Sunday, February 17, 2008

Feinstein Amendment to Farm Bill Would Close Enron Loophole

A measures reauthorizing the CFTC and closing the Enron loophole have been tacked on to a bipartisan Farm Bill and passed by the Senate. The bill is now in conference with a House-passed Farm Bill. The Feinstein amendment to the Farm Bill will put an end to the Enron-inspired exemption from government oversight now provided to electronic energy trading markets set up for large traders. It will ensure the ability of the CFTC to police all US energy exchanges to prevent price manipulation and excessive speculation. This bipartisan provision, championed by Senators Carl Levin (D-MI) and Dianne Feinstein (D-CA), would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating these energy prices.

The amendment also reauthorizes the Commodity Exchange Act until 2013. The legislation has the general support of the CFTC, the electronic exchange known as ICE, the New York Mercantile Exchange, the Chicago Mercantile, and the President’s Working Group on Financial Markets.

The legislation increases transparency in energy markets to deter traders from manipulating the price of oil and natural gas futures traded on electronic markets. It requires energy traders to keep records for a minimum of five years so there is transparency and an audit trail. It requires electronic energy traders to report trading in significant price discovery contracts to the CFTC so that the agency would have the information to effectively oversee the energy futures market. Manipulators could then be identified and punished by the CFTC.

The bill gives the CFTC new authority to punish manipulation, fraud, and price distortion. It requires electronic trading platforms to actively monitor their markets to prevent manipulation and price distortion of contracts that are significant in determining the price of the market.

One prime genesis of the measure was the fact that, when the Amaranth hedge fund was directed to reduce its position in regulated natural gas contracts, it simply moved its position to an unregulated exchange. The bill would essentially say that similar contracts on ICE and NYMEX will be regulated the same way. Last October, the four CFTC Commissioners released a report underscoring the critical need for increased oversight in U.S. energy markets. According to Sen. Feinstein, this bill includes what they asked for.

Congress determined that the current system regarding exempt commercial markets lacks
transparency. Traders are able to avoid revelations of their identity within these exempt commercial markets. In fact, based on a Senate investigation, it was discovered that the Amaranth hedge fund had excessively traded natural gas contracts to such a degree that it controlled 40 percent of all natural gas contracts on the New York Mercantile.

The New York Mercantile, which is subject to CFTC regulation, required Amaranth to reduce its holdings of natural gas contracts. The hedge fund’s response was simply to move its dealings to the exempt commodity market, thereby defeating the entire purpose of CFTC regulation and cloaking its potentially manipulative market power.

This was pursuant to the Enron loophole in the law, included in the Commodity Futures Modernization Act of 2000, which has allowed large volumes of energy derivatives contracts to be traded over-the-counter and on electronic platforms without federal oversight. The Enron loophole was inserted at the last minute into the CFMA and passed by Congress in late December 2000, in the waning hours of the 106th Congress. This loophole exempted from federal oversight the electronic trading of energy commodities by large traders. The loophole has helped foster the explosive growth of trading on unregulated electronic energy exchanges.

The Feinstein Amendment would grant the CFTC new authority to impose important requirements on electronic, OTC transactions that rely on the current exemption contained in Section 2(h)(3) of the CEA, but serve a significant price discovery function. These requirements include the implementation of market monitoring, the establishment of position limitations or accountability levels, the daily publication of trading information, and a number of other standards key to restoring transparency to this important corner of the energy markets.

The legislation would do more than require CFTC oversight; it would also require electronic exchanges, for the first time, to begin policing their own trading operations and become self-regulatory organizations in the same manner as futures exchanges like NYMEX. Specifically, the legislation would establish five core principles to which electronic exchanges must adhere, each of which parallels core principles already applicable to other CFTC-regulated exchanges and clearing facilities.

Implementing these core principles would require an electronic exchange to monitor the trading of contracts which the CFTC has determined affect energy prices, ensure these contracts are not susceptible to manipulation, require traders to supply information about these contracts when necessary, supply large trader reports to the CFTC related to these contracts, and publish daily trading data on the price, trading volume, opening and closing ranges, and open interest for these contracts. In addition, the electronic exchanges would have to establish position limits and accountability levels for individual traders buying or selling these contracts in order to prevent price manipulation and excessive speculation.

Electronic exchanges are intended to implement these position limits and accountability levels in the same way as futures exchanges like NYMEX. Moreover, it is intended that the CFTC will take steps to ensure that the position limits and accountability levels on all exchanges are comparable to prevent traders from playing one exchange off another.

The legislation would also require electronic exchanges to establish procedures to prevent conflicts of interest and anti-trust violations in their operations. These provisions parallel core principles already applicable to other CFTC-regulated exchanges and clearing facilities and are intended to function in a similar manner. These provisions are not restricted to trades involving contracts that affect energy prices, but apply to the entire exchange to ensure it operates in a fair manner.

In addition to requiring electronic exchanges to become self-regulatory organizations, the legislation would require the CFTC to oversee these exchanges in the same general way that it currently oversees futures exchanges like NYMEX. The legislation also, however, assigns the CFTC a unique responsibility not present in its oversight of other types of exchanges and clearing facilities. The legislation would require the CFTC to review the contracts on each electronic exchange to identify those which ‘‘perform a significant price discovery function’’ or, in other words, have a significant effect on energy prices.

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