SECTION: CAPITOL HILL HEARING TESTIMONY

LENGTH: 2319 words

COMMITTEE: SENATE AGRICULTURE, NUTRITION AND FORESTRY

HEADLINE: COMMODITY DERIVATIVES TRADING OVERSIGHT

TESTIMONY-BY: PROFESSOR JOHN C. COFFEE, JR., PROFESSOR OF LAW

AFFILIATION: COLUMBIA UNIVERSITY SCHOOL OF LAW

BODY:
Statement of Professor John C. Coffee, Jr. Adolf A. Berle Professor of Law, Columbia University School of Law

Committee on Senate Agriculture, Nutrition and Forestry

July 10, 2002

Transparency and Oversight of Energy Derivatives

I. Introduction

I want to thank the Committee for inviting me to appear today and begin by acknowledging that I am a generalist in the field of financial markets (and a specialist in the fields of securities regulation and corporate governance). However, I do not purport to specialize in derivatives regulation. Although I testified before this Committee at its initial hearing that led up to the Commodity Futures Modernization Act of 2000 (the "CFMA"), that testimony was also from the perspective of a generalist and focused on the need for greater legal certainty at a time when two federal agencies (the SEC and the CFTC) were quarreling about their jurisdictional boundaries.

Today also, I will again comment as a generalist, focusing on the issues of greatest public policy significance. As I see it, the following three stand out:

1. Would the amendment to the Commodity Exchange Act ("CEA") proposed by Senator Feinstein (the "Feinstein Amendment") result in significantly increased uncertainty, in effect undoing what the CFMA achieved? 2. Is there a need for greater transparency regarding the over- the-counter ("OTC") trading of energy derivatives?

3. Given the natural competition between the OTC market and the exchange traded market in energy derivatives, are there dangers that the Feinstein Amendment could hobble one industry to the advantage of the other? If so, what revisions might be appropriate?

In presenting this testimony, I have reviewed the Feinstein Amendment and representative statements furnished by the International Swaps and Derivatives Association, Inc. ("ISDA") and the New York Mercantile Exchange ("NYMEX").

II. Background When the CFMA was passed in 2000, the legal status of OTC swaps had become a matter of ongoing controversy. As a result of a highly publicized dispute between Proctor & Gamble Co. ("P&G") and Bankers Trust Co. ("Bankers"), in which the former had seemingly been overreached in swaps transactions with the latter, both the SEC and the CFTC asserted jurisdiction and brought (and settled) enforcement proceedings against Bankers. Private litigation was also commenced by P&G, which also raised (ultimately unsuccessfully) claims under both statutes. (1) Even more ominous was the fact that the CFTC, under then Chairwoman Born, had suggested that it might rescind or modify the Part 35 Swaps Exemption under which swap transactions amounting to trillions of dollars (in notional value) had been entered into. Understandably, the President's Working Group ("PWG") recommended that greater legal certainty be accorded to OTC financial derivatives by expressly exempting them from the CEA. The PWG limited its recommendation to financial derivatives, and during the hearings on the CFMA, the CFTC expressed reservations about extending the proposed exemption to apply to OTC energy derivatives. As CFTC Chairman Rainier told Congress, financial swaps were typically issued by bank affiliates, securities dealers, or FCMs, who were, respectively, subject to banking regulators, the SEC, or the CFTC. In contrast, the extension of the CFTC to energy derivatives created, he said, "a regulatory gap," as these products were "neither directly regulated as financial products, nor indirectly regulated by an agency with jurisdiction over commercial participants in the energy market." (2) The PWG also believed that OTC financial derivatives were far less susceptible to manipulation than derivatives on commodities and did not perform a price discovery function. (3)

As the CFMA was finally adopted, a compromise was reached under which derivatives based on commodities that are neither financial nor agricultural (a category that chiefly includes metals and energy products) were deemed "exempt commodities," which could be traded by eligible contract participants without CFTC regulation, but which remained subject to certain provisions of the CEA prohibiting fraud and manipulation. In short, the CFMA never truly exempted OTC energy derivatives from most of the fraud and manipulation provisions of the CEA.

Finally, the CFMA authorized the use of exchange-like electronic facilities for the trading of OTC derivatives based on financial commodities and "exempt commodities" (i.e., energy products and minerals). See in particular 7 U.S.C. section 2(h). This Section 2(h) exemption was critical for the operation of Enron-Online, which chiefly traded OTC energy swaps, and such electronic facilities will likely be the chief casualty of the Feinstein Amendment.

III. Policy Issues

A. Would the Feinstein Amendment Result in Greatly Enhanced or Unnecessarily Legal Uncertainty?

In my judgment, the Feinstein Amendment does not "undo" the desirable legal certainty that the CFMA created. The original uncertainty that led up to the CFMA arose because both the SEC and the CFTC could dispute whether a complex derivatives transaction was more like a futures contract (in which case the CFTC had jurisdiction) or more like an option (in which case the SEC arguably had jurisdiction). Nothing in the Feinstein Amendment will change the fact that the SEC is now totally out of the picture, as the CFMA amended both the Securities Act of 1933 and the Securities Exchange Act of 1935 to deny the SEC any authority over OTC derivatives (financial and non-financial). See, e.g., Securities Act of 1933, Section 2A, 15 U.S.C. Section 77b-1; Securities Exchange Act of 1934, Section 3A, 15 U.S.C. Section 78c-1.

The OTC derivatives industry has objected, however, that the Feinstein Amendment would eliminate the statutory exemption for transactions in exempt commodities conducted on an electronic trading facility (7 U.S.C. section 2(h)). Although it is true that this exemption would be sharply curtailed, it does not create uncertainty for most OTC energy swaps. This is because the statutory exemption under CEA Section 2(g) will remain available for swap transactions, provided that they are "subject to individual negotiation by the parties" and are "not executed on a trading facility." This exemption remains broad enough to cover the traditional OTC swaps market. Only the new electronic trading facilities (such as Enron-Online) are adversely affected by the proposed amendment of Section 2(h). Even then, the Feinstein Amendment does not prohibit an "electronic trading facility," but simply subjects it to a level of CFTC supervision and oversight similar to that applicable to NYMEX or other futures exchanges. In truth, the only difference between electronic facilities and futures exchanges is that the latter use the "open outcry" system while the former are electronic and automated. This is roughly the same difference between the New York Stock Exchange and Nasdaq, which are subject to the same regulatory regimes. I can discern no policy reason why a difference in the organization of trading (i.e., electronic vs. open outcry) should produce a day- versus-night difference in regulatory regimes in the case of the derivatives industry. Functional substitutes generally merit similar regulation.

Finally, even in those cases when Section 2(g) will not by its terms apply to confer an exemption, there remains the prior common law, as codified in the Part 35 Swaps Exemption, which would again come into play. That exemption worked reasonably well for nearly a decade, and the crisis in "legal uncertainty" that produced the CFMA arose only when (i) the CFTC threatened to repeal the Swaps Exemption, and (ii) the SEC asserted overlapping jurisdiction with the CFTC in some cases. No similar crisis is on the horizon.

The ISDA has also asserted that legal uncertainty will arise because of the overlapping jurisdiction of the CFTC and the Federal Energy Regulatory Commission ("FERC"). There is every reason why their respective jurisdictions should overlap because they have different missions. The CFTC is essentially an investor protection agency, whereas the FERC is more concerned with the protection of energy consumers. FERC has an interest in the oversight of derivatives transactions only to the extent that such transactions might be used to manipulate and inflate consumer prices. This is in sharp contrast to the former overlap of jurisdictions between the SEC and the CFTC, which are both investor protection agencies (with very different statutory regimes).

B. Is There A Need for Greater Transparency in the OTC Market for Energy Derivatives?

An FERC investigation of Enron's (and others') role in the California energy crisis is still pending, and I will make no assumptions about its eventual conclusions. Nonetheless, it should be remembered that the Presidents Working Group originally recommended an exemption only for OTC trading in financial derivatives, a recommendation that was based in part on the reasonable premise that because financial derivatives are not based on a commodity that has a finite supply, they cannot be easily manipulated. Energy derivatives are at the very least more susceptible to manipulation than are financial derivatives, and hence they stand in need of greater transparency.

A second justification for mandating greater transparency is that OTC energy derivatives and exchange traded energy derivatives are functional substitutes. Congress has long believed that it is important to mandate transparency in exchange-traded energy derivatives (and NYMEX, the party most regulated by this policy, agrees). Yet, if the major users of energy derivatives can "trade in the dark" by substituting OTC swaps for exchange-traded futures, that policy is undercut. Traders on the futures exchanges cannot know if large positions are being taken in the OTC market, and in times of market stress, this uncertainty could destabilize the market. Exactly this diagnosis was reached fifteen years ago by many commentators about the interplay of futures on stock indexes and securities and the danger that limited transparency in one market could affect the other. Following the1987 crash, the Brady Commission proposed the "One Market" concept as the polestar for future reform: namely, the recognition that the New York based equity markets and the Chicago based stock index market constituted a single integrated market that needed to be regulated consistently. This analysis is as least as apt for energy derivatives, whether traded over-the- counter or on exhanges.

C. Could Regulation Have Ulterior Motives?

Competitors love to subject their rivals to increased regulation - - in effect, to hobble them. For example, for years, the mutual fund industry has been calling for greater regulation of hedge funds. In this light, one has to be at least a little apprehensive that futures exchanges might wish to subject their less regulated competitors - - the electronic trading facility ("ETF") - - to burdensome regulation.

Indeed, one can analogize the ETF to the electronic communications networks (or "ECNs") that now dominate the trading of equities on Nasdaq. ECNs are substantially less regulated by the SEC than traditional exchanges, even though they increasingly compete with exchanges. Clearly, it would be a dubious policy to impose greater regulation on ECNs simply to equalize the relative burdens of regulation.

This analogy can only be carried so far, however, before it breaks down. ECNs are regulated (albeit to a lesser extent than exchanges) as broker-dealers, whereas in contrast ETFs today escape virtually all regulation.

Hence, I would support the transparency, disclosure and reporting obligations in the Feinstein Amendment. However, I do harbor reservations about subjecting ETFs to the CFTC's net capital rules. The net capital rules have long been antiquated, and their original purpose may have little relevance in the ETF context. Brokers-dealers are subject to net capital rules in order to protect their clients (including small retail clients for whom they typically hold cash and securities) against their possible insolvency. ETFs deal only with "eligible participants" who can better fend for themselves. If such persons are apprehensive about a counterparty's credit, they can devise contractual protections (such as a functional substitute for margin), or they could demand that a clearinghouse be developed for the OTC industry (which step the CFMA authorized).

My point is only this: of all the reforms proposed in the Feinstein Amendment, the application of the net capital rules to the OTC energy derivatives market may be the most costly and the least urgently needed. (4) In other respects, I believe that the benefits will outweigh the modest burdens. Functional regulation should require that functionally equivalent markets receive similar levels of regulation. Today, they do not, and the result is that an externality can arise: that is, not only do OTC energy markets escape transparency and oversight, but their ability to do so leaves traders in the more regulated market potentially in the dark.

1. See Proctor & Gamble Co. v. Bankers Trust Co., 925 F.Supp. 1270 (S.D. Ohio 1996).

2. See Testimony of the Honorable William Rainier, Chairman, Commodities Future Trading Commission on June 21, 2000.

3. The basic rationale here is that non-financial commodities have a finite supply and so the market in them can be cornered or squeezed, while this is not true for financial derivatives that are based on interest rates or currency values.

4. My position is not that net capital rules for either market is unwise or counter-productive, but just that the case has not yet been made for extending them to a market populated only by sophisticated parties.



LOAD-DATE: July 11, 2002