Veto-Proof Farm Bill Terminates Enron Loophole and Reforms Electronic Energy Markets

Congress has passed a veto-proof measure reauthorizing the CFTC and closing the Enron loophole as part of a massive Farm Bill. 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 would give the CFTC the ability to scrutinize these transactions in energy commodities and prosecute traders that are manipulating energy prices. The House passed the bill 318-106; the Senate vote was 81-15

The Enron loophole was codified in Section 2(h)(3) of the Commodity Exchange Act. It exempts from oversight the electronic trading of energy commodities by large traders. In closing the Enron Loophole, the measure would increase federal oversight 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 Farm Bill.

The Enron loophole has allowed large volumes of energy derivatives contracts to be traded over-the-counter and on electronic platforms without the federal oversight necessary to protect both the integrity of the market and energy consumers

The Act 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 recordkeeping 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 on regulated markets like the New York and Chicago Mercantile Exchanges. The exchanges will be required to monitor trading to prevent manipulation and price distortion; ensuring that 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.

The Act 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 measure. 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 Act 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.

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 CFTC is directed to adopt rules implementing the authorities provided by this Act regarding significant price discovery contracts. The conference report indicates that the Commission can consider the potential for arbitrage between a potential significant price discovery contract and an existing such contract in making a determination whether a contract has that status.

The conference report clarifies that, in determining appropriate position limits or position accountability limits under the Act, an electronic trading facility must consider cleared swaps transactions that are treated by a derivatives clearing organization as fungible with significant price discovery contracts.

Portfolio Margining

Following enactment of the CFMA, the CFTC and the SEC jointly promulgated rules relating to the margining of security futures products. Under those rules, security futures products have been subject to the same fixed-rate strategy-based margining scheme applicable to security options customer accounts, rather than the risk-based portfolio margining system typical in the futures industry. Many have argued that this has contributed to the low volume of trading in such products which, by contrast, have been successful in Europe.

The Act directs the CFTC and SEC to use their existing authorities to allow customers to
benefit from the use of a risk-based portfolio margining system for both security options
and security futures products. The detailed statutory test of a narrow-based security index was tailored to fit the U.S. equity markets, which are by far the largest, deepest and most liquid securities markets in the world. The Act provides clarity in this area by requiring the CFTC and the SEC to adopt rules providing criteria that will exclude broad-based indexes on foreign equities from the definition of narrow-based security index as appropriate.

Thus, the measure 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.