Testimony of James E. Newsome, Chairman
of the Commodity Futures Trading Commission
before the U.S. Senate Committee on Agriculture, Nutrition and Forestry

July 10, 2002

Thank you, Chairman Harkin, Ranking Member Lugar, and Members of the Committee for the opportunity to testify before you today. I would like to provide you with updates on several important topics, including the Commission’s progress in working with the SEC to permit the trading of security futures and in implementing the important anti-money laundering provisions of the Patriot Act. First, however, I would like to directly address certain issues regarding U.S. energy markets.

As you know, the Commission is an independent federal regulatory agency, whose mission is to oversee the futures and options markets in the United States. We take very seriously our mission to ensure that these platforms provide safe, sound and transparent markets for risk management and price discovery for a variety of commodities, including agricultural, financial, metal and energy products.

The energy markets are among the largest and most dynamic in the United States. Hundreds of billions of dollars in energy products - which would include electricity, natural gas, crude oil, and gasoline - are traded each year in the United States – both on-exchange and in the over-the-counter (OTC) Markets. The Commission regulates the on-exchange futures and options energy markets, which provide significant risk management and price discovery functions for both retail and institutional investors. Energy products are primarily traded on the New York Mercantile Exchange, which is registered with the Commission.

There is also significant trading in energy products in the OTC markets. As a general matter, the Commodity Futures Modernization Act of 2000 (CFMA) provided legal certainty for OTC trading in exempt commodities – such as energy products. In addition, the CFMA promoted the growth of electronic trading systems for these commodities. The level of Commission involvement in the OTC markets was tailored to the nature of the participants and commodities. The OTC markets in energy products are generally restricted to very large institutional investors. The CFMA authorized the Commission to investigate and prosecute fraud and manipulation in exempt commodity markets, with some limited exceptions. EnronOnline operated an electronic trading platform, which accounted for a sizable percentage of the OTC energy product market. It was not registered with the CFTC.

We are all well aware of the tragedies that occurred last fall surrounding the collapse of Enron. For instance, there have been numerous stories in the press regarding allegations of manipulations in energy markets. I would like to take a few minutes today to talk about these issues as they relate to the jurisdiction of the CFTC, and let you know what it is that we are doing to fulfill our obligations and responsibilities in these areas.

Currently, we are in the process of pursuing a comprehensive, detailed investigation of allegations raised by the Enron collapse, and we will aggressively continue such investigative efforts to detect and deter any illegal conduct in the markets we oversee.

Albert Einstein once said, “If you have seven days to solve a problem, spend six of them defining it.” From the beginning of the discussions on these energy issues, my position has been that we need to find the “facts” first, before proposing or supporting a “solution.” My position has not changed.

Allegations have been made that Enron and others manipulated the West Coast and California energy markets. These are serious allegations. Not only are they serious, they are jurisdictionally complex, potentially involving multiple regulatory authorities coordinating their differing jurisdictions. We are working actively with other authorities, cooperatively and aggressively, to pursue any and all allegations that are within our jurisdiction.

I have put the full resources of our Commission behind this investigation in order to make the appropriate determinations regarding whether or not illegal activity within our jurisdiction occurred. If indeed that proves to be the case, we will prosecute the wrongdoers to the fullest extent possible. I commit to keep you informed of our progress as we pursue this complex and wide-ranging investigation and I ask for your patience while we do so.

Looking beyond our energy investigations, I am happy to report that trading volumes show that the commodity futures and options markets continue to grow in their importance as providers of unique risk management tools and as a means of price discovery. Last year represented another record year for U.S. futures volume, up 60% over the prior year. Indeed, trading quadrupled over the last ten years. Remarkably, September 11th had no sustained impact on volume, which was already surging by September. In fact, September volume was almost normal, even on the New York exchanges, which I attribute to the foresight, resourcefulness, and tenacity of everyone at the New York Board of Trade, the New York Mercantile Exchange, and the hundreds of firms trading there who got these markets back up and running even before the stock markets resumed trading.

I am also happy to report substantial progress by the Commission in implementing the Commodity Futures Modernization Act. A great deal of rule modernization work was accomplished last year to implement those provisions of the new law regarding exchanges and clearinghouses. But that was only the first step.

Security Futures:

I can now report that the Commission has adopted all final rules, including margin rules, necessary to permit domestic trading in security futures without further delay. I expect that the SEC will act on the margin rules very shortly. This has been a challenging process. Each agency has its own unique oversight tradition, applicable to the very different needs of the capital formation markets and the risk allocation markets under our respective jurisdictions. But I believe that the structure agreed upon, though perhaps not ideal from any single perspective, is fair and workable. I also believe that it faithfully adheres to Congress’ intent. I appreciate the guidance and assistance that this Committee and its staff provided and I am looking forward to completing the foreign participation aspect in the very near future. I hope that you share my great interest in seeing how and by whom these important new risk management products will be utilized.

Intermediaries Study:

Of course, permitting the trading of security futures was only one aspect of the CFMA. The CFMA also mandated a review of rules affecting futures commission merchants and other types of intermediaries that play such important roles in the futures markets. Although the events of last fall changed everyone’s priorities for a time, the Commission has completed its study of intermediary rules -- following months of soliciting public input through interviews, written comments, and a public meeting -- and submitted that study to Congress. We will soon host several roundtables on related issues and I look forward to working with this important segment of the futures industry to develop appropriate rule revisions and potential legislative recommendations.

September 11th Responses:

In the wake of September 11th, the Commission and other financial regulators were charged implementing important anti-money-laundering provisions of the Patriot Act. We have worked closely with the Treasury Department, other regulators, and the futures industry to fulfill this national responsibility. The Commission has already approved a rule on customer identification requirements that has been sent to Treasury for its joint approval. We are finalizing another rule on suspicious activity reports from futures commission merchants and introducing brokers, which we plan to share with Treasury later this week.

Implementing relevant provisions of the Patriot Act was just one of the challenges and new responsibilities that faced the Commission in the wake of the attacks. As you know, our New York Regional Office was located on the 37th floor of 1 World Trade Center. Thankfully, all of our employees escaped without major physical injury. Using backup systems and with help from staff of the Chicago Regional Office and D.C. headquarters, we provided ongoing surveillance of the markets in the hours and days immediately following the attack. The Commission worked steadily to fully reestablish its permanent presence in New York City and earlier this year moved back into permanent space in Lower Manhattan from temporary quarters in Jersey City, New Jersey. The Commission and its staff are particularly appreciative and grateful for the assistance of Congress in securing the supplemental funding we needed to recover.

Two of the four largest commodity futures exchanges regulated by the CFTC were also based in Lower Manhattan: the New York Board of Trade and the New York Mercantile Exchange. Both were drastically impacted on September 11th and trading did not resume on either exchange for several days. Other futures exchanges, in Chicago and elsewhere, were impacted by events in New York, particularly by the closing of the stock markets, and experienced temporary interruptions in trading.

But in its preparedness and by its responses to this unprecedented disaster, the futures industry demonstrated foresight, resilience, and determination. Steady leadership, thoughtful contingency plans, prudent investments in redundant facilities and backup systems, the ingenuity of technical staffs, and the courage and tenacity of everyone in the industry, made possible a remarkably fast and effective resumption of trading, restoring for the U.S. economy rapid access to risk management and price discovery tools uniquely provided by the futures industry. The Commission, in coordination with local authorities, other federal regulators within the President’s Working Group on Financial Markets, the Congress, and the White House, strove to assist the industry in restoring operation of these important markets. In order to memorialize the lessons learned and to spark discussion within the industry on how to better prepare for future disasters we hope never to face, the Commission completed a detailed report on both its own and the industry’s efforts to recover from the attacks.

Internal Challenges:

As busy as this Commission has been with our efforts to fully implement the CFMA, and with unforeseen challenges like September 11th and Enron, we have also been hard at work transforming the CFTC into what I believe everyone will come to recognize as a more efficient, responsive, and effective oversight regulator that is well structured to properly oversee trading in the many innovative products and platforms that I believe will flourish under the CFMA. On July 1st, we officially replaced the Division of Economic Analysis and the Division of Trading and Markets with the Division of Market Oversight and the Division of Clearing and Intermediary Oversight. We have also added a new Office of the Chief Economist. The Offices of Public Affairs and Legislative and Intergovernmental Affairs have been combined to form the new Office of External Affairs. Each new leadership position is now filled by an experienced professional.

However, we continue to face a serious challenge in attracting and retaining the type of highly skilled and experienced staff needed to operate effectively with our new regulatory mandate under the CFMA. With that mandate, the Commission is moving from the role of a front-line regulator to a more flexible oversight role. Some might believe that, in this new capacity, the agency will need fewer resources than in the past. Just the opposite is true. The CFMA has opened the way for innovation that is creating new financial products and new trading platforms and also permitting the clearing system to respond in kind. I believe we have seen only the beginning of this exciting process.

Although this growth and innovation in the marketplace promises to provide real benefits to market participants and the economy as a whole, it also places increasingly greater demands on the resources of the Commission because our primary responsibilities have not changed. With new exchanges and alternate trading platforms, there is no longer a “template” to follow; rather, oversight must be tailored to fit a variety of markets along a spectrum of regulatory classifications from basic fraud and manipulation protections to full oversight. To continue to fulfill our mission to promote markets that are free from congestion or manipulation and to protect market participants from fraud and abusive practices, we must have staff with the proper training and with solid experience in the markets we oversee.

All too often, however, we lose good people just as they are coming into their own as commodity lawyers, economists, and trading specialists. Our turnover rate is more than twice the federal average. In most, if not all, cases the CFTC’s ability to compensate such highly skilled people lags not only far behind that of the private sector, but also well behind that of the other federal financial regulators, where turnover rates are significantly lower. Until recently, we were the only financial regulator still subject to the pay restrictions of Title V. While we are immensely grateful to the House and Senate for working so hard to successfully provide the Commission with a pay parity provision in the farm bill and we hope you will provide funding to fully implement this provision.

I thank you for the opportunity to testify today and will be happy to answer any questions you may have.