Former CFTC Official Says the Way Enron Loophole Closed Will Lead to Regulatory Arbitrage

A former senior CFTC official maintains that the manner in which the recent Farm Bill closed the Enron Loophole will lead to further regulatory arbitrage. In testimony before the Senate Commerce Committee, former Director of the Trading and Markets divisionMichael Greenberger said that, rather than simply bringing all energy futures contracts within the full U.S. regulatory format with exceptions granted on a case-by-case basis, the Farm Bill requires the CFTC to prove on a case-by-case basis through lengthy administrative proceedings that an individual energy contract should be regulated if the CFTC can prove that the contract serves a significant price discovery function. This contract-by-contract process will take months, if not years, to complete, he noted, and it will then apply only to a single contract. It will then be followed by lengthy and costly judicial challenges during which the CFTC will be required to show that its difficult burden has been met.

It has also been widely reported that the CFTC intends to use the new legislation to show that only a single unregulated natural gas futures contract, and no crude oil futures contracts, should be removed from the Enron Loophole and be fully regulated. Thus, by CFTC pronouncement, crude oil, gasoline and heating oil futures contracts will not be covered by the new legislation.

Moreover, in his view, the Farm Bill‘s attempt to end the Enron Loophole will doubtless lead to further regulatory arbitrage. If the CFTC should be able to prove that an individual energy futures contract has a significant price discovery function, and thus should be subject to regulation, traders will simply move their trading to equivalent contracts that remain exempt from regulation. This was the exact strategy employed by the Amaranth hedge fund when NYMEX imposed speculation limits on it in the natural gas futures market.

The Farm Bill did not close the foreign board of trade exemption (FBOT), which has resulted in a bill being introduced in the Senate to close the FBOT exemption. This exemption, which comes through CFTC staff no-action letters, never contemplated that an exchange owned by, or affiliated with, a U.S. entity would escape the CFTC regulation imposed on traditional U.S. exchanges. Nor did it contemplate that foreign exchanges would trade U.S. delivered contracts in direct competition with U.S. exchanges fully regulated by the CFTC. In response to the staff FBOT no action process, virtually every major foreign exchange in the world has placed its terminals within the U.S. pursuant to a no action letter.

S 2995 would address the FBOT exemption under which, for example, ICE is operating outside of CFTC jurisdiction for the purposes of crude oil. The major tenet of that legislation is that any exchange operating under a FBOT exemption may only do so if the CFTC finds that the non-U.S. regulator has regulation that is equivalent to that of the U.S. in several respects. According to the former official, Acting CFTC Chair Walter Lukken has already concluded that the U.K.‘s FSA regulation is not only comparable, but is a model for U.S. regulators. This statement is reflected in the no action letters that have already been awarded to ICE, under FSA regulation, and, more recently, to the Dubai Mercantile Exchange, where the CFTC has concluded that the Dubai Financial Service Authority‘s regulation of oil futures markets is the equivalent of the CFTC.

Thus, the former CFTC official concluded that, even if S. 2995 is enacted, it will preserve the status quo of FBOTs being allowed to trade U.S. delivered energy future contracts within the United States, but not be subject to U.S. regulation. For example, ICE, even though U.S. owned with U.S. trading engines, trading critically important U.S. delivered energy futures contracts, contracts that would almost certainly otherwise by regulated under the End the Enron Loophole provisions, would continue to be regulated by the United Kingdom.