Statement of Daniel Rappaport
Chairman
New York Mercantile Exchange

Before the United States Senate Committee on Agriculture, Nutrition, and Forestry

February 11, 1997

Mr. Chairman, and Members of the Committee, my name is Daniel Rappaport. I am Chairman of the Board of Directors of the New York Mercantile Exchange ("NYMEX" or the "Exchange.") On behalf of the Exchange, I wish to thank you for the opportunity to participate in today's oversight hearings on proposed amendments to the Commodity Exchange Act (the "Act").

The testimony which we will provide today will be presented as follows:

þ NYMEX profile
þ Investigations and studies on Sumitomo matter confirm existence of regulatory gap
þ NYMEX proposal to address regulatory gap
þ CFTC oversight is not an issue of extraterritoriality--a comparable structure currently exists to regulate foreign options in the United States

NYMEX Profile.

As you know, NYMEX is the world's premier energy futures exchange. It provides a regulated forum for price discovery and risk shifting for crude oil, heating oil, unleaded gasoline, propane, natural gas and electricity, as well as platinum and palladium. In addition, its wholly owned subsidiary, Commodity Exchange, Inc. ("COMEX"), is the world's premier trading forum for gold, silver, copper (in North America) and Eurotop 100 futures contracts. The combined marketplace is the world's largest physical commodity exchange and the nation's third largest futures exchange.

This year, 1997, marks the 125th anniversary of NYMEX. From its beginnings as The Butter and Cheese Exchange of New York, NYMEX grew to pioneer the development and engineer the growth of energy price risk management. Institutional creativity, effective management of a well-regulated, open and competitive auction market coupled with entrepreneurial spirit and dedication of its membership have propelled NYMEX to its current position as the world leader in the strategically critical financial markets for energy and precious metals. It is with that history and experience in mind that we offer our comments and suggestions to critically needed adjustments to the Act necessary for the futures industry to maintain its global leadership.

As we have said previously in testimony regarding the Act, NYMEX believes that much of the success we have enjoyed is the result of an effective regulatory framework. Our markets are utilized throughout the world based upon the recognition that the United States regulatory structure helps assure fairness and financial integrity in the marketplace and that the New York Mercantile Exchange knows how to manage these markets effectively. The Senate Agriculture Committee is to be commended for its concern and efforts to evaluate the legislative and regulatory oversight of United States commodity markets, and examine changes which are necessary for us to maintain our record as the world's leader in financial innovation and competitiveness.

In the financial markets, perhaps more than in any other industry in the world, technological advances and product engineering have made certain elements of the Act outmoded. In many instances, the regulated marketplace has been placed at a competitive disadvantage to the non-regulated marketplace. In other instances, existing statutory provisions have actually weakened the overall regulatory structure. Our position and comments have remained consistent from the start of this debate--NYMEX believes that neither the Commodity Exchange Act, nor the Commodity Futures Trading Commission ("CFTC" or "Commission") regulations require an overhaul; rather, certain modifications are necessary.

Mr. Chairman, you, the members of this committee, and your staff are to be commended for your hard work and diligence in developing the legislation which has been introduced to amend the Act. Our observations and suggestions today are given in the spirit of building on that progress, while taking advantage of knowledge gained and information acquired since the original legislation was introduced. The proposed legislation represents a significant step forward in addressing concerns and shortcomings which currently exist with the Act. In particular, the legislation recognizes significant weaknesses in current law:

þ Audit trail requirements should be tailored upon requirements to enhance market integrity, and to aid in the detection and prevention of abuse. Specifying a particular technological solution to achieve a standard without regard to cost or availability is unwise and unworkable. NYMEX has made great strides in improving our audit trail and in our ability to detect and prevent abuses, but we strongly feel that dictating an expensive--if indeed even available--electronic means which might only marginally improve the current audit trail is imprudent. Forcing that technological "solution" represents not only a waste of resources, but perhaps might lead to delays in development of systems and processes which improve the audit trail beyond that particular technology.

þ Acceleration of the currently lengthy approval process for new contracts and contract market rules is needed to address the growing need for domestic markets to efficiently design and implement instruments geared to the highly competitive marketplace of today. NYMEX, along with the other representatives of the futures industry here today firmly believe, based on knowledge gained from sometimes costly experience, that the ultimate decision on the usefulness or applicability of a new instrument will come not from exchange staff or a regulator, but from the market itself.

þ Recognition of the need to weigh benefits and costs of potential regulatory requirements is an important and significant part of the proposed legislation. Far too often in the past, inadequate consideration has been given to the costs of regulatory mandates relative to the benefits that those mandates might provide. Codifying language highlighting the need for the Commission to evaluate efficiency and competition, and risk management issues, while exempting investigatory, adjudicatory and emergency actions improves and clarifies the current relatively undefined process.

þ Appreciation that markets and market users have changed dramatically warrants review of the Treasury Amendment and other exemptive provisions. The rapid emergence of the Over-The-Counter ("OTC") market, dramatic increase in demand for risk management instruments and techniques, and increasing expertise in the financial and commodities industries have put great pressure on regulated futures exchanges to adapt to a more sophisticated and demanding clientele. To be able to maintain our global leadership position in market efficiency, transparency, and innovation, exchanges need to be able to have the flexibility to offer products and services which recognize the particular needs and capabilities of an experienced market user.

þ NYMEX is pleased that the sponsors of S. 257 have recognized the "systemic risk" to United States producers, processors and consumers that can occur when contracts for commodities for future delivery in the United States are marketed and sold here, outside the oversight of the CFTC and the Commodity Exchange Act. The problems in the United States marketplace associated with the Sumitomo incident highlighted the risk to commodity pricing presented when two separate regulatory regimes provide disparate levels of oversight. However, while the proposed language in Section 4 represents an improvement in attempting to solve the current regulatory gap, given the knowledge gained and studies conducted in the wake of the Sumitomo incident, it falls significantly short of providing United States producers, processors, and consumers with assurances of integrity in pricing.

NYMEX has joined other United States futures and options exchanges in a consolidated position on a number of recommended improvements to the Act. While the joint testimony goes into greater detail on those specific provisions, other than to express our support for the joint recommendations, I will not repeat them here. As mentioned above, we seek to build upon recent experience in further elaborating on concerns with the current law regarding United States delivery points for contracts traded on foreign boards of trade.

Investigations and studies on Sumitomo incident confirm existence of regulatory gap

In previous testimony before this committee last year, NYMEX outlined concerns that the Act's strict limitations on the Commission's authority over foreign boards of trade may, under certain circumstances, compromise the integrity of the prices of strategic domestic commodities which may result in significant adverse impact on interstate commerce and the national public interest. As you know, the underlying premise of futures regulation is set forth in Section 3 of the Act. That section provides that futures transactions "are affected with a national public interest," because they are engaged in by the public and a broad array of commercial interests, and are used for price discovery and risk shifting. To prevent harm to producers, processors and consumers of commodities in interstate commerce from improper influence on prices and transactions, regulation is "imperative for the protection of such commerce and the national public interest therein."

The events surrounding the Sumitomo incident and the subsequent investigations into the London Metal Exchange ("LME") marketplace confirm our contention that limitations in the Act prevent the CFTC from exercising an appropriate level of oversight under certain circumstances. Following the well publicized fallout from the Sumitomo incident, two independent evaluations of the LME were conducted:

þ British regulator studies LME--After the global headlines describing the Sumitomo incident and its link to the LME marketplace, the British regulator, the Securities and Investments Board ("SIB") asked market users and others interested in the markets to comment on the metals marketplace as well as structural and regulatory concerns with the LME. In December, the SIB released their summary and conclusions in "A Review of the London Metal Exchange." While many critical of the LME also criticized the SIB for being lenient in its conclusions contained in the report, the SIB did acknowledge significant shortcomings in the performance of the LME. Several of the shortcomings identified and recommendations for improvement include the following:

     1. Enhanced market monitoring, with strengthened large position reporting from actual customers          and not just brokers.
      2. Improvements in the transparency of the market, particularly of options and inter-office
      3. Tighter controls over and better transparency of warehousing arrangements.
      4. Changes in governance to avoid actual and perceived conflicts of interest.

While NYMEX believes the evidence exists for a much stronger response by the SIB on market oversight issues which are much more expansive than warehouses alone, the report itself confirms serious market oversight shortfalls to which we have called attention for the past two years. From the earliest stages of the Sumitomo incident, which began to come to light when the LME established copper warehouses in the United States in April of 1995, NYMEX has strongly contended that the LME has not aggressively sought to benefit, in terms of market oversight, from information held by the warehouses that are authorized delivery locations on its copper contract. This lax oversight has contributed to global market problems. LME was apparently either unable to discern the true facts associated with Sumitomo because of the lack of information on warehouse stocks of LME market participants, or unwilling to deal with them. LME's explanation on their lack of information in the physical market hinged on their contention that it was done by a non-member firm. As the principal regulator, the market has an obligation to gather information on market positions from participants to prevent manipulation and systemic risk. The physical side of the marketplace must also be reviewed to allow for the assessment of the potential for manipulation. The exchange must have authority to gather the information on stocks and ownership, which is essential to their role as primary market regulator. In today's global and interlinked financial marketplace, that information must also be made readily available to other regulators and markets which may be affected by actions such as manipulation occurring on one market, but affecting prices of commodities on other markets.

CFTC comments on SIB review--In a November 12, 1996 letter to the SIB, the Commission identified and commented upon several areas of shortcoming or ambiguity in regulatory oversight of the LME marketplace. Many of those same areas--market surveillance, daily pay and collect of margins, segregation of customer funds, information sharing, price transparency and warehouses--were cited by NYMEX in an October 15, 1996 letter to the SIB responding to their request for comments on the LME (Attachment 1). Of particular note, however, were Commission comments related to market manipulation and the applicability of the Financial Services Act ("FSA") to market manipulation on the LME. The CFTC's discussion noted that United States law, section 6 ( c ) of the Commodity Exchange Act gives the CFTC civil enforcement powers if it has reason to believe that manipulation is occurring, and Section 9 of the Act makes manipulation a felony. Their analysis of the extent to which the FSA makes manipulation a violation of the law is less clear, as indicated by their concluding comments on the topic:

     "The FSA requires as a condition as an RIE [Recognized Investment Exchange], among other      things, that an exchange's rules "must ensure that business conducted by means of its facilities is      conducted in an orderly manner and so as to afford proper protection to investors" (FSA      Schedule 4). Since manipulative conduct results in prices which do not reflect normal supply and      demand forces, it could be argued that FSA Schedule 4 currently requires all RIE's to prohibit      manipulation.

     To the extent that there are ambiguities regarding the duty to prohibit and to prosecute      manipulative conduct, whether under SIB Principles, the FSA requirement to maintain orderly      markets, or FSA section 47, we recommend that any such ambiguities be resolved as soon as      possible."

Clearly, ambiguity about such a fundamental concept as the illegality of market manipulation and the ability to enforce the law against violators should greatly concern this committee.

British lawmaker reacts to SIB report--Release of the SIB report also generated interest among British lawmakers. On December 19, 1996, a Bloomberg news report quoted the British Labor Party's Shadow Economic Secretary Mr. Mike O'Brien responding to the SIB report as saying:

     "LME was not responsible for most of the scandal. Problems arose outside their direct      supervision, but the SIB report shows LME was tested and found wanting. Self regulation failed      in the Sumitomo case. LME must now make urgent changes if it is to ensure its future as a      recognized investment exchange."

LME interprets SIB report--The most disappointing, but illuminating, comments on the SIB report came from the LME. In the face of a critical report, the LME apparently took it upon themselves to whitewash the results. In a December 19 story carried by Knight-Ridder, LME officials are quoted as saying:

     "The SIB has given a clean bill of health to our fundamental trading characteristics, such as       non-cash clearing, non-segregation (of client accounts) and the granting of credit by LME      members to their customers. Importantly, the SIB has further concluded that such trading      practices do not present any significant systemic risk. In this spirit, we will examine positively the      other changes recommended by the SIB in the areas of governance, resources, additional      transparency and further enhancements to our warehousing facilities."

It is precisely the words and actions of the LME, as quoted above which should give great pause to United States regulators and lawmakers charged with market oversight and concerned about regulatory comparability. LME's response neither indicates acknowledgment of a problem nor willingness on their part to honestly confront and address serious shortcomings in their market oversight.

þ British academic releases study on LME market manipulation--In December 1996, Professor Christopher Gilbert, a U.K. academic noted as an expert on commodity futures markets, released a study on the LME/Sumitomo scandal entitled "Manipulation of Metals Futures: Lessons from Sumitomo." Gilbert concludes that "Sumitomo manipulated the copper market, possibly from as early as 1985, but certainly over the period 1991-96." Gilbert's paper is critical of the LME and its regulatory system, citing how Sumitomo took advantage of the weaknesses in the system, and makes suggestions on changes in law and regulatory oversight, using the United States system as the basis for his recommendations. One notable point Gilbert makes independent of that contained in the CFTC's letter to the SIB cited earlier is that the Financial Services Act fails to explicitly define futures market manipulation as illegal, in spite of claims by the SIB that the FSA does so. Gilbert recommends that the FSA be amended to "make illegal any exercise of monopoly power in futures markets which has the effect of generating artificial off-exchange prices."

Gilberts's study makes a number of other observations and recommendations of which the following are particularly noteworthy:

U.S. experience proves that prevention rather than prosecution is the most effective deterrent to manipulation. Client position reporting, currently voluntary on the LME should be made mandatory by a statutory change and should include metal in LME warehouses. .

Transparency should be increased by adoption of a system such as the CFTC's Commitments of Traders reports, including LME warehouse stocks. .

While historic price carries and non-cash clearing "do not raise regulatory concerns," they are "unwise and impose additional risks on LME members." .

LME's day-of-delivery contracts, as opposed to month-of-delivery allow for a significantly greater risk of cash market distortion by LME market manipulation, and translates to a much more serious situation given the impact of manipulation on the LME on world copper prices.

Professor Gilbert's paper presents strong, unbiased support for observations put forth previously by NYMEX about LME market manipulation and its impact on global and United States copper prices in the following ways:

þ His research leads him to conclude that the LME market was manipulated by Sumitomo from 1991-96, and possibly as early as 1985.

þ Manipulation on the LME market has a very direct effect on global cash copper prices, thus a direct effect on the U.S. marketplace--and interstate commerce.

þ Gilbert feels that the 1986 FSA does not explicitly define futures market manipulation as illegal. That alone is a very powerful argument for allowing CFTC authority to evaluate and ascertain the adequacy of the regulatory regime of a foreign board of trade with U.S. delivery points having the ability to affect prices of U.S. commodities.

As mentioned previously, the contention that British law does not appear to make market manipulation illegal should be of great concern to regulators and to this committee. The potential ambiguity in British law may put United States markets and users of those markets at risk of manipulation on a foreign market which neither the market nor the regulator have the legal backing to prevent or upon which to take action if manipulation is identified.

NYMEX proposal to address regulatory gap NYMEX is pleased that the sponsors of S. 257 have recognized the "systemic risk" to United States producers, processors and consumers that can occur when contracts for commodities for future delivery in the United States are marketed and sold here, outside the oversight of the CFTC and the Commodity Exchange Act. The contrast and problems associated with the Sumitomo affair highlighted the risk to commodity pricing presented when two separate regulatory regimes provide disparate levels of oversight. In the circumstances related to Sumitomo, the copper industry traded futures on the COMEX in New York and on the London Metal Exchange ("LME"), based in London. Copper for delivery on contracts traded on the COMEX was available for delivery in COMEX approved warehouses in the United States. At the same time, copper for future delivery for LME traded contracts was deliverable at LME licensed warehouses virtually across the street from the COMEX approved warehouses. Market surveillance under the U.S. regime provided information on the amount and ownership of metal in the COMEX warehouses; the futures positions of large traders on COMEX; the cash copper positions of large traders on COMEX; and the hedge/speculative intentions of those traders. Parallel information was not available under the non-U.S. regime.

While we genuinely regard it as an improvement, Section 4 of S.257 simply does not go far enough to address the pricing risks that exists. Proposed Section 4(b)(2) of the Act mandates that the CFTC "consult" and "endeavor to secure adequate assurances" that a foreign futures contract with a U.S. delivery point "will not create the potential for manipulation of the price, or any other disruption in trading" of a U.S. commodity or futures contract. It does not empower the CFTC to do anything at all if the foreign regulator declines to consult with it, or if despite its best efforts, it is unable to "secure adequate assurances". Thus, it recognizes the problem, yet offers no real remedy. It puts the CFTC, producers, processors, consumers, the Exchanges and the financial community in the perilous position of determining that there exists a potential for manipulation of domestic commodity prices, yet lacking authority to act.

Clearly the sponsors could not have intended such a result. The Act should not mandate the CFTC to investigate whether a problem might exist, yet force it to stand idly by, watching, if it determines that it does. Accordingly, the NYMEX has proposed a modest amendment to the Act that would treat foreign futures contracts with U.S. delivery points on a parallel level with options contracts (Attachment 2). The Exchange's proposal for foreign futures contracts with U.S. delivery points would permit the marketing of those contracts consistent with rules promulgated by the CFTC. It simply provides the Commission with the authority necessary, at its discretion, to assure that United States citizens are offered an appropriate level of regulatory assurance that contracts marketed in the United States that are traded on foreign boards of trade with delivery points in the United States can not alter the integrity in pricing that is essential. We respectfully submit that this proposal is the remedy necessary to make Section 4 of the bill a complete and effective piece of legislation.

The NYMEX proposal is not unprecedented--in fact it tracks the authority given to the CFTC regarding oversight of foreign traded options under Section 4 c (b) of the Act. The existence of this authority offsets the two most often voiced objections to granting CFTC authority over foreign futures contracts with delivery points in the United States--concerns about extraterritoriality and expressed fears of retaliation. The options formulation has worked for years, and the CFTC has shown that it knows how to use it in a measured capacity.

Last year, the CFTC ended the requirement that all foreign options receive prior Commission approval before they could be marketed in the United States. At that time, the Commission reserved the right to revisit the issue if good regulatory practice warranted, including revisiting the issue on a market by market basis, if among other things, the Commission was "not able to obtain appropriate information related to the commodity option transactions of a specific exchange." This is completely consistent with what NYMEX has been asking Congress to do with respect to United States delivery locations: authorize the Commission to act if it needs to; leave the ultimate decision on whether and how much to regulate to the agency.

Conclusion

As we stated earlier, Mr. Chairman, you and the members of this committee are to be commended for your hard work and diligence in developing the legislation which has been introduced to amend the Act. Streamlining the process for contract and rule approval, removing the handcuffs which inhibit exchanges from developing new and innovative ways to serve a dynamic, global industry, and enhancing CFTC's oversight of warehouses serving as delivery points for futures contracts traded on foreign boards of trade are critically needed improvements. However, while the proposed warehouse provision represents a significant step forward in addressing concerns and shortcomings which currently exist with the Act, subsequent studies of the LME conducted after the legislation was introduced last year, and which have been recently made public, have heightened our concerns. The NYMEX proposal on United States delivery points for contracts traded on foreign boards of trade narrowly targets the current regulatory gap while carefully avoiding a solution which could be subject to claims of extraterritoriality or fear of retaliation.

NYMEX serves a global marketplace--one which is increasingly competitive and inter-related. As a regulated, public futures market we do have concerns with the uniformity and adequacy of regulatory oversight in areas where actions in foreign marketplaces have the potential to affect United States commerce. The Sumitomo affair should serve as a recent reminder that a problem in one market can affect the credibility and utility of many related markets. Examination of the regulatory structure of the LME has pointed out some serious shortcomings. United States law should not permit prices of United States commodities to be determined under regulatory regimes which do not properly protect U.S. producers, processors, and consumers. Until these shortcomings are addressed, the American public will continue to be unnecessarily exposed to the risk of paying or receiving prices that do not reflect the fair and transparent market prices that market participants have a right to expect. We urge this Committee and the Congress to support enhancement of the jurisdiction of the CFTC over foreign boards of trade offering contracts with delivery points in the United States to preempt such a situation here.

Mr. Chairman and Members of the Committee, NYMEX thanks you for your consideration and pledges its full support to work with you and your staff to address these issues and any others that may be of concern to you. Thank you very much.