Testimony of
Thomas J. Erickson, Commissioner

Commodity Futures Trading Commission


Committee on Agriculture, Nutrition, and Forestry

United States Senate

July 10, 2002

Chairman Harkin, Senator Lugar, distinguished members of the Committee, thank you for this opportunity to testify before you today. I have been asked to comment on three issues: the scope of the existing regulatory authority of the Commodity Futures Trading Commission (CFTC or Commission) over markets in over-the-counter (OTC) derivatives; the need for increased Commission authority to prevent fraud and manipulation; and legislative proposals pending before the Senate that would address any deficiencies.

The CFTC’s Role in Oversight of OTC Derivatives

Any discussion of the CFTC’s present jurisdiction must begin with an understanding of the effect of the Commodity Futures Modernization Act of 2000 (CFMA)[1] on the regulatory framework previously applied to derivatives markets. Passage of the CFMA in December of 2000 brought sweeping change to the regulation of derivatives in the United States – both on- and off-exchange. Nowhere was the change in the law more dramatic than in its effect on OTC derivatives, more commonly referred to as swaps.

Prior to the amendments of the CFMA, the Commodity Exchange Act (Act)[2] applied equally to all commodity derivative transactions. Many of the CFMA’s changes to the Act were based on the recommendations of the President’s Working Group on Financial Markets (PWG).[3] The PWG Report recommended that bilateral transactions in financial commodities between sophisticated counterparties be excluded from the CFTC’s jurisdiction for two reasons: first, because most of the market participants were otherwise regulated by at least one of the federal financial regulators;[4] and second, because the financial markets, such as those in interest rates, were too deep and liquid to be readily susceptible to manipulation.[5] The members of the PWG stated that the same case could not be made for physical commodity markets.[6] Accordingly, the PWG did not recommend any change in the oversight of physical commodity market transactions.

The CFMA adopted a variant of the PWG recommendations and created three categories of commodities. Each category defines the CFTC’s regulatory interest in derivative instruments, including swaps. Generally, under the CFMA financial commodities are excluded from the CFTC’s jurisdiction;[7] agricultural commodities are included in the CFTC’s jurisdiction;[8] and all other commodities – including energy and metals – are exempted from the CFTC’s jurisdiction.[9] What this means in application is not so simple.

In part, the complexity stems from the fact that the regulatory framework hangs on the distinction between “excluded” and “exempted” commodities. An excluded commodity, transaction, or market indicates that the Commission has no jurisdictional interest. An exempted commodity, transaction, or market, meanwhile, means that the Commission retains a jurisdictional interest, but that the law limits its application.

Ostensibly, under the CFMA, the CFTC retains anti-fraud and anti-manipulation jurisdiction over exempt commodities.[10] However, through other provisions in the law, the vast majority of OTC swap transactions in energy and metal commodities become excluded.[1] As a result, they are not subject to the Commission’s fraud or manipulation authorities. Not only do these transactions fall outside the jurisdictional reach of the CFTC, but in most cases, they are beyond the reach of any other federal financial regulator.

The Case For Restoring Fraud and Manipulation Authorities Over Swap Transactions in Exempt Commodities

Thus, we have a gap in the oversight of exempt commodity transactions. And plainly, this gap was not something the PWG intended when it made recommendations in its 1999 report. First, the report stated that exclusion was warranted where most market participants were otherwise overseen as financial institutions by a federal financial regulator. I do not believe that any of the entities currently under scrutiny in the energy markets is overseen as a financial institution by any of our federal financial regulators. Second, the PWG concluded that physical commodity markets were more susceptible to manipulation. Allegations of manipulation in energy markets certainly support this conclusion. Third, despite the conclusions of the PWG Report, under the CFMA virtually all OTC transactions in exempt commodities are excluded from the anti-fraud and anti-manipulation provisions of the Act.

The gap creates a conundrum. On the one hand, the Act expects full prosecution of manipulations of exempt commodities in regulated exchange markets. On the other hand, the regulatory regime in place today turns a blind eye to the manipulation of these very same commodities, if effected through OTC derivatives transactions. I cannot believe this was the intended result of the CFMA.

From a practical perspective, the Commission’s own experience has yielded some significant results in this area – results that would be difficult, if not impossible, to replicate under current law. For example, the Commission in 1998 reached a settlement with Sumitomo Corporation for the manipulation of global copper prices.[12] The Commission found that the manipulation imposed enormous costs on traders, manufacturers, retailers, and consumers of copper. More recently, the Commission settled with Avista Energy, Inc. for the manipulation of electricity futures.[13] Interestingly, the Commission found that the manipulation created artificial settlement prices in futures contracts and was done to enhance the value of Avista’s OTC swap positions.

I am skeptical that the Commission could replicate these cases in today’s market environment. As the Avista settlement underscores, commodity markets – cash, futures and options, and OTC swaps – are increasingly linked. We now know that wash transactions in unregulated swaps occur, and in certain cases send price signals that raise manipulation concerns. Thus, if we are serious about detecting and deterring fraud and manipulation, these authorities must apply to all derivatives transactions.

Derivatives markets bring unquestionable efficiencies to cash commodity markets. The consequent benefits extend not only to market users, but also to consumers. Thus, I believe that if Congress were to restore to the Commission its fraud and manipulation authorities, it must also provide the Commission with the tools to enforce these authorities. Derivatives marketplaces like electronic swap exchanges should adhere to certain, minimal regulatory obligations: among them are transparency, disclosure, and reporting.

Our experience with the futures markets has shown us that measures designed to increase market transparency instill confidence in markets, attract speculative liquidity, and increase market integrity by providing regulators with the means to monitor for fraud and manipulation. I believe application of these principles to derivatives markets generally is sound public policy, prudent business practice, and common sense. Unfortunately, we are presently witnessing some of the best arguments in favor of such changes.

U.S. energy markets are suffering a crisis in confidence. Six months ago we could define the scope of the crisis by the tens of millions of energy consumers in western states who believed the markets had been manipulated. To date, none of our federal regulators have been able to assure them that this was, or was not, the case, and it is not even clear which regulator should be answering the question. More recent revelations of wash sales by numerous commercial market participants have expanded the scope of this crisis – eroding the trust and confidence firms have in each other. In this environment, liquidity dries up and the market efficiencies created by all derivatives are put at risk. I believe this crisis in confidence is shaking the very foundation of our energy markets. Modest legislation is a good first step toward restoring this lost confidence and returning energy markets to a path of growth and efficiency.

Legislative Solutions

The only legislation that I am aware of pending before the Senate is that introduced last spring by Senator Feinstein, so I will limit my comments to that bill. Generally, the legislation would address the essential concerns I have outlined in my testimony. Moreover, the bill hews more closely to the recommendations of the President’s Working Group on OTC derivatives, as well as many of the expressed concerns of this Committee during the consideration of the CFMA. Could it do more? Certainly. Is it the right thing to do? Absolutely.

Ultimately, Senator Feinstein’s bill is pragmatic. It recognizes the benefits of market innovation by preserving the long-sought legal certainty for swaps – they remain for the most part “exempt” from CFTC jurisdiction. At the same time, however, the bill ensures that all derivatives transactions are subject to the Commission’s fraud and manipulation authorities. It would not require the registration of swap counterparties, but would require that they maintain books and records of transactions – something that should be routine practice in the industry. Finally, the legislation recognizes that all exchange markets serve price discovery and hedging purposes by imposing modest transparency, disclosure, and reporting obligations.

It is interesting to note that if EnronOnline were to have been operated by a bank, its risk exposures would have been reported to the banking regulators. Moreover, those regulators would have the authority to impose capital requirements on the market. The government, I believe, must be consistent in its expectations. Senator Feinstein’s bill embraces competitive markets in the context of consistent government standards. Enron and companies like Enron should have every right to establish markets and compete with banks, broker-dealers, and exchanges for market share. But if the right policy answer is that markets should be overseen, then all markets should be accountable to a federal financial regulator.


Consumers are the ultimate beneficiaries of properly functioning derivatives markets, whether those markets are private – like EnronOnline – or public – like the New York Mercantile Exchange. By the same token, consumers are the ultimate victims when markets are manipulated, or otherwise affected by unlawful behavior.

Whether there is ever anything found in current investigations of energy markets is irrelevant. We have a hole in our regulatory regime that allows for fraud and manipulation to operate free from sanction. We have markets experiencing a crisis in confidence. Modest legislation amending the commodities laws is appropriate in my view to restore confidence and build integrity.

Thank you for this opportunity to appear before you. I look forward to your questions.

[1] Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).

[2] 7 U.S.C. 1 et seq.

[3] Report of the President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (November 1999).

[4] Id. at 16. Federal financial regulators include the Federal Reserve Board of Governors, the Department of the Treasury, the Securities and Exchange Commission, and the Commodity Futures Trading Commission.

[5] Id.

[6] Id. (stating, “Due to the characteristics of markets for non-financial commodities with finite supplies, however, the Working Group is unanimously recommending that the exclusion not be extended to agreements involving such commodities.”).

[7] 7 U.S.C. 1a(13) and 2(d).

[8] Agricultural commodities are neither excluded nor exempted under the Act, and thus remain within the exclusive jurisdiction of the CFTC.

[9] 7 U.S.C. 1a(14) and 2(h).

[10] Section 2(h) of the Act affirmatively retains fraud and manipulation authorities over exempt commodities.[]

11 Section 2(g) of the Act excludes from Commission jurisdiction all swaps except those in agricultural commodities. Thus, swaps in exempt commodities are, in fact, excluded from CFTC oversight. In short, the exclusion trumps the exemption. Moreover, Section 2(e) of the Act excludes, among other things, electronic trading facilities engaged in trading swaps – whether through bilateral or multilateral exchange markets. Thus, by dint of the type of trading platform, another exclusion is effected.

[12] In re Sumitomo Corp., [1996-1998 Transfer Binder] Comm. Fut. L. Rep. (CCH) 27,327 (CFTC May 11, 1998) (finding that Sumitomo engaged in a scheme to manipulate the price of copper through actions taken on the London Metals Exchange, which caused artificially high prices in cash and futures markets in copper, including those in the United States, and assessing a $125 million civil monetary penalty).

[13] In re Avista Energy, Inc., et al., [2000-2002 Transfer Binder] Comm. Fut. L. Rep. (CCH) 28,623 (CFTC August 21, 2001) (finding that Avista manipulated the settlement prices of the Palo Verde and California-Oregon-Border electricity futures contract in order to increase the company’s net gain on certain OTC options positions, whose value was based on the settlement prices at issue).