**Testimony of Robert G. Pickel, Executive Director and CEO**

**International Swaps and Derivatives Association**

**Before the**

**U.S. House of Representatives**

**Committee on Agriculture**

**Subcommittee on General Farm Commodities and Risk Management**

**July 12, 2007**

Mr. Chairman and Members of the Committee:

Thank you very much for inviting ISDA to testify this morning. The work
which this committee has done in the past, and which it continues to do
today, plays a critical role in creating healthy, active markets for
risk management. Thank you very much for your leadership in this
important area.

**About ISDA**

ISDA, which represents participants in the privately negotiated
derivatives industry, is the largest global financial trade association,
by number of member firms. ISDA was chartered in 1985, and today has
over 800 member institutions from 54 countries on six continents. These
members include most of the world\'s major institutions that deal in
privately negotiated derivatives, as well as many of the businesses,
governmental entities and other end users that rely on over-the-counter
derivatives to manage efficiently the financial market risks inherent in
their core economic activities.

Since its inception, ISDA has pioneered efforts to identify and reduce
the sources of risk in the derivatives and risk management business.
Among its most notable accomplishments are: developing the ISDA Master
Agreement; publishing a wide range of related documentation materials
and instruments covering a variety of transaction types; producing legal
opinions on the enforceability of netting and collateral arrangements
(available only to ISDA members); securing recognition of the
risk-reducing effects of netting in determining capital requirements;
promoting sound risk management practices, and advancing the
understanding and treatment of derivatives and risk management from
public policy and regulatory capital perspectives.

**Overview of Derivatives**

Derivatives are critical risk management tools which allow producers and
end users of commodities to hedge the risk of adverse price movements.
In the most basic type of derivative, an option, the option writer will
sell to the buyer the right (but not the obligation) to purchase or sell
a fixed quantity of a good, at a fixed price, in some future period.
Options provide the basic building block of derivatives, and other types
of derivatives can be seen as a combination of options. For instance, a
long futures contract can be seen as the purchase of an option to
purchase a commodity combined with the simultaneous sale of an option to
sell that same commodity. Futures contracts are traded on organized
exchanges regulated in the United States by the Commodity Futures
Trading Commission. Privately negotiated derivatives, such as swap
agreements, are a type of derivative subject to negotiation between the
parties as to the fundamental material economic terms of the
transaction. Privately negotiated derivatives differ from exchange
traded futures contracts in that they are not fungible nor by their
terms subject to offset through the purchase of a contract with the
opposite characteristics (e.g., a counterparty cannot cancel out its
contractual obligations under a swap agreement to sell a fixed interest
rate by simply purchasing a swap agreement to buy the same fixed rate).
Another important differentiation is that OTC derivatives are typically
transacted between counterparties that meet certain standards for wealth
and sophistication.

Derivatives play an important role in allowing businesses to manage
risks unrelated to their core business. No doubt you are familiar with
how a family farm might sell December corn futures to hedge its risk of
a glut in the corn market, thus locking in today a corn price which will
allow it to remain in business in the future. Likewise, America's
largest corporations use this same strategy to manage the risk of
adverse movements in foreign exchange rates, interest rates, credit
prices, property values and virtually any other threat one can imagine.

**Overview of the Energy Markets**

Energy derivatives are used by a wide range of market participants
including energy companies, financial institutions such as banks and
hedge funds, and traditional end-users of energy. The motivations of
these market participants differ, and can include those looking to hedge
price risk as well as those looking to take a view on, or speculate, on
the movement of energy prices. Indeed, in some cases an entity will play
both roles, having positions designed to hedge the price risk associated
with its use of the physical commodity while at the same time holding
positions speculating on the movement of future prices. Hedging and
speculation play a symbiotic role in the functioning of a market,
hedging because it enables risks to be distributed optimally among
market participants, and speculation because it increases liquidity and
increases the alternatives available to those seeking to hedge their
risks.

**Allegations of Market Manipulation**

The growth of these markets has coincided with volatility in energy
prices, leading some to question whether the growth in derivatives
markets and the influx of new market participants has led to this
volatility. Even more sinister, some have alleged that volatility is the
result of attempts to manipulate the prices of energy commodities. For
instance, on June 25, 2007 the Senate Permanent Subcommittee on
Investigations claimed that "excessive speculation distorts prices,
increases volatility, and increases costs and risks for natural gas
consumers, such as utilities, who ultimately pass on inflated costs to
their customers." These very serious charges are of concern to everyone
involved in these markets, as no one, be they consumers, end users or
market participants themselves, would benefit from the intentional
manipulation of prices.

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Fortunately, there is very little evidence that markets in energy
commodities are subject to widespread manipulation. As noted by the Bank
for International Settlements (BIS) in its March 2007 Quarterly Update:

> Intuitively, one might expect large inflows of funds into commodity
> markets to cause prices to rise sharply, possibly to higher levels
> than are justified by economic fundamentals. The prima facie evidence
> seems to support this view, as financial activity has broadly
> increased in parallel with prices during the past four years. However,
> the results of empirical work on the impact of the growing presence of
> financial investors on commodity prices are less clear-cut. Several
> recent studies, which explore the relationship between investor
> activity and commodity prices, indicate that price changes have led to
> changes in investor interest rather than the other way around.

The BIS cites in support of this thesis studies conducted by James
Overdahl, Chief Economist of the Commodity Futures Trading Commission,
as well as a report by the International Monetary Fund. In addition to
these studies the Government Accountability Office, the Federal Trade
Commission, the Department of Energy and numerous academics likewise
have examined the question of whether manipulation of energy prices
exists and is having an adverse effect on consumers. All have reached
the same conclusion: energy prices are caused by the external forces of
supply and demand, influenced by factors such as refinery capacity and
hurricane activity, and not by the derivatives markets. As succinctly
stated in testimony before the House Energy and Commerce Committee by W.
David Montgomery, Vice President for CRA International, regarding
gasoline prices: "There has never been a finding that . . . price
increases were caused by any manipulation of the markets. "

Given the overwhelming evidence that derivatives do not lead to
manipulation of energy markets, it makes sense to ask what role these
instruments do play. In addition to serving as risk management tools,
the experience of market participants and academic research alike
confirms that on a macro level energy derivatives increase market
liquidity and depth and stabilize commodity markets. Both exchange
traded and privately negotiated derivatives contribute to more stable,
more efficient commodity markets.

**The Evolution of the Commodity Exchange Act**

Given the tremendous growth of the energy derivatives industry and the
role these products play in helping manage risk and stabilize markets,
it is worth considering how government policy in the United States
helped promote such a beneficial result. Even before the passage of the
Commodity Futures Modernization Act of 2000 the CFTC realized the
inappropriateness of applying a "one-size-fits-all" standard to
derivatives. Beginning in 1990 the Commission began creating protections
for energy transactions, such as the "Statutory Interpretation
Concerning Forward Transactions" and the 1993 Exemptive Order. These
administrative decisions provided some comfort to market participants
that their individually negotiated contracts would be protected from
unwarranted regulatory intervention, while at the same time ensuring
that market participants would be subject to the anti-manipulation
provisions of the Commodity Exchange Act (CEA).

Nevertheless, market participants were still exposed to the risk that
their contracts would be held legally unenforceable because of the
inappropriate application of the CEA to their private contracts. Because
the CEA was originally written to address exchange traded agricultural
commodities the law contained a provision making any off-exchange
future-like contract illegal (and thus unenforceable). This "legal
uncertainty," which threatened to undermine an important and growing
market, caused this Committee and its Senate counterpart, the House and
Senate Banking Committees, the House Commerce Committee and the
President's Working Group on Financial Markets to jointly undertake an
historic effort to improve and reform the CEA.

The Commodity Futures Modernization Act of 2000 greatly increased
American competitiveness in both the exchange traded and OTC derivatives
industries. For futures exchanges, the law created a principles-based
regulatory regime that greatly increased the flexibility and efficiency
of those markets. For OTC derivatives the law removed legal uncertainty,
protected the right of sophisticated counterparties to engage in
individually negotiated swap transactions and retained anti-fraud and
anti-manipulation authority over the OTC commodity markets.

**Regulation of OTC Derivatives**

It is important to recognize that OTC derivatives are subject to a broad
range of regulation. OTC market participants themselves, such as
commercial banks and broker dealers, are subject to plenary regulation
by their respective front line regulatory agencies (for example, the
Federal Reserve and the SEC; the CFTC likewise retains regulatory
authority over the operations of registered commodity trading advisors
and commodity pool operators.) This is important, since these OTC
dealers are the counterparty on the overwhelming majority of
transactions conducted in the over-the-counter markets. In addition to
the regulation of the counterparties themselves OTC energy derivative
transactions are subject to CFTC oversight under section 2(h)[^1] of the
Commodity Exchange Act

Section 2(h) deals with exempt commodities. These are commodities which
are neither financial nor agricultural, and include oil, natural gas,
coal and precious metals. Under 2(h) contracts between eligible contract
participants which are not traded on a trading facility are exempt from
most provisions of the CEA except for the Act's anti-fraud and
anti-manipulation provisions. Section 2(h) also exempts trades between
eligible commercial entities[^2] done on a principal-to-principal basis
when transacted on an electronic trading facility. In addition to being
subject to the anti-fraud and anti-manipulation provisions of the CEA,
exempt electronic trading facilities are subject to recordkeeping
requirements and must provide price, trading volume and such other
trading information as the CFTC determines is appropriate if the
Commission determines the entity serves as a price discovery market for
the underlying exempt commodity.

In addition to the Commodity Exchange Act, federal oversight of energy
products is also provided by the Federal Energy Regulatory Commission
(FERC). Amendments passed by Congress as part of the Energy Policy Act
of 2005 provided FERC with anti-fraud and anti-manipulation authority
over transactions in electricity and natural gas. These amendments to
the Federal Power Act and the Natural Gas Act are modeled after the
Securities and Exchange Commission's authority under section 10(b) of
the 1934 Securities and Exchange Act. The FERC's authority applies to
physical transactions in a commodity, as opposed to derivative
transactions which are under the exclusive jurisdiction of the CFTC.
Nevertheless, the two agencies' authorities in this area provide an
overarching web of regulation of both the physical and derivative energy
markets, giving a holistic view of these interlinked areas. CFTC and
FERC likewise have a Memorandum of Understanding allowing for
information sharing between the two agencies.

Oversight of the energy markets in the United States is thorough and
effective. Enforcement efforts by federal regulators have been very
successful in detecting, deterring and punishing misbehavior. Between
December 2002 and May 2007 the CFTC has collected over \$307 million in
civil penalties from defendants accused of wrongdoing in the energy
markets. Among ISDA member firms there is no doubt that these agencies
are providing strong oversight of these markets; they report regular
visits and requests for information from federal regulatory officials,
as part of the routine operations of their businesses.

**Calls for Greater Regulation are Unwarranted**

Almost immediately after Congress passed the CFMA there have been calls
in some quarters to repeal parts of that law. Nowhere have these calls
come more loudly than with regard to energy commodities. Fortunately
Congress has time and again rejected efforts to repeal the balance
between legal certainty for sophisticated institutional market
participants and the need for federal oversight provided by the CFMA.

For the most part, calls to revisit the CFMA rest upon claims of a lack
of transparency in the markets as well as insinuations of impropriety.
However, as discussed earlier in this testimony, there are no credible
studies which demonstrate a cause and effect relationship between
activities in the derivatives markets and consumer energy prices. More
to the point, as the Members of the President's Working Group have
repeatedly noted, there is no change in federal law as applied to
derivatives which could alleviate the volatility in energy prices which
have existed over the last several years. As Federal Reserve Chairman
Ben Bernanke noted in response to questioning in the Senate last
Congress: "I am unaware of any evidence that supports the view that
additional reporting requirements or other new regulations would reduce
energy prices or energy price volatility."

Energy prices respond to a variety of supply and demand related factors,
which have in recent years been aggravated by events such as an active
hurricane season, lack of refinery capacity, unusual weather patterns
and military and political crises in major oil producing regions.
Changing the CFMA will not address those factors, nor will it do
anything to alleviate consumer concerns about high energy prices.

**Consequences of Rewriting the CFMA**

Instead, amending the legal certainty for OTC energy derivatives
provisions of the Commodity Exchange Act will serve only to make
business less attractive in the United States. Already, American
competitiveness in the financial services arena is under assault from
foreign markets which are eager to attract lucrative US financial
services activity. As recently noted in the paper "Sustaining New York's
and the U.S.'s Global Financial Services Leadership," sponsored by New
York Mayor Bloomberg and U.S. Senator Charles Schumer:

"Europe's also the center for derivatives innovation. 'People feel less
encumbered overseas by the threat of regulation and so are more likely
to think outside of the box,' notes one US-based business leader."

OTC energy trades are done in the US by the choice of the market
participants, who favor the current regulatory environment and prefer
the strength of US courts and their respect for privately negotiated
agreements. But there is simply no reason that energy transactions which
do not call for the actual physical delivery of a commodity need be done
in the United States. Indeed, because these transactions can be done
electronically their execution can be readily relocated to more
favorable regulatory environments should they feel that the costs and
burdens of regulation have become too onerous.

Therefore Congress should tread carefully if considering legislating in
this area. To date the OTC derivatives markets have been robust, stable
and liquid, and provided the means for end users of energy products to
manage the risks of recent price volatility in a cost-efficient manner.
Making the use of these products too costly, through the application of
an inappropriate regulatory regime, would serve only to hurt American
businesses and ultimately consumers, while doing nothing to alleviate
energy prices.

**Conclusion**

Mr. Chairman and Members of the Committee, thank you very much for your
time today. This is an important issue, and the leadership which this
Committee has shown on this topic over the years has greatly improved
the legal and regulatory environment in the United States. Going forward
we are confident that you will continue to play a leading role in
promoting the health and growth of these markets. Thank you again and I
would be privileged to answer any questions you might have.

[^1]: Section 2(h) is sometimes derogatorily called the "Enron
    loophole," because of allegations that the provision was "snuck in
    at the last minute" in HR 5660, the legislation which contained the
    CFMA. In fact, numerous hearings were held on HR 4541, the original
    version of the CFMA. HR 4541 contained a similar provision to
    current 2(h) entitled "Exempt Commodities"; the bill was the subject
    of numerous hearings in the House, including four hearings in the
    House Agriculture Committee. In addition to HR 4541 the companion
    Senate legislation, S.2697, likewise contained a provision regarding
    energy commodities; S. 2697 was also the subject of legislative
    hearings.

[^2]: Eligible commercial entities are a narrower subset of eligible
    contract participants that, in general, are in the business of
    dealing in the underlying exempt commodity as a routine part of
    their operations.