Provisions in Farm Bill Would Close Enron Loophole

A measure reauthorizing the CFTC and closing the Enron loophole is included in the massive Farm Bill that has been reported out of a House-Senate conference and awaits congressional action, and a possible presidential veto. Provisions in the Food, Conservation and Energy Act (HR 2419) would end the Enron-inspired exemption from federal 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. These bipartisan provisions, championed by Senators Carl Levin (D-MI), Dianne Feinstein (D-CA), and Olympia Snowe (R-Me) would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating these energy prices.

The bill also requires the President’s Working Group on Financial Markets to work with the SEC and the CFTC to allow risk-based portfolio margining for security options and security futures products by September 30, 2009; and the trading of futures on security indexes by June 30, 2009, by resolving issues related to foreign security indexes.

In closing the Enron Loophole, the measure would increase federal oversight authority to detect and prevent manipulation and to limit speculation in U.S. electronic energy markets. It would increase transparency, and create an audit trail, impose firm speculation limits, and significantly increase financial penalties for cases of market manipulation and excessive speculation. The measure was approved as part of the CFTC Reauthorization Act of 2008, which is Title XIII of the act..

According to Senator Feinstein, the bill puts all significant energy trades on electronic platforms within the regulatory confines of the CFTC and imposes limits on the size of trader’s positions to prevent excessive speculation. It also ensures that there is an audit trail, imposes recording keeping requirements, and forces electronic exchanges to monitor trading behavior and prevent manipulation.

For contracts that are significant in determining commodity market prices, the CFTC will require the electronic exchange to provide strict oversight, similar to what takes place today on regulated markets like the New York and Chicago Mercantile Exchanges. The exchanges will be required to prevent manipulation and price distortion by monitoring trading to prevent manipulation and price distortion; ensuring contracts are not susceptible to manipulation; limiting the size of positions to prevent excessive speculation, and; reducing holdings of traders in violation of position limits. The exchanges will also have to establish an audit trail by collecting information on trading activity and supplying large trader reports to the CFTC. They will also have to enhance transparency by publishing price, trading volume, and other trading data on a daily basis.

Regarding electronic contract oversight, the bill directs the CFTC to review all electronic contracts to identify those that are significant in determining market prices and thus must be regulated under the bill. The CFTC will consider the following factors in making that determination: 1) If the contract is traded in significant volumes; 2) If the contract is used by traders to help determine the price of subsequent contracts. This is like using “comps” in the real estate market or “Blue Book” for auto sales; 3) If the contract is equivalent to a regulated contract and used the same way by traders. The CFTC refers to these contracts as “look-alikes.”

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.

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 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.