In advance of a House Agriculture subcommittee hearing last Wednesday, the Commodity Futures Trading Commission (CFTC) released a report calling on Congress to enact legislative changes giving the agency heightened oversight authority of certain lightly regulated contracts in exempt commercial markets (ECM) that perform significant price discovery for commodities in interstate commerce.
Testifying before the House panel, Acting CFTC Chairman Walter Lukken also asked lawmakers to increase the agency's civil and criminal penalty authority, boost its annual budget and clarify that its antifraud authority applies to bilateral principal-to-principal trades as well as "intermediated" transactions involving a broker-customer relationship.
The CFTC, in a 24-page report to Congress, did not recommend that lawmakers do away entirely with the multi-tiered approach to commodities regulation that was established seven years ago under the Commodity Futures Modernization Act (CFMA). That law requires the agency to more strictly oversee trading on demand contract markets (DCM), such as the New York Mercantile Exchange (Nymex), than transactions on electronic trading platforms known as ECMs and in over-the-counter markets.
Instead, the CFTC has asked Congress to give it greater oversight of specific, less-regulated ECM contracts, such as Atlanta-based IntercontinentalExchange's (ICE) natural gas contract that cash-settles based on the final settlement prices of the Nymex Henry Hub gas futures contract. This recommendation is "contract-specific and [does] not necessarily affect the entirety of an ECM's platform since ECMs host a broad range of products and contracts that may not serve a significant price discovery function," the agency said.
In the CFMA, Congress created a "light-touch regulatory category" for ECMs because it believed the risks associated with that market, which was directed more toward institutional investors, were low. The ECMs currently are not subject to full CFTC oversight, but they are required to comply with certain reporting and record-keeping requirements. They also are required to respond to "special calls" by the CFTC for information. And they are required to maintain records of suspected fraud or manipulation and notify the CFTC.
"To the extent that trading volume on an ECM contract remains low and its prices are not significantly relied upon by other markets, the current level of [CFTC] regulation is appropriate," the CFTC report concluded. However, when an ECM contract, such as ICE's gas contract, "matures and begins to serve a significant price discovery function for transactions in commodities in interstate commerce, the futures contract warrants some increased oversight to deter and prevent price manipulation or other disruptions to market integrity," it said.
Lukken told the House subcommittee that CFTC staff was especially "concerned that ECM cash-settled 'look-alike' contracts could provide an incentive to manipulate the settlement price of the underlying DCM futures contract to benefit positions in the 'look-alike' ECM contract."
The report followed a CFTC hearing in mid-September during which market participants, including ICE CEO Jeffrey Sprecher, proposed that heightened regulation of certain ECM contracts that mimic DCM contracts was appropriate (see NGI, Sept. 24).
Currently there are eight active ECMs in the United States, most of which trade natural gas, electricity or petroleum products. The largest ECM in terms of trading volumes and contracts traded is ICE, a global electronic platform that trades natural gas, electricity, natural gas liquids and chemicals. Some ECMs are small, start-up type ventures, while others have taken on the characteristics of DCMs, the CFTC noted.
ICE "has become a major trading venue for natural gas in direct competition with the [Nymex] natural gas benchmark futures contract," the CFTC said. "Based on comments of many traders and voice brokers, there appears to be an emerging consensus that ICE is a price discovery market for certain natural gas and electricity contracts. In addition, Commission staff has found that the traders on ICE are virtually the same as the traders on Nymex. All of the top 25 natural gas traders on Nymex are also significant traders on ICE."
Specifically, the CFTC urged Congress to amend the Commodity Exchange Act (CEA), from which it derives its authority, to require:
The agency said the decision as to whether a commodity contract serves a significant price discovery should be based on two factors: 1) the volume of trading of the relevant contract must be high enough to be able to impact other regulated contracts or to become an independent price reference or benchmark that is regularly used by the public; and 2) the linkage of ECM pricing to the settlement terms of a regulated contract on a DCM is an indication of significant price discovery since this allows for easier substitution of products between the linked markets.
ICE's Sprecher supported the CFTC's proposals, saying the "spirit of their recommendations is largely consistent with the views we have expressed in several testimonies this year" before Congress and the agency. "The concept of position accountability and 'self-regulatory-like' authority would provide ICE with the ability to take action in its markets if necessary."
Nymex CEO James E. Newsome said he also "strongly supports" the CFTC's proposed approach to oversee targeted ECM contracts that serve a significant price discovery function. These contracts "trigger a number of public policy concerns and warrant a higher degree of CFTC oversight and regulation."
In addition to its legislative recommendations, the CFTC said it plans to establish an Energy Markets Advisory Committee to conduct public meetings on issues affecting energy producers, distributors, market users and consumers, as well as others interested in or affected by energy futures markets. It also proposes to work closely with the Federal Energy Regulatory Commission to educate and develop best practices for utilities and others who use Nymex settlement prices as benchmarks in pricing their energy products.
In a related development last Wednesday, the CFTC amended its record-keeping rule to improve market oversight. The agency amended the rule to clarify 1) that traders holding reportable positions are required to keep information relating to those positions -- including information regarding positions and transactions held or executed outside the regulated market -- and to provide that information to the agency upon request; and 2) what constitutes hedging activity with respect to a reportable position.
"This clarification will bring added transparency. It also serves as an important complement to the CFTC's report released to Congress," Lukken said.
At the House subcommittee hearing, he requested that the CFTC's civil and criminal penalties be elevated to a maximum level of $1 million, and that the maximum prison term be doubled to 10 years for violations of the CEA. Lukken said this would put the CFTC on par with FERC, which was granted greater penalty authority under the Energy Policy Act of 2005.
As to the need for more funding, he said the CFTC is "stretched to the limit" with respect to staffing. "The Commission's funding has remained static over the past few years, while staff levels have decreased to historically low levels...In reauthorization, Congress should be mindful of the resources that are needed to fulfill the commission's mandate. I am hopeful that Congress will support sufficient funding of the CFTC at a level that matches its regulatory expectation for this agency and the growth of these markets."
Lukken also urged Congress to clarify the CFTC's antifraud authority for futures contracts to ensure that it applies to both bilateral principal-to-principal trades and "intermediated" transactions involving a broker-customer relationship. Principal-to-principal transactions occur between two eligible contract participants, including entities such as regulated banks or insurance companies, and well-capitalized companies or individuals.
"Without this clarification, the work of Congress...to protect energy markets from fraud could be rendered meaningless," he said.
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