From the November 01, 2007 issue of Futures Magazine • Subscribe!

CFTC on borrowed time

Remember when the debate was “for” or “against” a single-line reauthorization of the Commodity Futures Trading Commission (CFTC)? Since 2005, the CFTC has been operating on a continuing resolution and the fears of those single line proponents, who warned against opening up a can of worms by making changes, have come true. And with Democrats taking over Congress, the push to give the CFTC more authority over energy has increased.

Senators Dianne Feinstein (D-Calif.) and Carl Levin (D-Mich.) both are proposing legislation that would require more uniform regulatory supervision of exempt commercial markets (ECM) and designated contract markets (DCM). That lack of consistency and the opportunity it creates for market manipulation was the subject of both a CFTC and Congressional hearing in late September.

Published in July, “Excessive Speculation in the Natural Gas Market,” the U.S. Senate Staff report from the Permanent Subcommittee on Investigations, detailed how hedge fund Amaranth Advisors LLP exploited the differences between the New York Mercantile Exchange (Nymex) regulatory responsibilities to the CFTC as a DCM, and the relative lack of regulatory control that the CTFC has over the Intercontinental Exchange (ICE), an ECM. When Amaranth traders reached speculative limits at Nymex, they simply moved the positions to the ICE. That was followed by charges of manipulation against Amaranth by both the CFTC and the Federal Energy Regulatory Commission (FERC), which raised jurisdictional issues for the regulators.

The problem, as identified in the report, is that “current law requires our regulators to oversee U.S. energy markets with incomplete information and inadequate authority,” and in this case resulted in a $6 billion loss by Amaranth, a disruption of the natural gas markets and higher prices for consumers.

“I see no evidence that the CFTC has done anything throughout this whole affair,” Feinstein said when introducing her legislation last fall. “We need transparency in and federal oversight of our energy markets.” Her bill would require ECMs to collect large position reports, deliver that data upon request to the CFTC, and for U.S. based energy traders to keep similar records and report large trades of contracts with U.S. based delivery.

At the CFTC hearing to examine trading on DCMs versus ECMs in mid September, Jeffrey C. Sprecher, chairman and CEO of ICE, said that for some contracts, such as ICE’s cleared OTC Henry Hub swap contract, which settles on the Nymex natural gas futures price, “a heightened level of DCM-like regulation, including heightened reporting and a system of position accountability may be appropriate.” But he adds that such a system would not be appropriate for most OTC markets, which he characterized as illiquid, thinly-traded niche products, as those more onerous requirements would result in less efficient markets and harm end users.

“Nymex believes that the [Commodity Exchange Act] should be amended to require routine mandated large trader reporting and position accountability requirements for financially settled ECM contracts that are highly linked to and functionally equivalent with regulated DCM contracts,” said James E. Newsome, Nymex’s president and CEO and primary rival to ICE. “Such ECMs also must be assigned self-regulatory organization duties to police their own markets and to submit applicable rule changes to the CFTC in a manner similar to other regulated entities.”

In his testimony, Craig Donohue, CEO of the CME Group Inc., said the distinctions between OTC and regulated exchange markets have “blurred to the extent that disparity of regulatory treatment is no longer justified.” Donohue favors an end to the ECM designation, a move that would add the cost and complexity of self-regulation to those companies currently operating as ECMs.

Richard L. Sandor, chairman and CEO of the Chicago Climate Exchange and an ICE board member, testified he opposes the elimination of the ECM category and says requiring all exchanges to earn a DCM designation would be so costly as to stifle innovation; and he’s not alone.

“Requiring position reporting all the time, you’re collecting a lot of information that is meaningless,” says Craig Pirrong, professor and director of energy markets for Global Energy Management Institute at the University of Houston. “It has no bearing on manipulation because manipulation is not taking place.” He adds that it’s much more efficient to identify manipulation when it occurs and then identify who did it, and describes the cost-benefit ratio of requiring even increased reporting as a disaster.

Based on the testimony from Sprecher, Newsome and Donohue you can reasonably expect ICE’s Henry Hubb natural gas contract to soon be treated like a regulated commodity on a designated contract market, Pirrong predicts. But that tighter regulation may have the unintended consequence of creating regulation that is readily circumvented, while pushing business to other venues. “There is enough industry opposition to this that I would not be surprised if, even under a Democratic Senate, that these things won’t go anywhere,” he says.

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