Statement of Neal L. Wolkoff,
Executive Vice President and Chief Operating Officer
New York Mercantile Exchange, Inc.
Before the United States Senate Committee on Agriculture, Nutrition, and Forestry
"Commodity Derivatives Trading Oversight"
10:00 a.m., July 10, 2002
Mr. Chairman, my name is Neal Wolkoff. I am the Executive Vice President and Chief Operating Officer of the New York
Mercantile Exchange, Inc. ("NYMEX" or the "Exchange"), which is the world's largest forum for the trading and clearing
of energy contracts. As you and the other members of this committee know, NYMEX is a federally chartered marketplace,
fully regulated by the independent federal regulatory agency, the Commodity Futures Trading Commission ("CFTC" or the
"Commission"). On behalf of the Exchange, its Board of Directors and members, I want to thank you and all the members
of the committee for the opportunity to participate in today's hearing to study and discuss regulatory issues in the energy
marketplace.
Beginning with the turmoil leading up to the Enron bankruptcy last December, and continuing through the recent
revelations of controversial trading practices, the energy marketplace and many participants have faced unprecedented
challenges. A number of significant market participants have experienced dramatic reductions in stock valuation, and
credit rating downgrades. A continuation of that trend could seriously threaten liquidity in the cash commodity energy
marketplace. Loss of liquidity and reduced competition clearly will translate to higher energy costs for consumers, and will
serve as another stumbling block to a U.S. economy seeking to recover from the recent downturn.
As this committee and other policy makers and regulatory officials consider what legislative or regulatory remedies may be
necessary, the admonition often attributed to Hippocrates, "First, do no harm," comes to mind. In our 130 years as an
organized commodity exchange, NYMEX has had to deal with a number of serious crises involving shifts in energy market
prices or involving energy market participants. That experience leads us to believe that this current situation can be dealt
with effectively after a careful examination of the situation.
In prior hearings, we have stated our position that we believe a regulatory gap exists in energy and metals market oversight.
Specifically, fully unregulated central marketplaces have developed for the trading and discovery of price of physical and
derivatives markets. We recommend, as detailed below, adoption of specific measures pertaining to these unregulated
electronic central marketplaces. We do not recommend a significant increase in the scope of regulation addressed to the
participants in those markets, and believe that the approach of the Feinstein-Fitzgerald amendment, which called for record
retention among market participants in unregulated central markets is generally sufficient. (1)NYMEX believes that recent events have
underscored the existence of the previously mentioned regulatory gap. Among the several legislative proposals, it is our belief that legislation developed and sponsored by Senator Dianne Feinstein and
Senator Peter Fitzgerald is a targeted approach to eliminate the regulatory gap.
Our testimony today will begin with a description of the energy marketplace that is served by NYMEX, followed by a summary of the regulatory oversight under which we operate, and its relationship to the
over-the-counter energy marketplace. The importance of an efficient, liquid, transparent market is emphasized next as we illustrate, using recent examples, the critical role competitive markets play in
times of significant uncertainty. Then we will offer a brief description of the market response to problems arising from the Enron collapse. Finally, our discussion will focus on the market impact and other
issues, including regulatory matters, arising from the Enron bankruptcy and the more recent revelations of controversial trading practices by certain energy market participants, followed by a discussion of
legislative and regulatory issues linked to current market concerns. Our remarks today will be presented in the following order:
§ The Energy and Metals Marketplace - The Role of NYMEX
§ NYMEX is Regulated by the Commodity Futures Trading Commission
§ The Critical Value of Competitive, Liquid, Transparent Markets in a Crisis is Proved Over the Past Decade
§ The Enron Collapse Provided a Further Test of the Marketplace
§ Legislative and Regulatory Issues
The Energy and Metals Marketplace - The Role of NYMEX
The New York Mercantile Exchange, Inc., was established in 1872, and has grown to become the world's largest exchange for energy and precious metals. As a regulated commodity futures and options
exchange, NYMEX has served a diverse domestic and international customer base by bringing price transparency, competition, market neutrality and efficiency to energy and metals markets, and provides
businesses with the financial tools to deal with market uncertainty. While much of our testimony focuses on the energy marketplace, the same principles outlined below apply to the metals marketplace.
Although NYMEX is predominantly a marketplace for commercial participants in the energy realm to hedge risk and to discover prices on large volume transactions, the benefits of this marketplace accrue
to the consumers of energy who receive prices based on open and fair competition. In addition to prices being competitively determined on NYMEX, the Exchange also assures that the prices for all
transactions occurring on its floor are transparent. They are disseminated world-wide immediately upon execution via the market ticker, and are accessible real-time through a variety of market data vendor
services.
The transparency of NYMEX prices, and the integrity of its markets, makes NYMEX a widely accepted and reliable benchmark for energy pricing which is vital to our economy. The visible and highly
competitive daily transactions of energy futures and options on the exchange provide a true world reference price for each of the commodities traded. In the aftermath of the collapse of Enron, NYMEX has
played a leading role in ensuring against a broader financial adversity in the energy marketplace through its secure liquid market.
In addition to price transparency, the Exchange is used and relied upon as an open forum for hedging energy price risk. Risk shifting, in the secure liquid markets that NYMEX provides, allows commercial
interests to "hedge" the risk of price fluctuations that could affect planning of their business operations, and consequently profitability, by using futures and options contracts to "lock in" energy costs.
NYMEX publishes settlement prices each day reflecting the value of each commodity and contract month. Because the settlements reflect actual trades, and not market sentiment, they are relied upon
heavily by the energy industry as benchmarks for many physical and OTC contracts. NYMEX has recently received a copyright designation for this.
Along with the openness and transparency of its trade execution operations, NYMEX's clearinghouse protects all participants against counterparty credit risk, which is simply the risk of failure of either one
of the two parties to a transaction (the buyer or the seller) to pay such funds as they become due to his counterpart as a result of the trade. Through a system of cross guaranties among the brokerage firms
and banks that comprise NYMEX's clearinghouse, credit risk is removed from each participant, because financial performance is guaranteed by the Exchange and backed by its clearing members.
Customer funds are held by the Exchange and its clearing members in trust accounts that are fully segregated from the exposure and funds of the clearing firm or the Exchange itself. Over-the-counter
("OTC") or off-Exchange, transactions do not carry this level of protection against credit exposure.
NYMEX is Regulated by the Commodity Futures Trading Commission
The federal government has long recognized the unique economic benefit futures trading provides for price discovery and managing price risk. The Senate Agriculture and Natural Resources Committee, as
a primary overseer of United States commodity markets, has played a key role in creating a regulatory framework that has been so successful over the years. The modern era of commodity market
regulation began in 1974, when Congress created the Commodity Futures Trading Commission, giving it authority to regulate commodity futures and related trading in the U.S. A primary function of the
CFTC is to ensure the economic utility of futures markets as hedging and price discovery vehicles--encouraging transparency, competitiveness, efficiency, and market and trade practice integrity and
fairness. Regulated markets must file all terms and conditions of contracts, and contract changes, with the CFTC. The Commission also oversees registration of firms and individuals who either handle
customer funds or give trading advice. It conducts and monitors rule enforcement at U.S. futures exchanges.
As part of the federal mandate, NYMEX performs many self regulatory functions, and its rule enforcement program is under the jurisdiction and watchful scrutiny of the CFTC. As a designated Self
Regulatory Organization ("SRO") NYMEX is responsible to police the conduct of its members and markets, and to adopt rules which are designed to protect the public interest. The Exchange expends
considerable resources to maintain a compliance function, including market and financial surveillance, as well as a disciplinary process for those who might violate any of the Exchange's rules. Of course,
unregulated electronic central marketplaces do not have an SRO designation, and operate without participant rules or an investigative or enforcement mechanism. The CFTC also lacks routine tools to
oversee the conduct of these marketplaces. (2)
Unregulated Physical Markets Also Evolved to Provide Risk Management
Another component of the energy marketplace is comprised of exchanges and intermediaries not falling under the jurisdiction of the CFTC, and, thus are largely unregulated. These markets, referred to as
OTC or derivatives markets have grown rapidly - particularly over the past decade. The trading subsidiary of Enron, EnronOnline ("EOL"), was, prior to the parent's financial failure, a marketplace for
physical delivery of energy products (meaning that buyers and sellers actually intended to make or take delivery of the commodity bought or sold), and also for unregulated financial instruments called
"swaps." In addition to EnronOnline, a number of other electronic trading platforms, and telephone brokers offer OTC instruments that look and function similarly to or identically to NYMEX' contracts.
There are, however, several key differences between these platforms and the NYMEX marketplace:
§ The counterparties bear the credit risk of each other - these transactions are not cleared;
§ Pricing is not transparent to the public; and
§ The platforms are not regulated, and have no obligation to police themselves for fraud, manipulation or other misconduct.
An OTC deal is a contract usually arranged through an intermediary such as a major bank or the trading wing of an energy company. As compared to a standardized contract traded on a futures exchange,
while an OTC deal can involve customized terms, the great majority of OTC energy swaps in recent years generally have involved standardized terms with the exception of credit terms. A swap is generally
exemplified by an agreement whereby a floating price is exchanged for a fixed price over a specified period, thus allowing a buyer or seller of energy products to "lock in" a specific price, and avoid the risk
of floating prices. The economic purpose of an OTC transaction, therefore, is usually the same as the economic purpose of a NYMEX transaction. The swap is a financial arrangement that involves no
transfer of physical energy; both parties settle their contractual obligations by means of a transfer of cash. The agreement defines the volume, duration and fixed reference price (which for most contracts in
the U.S. for crude oil or natural gas is the NYMEX price). Differences are settled in cash for specific periods - monthly, quarterly or biannually.
Typically, OTC market participants utilize NYMEX not only as a price reference, but also to hedge their own price exposure resulting from the swap agreements or physical contracts agreed to by the
parties. Thus, in the energy marketplace, there is substantial interaction between NYMEX and the physical and OTC energy markets.
The Critical Value of Competitive, Liquid, Transparent Markets in a Crisis is Proved Over the Past Decade
Nothing illustrates the critical value of an efficient, transparent energy market better than the events of the past decade. We refer you to the three following examples of performance during serious market
situations over the past decade:
Example 1 -Market Response to Persian Gulf Crisis
Example 2 - Market Response to Heating Oil Price Spike
Example 3 - Market Response to World Trade Center Attack, September 11, 2001
The three preceding illustrations serve to emphasize two important points:
§ Transparent, liquid, and competitive energy markets have provided a critical and valuable service in times of serious market stress.
§ As concerns about the current regulatory structure are considered by policy makers and regulators, care must be taken to ensure that any added regulatory measures target problem areas, and do not inhibit
critically needed market functions or flexibility.
The Enron Collapse Provided a Further Test of the Marketplace
In the early stages of Enron's difficulties in the fall of 2001, some observers feared that Enron's substantial position in the OTC marketplace could pose serious problems for a significant number of market
participants. Those fears were well-founded, although fortunately, they did not come to pass. Enron's counterparties realized the risk in being paired against a company in ever-worsening condition and
made alternative arrangements, including transferring positions to the NYMEX.
During that same period, NYMEX used its existing market surveillance tools such as large trader reporting, position limits, and position reporting to alert management to potential problems. In addition to
maintaining vigilant monitoring of market positions and margin and other financial information, the Exchange implemented a number of measures to address issues arising from the Enron situation:
§ Margin requirements (cash required as a guarantee of fulfillment of a futures contract) on natural gas contracts were increased.
§ Approval was sought from, and granted by, the CFTC for the use of EFS ("Exchange of Futures for Swaps") instruments for natural gas to allow market participants to migrate their positions
from the OTC marketplace to NYMEX, where financial performance is guaranteed.
§ Exchange policies to reduce exposure to Enron's credit risk by NYMEX traders were implemented.
The response of market participants to the measures implemented by NYMEX was dramatic. Indeed, as the measures were enacted, we witnessed a remarkable "flight to quality," as market participants
moved to the NYMEX where financial performance is guaranteed by the safety and soundness of a federally regulated clearinghouse.
Legislative and Regulatory Issues
Until all the facts are in, one cannot say with any certainty which of several possible causes brought about the Enron bankruptcy, including regulation or deregulation. However, recent revelations about
market practices by several energy market participants have shifted the issue of whether or not regulation is warranted. Instead of looking at the impact of regulation or the lack of regulation as it affected
Enron, policy makers are evaluating the need for additional measures based on the broader revelations of questionable market practices.
Episodes like the Enron collapse, where a major market participant fails, heighten the awareness that the Exchange is a safe haven, and that the benefits to doing business on a regulated marketplace hold
enormous appeal, or should, to any corporation with credit or price exposure to energy. We believe that corporate boards and treasury offices should become more involved as a matter of their fiduciary
obligations to their employees and shareholders to learn about the differences between regulated and unregulated marketplaces. However, we do not believe that business should be compelled to use
NYMEX by virtue of a regulatory or legislative fiat.
In a "Special Comment" report dated May 2002, Moody's Investors Research identified significant business reasons for the energy sector to conduct its transactions in a different, more regulated manner:
"the lack of regulatory oversight of this [energy trading] activity, and the opaque accounting are not conducive to maintaining counterparty confidence." The Moody's report recognizes that a solution to the
current crisis in OTC energy trading requires a "near term," "fundamental restructuring," with self-imposed business solutions. Among its limited suggestions, Moody's recommends "the establishment of a
clearing system that would provide liquidity, transparency and a more efficient transfer of credit risk." (Quotations from "Summary Opinion," p.1).
Contemporaneous to the publication of this report, NYMEX, recognizing similar industry issues, planned, and last week implemented, an "OTC" clearing mechanism, which is fully regulated and under the
oversight of the CFTC. The CFTC, we might add, has been assertive in overseeing the creation and rules surrounding this new endeavor. We mention it not as evidence of a need for more regulation, but as
an example of the marketplace - in this case the regulated marketplace - providing innovative solutions to business problems that take into account the public interest.
We have consistently stated our position that legislation should not be enacted that would have the effect of dictating "winners" or "losers" in the risk management marketplace. During the consideration
of the Commodity Futures Modernization Act of 2000 (the "CFMA"), we repeatedly stated our deep concern with a narrow provision targeting energy and metals futures markets. Specifically, while we
were supportive of, or neutral to, much of the CFMA, our major concerns centered around a provision that appeared in both the House (H.R. 4541) and Senate (S. 2697) versions of the legislation as
introduced in May of 2000. This provision was actively pushed by Enron, among others, and would have exempted energy and, in the House version, metals futures contracts traded on electronic trading
platforms from nearly all federal regulatory oversight.
Thankfully, Mr. Chairman, you, and Senator Richard Lugar along with the members of the Senate Agriculture Committee recognized the serious policy flaws with this extreme deregulatory measure, and
quite courageously challenged Enron and others, preventing it from becoming law in its most egregious form. Still, as passed, it created a distinction between electronic and open outcry exchanges.
NYMEX had opposed the exemption from its inception, and had supported its elimination from both the Senate and House versions of the CFMA. To this day, we fail to understand the distinction between
an exempt exchange doing business electronically, and one doing business on an open-outcry trading floor, should there have been interest in creating such a forum.
The recent spate of revelations of questionable trading practices has added another level of "angst" to an already nervous marketplace. The need is immediate to restore the confidence of the public and
market participants. After carefully evaluating various proposals to increase market oversight, we have concluded that a proposal put forth by Senators Dianne Feinstein and Peter Fitzgerald is carefully
targeted to correct gaps that currently exist in energy and metals market oversight. Far from being as expansive as some opponents have charged, the Feinstein amendment is narrowly tailored to target a
specifically identified gap in energy and metals market oversight. It would not result in forcing all derivatives transactions onto the most heavily regulated markets. Instead, this amendment, while
maintaining the flexibility that Congress has provided to emerging markets in terms of how they organize their business lines under various new regulatory tiers, would also give the CFTC additional tools
with respect to certain of these new regulatory tiers and other transactions to ensure that the CFTC can obtain necessary information to conduct proper oversight of such markets and transactions. It does
not seek to expand authority to other financial markets, such as involving fixed income or equity swaps, and, frankly, many of our energy market participants have told us they support it. The
Feinstein-Fitzgerald amendment deserves support for the following reasons:
§ The proposal would refine the definition of trading facility as applied to energy derivatives markets and would further require that any such market not otherwise regulated by the CFTC would be accountable to them.
§ In addition, the proposal would give the CFTC vitally important tools to monitor such markets, including large trader reporting.
§ The proposal would also ensure that the CFTC has the authority and ability to obtain access to information critical to market oversight and to make market information public to the extent that the
Commission determines that it is in the public interest to do so.
In testimony presented over the past decade, NYMEX has consistently supported and advocated the need for the market oversight that the centralized markets provide. Based on our experience as a
successful marketplace operation, components important to the marketplace include:
§ Position limits
§ Large trader reporting
§ Surveillance
We believe that CFTC oversight is appropriate and beneficial in areas that provide oversight and uniform standards aimed at protecting the ongoing financial integrity, market integrity and trade practice
integrity of the marketplace. We believe that correct emphasis has been placed on the financial integrity and trade practice protections that the self-regulatory structure of this industry has always provided.
The deepest, most liquid markets--that provide the most efficient price discovery and risk shifting-- occur on the centralized market, i.e. NYMEX, where market and financial integrity oversight is a routine
part of doing business.
We do have some concern that an overly broad legislative response to recent revelations would have a negative impact on all energy markets without providing significant additional regulatory benefits. In particular, we are concerned that the focus of regulation will impose new restrictions on market participants, as opposed to the central marketplaces themselves. The scheme of futures market regulation is focused on the exchanges and brokerage firms which handle customer funds and engage in sales practices. Customer regulation is kept to a minimum, most notably to prevent fraud and manipulation. Those customer standards are already imposed under the CFMA; however, as mentioned above, the central marketplaces (while there are brokers, there is no futures commission merchant equivalent in the OTC marketplace) have managed to escape having any responsibilities, and operate under a purelycaveat emptor scheme of market oversight. This open hole in the OTC scheme of regulation - albeit light regulation - should be addressed. A deliberate and thoughtful legislative approach is appropriate to avoid drying up market liquidity in the cash commodity energy markets and thus severely harming energy markets that impact on every segment of our economy. As we stated at the outset, there is real value in avoiding unintended consequences by striving to do no harm.
It is important that the Senate take this opportunity to restore public faith and confidence in our competitive markets. The amendment's provisions addressing regulatory gaps in the CFTC regulatory
"umbrella" can provide an important, meaningful and carefully focused improvement in market oversight, and is an important step in rebuilding faith and confidence in a competitive energy marketplace.
The energy marketplace has dealt with many crises effectively
Chief among the lessons to be learned taken from the Enron bankruptcy is the value provided by the federally chartered, regulated commodity marketplace in supplying market oversight and credit
enhancement. The ability of market participants to move from largely unregulated trading platforms to the Exchange where transparency, liquidity, and market oversight are the applicable watchwords,
proved to be of critical value in avoiding broad ranging disruptions as Enron's problems became known. In this regard, we also wish to note that the CFTC acted expeditiously in recent weeks to approve a
new NYMEX initiative that facilitates the movement of OTC transactions onto our more transparent and regulated exchange by allowing such transactions to be converted into regulated futures positions
and eventually to be cleared by the Exchange.
The situation could have been far different had the unwise proposal to nearly completely eliminate regulatory oversight of energy and metals futures and options contracts traded on electronic trading
platforms been adopted as originally proposed in the CFMA legislation in 2000. As it turned out, market participants availed themselves of the safety and credit enhancement provided by the regulated
marketplace.
The broader concerns arising from questionable trading practices which have recently come to light serve to illustrate a regulatory gap which we have identified and discussed in prior testimony. As Congress moves forward in the examination of the complex issues arising from the Enron bankruptcy, and in consideration of how the benefits of transparency, market oversight, and enhanced competition can be extended to the broader energy marketplace, including that of electricity, these lessons should be remembered. We believe that the legislation developed by Senator Feinstein and co sponsored by Senator Fitzgerald corrects the current gaps in oversight and accountability, and will provide a sound basis for building public confidence in the fairness and transparency of the energy and metals marketplace.
Once again, Mr. Chairman, thank you for the opportunity to participate in this important discussion.
1 In the adoption of the Commodity Futures Modernization Act, the CFTC's Part 35 prohibition against wash trading, which had applied to all off-exchange derivatives transactions, was eliminated. There are sound reasons to reverse that decision, although we believe that accounting rules and securities laws already prohibit such trades. Since this is a current prohibition in other bodies of law, we would not see a re-introduction of the prohibition in the Commodity Exchange Act to constitute "new regulation."
1 In order to investigate possible fraud or manipulation on an unregulated electronic market, the CFTC needs to make a "Special Call" for information, and has no broad record inspection rights as a matter of course as it does with an exchange. The electronic markets themselves also are not subject to antifraud or antimanipulation rules, and so have no incentive or obligation to adopt rules governing proper market conduct, and have no mechanism to police their participants.