Oral Testimony of James E. Newsome before the
U.S. Senate Committee on Energy and Natural Resources

January 29, 2002

Thank you, Chairman Bingaman, and members of the Committee. I appreciate the opportunity to testify on behalf of the Commodity Futures Trading Commission. I would like to say first -- as a regulator and as a citizen -- that I have great sympathy for the people who are harmed by incomplete and inaccurate financial information. I share the concern of many that appropriate inquiries be made to ensure that investors, creditors, and others who rely on the accuracy of financial disclosures by publicly-held companies can continue to do so with the fullest confidence. I commend the Securities and Exchange Commission for having opened an investigation into these matters.

I would also like to take a moment to commend Mr. Viola and everyone at the New York Mercantile Exchange, as well as at the New York Board of Trade, for their remarkable reactions to the September 11th attacks. Their courage, tenacity, and foresight in restoring market operations in the face of unprecedented challenges and terrible personal tragedies deserve the gratitude of every business, investor, and consumer because these markets play critical roles in the economy. The fact that NYMEX and NYBOT were up and running within only days of the attacks helped avert the possibility of further economic disruptions and should give us all great confidence in the resilience and strength of these institutions.

I would like to tell you today about the important role of the futures markets in our economy and the role of the CFTC in overseeing those markets, particularly with respect to the energy markets and how that role changed with passage of the Commodity Futures Modernization Act. I will describe how we responded to the Enron situation last fall and would like to finish with some thoughts on how the Commission might contribute as we move forward.


The Commission perceives its mission as twofold: to foster transparent, competitive, and financially sound markets, and, to protect market users and the public from fraud, manipulation, and abusive practices. While the stock markets provide a means of capital formation, a way for new and existing businesses to raise funds, the futures markets provide producers, distributors, and users of commodities with a means to manage their exposure to commodity price risk. Futures contracts based on non-agricultural physical commodities like metals or energy products and on financial commodities like interest rates, foreign currencies, or stock market indices now serve the risk management needs of businesses in so many sectors of the economy that trading in these newer contracts is now nine times that in agricultural contracts.

Although the primary purpose of the futures markets is risk management, many futures markets also play an important price discovery role in which many businesses and investors that are not direct participants in futures nonetheless refer to the quoted prices of futures market transactions as reference points or benchmarks for other types of transactions and decisions.

How the CFTC Performs Its Mission

To fulfill its mission, the Commission focuses on issues of market integrity and pursues a multi-pronged approach to market oversight. We seek to protect the economic integrity of markets against price manipulation through direct market surveillance and oversight of the exchange’s surveillance efforts. The heart of our direct surveillance is a large-trader reporting system, under which commodity brokers (called futures commission merchants or FCMs) and foreign brokers file daily reports with us that aggregate positions across FCMs and accounts to give a truer view of large trader presence. Commissioners are apprised of market activity and possible problems at weekly surveillance meetings. If attempted manipulation is indicated, our Enforcement Division aggressively prosecutes violations of the Commodity Exchange Act.

In protecting the financial integrity of the markets, our priorities are to avoid disruptions of the clearing and settling system and to protect customer funds entrusted to FCMs. As an oversight regulator, the Commission reviews the audit and financial surveillance work of the exchanges and also monitors the health of FCMs directly. We also review clearinghouse procedures for monitoring risks and protecting customer funds. And the Enforcement Division investigates and prosecutes FCMs alleged to have violated capitalization requirements or to have committed compliance failures in the handling of customer business.

To protect the operational integrity of the markets, the Division of Trading and Markets requires extensive recordkeeping, proper customer disclosures, fair sales and trading practices, and appropriate training of industry professionals. The Enforcement Division prosecutes trade and sales practice abuses against customers.

CFTC’s Role in Energy Markets and Response to Enron Situation

We oversee on-exchange trading of futures and options contracts based on such things as crude oil, natural gas, heating oil, propane, gasoline, and coal. The overwhelming majority of on-exchange energy transactions are executed on NYMEX. Please note that the CFTC does not regulate trading of energy products on the spot (cash) or forward markets, which are excluded from our jurisdiction by the Commodity Exchange Act.

Because Enron was a large trader on the NYMEX, its on-exchange activities have been regularly monitored by our staff. At this time, we have no indication that manipulation of any futures market was attempted by Enron. However, the rapid financial deterioration of Enron presented a separate concern for the Commission: Could its positions be unwound without price volatility or reduced liquidity? In fact, these markets proved to be quite resilient. When Enron’s positions were closed out, prices did not spike up or down nor did liquidity dry up.

When Enron’s financial troubles became known last fall, staff from our Division of Trading and Markets worked closely with the NYMEX clearinghouse and the FCMs that were carrying most of its positions to monitor and manage the winding down of those positions. By adjusting margins and other appropriate measures the clearinghouse was able to accomplish a very smooth landing while protecting the FCMs and their other customers. By mid-December, all of Enron’s positions on the regulated exchanges had been liquidated. I believe that this episode was a success for the system of financial controls in the on-exchange futures markets.

How the CFMA Changed Things

In 1999, the President’s Working Group on Financial Markets released its report on over-the-counter derivatives, which recommended providing legal certainty for off-exchange derivatives transactions. Congress considered these recommendations and ultimately codified many of them, together with substantial reforms of the regulatory regime for exchange-traded futures, in the Commodity Futures Modernization Act of 2000.

With respect to energy-based futures, the CFMA exempted two types of markets from much of the CFTC’s oversight. The first is bilateral, principal-to-principal trading between two eligible contract participants, which include sophisticated entities such as regulated banks or insurance companies and well-capitalized companies or individuals (for example, those with assets of at least $10 million). The second is electronic multilateral trading among eligible commercial entities, which include eligible contract participants that can also demonstrate an ability to either make or take delivery of the underlying commodity and dealers that regularly provide hedging services to those with such ability.

Suggestions on Moving Forward

I would like to first note that the CFTC, as part the President’s Working Group, is now participating in a study of corporate disclosure issues that may yield valuable suggestions for how both industry and the government may seek to prevent repeats of the Enron situation. Within the Commission, we have proposed a reorganization of the CFTC that will consolidate our market oversight functions into one division to help improve an already excellent program.

Mr. Chairman, as a regulator, I believe that it is important to constantly review current policies and procedures, especially given today’s dynamic marketplaces, to ensure that appropriate levels of regulation are maintained. The significance of the Enron situation and its ramifications generally deserve study and recommendations for improvements. Some of these responses will come from the Congress, others from regulators, and still others from the industry. Having said this, I was a supporter of the CFMA because I sincerely believed that a one-size-fits-all approach to regulation was outdated, especially with all of the business and technological innovations that we have seen in recent history.

Tailoring regulations to the nature of the participant, the product, and the facility on which it is traded seemed, in my view, to be appropriate concepts on which to define a federal regulatory interest. To date, I have seen no evidence to the contrary. However, we will continue to monitor the markets within our jurisdiction, and we will continue to utilize all authorities given to us by the Congress to aggressively pursue CEA violations.

The Commission stands ready to work with this Committee, the Congress, other regulators, and the industry to find appropriate responses. Thank you for the invitation to appear before your Committee. I will be happy to answer any questions you may have.