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Financial Regulators Propose Broad Reform of OTC Markets

Seeking to bring more transparency and accountability to the commodity derivatives marketplace, the federal government's top three financial regulators Wednesday recommended a "series of comprehensive reforms" for over-the-counter (OTC) markets. The reforms include provisions for central clearing.

The current financial crisis "was caused by in part significant gaps in the basic framework of oversight over critical institutional markets," said Treasury Secretary Tim Geithner. The lack of regulation over OTC derivatives, especially credit default swaps, "contributed greatly to the financial mess," agreed Mary Shapiro, chairman of the Securities and Exchange Commission (SEC).

The reforms proposed by Treasury, the SEC and the Commodity Futures Trading Commission (CFTC) are aimed at creating a stronger financial system.

The agencies propose to require for the first time that all standardized OTC products be centrally cleared. This is "enormously important," Geithner said during a press briefing at the Treasury Department. They also recommend that all major dealers who operate in these markets be subject to appropriate regulation and supervision, with standards-of-conduct requirements.

Moreover, the agencies propose to move the standardized parts of these markets onto exchanges and to appropriately regulated, transparent electronic trading platforms. The CFTC and the SEC would be given greater power to prevent market manipulation and abuses under the proposed reforms.

All the reforms would require Congress to make changes to existing laws, Geithner said. "We're going to begin the process of consultation with the Congress on how to design those laws," he noted.

The United States also needs to ensure that foreign countries where these products are traded take complementary actions, according to Geithner.

The proposed reforms have four broad objectives: 1) prevent activities in these markets from causing systemic risks; 2) promote more efficiency and transparency in markets; 3) prevent manipulation and fraud; and 4) reduce risks to less-sophisticated retail participants.

"Looking forward, we are hopeful that today's announcement will add to the significant substantive discussions already under way with congressional leaders and the president's working group to strengthen the regulatory framework for this nation's financial system," said Michael Dunn, CFTC acting chairman. "We support legislative initiatives that amend the CEA [Commodity Exchange Act] to allow us to fulfill our two core missions: to protect market users and the public from fraud, manipulation and abusive practices related to the sale of commodity and financial futures and options; and to foster open, competitive and financially sound futures and option markets."

Speaking earlier in the day at a meeting of the newly expanded Energy and Environmental Markets Advisory Committee (EEMAC), which is headed by the CFTC and composed of experts from some of the world's leading energy, environment and exchange companies and organizations, the words "transparency" and "visibility" were used freely.

"The thing that we have strived for...is more information and more transparency," said Dominick A. Chirichella, founding partner of the Energy Management Institute and an EEMAC member. "Now that we have achieved a lot of that, we've opened up the marketplace to the world's interpretation of that information. The thing that makes these markets move the way they move [has shown] that all of our interpretations are very different when we look at the same information. The one thing we know is it is not a complete picture of the information because we don't have the complete picture."

Chirichella said the CFTC has a tremendous task in regulating energy commodities, especially because there are three major commodity markets for every commodity. "We have the physical market that gets traded many multiples of what we consume; we have regulated financial instruments such as Nymex and ICE [IntercontinentalExchange]; and then we have over-the-counter markets, which are not regulated. The thing that is lacking from both the physical side and the OTC side is really an understanding, or visibility, of what is actually getting done.... The utilization of over-the-counter instruments is not the issue. The issue is truly just visibility. With more visibility and more information that is made available to all of the participants and the general public, a much better understanding comes."

Chirichella pointed out that based on Tuesday commodity prices, crude and natural gas futures were each trading at a 50% premium to where he believes they should be trading based on fundamentals. "Who is doing that?" he asked. "It is certainly not traders based on fundamentals. It is certainly not traders based on an understanding of what is going on in the supply and demand characteristics of the market. It is the people who I like to call the forward viewers that are seeing a recovery in the marketplace. It is that recovery premium that is driving this thing."

Chirichella urged the CFTC to "regulate wisely," which he believes primarily involves "a lot more visibility and not so much negative feelings toward words like 'over the counter' or 'physical business' or anything else like that."

Chuck Vice, president of ICE, a leading operator of global regulated futures exchanges and OTC markets, took umbrage with Chirichella's claims of where prices should actually be considering the current fundamentals. "No disrespect, [but] I don't think it is helpful to have a presentation where someone is making the point that the obvious price of [crude oil] is $40/bbl, not what the market is saying it is," Vice said at the EEMAC meeting. "The market reflects expectations. It doesn't always get it right. Sometimes it overshoots, sometimes it undershoots, but if you look at the housing market where there are essentially no supply constraints like you certainly have in crude oil, no geopolitics and none of the complicating factors, and yet no one recognized the fact that housing prices could not continue to go up by 6% a year forever, which is obvious in retrospect. I think to be here today and say natural gas should be this, or crude oil should be that, is very dangerous" because it can lead to the drawing of quick conclusions and quick remedies, which "don't really solve the problem."

Vice added, "I think we need real solutions, productive solutions and not knee-jerk reactions to things that have been discussed for years. Quite frankly, action, and effective action, has already been taken in terms of the Farm Bill, the electronic OTC markets and with the amended 'no action' letter to the Foreign Board of Trade."

Kevin Fox, managing director and energy trader for D.E. Shaw & Co. LP, said his views on OTC trading are uncommon among traders. "I'm 100% confident that the OTC markets need to be regulated. There is no doubt in my mind that needs to happen -- and happen fast," he said. "I also think there is a problem with hedge exemptions. The terminology I have seen recently is 'bona fide' hedge exemptions, which would imply there are not bona fide hedge exemptions. Probably the easiest way to fix that is to add clarity. I would like to know who has a hedge exemption, how much of a hedge exemption they have and for how long they have it. For some reason there is a veil of secrecy about that. I have asked for this information in the past and have been flatly denied. If you are a speculator and you have a hedge exemption, I think you should be held accountable to explain your position."

Commenting on the market's radical movement of the last year, Chirichella noted that extremely low prices are just as difficult for the industry as the upward move of last summer. "We've just had this catastrophic move to the downside, which is just as damaging to the future of energy as the upward move we had last year," he said. "Capex [capital expenditure] budgets are down and drilling rig counts are down to less than half of where they were a year ago. What we are seeing more and more is the formation of the next cycle that is coming. It might be a year from now, maybe two or three years, but we are going to see higher prices again because the global economy is going to recover. As the global economy does recover, demand is going to go back up again and supply is going to be lagging."

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