limits. In doing so, we are considering several important issues. First, we must make sure that market participants can engage in bona fide hedging.
We have received substantial public input on this issue, as well as all aspects of this proposal. I know all four commissioners recognize the importance of this issue. It is vital that commercial end users be able to engage in bona fide hedging. We recognize hedging strategies are varied and complex, and we are considering these comments carefully.
In this regard, it has been suggested that we rely on the exchanges with respect to the review of applications for what are known as “non-enumerated” exemptions. We are taking a closer look at this issue. We should consider whether we can design a satisfactory process that relies on the exchanges to grant timely exemptions. We would need to have standards to insure our regulatory goals are met. We would need to have a review process so that the Commission could review the determinations of the exchanges. We would need to have adequate disclosure and transparency. But if those goals can be met, such a process might help achieve efficiency while still insuring accountability and transparency.
Another important issue is how we set the limits in the first place. And in setting the limits, it is important that we have accurate estimates of deliverable supply of a commodity. We have therefore solicited and received public input on this issue. We have received from exchanges, for example, estimates for many commodities at issue. And in setting the limits, we set forth in the proposed rule a few different options that we are considering.
In short, let me just say that this is a complex rule, and we intend to take the time necessary to get it right.
We are also working to finish our proposed rule on margin for uncleared swaps. This would require swap dealers to post and collect margin from their counterparties on uncleared swaps, much as is required on cleared swaps. It is designed to help reduce the risk of those trades and so reduce the risk to our financial system as a whole. I want to highlight that our proposed rule does not require swap dealers to collect margin from commercial end-user counterparties. We know commercial end-users do not pose the same risk as large financial institutions.
I also want to note an upcoming issue on a completed rule. As you know, under the swap dealer rules adopted in 2012, the threshold for determining who is a swap dealer will decline from $8 billion to $3 billion in December of 2017 unless the Commission takes action. I believe it is vital that our actions be data-driven, and so we have started work on a comprehensive report to analyze this issue. We will make a preliminary version available for public comment, and seek comment not only on the methodology and data, but also on the policy questions as to what the threshold should be, and why. I want us to complete this process well in advance of the December 2017 date so that the Commission has some data, analysis, and public input with which to decide what to do.
Regulation, Costs, and Liquidity
Let me add that as we think about the swap dealer de minimis rule and the margin for uncleared swaps rule, we are thinking about the implications for the costs of transactions and for liquidity in our markets. We recognize, for example, that while the margin rule for uncleared swaps exempts commercial end users, it is still relevant to them insofar as it may affect the cost of doing business for swap dealers. And the same is true with the swap dealer de minimis threshold. We are attentive to the effects of regulation on costs and liquidity in other areas as well. For example, we are discussing with bank regulators the implications of the supplemental leverage ratio or SLR on the costs of clearing. I am concerned that the manner in which the SLR treats segregated cash margin creates a disincentive to clearing.
Issues of the effect of regulation on cost and liquidity are complex subjects, beyond what I can cover today. I will just note that when we consider a subject like liquidity, we need to look at many factors, for regulation is just one change in our markets. There have been many other important changes in market structure. For example, some have noted the decline in the number of clearing members or futures commission merchants, in the last few years as perhaps a consequence of regulation. But in fact, the number of FCMs has been declining pretty steadily since 2005. We are taking a close look at this, and I think there are many factors causing the trend. One thing we have noted is much of the decline occurred among firms that didn’t handle customer funds. We have also seen changes in market structure due to electronic and in particular automated trading. The percentage of trades in Henry Hub natural gas futures contracts that is conducted by automated trading on at least one side is about 80%; the figure is around 40% for both sides of the trade. We are also currently considering the implications of automated trading.
So my point today is simply that the issues of market liquidity deserve our attention, but we must recognize that there are many factors at play here.
Finally, I want to discuss the issue of benchmarks which has been the focus of enforcement activity and important policy concerns as well. While our enforcement activity has focused on financial benchmarks, the policy concerns I want to discuss pertain to benchmarks across the board, including those in the energy industry.
We have brought a number of enforcement actions over the last few years regarding manipulation of benchmarks, such as foreign exchange, LIBOR, and now last week, ISDA FIX. Last week, for example, we, together with the Justice Department and other authorities, announced settlements with five major banks imposing penalties and remedial measures for their attempted manipulation and false reporting of global foreign exchange benchmark rates. We brought a similar case against five other banks a few months ago.
Concurrently with last week’s foreign exchange case, we imposed fines and remedial measures on one of the banks, Barclays, for similar misconduct in regard to the U.S. Dollar International Swaps and Derivatives Association Fix or ISDA FIX, a key interest rate benchmark. We found that, beginning at least as early as January 2007 and continuing through June 2012, Barclays traders attempted on many occasions to manipulate the fixing price, and made false reports concerning it. This is the first enforcement action addressing abuses of this benchmark.
We have also brought several cases against banks for manipulation and attempted manipulation of LIBOR. As you know, LIBOR is used for a wide variety of financial contracts. The process for setting LIBOR was based on submissions by banks, but these banks were changing their submissions in order to benefit their own proprietary positions or protect their reputation. The CFTC brought the first case involving LIBOR manipulation in June 2012, and this is the sixth large bank against which we have settled such charges.
The need for integrity when it comes to the administration of benchmarks is critical. I want to talk for a minute about the approach being considered in Europe and its implications for our markets. In Europe today, legislation is being considered that could effectively require government oversight of benchmark administrators. This legislation could prohibit European banks and asset managers from trading products in our markets that are tied to benchmarks, unless the European Commission determines that the benchmarks are supervised in an equivalent manner.
Now as you may know, there are thousands of contracts in our markets that rely on benchmarks or other indices. These range from the S&P 500 to the many benchmarks in the energy markets put out by third parties such as Platts or Argus. The United States does not have a government-sponsored supervisory regime for benchmarks. That’s simply not how our system works.
I have expressed these concerns to European officials. I have encouraged them to recognize that alternatives to government regulation of benchmarks can achieve the results they desire. For example, our law gives us the power to review new proposed contracts and determine whether they may be susceptible to fraud and manipulation, and we can engage in surveillance and enforcement on an ongoing basis to identify and deter manipulation.
I have also encouraged European officials to consider the work of the International Organization of Securities Commissions (IOSCO) in this area, which the CFTC helped lead. IOSCO’s Principles for Oil Price Reporting Agencies (PRA Principles) and Principles for Financial Benchmarks set forth standards that address methodology, governance, conflicts of interest, and disclosure. The oil price reporting agencies have been voluntarily complying with these standards.
I have suggested they consider focusing their standards on those benchmarks that are most widely used, so that smaller contracts are not subject to costs of compliance that could be prohibitive. It is especially important that we do not inhibit innovation in our markets by imposing upfront, significant costs for regulatory compliance regarding benchmarks before a contract has even developed significant liquidity.
The integrity of benchmarks and indices is vital to our financial system. I hope that we can continue to work with our international counterparts to ensure benchmark integrity in a way that recognizes that most benchmarks are not administered by, or regulated by, a government agency.
The energy commodity markets are global and complex. Prices in these markets are important metrics that can profoundly impact our economy. I know you face daily, difficult challenges managing risk in these markets. I believe our job at the CFTC is to create a regulatory framework that helps you manage risk by promoting transparency, integrity, and regulatory certainty. I welcome your input as we continue to work toward those goals.
Thank you for inviting me. I would be happy to take some questions.
Last Updated: May 26, 2015