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The Effect of the Bankruptcy of Enron on the Functioning of Energy Markets
Subcommittee on Energy and Air Quality
The Honorable James E. Newsome
Thank you, Chairman Barton, and members of the Subcommittee. I appreciate your having given me the opportunity to testify here today on behalf of the Commodity Futures Trading Commission. I would first like to say -- both as a federal financial regulator and as a citizen -- that I have great sympathy for those who are harmed by incomplete or inaccurate financial information. I also share the concern of many that appropriate action be taken to ensure that investors, creditors, commercial counterparties, and others who rely on the accuracy and completeness of financial disclosures by publicly-held companies can continue to do so with full confidence. Today, I would like to
tell you 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 energy-based contracts --
and how that role has changed under the Commodity Futures Modernization
Act. I will also describe how the
Commission responded to the Enron situation last fall and would like to finish
with some thoughts on how the Commission might make a contribution as we move
forward. Background: The Commission was created by Congress in 1974 to oversee the nation's commodity futures and options markets. The Commission perceives its mission to be twofold: to foster transparent, competitive, and financially sound markets, and, to protect market users and the public from fraud, manipulation, and abusive practices. There are important differences between the futures markets and the stock markets. While the stock markets provide a means of capital formation, a way for new and existing businesses to raise funds, the futures markets perform a different role, providing producers, distributors, and users of commodities with a means to manage their exposure to commodity price risk. Historically, commodity futures and options were traded primarily on agricultural products. And while contracts based on agricultural products are traded as actively today as ever, a great many futures contracts are now based on non-agricultural physical commodities like precious metals or energy products and on financial commodities like interest rates, foreign currencies, or stock market indices. Because they serve the risk management needs of businesses in virtually every sector of the economy, the volume of trading in these financials and non‑agricultural physicals is now nine times that in agricultural contracts. While farmers and ranchers continue to use futures contracts to effectively lock in the prices for their crops and herds months before they come to market, manufacturers now can also use futures contracts to plan their raw material costs and to reduce uncertainty over the prices they receive for finished products sold overseas. Mutual fund managers can use stock index futures to protect against market volatility and effectively put a floor on portfolio losses. And electric power generators can use futures contracts to secure stable pricing for their coal and natural gas needs. These producers, distributors, and users of commodities (whether physical or financial) are called hedgers. The futures contract positions that hedgers put on are referred to as covered positions. For example, a power generator's obligation to purchase natural gas will be covered by its ability to use that natural gas in its electricity generation. There are other participants in the futures markets who take uncovered positions in the hope of making profits rather than mitigating risks. These individuals and firms are known as speculators and they contribute to the smooth operation of a futures market by increasing its liquidity. Because the needs of different hedgers for long or short positions may not always be perfectly balanced, the presence of speculators increases market effectiveness by better ensuring that hedgers will be able to put on positions they need. Although I have described the primary purpose of futures markets as mechanisms for risk management, it should be noted that many futures markets play another important role in the economy, that of price discovery. Many businesses and investors that are not direct participants in the futures markets nonetheless refer to the quoted prices of futures market transactions as reference points or benchmarks for other types of transactions and decisions. This is particularly important in many agricultural markets where no other means of price discovery exists outside of the quoted futures prices but it is also true in other sectors, including many energy markets. How the CFTC Performs Its Mission: In seeking to fulfill its mission to foster transparent, competitive, and financially sound markets and to protect market users and the public from fraud, manipulation, and abusive practices, the Commission focuses on issues of integrity. We seek to protect the economic integrity of the futures markets so that they may operate free from any fraud or manipulation of prices. We seek to protect the financial integrity of the futures markets so that the insolvency of a single market participant does not become a systemic problem affecting other market participants or financial institutions. We seek to protect the operational integrity of the futures markets so that transactions are executed fairly, so that proper disclosures are made to existing and prospective customers, and so that fraudulent sales practices are not tolerated. The Commission pursues these goals through a multi-pronged approach to market oversight. We seek to protect the economic integrity of the markets against attempts at manipulation through direct market surveillance and through oversight of the surveillance efforts of the exchanges themselves. The heart of the Commission's direct market surveillance is a large‑trader reporting system, under which clearing members of exchanges, commodity brokers (called "futures commission merchants" or "FCMs"), and foreign brokers electronically file daily reports with the Commission. These reports contain the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations. Because a trader may carry futures positions through more than one FCM and because a customer may control more than one account, the Commission routinely collects information that enables its surveillance staff to aggregate information across FCMs and for related accounts. Using these reports, the Commission's surveillance staff closely monitors the futures and option market activity of all traders whose positions are large enough to potentially impact the orderly operation of a market. For contracts which at expiration are settled through physical delivery, such as in the energy futures complex, staff carefully analyze the adequacy of potential deliverable supply. In addition, staff monitor futures and cash markets for unusual movements in price relationships, such as cash/futures basis relationships and inter-temporal futures spread relationships, which often provide early indications of a potential problem. The Commissioners and senior staff are kept apprised of significant market events and potential problems at weekly market surveillance meetings, and on a more frequent basis when needed. At the weekly market surveillance meetings, surveillance staff brief the Commission on broad economic and financial developments and on specific market developments in futures and option markets of particular concern. At least one energy product market is usually discussed and officials from the Energy Information Administration of the Department of Energy periodically attend such meetings. If indications of attempted manipulation are found, the Enforcement Division investigates and prosecutes alleged violations of the Commodity Exchange Act (the "Act" or "CEA") or the Commission's regulations. Subject to such actions are all individuals that are (or should be) registered with the Commission, those who engage in trading on any domestic exchange, and those who improperly market commodity futures or option contracts. The Commission has available to it a variety of administrative sanctions against wrongdoers, including revocation or suspension of registration, prohibitions on futures trading, cease and desist orders, civil monetary penalties, and restitution orders. The Commission may seek federal court injunctions, restraining orders, asset freezes, receiver appointments, and disgorgement orders. If evidence of criminal activity is found, matters may be referred to state authorities or the Justice Department for prosecution of violations of not only the CEA but also state or federal criminal statutes, such as mail fraud, wire fraud, and conspiracy. Over the years, the Commission has brought numerous enforcement actions and imposed sanctions against firms and individual traders for attempting to manipulate prices, including the well-publicized cases against Sumitomo for alleged manipulation of copper prices and against the Hunt brothers for manipulation of the silver markets. In protecting the financial integrity of the futures markets, the Commission's two main priorities are to avoid disruptions to the system for clearing and settling contract obligations and to protect the funds that customers entrust to FCMs. Clearinghouses and FCMs are the backbone of the exchange system: together, they protect against the financial difficulties of one trader from becoming a systemic problem for other traders or the market as a whole. Several aspects of the oversight framework help the Commission achieve these goals: (1) requiring that market participants post a performance bond, referred to as "margin," to secure their ability to fulfill obligations; (2) requiring participants on the losing side of trades to meet their obligations, in cash, through daily (and sometimes intraday) margin calls; (3) requiring that FCMs segregate customer funds from their own funds and protect these customer funds from obligations of the FCM; and (4) monitoring the capitalization and financial strength of intermediaries, such as FCMs and clearinghouses. The Commission works with the exchanges and the National Futures Association (the "NFA") to closely monitor the financial condition of FCMs. The Commission, the exchanges, and the NFA receive various monthly, quarterly, and annual financial reports from FCMs. The exchanges and the NFA also conduct annual audits and daily financial surveillance of their respective member FCMs. Part of this financial surveillance involves looking at each FCM's exposure to losses from large customer positions that it carries and one way in which such positions are tracked is through the large trader reporting system. As an oversight regulator, the Commission primarily reviews the audit and financial surveillance work of the exchanges and the NFA but also monitors the health of FCMs directly, as necessary and appropriate. We also periodically reviews clearinghouse procedures for monitoring risks and protecting customer funds. As with attempts at manipulation, the Commission's Enforcement Division investigates and prosecutes FCMs that are alleged to have violated financial and capitalization requirements or to have committed other supervisory and compliance failures in connection with the handling of customer business. Such cases can result in substantial remedial changes in the supervisory structures and systems of FCMs and can influence the way particular firms conduct business. This is an important part of the responsibility of the Commission to ensure that sound practices are followed by FCMs. Protecting the operational integrity of the futures markets is also accomplished through the efforts of several divisions within the Commission. The Division of Trading and Markets promulgates requirements that mandate appropriate disclosure and customer account reporting, as well as fair sales and trading practices by registrants. Trading and Markets also seeks to maintain appropriate sales practices by screening the fitness of industry professionals and by requiring proficiency testing, continuing education, and supervision of these persons. Extensive recordkeeping of all futures transactions is also required. Trading and Markets also monitors compliance with those requirements and supervises the work of exchanges and the NFA in enforcing the requirements. And, as with the Commission's efforts to protect the economic and financial integrity of the futures markets, the Division of Enforcement also plays an important role in deterring behavior that could compromise the operational integrity of the markets. Enforcement investigates a variety of trade and sales practice abuses that affect customers. For example, the Commission brings actions alleging unlawful trade allocations, trading ahead of customer orders, misappropriating customer trades, and non-competitive trading. The Commission also takes actions against unscrupulous commodity professionals who engage in a wide variety of fraudulent sales practices against the public. The CFTC's Role in the
Energy Markets and Our Response to the Enron Situation: The Commission oversees on-exchange trading of energy-related futures and options contracts based on such things as crude oil, natural gas, heating oil, propane, gasoline, and coal. Several U.S. exchanges are designated to trade energy product futures and options, but the overwhelming majority of on-exchange transactions are executed on New York Mercantile Exchange (the "NYMEX"), where contracts in each of the products I mentioned are actively traded. The CFTC does not regulate trading of energy products on spot (cash) markets or forward markets, which are excluded from our jurisdiction by the CEA. Because Enron was a large trader of energy-based contracts traded on the NYMEX, its on‑exchange activity has been monitored by our market surveillance over the years. At this time, we have no indication that manipulation of any on-exchange futures market was attempted by Enron. However, the rapid financial deterioration of Enron last year presented an additional concern for the Commission: Could Enron's on-exchange futures positions be closed out without causing sudden price volatility or unduly reducing liquidity? In fact, Enron was but one of many significant participants in these large and liquid markets and the markets proved to be quite resilient. When its financial difficulties became known and Enron voluntarily closed out its positions, energy futures markets showed remarkably little reaction. The prices of energy-based futures did not spike nor did liquidity dry up. As would the financial difficulties of any large futures customer, Enron's difficulties also raised concerns about the ability of the FCMs that carried Enron's on‑exchange futures positions to successfully close out those positions if Enron were to fail to meet margin calls. 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 affected FCMs to monitor and to manage the closing out of these positions. By appropriately adjusting margin requirements, the clearinghouse was able to ensure that adequate Enron funds remained on deposit at the FCMs, which both provided additional security for the FCMs and their customers and gave Enron a strong incentive to reduce its positions as quickly as possible. The closing out of Enron's on-exchange positions was accomplished quickly and smoothly so that, by the time of Enron's bankruptcy filing, the risks to which FCMs were exposed, as measured by standard margin requirements, had dropped by 80% from only a week earlier. By mid-December, all of Enron's positions on the regulated exchanges had been liquidated. (Enron also owned a small subsidiary FCM, Enron Trading Services, that carried no positions for other customers and only a very small portion of Enron's own on‑exchange positions. At all times, ETS had regulatory capital several times the required level. Also by mid-December, ETS had transferred its customers to other FCMs.) I believe that this episode was a success for the system of financial controls in the on‑exchange futures markets. There were no disruptions to the system of clearance and settlement. Enron met all its obligations. No customer lost any funds entrusted to any FCM. How the Commodity Futures
Modernization Act Changed Things: The Commodity Futures Modernization Act of 2000 (the "CFMA") was signed into law by President Clinton on December 21, 2000. It amended the Commodity Exchange Act to, among other things, provide legal certainty for over‑the‑counter derivatives products. For contracts based on energy products and certain other non‑agricultural and non‑financial commodities, the CFMA added a new Section 2(h) to the Act that exempted two types of markets from much of the CFTC's oversight. The first type is bilateral, principal-to-principal trading between two eligible contract participants, a category that includes sophisticated entities such as regulated banks and well‑capitalized companies or individuals (for example, those with assets of at least $10 million), among others. The second type is electronic multilateral trading among eligible commercial entities, such as eligible contract participants that can also demonstrate an ability to either make or take delivery of the underlying commodity (called "eligible commercial entities") or dealers that regularly provide hedging services to those entities. Suggestions on Moving Forward: As an oversight regulator, we will continue to look at how and why the markets within our statutory jurisdiction respond the way they do, whether well or poorly, to situations such as the failure of a significant participant. Separately, as a member of the President's Working Group on Financial Markets, the CFTC is working with the SEC, the Treasury Department, and the Federal Reserve Board to review for the President possible improvements in accounting, auditing, disclosure practices with respect to publicly‑held companies. And, within the Commission, we recently proposed a reorganization plan that will consolidate our market oversight functions into one division to help improve already excellent programs in market and financial surveillance. The Enron situation has led some to call for further responses from Congress and regulators, even for re-regulation of markets that were provided legal certainty by the Commodity Futures Modernization Act. While I agree that it is prudent for a regulator to constantly review its policies and procedures to ensure that an appropriate level of oversight is exercised, I also believe that a situation of this magnitude deserves careful consideration before a regulator seeks to take action. I believe that regulators should make sure that the true problem has been identified before remedies are pursued. I supported passage of the CFMA because I sincerely believed that a one‑size‑fits‑all approach to regulation was outdated, particularly in light of important advances in technology within the financial services industry. Rules tailored to the participant, the product, and the trading facility seemed to me to be a more appropriate approach than the prescriptive regulations of the past. To date, I have seen no evidence to the contrary in my agency's initial analysis of the Enron situation. The CFMA was enacted after a number of hearings conducted by our House and Senate oversight committees in the context of reauthorizing the Commission. Many issues relating to evolving markets received a full airing and important changes to the law were agreed upon as a result. I believe that any departure from the path of progress represented by this important piece of legislation should be approached with extreme caution. We will continue to monitor the markets within our jurisdiction and to utilize all authorities given to us by the Congress to aggressively pursue violations of the Commodity Exchange Act. We stand ready to work with this Subcommittee, the Congress, other regulators, and market participants. Thank you for the invitation to appear before your Committee. I will be happy to answer any questions you may have.
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