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86–213 PDF 2003

S. HRG. 107–897

CFTC REGULATION AND OVERSIGHT OF

DERIVATIVES

HEARING

BEFORE THE

COMMITTEE ON AGRICULTURE,

NUTRITION, AND FORESTRY

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

JULY 10, 2002

Printed for the use of the

Committee on Agriculture, Nutrition, and Forestry

(

Available via the World Wide Web: http://www.agriculture.senate.gov

COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

TOM HARKIN, Iowa, Chairman

PATRICK J. LEAHY, Vermont

KENT CONRAD, North Dakota

THOMAS A. DASCHLE, South Dakota

MAX BAUCUS, Montana

BLANCHE L. LINCOLN, Arkansas

ZELL MILLER, Georgia

DEBBIE A. STABENOW, Michigan

BEN NELSON, Nebraska

MARK DAYTON, Minnesota

PAUL DAVID WELLSTONE, Minnesota

RICHARD G. LUGAR, Indiana

JESSE HELMS, North Carolina

THAD COCHRAN, Mississippi

MITCH MCCONNELL, Kentucky

PAT ROBERTS, Kansas

PETER G. FITZGERALD, Illinois

CRAIG THOMAS, Wyoming

WAYNE ALLARD, Colorado

TIM HUTCHINSON, Arkansas

MICHEAL D. CRAPO, Idaho

MARK HALVERSON, Staff Director/Chief Counsel

DAVID L. JOHNSON, Chief Counsel for the Minority

ROBERT E. STURM, Chief Clerk

KEITH LUSE, Staff Director for the Minority

(II)

(III)

C O N T E N T S

Page

HEARING(S):

CFTC Regulation and Oversight of Derivatives .................................................... 01

Wednesday, July 10, 2002

STATEMENTS PRESENTED BY SENATORS

Harkin, Hon. Tom, a U.S. Senator from Iowa, Chairman, Committee on

Agriculture, Nutrition, and Forestry .................................................................. 01

Feinstein, Hon. Dianne, a U.S. Senator from California ...................................... 03

WITNESSES

PANEL I

Erickson, Thomas J., Commissioner, Commodity Futures Trading Commission, Washington, DC .......................................................................................... 13

Newsome, James E., Chairman, Commodity Futures Trading Commission,

Washington, DC ................................................................................................... 11

PANEL II

Coffee, John C., Jr., Professor, Columbia Law School, New York, New York .... 38

Dodd, Randall, Director, Derivatives Study Center, Washington, DC ................ 35

Green, Richard C., Chairman, Aquila, Inc., Kansas City, Missouri .................... 45

Patrikis, Ernest T., Senior Vice President and General Counsel, American

International Group, Inc., International Swaps and Derivatives Association

(ISDA), New York, New York ............................................................................. 41

Wolkoff, Neal L., Executive Vice President and Chief Operating Officer, New

York Mercantile Exchange, Inc., Washington, DC ............................................ 42

APPENDIX

PREPARED STATEMENTS:

Harkin, Hon. Tom ............................................................................................ 66

Coffee, John C., Jr. ........................................................................................... 130

Dodd, Randall ................................................................................................... 90

Erickson, Thomas J. ......................................................................................... 74

Green, Richard C. ............................................................................................. 164

Newsome, James E. .......................................................................................... 69

Patrikis, Ernest T. ............................................................................................ 138

Wolkoff, Neal L. ................................................................................................ 152

DOCUMENT(S) SUBMITTED FOR THE RECORD:

Electric Power Supply Association .................................................................. 195

Falvey, James M. .............................................................................................. 189

Leahy, Hon. Patrick ......................................................................................... 182

Lincoln, Hon. Blanche ...................................................................................... 172

Miller, Hon. Zell ................................................................................................ 175

Page

IV

DOCUMENT(S) SUBMITTED FOR THE RECORD—CONTINUED

Wood, Pat III ..................................................................................................... 186

(1)

CFTC REGULATION AND OVERSIGHT OF

DERIVATIVES

WEDNESDAY, JULY 10, 2002

U.S. SENATE,

COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY,

Washington, DC.

The committee met, pursuant to notice, at 9:35 a.m., in room

SD–106, Dirksen Senate Office Building, Hon. Tom Harkin, [Chairman of the Committee], presiding.

Present or submitting a statement: Senators Harkin, Lincoln,

Miller, Nelson, Lugar, Fitzgerald, and Crapo.

The CHAIRMAN. Good morning. The Senate Committee on Agriculture, Nutrition, and Forestry will come to order.

This morning, I am pleased to welcome everyone to our committee for a hearing on regulation of markets in over-the-counter derivatives and the CFTC’s oversight role. The main focus of this

hearing will be the regulatory treatment of derivatives, based on

‘‘exempt commodities,’’ such as energy and metals, following the

passage of the Commodity Futures Modernization Act of 2000. During this hearing, the committee intends to examine the scope of the

CFTC’s authority and its exercise of its authority to ensure market

transparency, to prevent and punish fraud and manipulation, and

to restore confidence in these markets.

The impact of OTC derivatives markets reaches well beyond the

immediate parties to the transactions. The integrity of these markets and the confidence in them are critically important to shareholders, investors, consumers, and the broader economy.

The OTC derivatives markets have assumed an increasingly

large role in the U.S. economy. A recent conservative estimate put

the size of the global OTC derivatives markets at $111 trillion. The

U.S. share of that market is estimated to be at least two-thirds.

Derivatives based on exempt commodities, such as energy and metals, make up a very small percentage, probably no more than 2 percent of the total OTC derivatives market. However, derivatives

play an increasingly important role in energy and metals markets,

which are, in turn, critical to our overall economy.

When the CFMA was enacted in December of 2000, one of its primary goals was to ensure the legal certainty for OTC derivatives.

For the most part, the CFMA was based on the recommendations

of the President’s Working Group on Financial Markets issued in

1999. The President’s Working Group recommended that certain

transactions involving financial derivatives be excluded from the

CFTC’s jurisdiction. The President’s Working Group did not recVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
2

ommend a similar exclusion for transactions involving energy and

metals derivatives.

During development of legislation in the Senate, there was discussion of the issue of oversight of energy and metals derivatives

markets. Senator Lugar and I both supported in this committee a

version of the legislation that was consistent with the recommendations of the President’s Working Group and excluded only financial

derivatives, not energy and metals derivatives, from the CFTC’s jurisdiction. The bill codified an exemption with specific safeguards

for certain commodities, such as energy and metals.

The final version of the legislation included in the omnibus appropriations bill differed from our committee bill regarding energy

and metals derivatives markets. I supported the CFMA, although

I had some concerns about its treatment of energy and metals

products. There is a statement I gave on the floor to which I would

refer you that is in the Congressional Record regarding that, because I thought at the time it had a number of very positive features. On the whole, I thought it was a good bill, and I still think

it is. It is important that we do not undermine the legal certainty

that the legislation brought to the CFTC derivatives market. However, if there are unaddressed problems with some types of derivatives that could give a black eye to all OTC derivatives, then we

are going to have to take a look at that.

Although the CFTC is currently investigating allegations of fraud

and manipulation in the Western energy markets, some have suggested that the CFTC does not, because of the passage of the

CFMA, have sufficient authority to effectively and successfully investigate and punish fraud and manipulation in derivatives markets for exempt commodities, again, energy and metals. Questions

have also been raised about the CFTC’s ability to prevent fraud

and manipulation in the first place.

Today’s hearing will focus on these issues and I hope it will help

answer some of these questions. We hope also to discuss possible

legislative solutions to any problems identified in the existing regulatory framework for OTC derivatives based on exempt commodities.

Our first witness, of course, Senator Feinstein, has proposed legislation to increase transparency in the energy and metals derivatives markets and to clarify and strengthen the CFTC’s authority

to investigate and punish fraud and manipulation in those markets.

In addition to the distinguished Senator from California, we have

two panels of witnesses here with us today. The first panel consists, of course, of chairman Newsome and commissioner Erickson

of the CFTC, and we are pleased that they could be with us today.

Our second panel consists of witnesses Randall Dodd, Director of

the Derivatives Study Center; John Coffee, Professor of Law at Columbia; Neal Wolkoff, the Executive Vice President and COO of the

New York Mercantile Exchange; Mr. Patrikis representing the

International Swaps and Derivatives Association; and Richard

Green, Chairman of Aquila, Incorporated, an energy trading company. We welcome all the witnesses to the committee and look forward to our hearing.

3

With that, now I would turn to our distinguished ranking member, Senator Lugar, who provided such great leadership and I was

pleased to work with him very closely in working out the CFMA

that was passed in the year 2000, which as I just stated in my

opening statement, I still think is a good bill and has a lot of good

things in it. Perhaps now we have to look at some of the other

things that are exempt and that is what the purpose of this hearing is. Senator Lugar was one of the driving forces in the Modernization Act and I turn now to him for his statement.

[The prepared statement of Sen. Harkin can be found in the appendix on page 66.]

Senator LUGAR. I thank you very much, Mr. Chairman. I just ask

that my statement be placed in the record in full.

The CHAIRMAN. Without objection.

Senator LUGAR. I would just make the comment that I think your

recitation of the history of the Commodities Futures Act is accurate

and certainly reflects the gravity of the situation our committee

faced. We met regularly, and, in fact, a number of the hearings

were in this room, with Alan Greenspan, the Secretary of the

Treasury, and other people who felt after the long-term capital

management failure that the financial institutions of this country

could be jeopardized and that at least the laws that were on the

books might contribute to that jeopardy.

We took that seriously and proceeded really for the better part

of a year and a half, as you will recall, through seminars that involved many people in all facets of the futures industries, as well

as experts from academia and governmental responsibility, and in

the final stages of that Congress, the Act finally came from conference in the manner you suggested.

It is fully appropriate that this committee have an oversight of

how that has worked. We have been busy in other things, including

a comprehensive farm bill, and it is appropriate we return now to

some of our previous work. I welcome the hearing. I am delighted

that our colleague, Senator Feinstein, leads off this morning because she has given a great deal of thought and leadership in this

area. I thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator Lugar, and again, I thank

you for your great leadership in this area.

The CHAIRMAN. Now, we welcome our distinguished fellow Senator from the State of California who has again taken up this issue

with great force and great intellect and has painted for the public

the picture of what has happened in California and why we need

to revisit this issue of whether or not they should be exempt or not.

I thank Senator Feinstein for being here. Your statement will be

made a part of the record in its entirety, and please proceed as you

so desire, Senator Feinstein.

STATEMENT OF HON. DIANNE FEINSTEIN, A U.S. SENATOR

FROM CALIFORNIA

Senator FEINSTEIN. Thank you very much, Mr. Chairman, and

thank you very much, Senator Lugar, Senator Miller, for being

here. Mr. Chairman, I particularly appreciate your keeping your

word. I have been pestering you for this hearing for a while and

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I thank you very much for holding it, and I want to thank both of

you for your work.

Mr. Chairman, you accurately quoted the record, and I appreciate that very much. This committee did include CFTC oversight

over energy derivatives when the bill came out. The Senate bill did.

As you know, in conference, that was changed.

Mr. Chairman, last night, I was listening to some former CEOs

on television rather critical of the Congress for not taking steps to

really close loopholes and exert the kind of legislation that would

produce the kind of regulatory oversight over the markets. This is

one of those loopholes that happened in 2000 and I want to thank

you for holding this hearing on this legislation which would restore

oversight, transparency, and reporting to energy trading markets

and ensure that the CFTC has full anti-fraud and anti-manipulation authority, including the authority to investigate wash trades.

This bill closes the loophole that you refer to. That loophole created a kind of niche market so that derivatives traded online could

be traded without any anti-fraud, anti-manipulation oversight,

without transparency, without net capital requirements, with no

records and no audit trail. This was wrong, in my view, Mr. Chairman.

Let me speak for a moment about what we have learned about

the energy sector in the past couple of months and the operations

of some of the energy companies. First, CMS Energy admitted that

80 percent of its trades were round-trip or wash trades and were

made simply to increase volume. That is 80 percent. Reliant admitted to $6.4 billion in wash trades from 1999 to

2001, which the company characterized as energy swaps. Three, Duke confessed to $1.1 billion in wash trades and stated

that $650 million of these trades were executed on the Intercontinental Exchange, an electronic trading facility exempt from CFTC

oversight because of the Commodities Futures Modernization Act.

As I understand how the Intercontinental Exchange works, not

only does this exchange have no responsibility for trades or wash

trades executed on its exchange, it does not take any responsibility

for checking that a transaction has, in fact, even been executed.

Thus, a company could manipulate prices or game the market

without even executing a single trade.

Now, what is a wash trade? A company sells to another who sells

back at the same price at the same time. The result boosts revenue

without any trade actually having taken place. In my view, it is

flim-flam and it artificially inflates revenues and creates an illusion of activity to raise stock prices, and that is what has been

going on and it goes on in secret. There is no audit trail. There is

no record kept. There is no anti-fraud, anti-manipulation oversight.

In the past year, 12 of the largest energy companies in the

United States have lost about $188 billion of capital. That is 71

percent of their market value. The credit ratings of several of those

energy companies have been severely downgraded. Some are at

junk bond or near junk bond status today.

In the past month, Dynegy and Aquila have both halted their energy trading operations. I understand that Williams is on the verge

of doing the same thing. Yet many of these energy companies continue to fight transparency, record keeping, and Federal oversight,

5

the very components that are vital for markets to work and for investors to be confident of an upright and fair system.

I want to briefly explain my interest in all of this. In May 2000,

a severe energy crisis began in California. Electricity that had typically sold for $30 a megawatt hour all of a sudden started to sell

for ten times that. This led to the bankruptcy of California’s largest

investor-owned utility and the near-bankruptcy of California’s second-largest investor-owned utility. It also resulted in overcharges of

billions of dollars to California rate payers and taxpayers.

In November, California encountered a natural gas crisis. Natural gas is the main cost component of electricity. At one point, what

came to my attention was that natural gas was selling at $12 a

decatherm in San Juan, New Mexico, and $59 a decatherm in

Southern California. Now, transportation cost to move that gas is

only a dollar and yet that gas solo for $59. What was happening?

Just about the time Congress passed the Commodities Futures

Modernization Act exempting electronic energy trading exchanges

from oversight, the crisis began spreading to other Western States.

For more than 6 months, Oregon, Washington, and the other Western States experienced the same price spikes as California. The entire crisis lasted for more than a year while energy companies like

Reliant, Enron, Duke, Williams, AES enjoyed record revenues and

profits.

Obviously, we are all a bit wiser today about energy’s markets

and the wash trades, in particular. Wash trades, or round-trip

trades, involve two or more companies plotting together to execute

offsetting trades. I cannot think, really, of a legitimate reason for

doing a wash trade, but wash trades can significantly enhance revenues, as I have pointed out, if they are done on an exchange like

the Intercontinental Exchange and they can certainly influence

price. In my book, this is outright fraud, and these trades would

be illegal if they were done on the NYMEX, the Chicago Mercantile, or the Pacific Exchange, and those exchanges would have

the responsibility to report it.

However, there is no such reporting or enforcement requirement

on electronic exchanges because of, as I have said before, the

CFMA created a big loophole. This legislation would ensure that

wash trades are subject to full CFTC oversight no matter where

they are done, by telephone or by electronic exchange.

Of course, there is Enron, which controlled a large share of the

energy market while they engaged in activities that were downright illegal. Many of these activities could have been prevented or

at least stopped if regulators had simply had the proper authority

and the will.

Now, as I understand it, if I were to trade, let us say, natural

gas to you, Senator Harkin, and deliver it to you, that trade is covered by the Federal Energy Regulatory Commission. A record is

kept and the Commission has jurisdiction. If I sell it to you and

you sell it to Senator Lugar, who sells it to Senator Miller, who

sells it to any other entity, none of those interim trades are covered. Or if you sell it back and forth, they are not covered, and

there is no record kept, there is no transparency, there is no antifraud and anti-manipulation oversight. That is the loophole, and I

6

believe companies stepped into this loophole and utilized this loophole to game the market.

What I am asking here today, and I am joined with Senator Fitzgerald, Senator Corzine, Senator Durbin, Senator Wyden, Senator

Boxer in asking you to please close this loophole.

I am very pleased, and I would like to commend Aquila. Aquila

came in, talked to us about the legislation, recommended a couple

of changes. We did our due diligence on those changes and we

made those changes, and my understanding is that Aquila is going

to testify later this morning in support of this legislation.

All I can say is that the time really has come. We have seen the

game. We have seen the manipulation of the market. We see the

absence of transparency. The time has come to close this loophole.

Thank you very much, Mr. Chairman.

The CHAIRMAN. Senator Feinstein, thank you very much for a

very erudite statement, very clear, very concise, and that really

drives home what we should be looking at here.

The CHAIRMAN. As you know as well as I do, trying to translate

this into terms that the average person understands and how it affects the average person is very difficult. I mean, you are talking

about OTC derivatives and derivatives markets and all of a sudden

eyes glaze over. How does that affect me? I just want to pay my

gas bill and get my gas and that is it, or my electric bill.

We need to be able to tell the average consumer out there in

California, in Iowa, in Indiana, how this affects them, how it really

affects the markets, how it affects their bottom line and how it affects a lot of the investors in these companies. That is a real challenge we have to do. It is difficult, but we will try our best.

Senator FEINSTEIN. Mr. Chairman, may I say just one thing——

The CHAIRMAN. Sure.

Senator FEINSTEIN [continuing]. Because it is important that the

committee know. There was concern that this amendment might

cover financial derivatives. We have done our due diligence and we

have redrafted it earlier to see that it does not cover financial derivatives. It strictly covers energy and metals. It does cover swaps,

wash trades, as you know.

The CHAIRMAN. Sure.

Senator FEINSTEIN. You are absolutely right, and, of course, the

way this affects the individual is that it prevents the kind of oversight that can see that the market is functioning in a straight-up,

straightforward way, so it allows gaming. Now, what does that

gaming do? That gaming raises prices for consumers, and if you do

not have the net capital in many of these trades, as apparently

Enron did not, the house of cards that is built can crumble and you

are left with companies that get into very deep financial trouble,

and that has happened and that also affects our constituent because it affects the stock and people lose their money when they

have invested in publicly controlled companies.

It is very important. I ran into an officer of the Pacific Coast

Stock Exchange when I was in California and he was adamant. He

did not understand why—if somebody trades over that exchange,

there is a record, there is transparency, there is oversight, there is

attribution—why we would allow the creation of these niche entities where none of this would exist, and, of course, they were origiVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
7

nally taken advantage of. Now, at least according to a Wall Street

Journal article yesterday which says, ‘‘Energy Woes Drain Online

Power Trading, Brokers Switch Back to Telephones,’’ which we

would cover, ‘‘Exchange Pits Admit Quick Fizzle of Once Booming

Business Niche.’’ It is very important that we do our due diligence

and provide that oversight.

The CHAIRMAN. Thank you Senator Feinstein.

Senator FEINSTEIN. Thank you.

The CHAIRMAN. Senator Lugar.

Senator LUGAR. Senator Feinstein, in your bill, and I know you

in the draft have given a lot of thought to this, but explain to me

why you make a distinction between trading on the platforms of,

say, telephones and Internet, involving what are described as lesssophisticated retail customers—these people would be subject to

the anti-fraud, anti-manipulation provisions of the CFMA, as opposed to OTC trading of physical commodities, including energy

and metals, on bilateral electronic trading facilities, and these

would be the sophisticated persons, at least as defined, who would

now be subject to anti-fraud, anti-manipulation, but also reporting

and record keeping provisions, and that would include the capital

margin requirements, daily trade volume, large trader reports, and

so forth.

Essentially, my first question is why not apply the same ore rigorous standards to everybody?

Senator FEINSTEIN. What we have tried to do—and I am not

averse to doing that, but what we have tried to do is to apply it

where the most volume is, and to cover the phone transactions for

anti-fraud and anti-manipulation oversight to require that a record

be kept, as well as these electronic exchanges.

Senator LUGAR. I understand that, and, of course, the difficulty

of all of that record keeping with phone transactions and the socalled less sophisticated involves a great deal more administration,

some critics would say a prodigious amount. I do not know. Experts

will have to—— Senator FEINSTEIN. That is correct. That is another reason why

we left it out.

Senator LUGAR [continuing]. Have to take a look at this. On the

other hand, it occurs to me as we are busy trying to close perceived

loopholes, the sophisticated might move to the telephone and become unsophisticated. I do not know how precisely things move in

this particular area, and so this gave me some concern as I read

through, knowing that this has given you a lot of concern, likewise,

and others who have been working with you. I wanted to raise it

for your consideration and your thoughtfulness today.

Senator FEINSTEIN. Yes. The only way—because you are right.

We cover it for anti-fraud and anti-manipulation oversight, and you

are right about the paper. The other thing would be just to prohibit

anything that is not traded over one of these big exchanges and we

have not gone that route.

I certainly am going to watch very carefully. If there are signs

of gaming and manipulation, we at a later time may have to do

this, and that is just prohibit the use of the phone for these kinds

of trades. At this stage, we have tried to do just—in other words,

to limit it, to provide for anti-fraud, anti-manipulation, that a

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record be kept, et cetera. We also provide that with respect to capital requirements, that the CFTC would set those capital requirements based on risk.

Senator LUGAR. Well, that is helpful, and maybe some other testimony today will be enlightening, too. By raising this early in the

hour, others may have some appraisal—— Senator FEINSTEIN. Right.

Senator LUGAR [continuing]. Because this is a critical part of it.

The other question I have is you have pinned down energy and

metals. Some will say there are additional commodities out there.

They have identified weather and broadband, for example, and

asked, while we are at it, why do we not tackle weather and

broadband. Maybe there are others in addition to that. Do you have

any response to the inclusiveness question?

Senator FEINSTEIN. Yes. We, and it is controversial with some of

our colleagues to include metals. I understand that the silver people do not want to be included. However, if you look back into the

past, there has been fraud in the metals market and this is why—

and I am glad that my co-sponsor, Senator Fitzgerald, has arrived—that is why we included it, because there have been instances of fraud and they were rather large when they took place.

I do not quite see, if we are going to cover energy, why we should

create a loophole and allow metals out of it.

Senator LUGAR. No, I was not suggesting that. I was suggesting

that some would say beyond metals and energy—— Senator FEINSTEIN. In broadband?

Senator LUGAR [continuing]. How about broadband and weather?

Senator FEINSTEIN. We have not had any experience with that to

be able to go back and say there was fraud. I am not averse. I believe, and history is going to show this to be correct, that we should

not create any loopholes, that what we need to do to provide for

investor confidence is to have transparency. Transparency is good.

If people can examine a trade or the CFTC or the FERC or the

SEC, whatever the appropriate body is, can examine a trade and

say, this trade is forthright, it is straight-up, it stands the test of

scrutiny, that is fine.

To create an anonymity where all these things can take place

without records, without capital requirements, without audit trails,

without oversight, is a mistake and I think it creates the opportunity for the hot-shot young trader, bright but perhaps with not

the level of ethics that we want, to make a lot of money and to

game the system, and I do not want to see us do that and I do not

believe stockholders do, either.

Senator LUGAR. I thank you for your testimony. Let me just say

that I feel equally outraged, as you do, about the energy trading

business. We have to have reform. The purpose of my questions is

to see how broad the reform ought to be, and not to rebut the need.

Senator FEINSTEIN. Right. I understand that.

Senator LUGAR. It seems to me there is a glaring problem here

that really demands public attention, and so I appreciate the hearing and I thank you for your work.

Senator FEINSTEIN. Thank you very much.

The CHAIRMAN. Thank you, Senator. I know that you have a

schedule conflict, Senator Feinstein. I would ask other members if

9

they would be so kind as to permit Senator Feinstein to leave, if

that is all right, and then we can move on to our panel.

Senator FITZGERALD. If I could just thank Senator Feinstein for

appearing before our committee. I co-sponsored the legislation with

Senator Feinstein when we offered it as an amendment. I am supportive of this legislation as we try to bring forward a full bill.

I would point out that the President’s Working Group specifically

recommended, unanimously, that the exclusion that is available for

financial commodities with infinite supply not be extended to nonfinancial commodities with a finite supply. Somehow, while we

tried to craft a bill that met the recommendations of the President’s Working Group, somehow, somewhere in the process, somebody slipped in this mysterious exemption for energy and metals

trading and they are being treated differently than all other nonfinancial commodities that have a finite supply.

We have to close the loophole and I thank Senator Feinstein and

compliment her for her tenacity on this issue. I will be with you

every step of the way on this. I was much chagrined that we could

not pass that very simple reform on the Senate floor.

Senator FEINSTEIN. I want to thank you, Senator. You have been

with me all the way. You were there when we tried to settle problems with Senator Gramm, were not able to do so, and I really appreciate your work on this, as well. Thank you.

Senator FITZGERALD. Thank you.

The CHAIRMAN. Senator Lincoln or Senator Miller.

Senator CRAPO. Mr. Chairman, I just had a question that I was

going to ask with regard to what happened back with the CFMA,

but I could ask that of the chairman, since you were there at the

time, and we could let Senator Feinstein leave.

Senator FEINSTEIN. Thank you. Thank you, Mr. Chairman, and

thank you, Mr. Crapo.

The CHAIRMAN. Thank you, Senator Feinstein, very much.

Now we would like to bring to the witness table Mr. James

Newsome, the Chairman of the Commodity Futures Trading Commission, and Mr. Tom Erickson, a commissioner of the CFTC.

Senator CRAPO. Mr. Chairman, while they are taking their

seats——

The CHAIRMAN. Senator Crapo, yes. You had something you

wanted to ask.

Senator CRAPO. Yes. In your opening statement, you indicated

that when the Senate was dealing with the CFMA a few years ago,

that the bill that the Senate voted on was changed in conference

in a specific way that you had concern about. Could you tell me

what that—I did not quite understand what that change was that

you were describing there.

The CHAIRMAN. What happened was when Mr. Ranier, at that

time, had testified—there was a President’s Working Group that

had made recommendations to this committee under the leadership

of Senator Lugar, and perhaps he could best answer that question

rather than me because he was chairman at the time, but we agree

that we worked very closely on this. When we passed it, we kept

the distinction between the financial derivatives—and help me out

here, Dick—the financial derivatives and those other derivatives

10

that covered things that were in limited supply, like energy and

metals.

We felt at the time, that because of the—the amount of interest

rate trading and things like that in financial markets, that you

could make that distinction, and so we left it that way, and that

is how it passed the committee. We never got it on the floor and

it was wrapped into the omnibus appropriations bill. When it was

wrapped in the omnibus appropriations bill all of a sudden, that

distinction disappeared. Therefore, the exemption that we had had

for the financial derivatives was then applied to the metals and energy derivatives.

We were confronted at that time with a vote on whether to pass

the CFMA as a part of the omnibus appropriations bill or to let the

whole thing fall. Well, it was part of it. I made a statement on the

floor at the time saying that there were a lot of good things in the

Act. This committee, under Senator Lugar’s guidance, had done

great work, I think, in modernizing the Act. I said at the time I

did not agree with erasing this distinction between financial derivatives and energy and metals, but in the overall interest of getting the bill passed, we would do it and get it passed, and that is

exactly what happened.

Senator CRAPO. Just so I understand, as I understand the bill

that passed, it had an exclusion for financial transactions—— The CHAIRMAN. That is right.

Senator CRAPO [continuing]. An exemption for energy and metals

and some other transactions—— The CHAIRMAN. Right.

Senator CRAPO [continuing]. Then complete coverage for other,

like farm commodities and other types of transactions. It created

three categories, and I am just trying to understand whether this

change that you are talking about was the establishment of the

middle category or whether that exemption category was in the

original proposal.

The CHAIRMAN. Say that again.

Senator CRAPO. Interestingly, this Act created, as I understand

it, and I was not here when that happened in the Senate, but as

I understand it, what happened was it created three categories, basically, excluded transactions, which were totally not covered—— The CHAIRMAN. That is right.

Senator CRAPO [continuing]. Exempted transactions, which were

subject to anti-fraud and price manipulation and other protections,

and then totally covered transactions, which would be subject to

over-the-counter trading requirements and so forth. Were those

three categories in what the Senate originally considered or was

the situation you are talking about where it was changed something that created one of those three categories?

The CHAIRMAN. Mr. Erickson is going to testify to that, but

again, as I understand it, the Senate bill fully and clearly maintained CFTC’s anti-fraud and anti-manipulation authority over exempt commodities, such as energy and metals. Now, there seems

to be an ambiguity as to their authority to do this and that is really what we are trying to clear up, that ambiguity, and to make

sure that they do have that authority.

Senator CRAPO. All right.

11

The CHAIRMAN. Senator Lugar.

Senator LUGAR. Let me just add one thought, and others may

have more, but essentially, the bill that came out of this committee

had no exemptions for metals and energy. Somewhere in the conference procedure, and I do not really remember when because we

were at the end of the session. This bill had been given up for dead

a long while back, that is, the totality of it, despite Alan Greenspan, the Secretary of the Treasury, the President’s Working

Group, and almost everybody who was worried about the financial

condition of the country centered upon this as a salvation.

Somebody in the process of that conference talked about exemption of bilateral trade on electronic platforms, precisely the sort of

thing that Enron was to be involved in.

Senator CRAPO. All right. Just so——

Senator LUGAR. We all should have been brighter, perhaps, in

reading the type, but nevertheless, that is one that already occurred and that is why it is there.

Senator CRAPO. For the benefit of the chairman and the ranking

member and the witnesses, I guess the question I am getting at is

it seems to me that complete coverage under the Act requires basically that the transactions be handled on the Chicago and New

York Exchanges and a very major change in terms of how they are

handled from today. The Act created a middle category that had

the protections for transparency and price manipulation and antifraud provisions and so forth but did not require a certain category

to be subjected to being traded on the exchanges.

The question I am trying to get at, and I guess maybe the witnesses can help answer this, is whether the original approach of

the President’s Commission contemplated that everything would be

traded on the exchanges except financial transactions, or whether

this middle category was initially there and somehow there is now

a question as to whether there is complete transparency.

The CHAIRMAN. Mr. Crapo, I think that is the question, and I

hope that Mr. Newsome and Mr. Erickson are going to address that

in their testimony.

Senator CRAPO. Thank you, Mr. Chairman.

The CHAIRMAN. If not, we will get into it. Thank you very much.

Now we welcome James Newsome, chairman, and Tom Erickson,

commissioner. Both of your testimonies will be made a part of the

record in their entirety and we welcome you here. Please proceed,

Mr. Newsome.

STATEMENTS OF JAMES E. NEWSOME, CHAIRMAN,

COMMODITY FUTURES TRADING COMMISSION,

WASHINGTON, DC

Mr. NEWSOME. Thank you very much, Mr. Chairman, Senator

Lugar, and members of the committee. I am honored to have the

opportunity to testify before you today along with my colleague,

commissioner Erickson from the CFTC.

In my written submission, I have provided an update on a number of important issues that the Commission is addressing, issues

that I think you are interested in. Certainly, the Commission has

been very busy since the passage of CFMA. However, this morning,

I will focus directly on energy markets.

12

The CFTC is an independent Federal regulatory agency whose

mission is to oversee the futures and options markets in the United

States. We take very seriously our mission to ensure that these

platforms provide safe, sound, and transparent markets for risk

management and price discovery for a variety of commodities, including agricultural, financial, metals, and energy products.

The energy markets are among the largest and most dynamic in

the United States. Hundreds of billions of dollars in energy products, which would include electricity, natural gas, crude oil, and

gasoline, are traded each year in the United States, both on exchange and in over-the-counter or the OTC markets.

The CFTC regulates the on-exchange futures and options energy

markets, which provide significant risk management and price discovery functions for both the retail and institutional investors. Energy products are primarily traded on the New York Mercantile Exchange, which is CFTC registered and regulated.

There is also significant trading in energy products in the OTC

markets. As a general matter, the CFMA provided legal certainty

for OTC trading in exempt commodities, such as energy products.

In addition, the CFMA promoted the growth of electronic trading

systems for these commodities. The level of CFTC jurisdiction regarding the OTC market is tailored to the nature of the participant

and the commodity. The OTC markets in energy products are generally restricted to large institutional investors that do not need

the same protections as retail investors.

The CFMA provided the CFTC with the ability to investigate and

prosecute fraud and manipulation in the exempt commodity markets, with some limited exceptions. Enron Online operated an electronic trading platform which accounted for a sizable percentage of

the OTC energy product market. It was not registered with the

CFTC.

We are all aware of the tragedies that occurred last fall surrounding the collapse of Enron. There have been numerous stories

in the press regarding allegations of manipulations in energy markets. Currently, we are conducting a comprehensive, detailed investigation of allegations raised by the Enron collapse and we will continue such investigative efforts to detect and to deter illegal contact

in the markets we oversee.

Albert Einstein once said, if you have 7 days to solve a problem,

spend the first 6 days defining it. From the beginning of the discussions on these energy issues, my position has been that we need

to find the facts first before proposing a solution. My position has

not changed.

As to allegations made earlier this year about Enron’s role in certain energy market problems, let me assure you that this matter

is my highest priority. We are deep into a comprehensive investigation of both the public allegations and other allegations we have

uncovered which may involve violations of the Commodity Exchange Act. During the course of our investigation, the Commission

has closely coordinated its efforts with the SEC, the FERC, and the

Justice Department so that all relevant information is shared and

so that investigations continue to proceed without delay.

If violations of the Commodity Exchange Act are uncovered, we

will aggressively prosecute those responsible to the fullest extent of

13

the law. The markets for commodity futures and options serve an

important role in our economy and I am committed to protect their

safety and their integrity.

As I have said before, the CFMA, in my opinion, created a proper

regulatory balance regarding exempt OTC markets to protect the

public interest by providing the CFTC with appropriate authority

to require transparency when needed for price discovery, to demand records for viewing, and the ability to prosecute fraud and

manipulation, at the same time while creating legal certainty and

allowing the flexibility needed for market innovation and growth to

occur within our jurisdictional boundaries, and it provided market

participants with a choice based upon their business needs.

However, Mr. Chairman, if after or even during our investigation

it becomes apparent to me that CFMA changes are needed in order

for the CFTC to fulfill its mission, I will immediately relay those

needs to the committees of our jurisdiction.

Mr. Chairman, I continue to offer a detailed briefing of our investigation at your convenience, and certainly I look forward to answering any questions that you might have.

The CHAIRMAN. Thank you, Mr. Newsome.

[The prepared statement of Mr. Newsome can be found in the appendix on page 69.]

The CHAIRMAN. Before beginning questions, the chairman will

now turn to Mr. Erickson, a commissioner of the Commodity Futures Trading Commission. Mr. Erickson.

STATEMENT OF THOMAS J. ERICKSON, COMMISSIONER,

COMMODITY FUTURES TRADING COMMISSION,

WASHINGTON, DC

Mr. ERICKSON. Thank you. Chairman Harkin, Senator Lugar,

distinguished members of the committee, thank you for this opportunity to appear before you this morning.

I have been asked to comment on three things: First, the scope

of the Commission’s existing regulatory authority over OTC derivative markets; second, the need for increased Commission authority

to prevent fraud and manipulation; and third, the legislative proposals pending before the Senate that would address any deficiencies.

Passage of the CFMA in December of 2000, as you have indicated, brought sweeping change to the regulation of derivatives in

the United States, both on- and off-exchange. Nowhere was the

change in law more dramatic than its effect on over-the-counter derivatives, more commonly referred to as swaps.

Many of the CFMA’s changes to the Act were based on the recommendations of the President’s Working Group on Financial Markets. Although the PWG report recommended that bilateral swap

transactions in financial commodities be excluded from the CFTC’s

jurisdiction, it concluded the same case could not be made for physical commodities. The PWG was unanimous in its agreement that

the exclusions should not extend beyond financial products.

The CFMA adopted a variant of the PWG recommendations and

created three tiers or categories or commodities. Each category defines the CFTC’s regulatory interest in derivative instruments, including swaps. Generally, financial commodities are excluded from

14

the CFTC’s jurisdiction. Agricultural commodities are included. All

other commodities, including energy and metals, are exempted

from the CFTC’s jurisdiction.

What this means in application is not so simple. In part, the

complexity stems from the fact that the regulatory framework

hangs on the distinction between excluded and exempted. An excluded commodity transaction or market indicates that the Commission has no jurisdictional interest. An exempted commodity

transaction or market, meanwhile, means that the Commission retains its jurisdictional interest, but that the law limits its application.

Ostensibly, under the CFMA, the CFTC retains its anti-fraud

and anti-manipulation authorities over exempt commodities. However, through other provisions in the law, the vast majority of swap

transactions in energy and metals commodities markets become excluded. As a result, they are not subject to the Commission’s fraud

or manipulation authorities.

Thus, we have a gap in the oversight of the regulation of exempt

commodity transactions. On the one hand, the Act expects full

prosecution of manipulations in exempt commodities in regulated

exchange markets. On the other hand, the regulatory regime turns

a blind eye to the manipulation of these very same commodities if

effected through over-the-counter derivative transactions. I cannot

believe this was the intended effect of the CFMA.

From a practical perspective, the Commission’s own experience

has yielded some significant results in these areas, results that

would be difficult, if not impossible, to replicate under the current

law. For example, the Commission in 1998 reached a settlement

with Sumitomo Corporation for the manipulation of global copper

prices. The Commission found that the manipulation imposed enormous costs on traders, manufacturers, and ultimately consumers of

copper. More recently, the Commission settled with Avista Energy,

Incorporated, for the manipulation of electricity futures.

I am skeptical the Commission could replicate these cases in today’s market environment. As the Avista settlement underscores,

commodity markets, cash, futures and options, and over-thecounter swap transactions, are increasingly linked. We now know

that wash trades and transactions in unregulated swap markets

occur, and in certain cases send price signals that raise manipulation concerns. Thus, if we are serious about detecting and deterring

fraud and manipulation, these authorities must apply to all derivative transactions on those commodities.

Derivatives markets bring unquestionable efficiencies to the cash

markets. The consequent benefits extend not only to market participants, but also to consumers. Thus, I believe if Congress were

to restore to the Commission its fraud and manipulation authorities, it must also provide the Commission with the tools to enforce

these authorities.

Derivatives marketplaces, like electronic swap exchanges, should

adhere to certain minimal regulatory obligations, among them,

transparency, disclosure, and some reporting. Our experience with

the futures markets has shown us that measures designed to increase market transparency instill confidence in markets, attract

speculative liquidity, and increase market integrity by providing

15

regulators with the means to monitor for fraud and/or manipulation. I believe application of these principles to derivatives markets

more broadly is sound public policy, prudent business practice, and

common sense.

Unfortunately, we are presently witnessing some of the best arguments in favor of reinstating these principles into our markets.

U.S. energy markets are suffering a crisis in confidence. Six

months ago, we could define that crisis by the tens of millions of

energy consumers in Western States who believed the markets had

been manipulated. Today, none of our Federal regulators has been

able to assure them that this was or was not the case, and it is

not even clear which regulators should be answering the question.

More recent revelations of wash sales by numerous commercial

markets have expanded the scope of this crisis, eroding the trust

and confidence firms have in each other. In this environment, liquidity dries up and the market efficiencies created by all derivatives are put at risk. Modest legislation is a good first step toward

restoring the lost confidence and returning to the energy industry

the ability to grow those markets and make them efficient.

The only legislation I am aware of currently that is pending is

that introduced by Senator Feinstein, and she was here to testify

this morning about that. I will limit my comments to that bill.

Generally the legislation would address the essential concerns I

have outlined in my testimony today. Moreover, the bill hues more

closely to the recommendations of the President’s Working Group,

as well as to many of the expressed concerns of this committee during the debate over the Commodities Futures Modernization Act.

Could it do more? Certainly. Is it the right thing to do? In my opinion, yes.

Ultimately, Senator Feinstein’s bill is pragmatic. It recognizes

the benefits of market innovation by preserving the long-sought

legal certainty for swaps. They remain, for the most part, exempt

from the CFTC’s jurisdiction. At the same time, however, the bill

ensures that all transactions in those commodities are fully subject

to the Commission’s anti-fraud and anti-manipulation authority.

It would not require registration of swap counterparties, but it

would require they maintain books and records, something that is

probably a routine practice in the industry.

Finally, the legislation recognizes that all exchange markets

serve price discovery and hedging purposes and imposes modest

transparency disclosure and reporting requirements.

I would be remiss if I did not mention one other aspect of Senator Feinstein’s bill that I think is absolutely critical for the Commission. An issue that we have struggled with for some years is the

current extent of our fraud authority. Just prior to passage of the

CFMA, the Seventh Circuit Court of Appeals indicated that our

fraud authority extended only to agency relationships, which

means that it would apply only to transactions where there is an

intermediary or a broker doing the business on behalf of a customer. Thanks to clarification in the CFMA, we now have some authority over dealer markets in foreign currencies, but our fraud authority continue to be limited in that respect. Certainly it would be

similarly limited on the bilateral dealer markets in energy markets

for the same reason. Senator Feinstein’s bill addresses that probVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
16

lem in the existing legislation and would fix our fraud authority so

that it would apply to non-intermediated markets.

Consumers are the ultimate beneficiaries of properly functioning

derivatives markets, whether they are private, like Enron Online,

or public, like the NYMEX. By the same token, consumers are the

ultimate victims when markets are manipulated or otherwise affected by unlawful behavior. Whether there is anything found in

the current investigations of energy markets is really irrelevant.

We have a hole in the regulatory regime that allows for fraud and

manipulation to operate free from sanction. We have markets experiencing a crisis in confidence. Modest legislation amending the

commodities laws is appropriate, in my view, to restore confidence

and build integrity.

Thanks very much for your indulgence. I look forward to your

questions.

The CHAIRMAN. Thank you very much, Mr. Erickson.

[The prepared statement of Mr. Erickson can be found in the appendix on page 74.]

The CHAIRMAN. I will start with you, commissioner Erickson. Mr.

Newsome in his testimony emphasized that the CFTC is proceeding

with an investigation of energy trading companies under its antifraud and anti-manipulation authority. Your interpretation of

CFMA’s exemptions and exclusions, however, is that, in fact, it is

unclear that the CFTC has anti-fraud and anti-manipulation authority over certain transactions in exempt commodities. How do

you explain this?

Mr. ERICKSON. I am fully supportive of any enforcement endeavors that we might undertake. I would just point out that, yes, I am

certain and convinced and confident that we do have a gap in what

actually is covered by those fraud and manipulation authorities.

I know that you have all been provided with some slides that I

have used for some other presentations, and I think that this will

also get to Senator Crapo’s initial question.

Mr. ERICKSON. On the surface, Section 2(h) of the Act affirmatively does retain and apply our anti-fraud and anti-manipulation

authorities to certain transactions. Section 2(g) of the Act is an exclusion for swap transactions, and that provision says that in all

commodities except agricultural commodities, swap transactions

are completely excluded from the Commission’s jurisdiction. That

takes them out of the jurisdiction for all purposes, including fraud

and manipulation.

The California activity certainly occurred prior to implementation of the Commodity Futures Modernization Act, so I would expect that we will have some activities that are currently under investigation that would be activities that occurred prior to implementation of the Commodity Futures Modernization Act. For those

that occurred after, the Commission will have to assess what kind

of case we have to move forward on either side of that line.

The CHAIRMAN. Let me see if I understand this. Part of the Act

exempts them, and there is another part of the Act that excludes

them.

Mr. ERICKSON. Right.

The CHAIRMAN. Which trumps which?

17

Mr. ERICKSON. Well, that the exclusion trumps and nothing applies. The Section 2(g) transactions are swap transactions that are

among sophisticated counterparties.

The CHAIRMAN. Right.

Mr. ERICKSON. They are subject to individual negotiation, and

they are also conducted in these commodity markets. There are

limitations. The swaps market largely is a market of these kinds

of transactions between sophisticated counterparties. They are

done with some opportunity for negotiation and they have individual creditworthiness that applies.

The CHAIRMAN. Mr. Newsome, what is your authority, then, to

obtain information and oversee the markets and investigate and

punish fraud and manipulation if they are excluded? What is your

authority?

Mr. NEWSOME. Thank you, Mr. Chairman. There are two points,

if allowed, that I would like to try and make, both brought up by

Senator Crapo and discussed earlier.

The first point is what was the intent of the President’s Working

Group toward exemptions or exclusions. We need to point out that

the CFMA had the unanimous support of the President’s Working

Group, so it is very difficult to say that the CFMA did not follow

their intent when they unanimously supported the legislation.

The President’s Working Group also did specifically address the

energy exemption. Some of the discussion we have heard today,

certainly while it is very accurate, I do not think told the whole

story, and I will quote from the President’s Working Group report,

which said, ‘‘The CFTC should, however, retain its current authority to grant exemptions from derivatives involving non-financial

commodities as it did in 1993 for energy products, where exemptions are in the public interest and otherwise consistent with the

CEA.’’ The PWG went on to say that, ‘‘Nothing in this report

should be construed to affect the scope of exemptions that are currently in effect.’’ The reality was that, administratively, in 1993, the Commission,

following the advice of Congress, exempted—had the energy exemption which removed them from Commission oversight. The CFMA

codified that exemption.

As we look at the difference between exemption and exclusions,

it is very technical and it is very legalistic and at times, I think

it is difficult to understand. Obviously, people that are very sincere

in fulfilling the mission of the Commission do not agree in all aspects of that. Wise people today have shown that we do not agree

in exactly what the language says. I would like to try to address

now most specifically your question, what I consider a misunderstanding of the CFMA regarding the Act’s exclusions versus its exemptions.

Some have said, and some very sincerely feel that, in effect, the

exclusions trump the exemptions, thereby undermining the fraud

and manipulation authority of the Commission. In my opinion, this

is a misreading of the statute. The intent and effect of the CFMA

was clearly not to undermine the CFTC’s authority, but to provide

legal certainty to markets and tailor regulation to the nature of the

participants and to the commodities traded. Simply stated again,

swaps transactions were excluded from our jurisdiction prior to the

18

CFMA by administrative action of the CFTC and they were excluded after the CFMA by codification of Congress. Whether the

swaps are in T-bills or in natural gas, the analysis is the same.

However, as Senator Crapo pointed out, the CFMA did provide

another level of regulation, that of regulation for exempt commodity transactions that are not determined to be swaps. At this level

of regulation, it provides certain fraud and manipulation authorities and, indeed, transparency requirements, as determined by the

CFTC. This provision is not related to swaps transactions, nor do

I believe that it is trumped by the swap’s exclusion for transactions

in energy products that are not deemed to be swaps transactions.

The CHAIRMAN. I have some followup questions I will ask, but

my time is obviously up now. I turn to Senator Lugar.

Senator LUGAR. Thank you, Mr. Chairman.

Let me just ask each one of you, I appreciate the informed discussion as to exclusion and exemption, what the President’s Working Group wanted and what was always there. It seems to me that

everybody was operating in a way, as you say, to enhance the

CFTC’s authority, and likewise, to save the financial system of the

country at the time. However, something went wrong.

Clearly, the Enron circumstances—and that is not the only situation, perhaps, but that is pretty evident—was a disaster for a lot

of people in America. Leaving aside all the rights and privileges of

the traders, as Mr. Erickson has said, the consumers, ordinary people finally have to enter into this situation. We may have worked

very hard to make certain that everybody who is a professional in

the business, who has a stake and so forth, is accommodated, but

we have worked very hard, say, prior to long-term capital management, and that was a disaster of unbelievable dimensions, so complex that most Americans do not realize what might have hit them,

but at the same time, we ought to, somebody, regulators, legislators. We got busy and we tried to get our arms around this thing.

I remember going to a meeting involving not only Wall Street

people, but Federal Reserve people, and others in the aftermath of

long-term capital management. There was an extraordinary gloom

about all of our exchanges all over the world among people who

were the largest players, leaving aside the public, that only was

mildly interested in what seemed to be a debacle of some very

bright people who thought they had finally, with Nobel Prize winners, beat the system.

In this situation, the thing I am wondering is Senator Feinstein

has come forward with a piece of legislation, but at this point, I

would have hoped that CFTC would have come forward with a

piece of legislation. In other words, you are the most informed people. You understand the requirements that you have to meet. You

are struggling, as you pointed out, trying to go through all the circumstances of Enron or others trying to see whether you have jurisdiction. Whether somebody did something and should be prosecuted, all of that is important, although we are talking today

about whether we have jurisdiction at all, quite apart from whether

anybody did anything wrong. Clearly, something has to change

here.

Now, Senator Feinstein has offered a bill. I have not been one

of the original co-sponsors because I hoped that there would be

19

something forthcoming from those who are responsible and who

were informed. Nothing is forthcoming. Essentially, they are saying

they need more time. They are still working their way through all

the circumstances of this situation.

Maybe because of the discouragement of this, as you pointed out,

energy trading is so far down that we temporarily do not have to

worry about it, but I doubt whether that will be the case for long.

In my own view, I suppose we will be, in absence of a better alternative, to co-sponsor the Feinstein legislation and try to get it

passed. We are going to have testimony today why that is good or

bad or indifferent, but there is no doubt in my mind something has

got to happen and it is very important it happen quickly rather

than in the hereafter, given an egregious failure, and it is every bit

of that.

Now, is it possible that the two of you or your colleagues or anybody in the CFTC is going to come forward, really, with some remedy that you think makes sense in terms of the public, not just the

traders, not just the pros, but the general public of this country

that is looking to you, that is looking to us for somebody to get a

handle on something that egregiously is wrong? What do you have

to say to that?

Mr. NEWSOME. Thank you very much, Senator Lugar. You raise

very legitimate issues and points, and certainly, I am not here to

say that absolutely nothing should be done. It is very prudent for

we as regulators and you as the Congress to continually look at all

legislation to see if it continues to serve the purpose that was intended.

My thoughts simply are this. As Chairman Harkin commented

earlier, we spent almost 2 years in the drafting of the CFMA.

There were very deliberate discussions and debate leading up to

the passage of the CFMA and there was very broad acceptance of

what Congress passed.

There are discussions of wide, sweeping changes to the Act that

will totally change the regulatory direction that was taken just a

short time ago. Certainly, that in order to make such broad, sweeping changes, there needs to be more deliberate debate over whether

or not that is the direction that needs to go, what potential impact

that could have on markets.

With regulation comes a cost, and in this area, I think very substantial regulatory cost, both in terms of taxpayer dollars to the

Commission to fulfill what its new mission potentially might be,

and huge costs to market participants. I do not feel comfortable

recommending that cost to producers or to market participants

until we have spent our time making sure that whatever legislation

passes does, indeed, solve the problems that have been created by

the Enron collapse and the energy situation.

Senator LUGAR. Mr. Erickson, what is your view?

Mr. ERICKSON. I personally would be pleased to work toward a

solution. We absolutely should. It seems that there is general acceptance of the idea that fraud and manipulation ought to apply to

these physical commodity markets. Perhaps there are other ways

to just cement that in the law. Currently, there is, at best, an argument about whether the law applies in certain situations. That certainty will really build confidence in this market and I would be

20

pleased to pursue legislative avenues. The unfortunate reality is, it

is a legislative solution in this case and I think it is necessary.

Senator LUGAR. The legislative solution Senator Feinstein and

others have proposed is that clearly sophisticated traders be subject to reporting, the transparency, the rest of it. The question I

raised of her is what about the risks, people dealing over the telephone without records and so forth. Once again, I admit probably

a much broader cost, as Chairman Newsome has said, getting into

all of that. At this point, my suspicion of the ability of people to

create fraud knows almost no bounds when it comes to this energy

thing.

We really have to get a handle on it, and this is why, ideally,

Chairman Newsome, the perfect would be great and we would have

endless meeting of this committee and get the President’s Working

Group revved up again and so forth. After all of that, let me just

simply say, legislatively, it was very hard to get that Act passed.

It occurred almost in the dead of night, at the end of a Congress,

in the middle of an appropriations hassle. That was not the ideal

circumstance. That is the legislative reality of these situations.

I am just saying the Feinstein bill, as you have said, Mr.

Erickson, is a modest attempt. I hope while we are doing any attempt, because we do not have very many opportunities, we try to

get it as right as we can, but we really need help.

Here, we have Senator Feinstein. She is working from her constituency in California in which people feel badly aggrieved, understandably, given all the public testimony about the manipulation

that occurred. This is no longer speculative. People were doing

wrong.

What do we do about it, aside from wait for the best solution to

come along, and not unintended consequences and all the rest of

that? That is not good enough. It just seems to me that we need

some help technically from CFTC as opposed to at least rationalizations that the jury is still out. Well, it will be out, I think, for a

long while. We have to act, I believe.

Are you about to make another comment?

Mr. ERICKSON. If I might, one of the things that strikes me is

that the Feinstein bill really does put these commodities back

where they were 18 months ago. To the extent that there was a

cost associated with monitoring for manipulation in swaps, it is the

same cost. We had electronic trading systems in existence prior to

the CFMA.

The difference between before and after, under our regulatory exemptions, is that the agency previously retained its authority. It

had the ability to do the investigation where it saw the potential

for wrongdoing. The Feinstein bill simply applies fraud and manipulation back to those transactions. I am sympathetic with your concerns about the phone trade, but that has been around. We have

had some experience with those transactions for 10 or 12 years.

What she tried to do was pretty pragmatic and just makes sure

that fraud and manipulation affirmatively applies to the bilateral

marketplace, those transactions that might occur between the two

of us. Once you have some kind of a marketplace, whether it is

electronic or physical, you have additional transparency obligations

that attach because that is where I see, that you run the greatest

21

risk of price signals being sent, and uneconomic price signals being

sent into these markets that can have a manipulative effect. That

is why I called the solution that she brought forward to be pragmatic. Thank you, Senator.

The CHAIRMAN. I will proceed in order that Senators arrived to

the committee. It will be Senator Miller, Senator Crapo, Senator

Fitzgerald, Senator Lincoln, and Senator Nelson. Senator Miller.

Senator MILLER. Thank you, Mr. Chairman, and thank you for

holding this hearing.

Perhaps—well, not perhaps, I know that this is oversimplifying

a very, very complex issue and problem, but is not what we are trying to get at, all of us, a way to protect the American consumer,

not disrupt the success of honest companies, not cripple the entire

energy trading market, but protect, as I said in the very beginning,

the American consumer?

I want to ask this of each one of you, and if you want, you can

just answer it yes or no or you can elaborate as much as you want

to. Do you believe that the Feinstein amendment would have prevented the fall of Enron or the California energy crisis?

Mr. NEWSOME. Thank you, Senator Miller.

Senator MILLER. That is, by the way, why I liked your Einstein

quotation, of 6 days of looking at what we are trying to get at, the

goal, before we do anything else. Excuse me.

Mr. NEWSOME. That is fine. In regard to your specific question,

my answer today would have to be no, I do not think it would. If

we look at what we know about that situation, we know that energy prices were very high and volatile in the West. We know that

there was round-tripping that was confirmed by the companies

themselves, and I might add that wash trades are illegal in futures

markets. They are wrong, they are fraudulent, and they should be

considered such in all markets.

At the end of the day when we look at what created the Enron

situation, I think at least it appears that the majority of their problems had to do with accounting fraud, as are a lot of the other companies that we are looking at. Now, that said, that does not mean

that we should not take another look at where we are with the

CFMA and what is going on.

Certainly, as Senator Lugar suggested, the CFTC is more than

happy to provide whatever thoughts, technical assistance to this

committee in terms of looking at Senator Feinstein’s legislation or

any other legislation that could have an impact on the CFMA. As

you indicated, Senator Miller, the majority of the people in this

business, like any other business, are good people. We all want to

make sure, even though we have differing opinions of how to do it,

we all want to make sure that the bad players in these markets

are removed from the markets and that they are justly punished.

In my opinion, as we look at this situation, it is more appropriate

to make sure that we have strong, swift enforcement to serve as

the deterrent to wrongdoers, and I would add that as this committee looks at what should be done to the CFMA, my suggestion

would be that we need to make sure that we strengthen the Commission’s authority in fraud and manipulation and that we

strengthen our enforcement actions, and I think that can have as

strong a deterrent as anything that we may talk about today.

22

Senator MILLER. commissioner Erickson, do you think that the

Feinstein amendment, if it had been in effect, would have prevented the California energy crisis?

Mr. ERICKSON. Regulation is never a panacea. It does not answer

every question. Part of it is the willingness of the independent regulators to exercise their authority. You cannot give any guarantees

that the Enron bankruptcy would not have occurred if we had some

authority over its trading environment.

Now, there are a couple of points that I would like to expand

upon. What we have is a situation where we know that there are

parts of this market where fraud and manipulation can take place

and it is outside our ability to sanction. That is the hole that needs

to be filled. The Feinstein bill does that. It gives us the tools that

would be necessary to surveil and have a chance at detecting some

kind of risk exposure that Enron had taken on through Enron Online that was otherwise not apparent.

If we had had capital requirements attached to Enron Online, as

any banking regulator would have required, we may have had information. I cannot promise a result. It would have given us a

chance, a better chance, at detecting any kind of overexposure that

they had financially.

Dynegy gave us a real breather during those 3 weeks of November. They came in and held an offer on the table for the merger

and acquisition of Enron, and it allowed all these swap

counterparties to Enron, either individually or through Enron Online, to reassess their credit exposure to Enron and try and exit

those positions. Now, I understand some people were not as successful as others and they still had a day of reckoning where they

lost several millions of dollars because of their Enron exposures.

If Dynegy had not been there to allow people to reassess their

exposure, we may have seen a little bit more systemic risk in the

market and a much more hurtful effect of the Enron winding down,

because what we know is the day Enron went bankrupt, Enron Online went dark. If you had been in that marketplace at that point,

you would have had naked exposures.

The CHAIRMAN. Thank you, Senator Miller.

Senator Crapo.

Senator CRAPO. Thank you very much, Mr. Chairman.

Mr. Erickson, as I understand your testimony, your concern—tell

me if I am correct about this—your concern is essentially that Section 2(g) of the Act excludes from the fraud, manipulation and

transparency provisions the jurisdiction of the Commission over derivatives transactions or swap transactions, is that correct?

Mr. ERICKSON. In all commodities except agriculture.

Senator CRAPO. Correct, in all commodities except agriculture.

Mr. ERICKSON. Yes, that applies to the energy and metals markets.

Senator CRAPO. If I understand Mr. Newsome’s testimony, he

does not read the Act that way, but if we were to make it clear that

Section 2(g) did not exclude these transactions from the fraud,

price manipulation, and transparency provisions, would that address your concern, Mr. Erickson?

23

Mr. ERICKSON. Yes, and it does get to the heart of what the Feinstein bill does. It says transactions, even those conducted pursuant

to 2(g), would be subject to our fraud and manipulation authority.

Senator CRAPO. Well, let me get into that, then, because I am

reading a summary of the bill—I have not got the bill itself before

me, but the summary that I am reading seems to be much, much

broader than that. Let me first just ask you a question. Do you believe that all of these other transactions that we are talking about,

other than the agriculture transactions and the financial transactions, do you believe that they should all be subject to full coverage, full trading on the commodities exchanges and so forth?

Mr. ERICKSON. Absolutely not. Our history over the last two decades has really demonstrated the absolute need for all of these

kinds of derivatives, whether they occur on- or off-exchange. They

are integrally linked. They are global markets. They add incredible

efficiencies to all commodity markets. I just think in this area of

exempt commodities, most of these commodities are of limited supply. Many of them are physical commodities, and our experience

with those kinds of commodities is that they are more susceptible

to manipulation.

Senator CRAPO. Let me just say, my reading of the act that is

being proposed, of the Feinstein bill that is being proposed, is that

it literally repeals the definition of exempt commodities, and if I

read that correctly, it leaves us with a situation where you are either excluded totally or you are covered totally. Am I wrong in

that?

Mr. ERICKSON. I believe the first bill that was introduced, S.

1951, would have eliminated 2(g) completely and would have started out with a new exempt commodities section that would just affirmatively have applied fraud and manipulation authority.

What is in place now is there is no change to the framework,

and, in fact, the exempt status of all the exempt commodities is retained. This is absolutely critical for the legal certainty of the

transactions so that we do not run into the problem that you previously identified that would potentially force them all onto an exchange environment. That is something that nobody, I think, would

make an argument for.

Senator CRAPO. Then we can agree, though, that with regard to

the issue that we need to address, as I see it, from your testimony,

it is rather specific. We need to address the concern that you have

identified with what Section, in your opinion, Section 2(g) has done

to the rest of the Act.

Mr. ERICKSON. Yes, and I can maybe provide a little bit more.

The definitions of exempt commodity transactions and the swap

transactions are slightly different, and that is why I believe 2(g)

trumps, because the definition of swap transaction in 2(g) is composed of three parts and the definition of transactions exempt commodities is only composed of two parts. They are nearly identical.

In 2(g), if you have the opportunity for individual negotiation, they

are excluded. That is why I think it trumps for that broad swath

of the swap market, which is 80, 90 percent of all derivatives trading.

Senator CRAPO. It seems to me that whether you are right or

wrong about that, at least the issue, as I see it, from your perspecVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
24

tive, is that interpretation of Section 2(g) and the resolution of the

issue would be simply clarifying that your interpretation is corrected and that the application is thorough with regard to the

fraud, price manipulation, and transparency provisions.

Mr. ERICKSON. That is the heart of the issue. Everything else is

providing the obligation for markets to have some level of transparency in their marketplaces.

Senator CRAPO. I assume that you are aware of the testimony

that came in before the Banking Committee and in other contexts

about the value of derivative transactions to our economy, Alan

Greenspan having said that they may have provided the stability

that kept us from going deeper into the trough during this last

troubled time. Do you agree with that?

Mr. ERICKSON. Absolutely. There is no question about the value

of these transactions, and my concern about this market, in particular with energy, is the market is fading away. By attaching

some key elements of market integrity to the regulatory regime you

would really let the marketplace itself take off again. The participants in energy markets do not have the confidence to trade with

one another. Most of the energy platforms that are sanctioned

under the law are not in operation today.

Senator CRAPO. Thank you. Mr. Newsome, I understand that you

disagree with Mr. Erickson in terms of the interpretation as to

whether 2(g) does what he believes it does, but do you agree that

energy and minerals transactions should not be subject to full coverage and to required trading on commodities exchanges?

Mr. NEWSOME. It depends upon the trading system and the nature of the participants that are doing the trading, and I think

there underlies the premise of the whole CFMA, because the regulatory structure was based upon the product, the type of trading

system, and the participant involved in the trade of the product. I

would still agree that the criterion in which we should move forward with still should be based upon those different criteria.

Senator CRAPO. Thank you. Mr. Erickson, one last question. Are

you aware of any evidence at this point in time that would indicate

that a cause of the Enron situation was related to transactions in

derivatives?

Mr. ERICKSON. No, I am not aware of any direct evidence. I am

concerned, though, that when we have a corporate bankruptcy, a

marketplace evaporates.

Senator CRAPO. Thank you.

The CHAIRMAN. Thank you, Senator Crapo.

Senator Fitzgerald.

Senator FITZGERALD. Thank you very much, Mr. Chairman, and

at the outset, I would say that I guess we have invited the International Swaps Dealers Association to testify later. I would actually like to hear testimony from ICE, the Intercontinental Exchange, that is lobbying so heavily against closing this loophole because I really think the bill concerns them more specifically than

swaps dealers in general. I would hope we could get to hear from

ICE specifically, as their owners are a number of large banks that

are heavily lobbying Congress not to close this exemption and I

would like to hear from them publicly.

25

I have some questions for both the members, and thank you both

for being here. I guess under the old Act and under the new Act,

we have the Section 4(c) exemption authority where the Commission can grant a no-action letter. Would it not be better, Mr.

Newsome, to go back to the old laws where we had some authority

over these now totally excluded energy and metals online trading

facilities, and if the Commission wanted to exempt the Intercontinental Exchange or Enron Online, there could be a vote and you

guys could send Enron Online a letter exempting them?

Mr. NEWSOME. The 4(c) exemptive authority of the Commission

is extremely important, I think, because it gives the Commission

some flexibility, and I think flexibility is key in terms of how we

move forward from a regulatory standpoint.

Senator FITZGERALD. Even if we closed off this 2(g) exemption,

you would still have the flexibility to exempt Enron Online if the

Commission wanted to do that. You could have hearings on it. You

could take a vote, and if the Commission voted to send a no-action

letter to Enron Online or the Intercontinental Exchange, you could

do that. You would still have the flexibility, would you not?

Mr. NEWSOME. That may be the case. That is not something that

I have looked at specifically. I know that the flexibility of the

CFMA, the flexibility of the Commission to utilize 4(c) is extremely

important because there is no way we can sit here and look at how

the markets might move or what problems we might face in the future, so——

Senator FITZGERALD. Right now, you do not have the flexibility

because Enron Online and Intercontinental Exchange are just exempt by statute here with Section 2(g).

Mr. NEWSOME. Exactly. Exactly.

Senator FITZGERALD. You do not have flexibility.

Mr. NEWSOME. Flexibility is a good thing.

Senator FITZGERALD. By closing off 2(g), you would still have the

flexibility provided by 4(c). OK. You said that wash trades are illegal in all markets at all times, and I would assume you would

mean in energy and metals trading online. Is that the case? Is it

illegal to make a wash trade on one of these exempted online energy trading facilities?

Mr. NEWSOME. My Southern slang is difficult to understand, Senator. I said in our markets.

Senator FITZGERALD. In the ones you regulate?

Mr. NEWSOME. In the ones we regulate, there is——

Senator FITZGERALD. You do not have authority to pursue a wash

trade in an online energy trading facility, do you?

Mr. NEWSOME. No, I would not say that. To me, when you look

at round-tripping or the activity that is taking place, and that is

something that we are very aggressively investigating, but when

we look at that, I think it brings up two points. One, it appears

to me to be fraudulent. Two, we are looking at whether or not that

was used to manipulate the market. In either of those cases, it

would be illegal and we would have the authority to bring charges.

Senator FITZGERALD. Do you not have the authority to the extent

it occurred under the old Act under the authority you had 18

months ago? If the new Act were in effect the whole time these

transactions were occurring, is it not true that under the current

26

Act, you could not go after a wash trade occurring on one of these

online energy or metals facilities?

Mr. NEWSOME. I think——

Senator FITZGERALD. Could you point to the section of the Act

that would give the ability to go after that wash trade?

Mr. NEWSOME. Unfortunately, I could not point to that section

this morning. The new Act took out the specific language regarding

the Commission’s ability to prosecute wash sales in the type of

markets that you are talking about, the exempt markets. However,

I still believe that through our anti-fraud, anti-manipulation authority, the Commission has the ability to prosecute in this instance. We are agreeing that we can do it. It may not be quite as

simple now as it was 18 months ago because of the removal of the

specific wash sale language.

Senator FITZGERALD. Mr. Erickson, would you have a response to

that? Do you think you have the authority to go after wash trades

in Enron Online under the current Act?

Mr. ERICKSON. No, I do not. I do not think the Commission retains its direct authority to pursue wash sales as a violation.

Senator FITZGERALD. Everybody agrees that wash trades are bad.

Do we not want to give the Commission that authority to go after

and prevent wash trades? It is an outrage. It was an enormous outrage, what was going on in the energy trading market. Do you both

not agree, we want to be able to clear your authority to pursue

wash trades?

Mr. NEWSOME. There is no question that they are bad. They are

wrong. They are illegal. Given our anti-fraud, anti-manipulation

authority, we do have the ability to go after them for that and we

are currently investing that.

Senator FITZGERALD. Are these online energy trading facilities

not exempt under Section 2(g) from you going after them for fraud?

Mr. Erickson thinks they are exempt. You do not think they are

exempt.

Mr. ERICKSON. Not only exempt, but excluded.

Mr. NEWSOME. They are exempt. The question is whether or not

they are excluded and I continue to believe that we have the authority to go after them for these instances.

Senator FITZGERALD. Are you going to pursue action for trades

at Enron Online for wash trades?

Mr. NEWSOME. Sir?

Senator FITZGERALD. Are you going to pursue action against

Enron Online for wash trades?

Mr. NEWSOME. We are currently investigating that matter now.

Senator FITZGERALD. OK. Have you encountered any arguments

from Enron Online’s lawyers that you do not have the authority to

do that?

Mr. NEWSOME. I have not spoken personally to Enron Online’s

lawyers, but I will be glad to followup on that and give you a more

specific briefing, Senator, of exactly what we have.

Senator FITZGERALD. Thanks, Jim. Thank you both. I appreciate

the time.

The CHAIRMAN. Thank you, Senator Fitzgerald.

27

I have to leave. My bill is up in another committee and I have

to go work that, because it is my bill. Senator Lugar is going to

take over and finish chairing the hearing.

I just have to say again that I have been, as I am sure Senator

Lugar has been, involved in the CFTC since its beginning in 1975,

when I first came on the Agriculture Committee in the House, and

I have talked with my staff and I am trying to remember through

all those years why it is that we need this exemption. Why is it

that we carved out a certain exemption? I know why we did exclusions. That is clear, why we have exclusions, covered by other entities, that type of thing. Why we have an exemption, I do not know.

Maybe it is just something we wrote in there to give lawyers a lot

of work. I do not know.

I guess I am of the position now that I am thinking that, sort

of along the lines of Mr. Fitzgerald, I do not know and I do not

want to put words in his mouth, maybe we really ought to reexamine whether or not we need an exempt category. Maybe there ought

to be exclusions or not exclusions. If they are excluded, fine. If they

are not, you ought to have jurisdiction.

The questions on Enron and stuff, maybe not. Maybe having

them regulated and not exempt may not have stopped Enron, but

it may have at least precluded whatever part or whatever role the

derivatives played in the collapse of Enron. That might have

helped to do that. It might have served as an early warning signal

to others as to what Enron might have been up to.

I leave the committee and I am going to turn it over to Senator

Lugar, but I just ask the question. Maybe we ought to really take

a look again at 2(g) and why it is even there in the first place.

Thank you very much.

I guess Senator Nelson is next. Thank you, Senator Lugar.

Senator NELSON. Thank you, Mr. Chairman.

First of all, I want to thank the gentlemen for being here and

to commend Senator Feinstein for working so diligently with so

many stakeholders to come up with legislation that at least addresses the question about structure and transparency, and so I

truly appreciate that.

I also would like to note that Mr. Einstein seemed to presume

that things might happen in 7 days, 6 days of study, 1 day of decision. I notice more than 6 days have gone by studying and we have

not come to the seventh day for a decision about how to fully investigate or get an investigation accomplished.

From my particular perspective, having had Enron located in Nebraska before it suddenly uprooted and went to Houston, with hundreds of people affected with their retirement accounts riddled by

the Enron collapse and numbers of people in Nebraska and related

to Nebraskans left out of work, it is going to be very difficult for

me to go back and tell them that what we have here is a problem

of exclusion versus exemption. You can appreciate they are not interested in hearing that. What they are interested in finding out

is whether the derivatives issue contributed in any significant way,

and if it did at least in part in some way to the collapse of Enron

and their complete demise in terms of their financial security, they

want to know that, first of all, it has been studied, investigated,

and that some appropriate action has been taken.

28

I have some questions I would like to ask you. First of all, I

think I understand, Mr. Erickson, you are suggesting that the

Feinstein legislation would, first of all, do no harm, and second,

though, the question is, will this grant you the authority to investigate and continue the process that seems to be ongoing right now,

to come up with some conclusions about what, in fact, happened,

and then second, is it sufficient to protect the public as you move

forward.

Mr. Newsome, since you brought up the question of—I will leave

Feinstein to Mr. Erickson and I will leave Einstein to you. How

much time do we need to take to study before we come to that day

when we now decide this is, in fact, the answer?

Mr. Erickson.

Mr. ERICKSON. Are you sure we cannot swap those?

Senator NELSON. No, no.

[Laughter.]

Mr. ERICKSON. You are right on the timing issue. Markets are

funny. The next event may be in 1 day, it may be 1 week, it may

be 1 year. We cannot really define the time.

With respect to Senator Feinstein’s legislation, I continue to look

at it as a pragmatic and modest approach. It affirmatively confers

to this Commission fraud and manipulation authority, which is essential. The reinstatement of those authorities clearly over the derivatives in these markets would have a prophylactic effect on what

people are willing to do.

There is a Governor in place and if people understand that the

transactions are subject to some regime, they may temper the questionable kinds of transactions they are entering and the purposes

for which they are entering those transactions. They also, may temper the leverage, because I think that is something we really do not

remember all the time, that these are leveraged transactions and

they operate pursuant to agreements where, if you are concerned

about credit, you can ask for a bigger pot of money to be held in

basically a deposit account.

I am generally pleased with the Feinstein bill. Yes, it could do

more. We could say that if you are running a marketplace where

price discovery occurs, it ought to take place in a registered marketplace.

Senator NELSON. A framework.

Mr. ERICKSON. Yes.

Senator NELSON. Transparency.

Mr. ERICKSON. Yes, within our two categories of marketplaces.

We have the most highly regulated market, the designated contract

market, which is for retail customers. That is what most futures

and option markets are today. We also have what currently is an

unused part of the framework, which I think is really innovative,

and that is the derivative transaction execution facility, which is

designed for markets like ICE to find a place in the regulatory regime and yet have a much lighter regulatory treatment.

That is something that is not in the Feinstein bill, but if you

really wanted to cement down what kind of transparency you are

expecting out of a marketplace, that is something you could look

at and just require marketplaces to have some category of registration.

29

Senator NELSON. Now the question, of course, chairman

Newsome, is how much time does it take to conclude the investigation to come up with some conclusion?

Mr. NEWSOME. If you will allow me, I would like to expand beyond that time just to—— Senator NELSON. Sure.

Mr. NEWSOME. It is very difficult to say. We are investigating numerous allegations, of which manipulation is one. Manipulation

cases are very complex. They take a lot of time. For example, the

two manipulation cases that commissioner Erickson brought up,

Sumitomo and Avista, those occurred on our most regulated markets. It is impossible to prevent manipulation. They occurred on

the very regulated markets and they were very time consuming.

Sumitomo, in fact, took almost 5 years with access to all of the information.

I do not mean to say that Enron is going to take that long because we are very aggressively pursuing that and we have assistance from other agencies and we are going to move as quickly as

possible. I cannot give you a specific timeframe because as we go

forward, we have uncovered additional information which we have

to move on.

I suspect that it is not an all or nothing situation, that there are

going to be stages. We are going to finish parts of the investigation.

If there are violations, we will bring charges and then we will move

forward with the additional parts of the investigation.

Back to your initial comment about constituents, I could not

agree more. We want real solutions. If there are problems there,

we want to address them. In order for us to look at real solutions,

we have to first determine what the real problems are, and therefore, I think the importance of our investigation is we move forward in trying to find out what we have learned.

Clarification and commissioner Erickson and I are in full agreement that clarification of anti-fraud and anti-manipulation authority is a good thing. I mean, if there are players who are not operating by the guidelines, we want to make sure that we have the ability to go out and prosecute those people. I do not think there is any

question about that by anyone.

The real discussion goes back to the front-end regulation, when

we start looking at market surveillance and transparency. I do not

think the debate has been held that what is the real cost to the

front-end regulation? What does it mean?

I want to take, for example, transparency. Transparency is like

motherhood and apple pie. Transparency is a good thing and we all

want very transparent marketplaces, and in markets which we

oversee that serve a price discovery function, those markets are

transparent and the CFMA gives the authority to the Commission

in exempt marketplaces to require transparency if that market

comes to serve a price discovery function.

To say that across the board, all of these markets should be

transparent is something that deserves a closer look. Transparency

in small, illiquid, or very specialized markets could actually have

a negative impact. They could distort market prices more than they

could help. I do not know that, but we need to look at it, because

when you have the non-standard contracts that we are talking

30

about in many instances in these exempt markets, they are differing in size, they are differing in terms, they are differing in conditions, they are different because of differences in counterparty risk.

What does all of that mean in terms of making this transparent?

What kind of distortion could that have on our very standard markets which we utilize for price discovery? It simply needs to be

looked at.

Senator NELSON. I thank you for your answers.

Mr. Chairman, if I might just conclude, I agree with transparency and it would seem to me that even though you might have

some distortion to the market by transparency in certain cases,

that the market would adjust to that over some period of time, that

it would recognize and take that into account.

Let me conclude by saying that understanding leverage, only

from the standpoint of the insurance industry, it does not matter

how much surplus you have against the risks you have taken if you

do not have any losses. The reason you compare surplus to the liabilities and exposure of the insurance business is because there

are going to be losses and the question is what will those losses be.

I suspect in the case of transparency and in the case of understanding these transactions, you want to know what the potential

exposure is if everything goes wrong. Can they withstand that kind

of exposure? Hopefully, this legislation would help you be in a position, and/or others looking at the transparency of the transactions,

to make that kind of conclusion, not the average person on the

street, but those who are sophisticated in this market, in this kind

of business.

I thank you. Thank you, Mr. Chairman.

Senator LUGAR [presiding]. Thank you very much, Senator Nelson.

Senator Crapo, do you have additional questions?

Senator CRAPO. Yes. Thank you, Mr. Chairman.

I know we have gone over this before, but I want to be sure that

I have it right. As I listened to the testimony of both of you, it

seems to me that there is actually a lot more agreement than disagreement with regard to what we ought to be doing and where we

ought to be. The disagreement, as I understand it, is over whether

2(g) excludes from the fraud and manipulation provisions swaps

transactions. Am I correct about that? Would the two of you agree

that that is the core of the disagreement between your testimony?

Mr. NEWSOME. 2(g) certainly does exclude swap transactions. I

do not think there is——

Senator CRAPO. It excludes them from fraud and manipulation

protections?

Mr. NEWSOME. Two-g excludes them from jurisdiction of the

CFTC, period.

Senator CRAPO. All right. Then I guess I am misunderstanding

what the difference is. How would you characterize the difference

of your testimony, then, Mr. Newsome, between you and Mr.

Erickson?

Mr. NEWSOME. In a nutshell, you have the exclusions. You have

the exemptions. Under the exemptive category, we have appropriate anti-fraud, anti-manipulation authority. We have approVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
31

priate authority to require transparency if that market comes to

serve a price discovery function.

Senator CRAPO. Regardless of Section 2(g)?

Mr. NEWSOME. Well, they are obviously separate. There are criteria for exclusions under 2(g) and there are criteria for exemptions

under 2(h). Another thought process is that 2(g), the exclusion of

2(g) trumps the exemption of 2(h) and I do not think that is correct.

Senator CRAPO. All right. That is what I was trying to say. Mr.

Erickson, do you agree with that as the characterization of the difference between you in your opinions today?

Mr. ERICKSON. Yes, I would concur with what the Chairman has

said. It is just a matter of how you look at the way these markets

are structured, as well. You have the exclusion that attaches just

to swaps and swaps are defined by 2(g). My view is that anything

that fits in 2(g), is out. It is out as a bilateral transaction, but it

is also out if it is done on an electronic exchange marketplace because of another section 2(e) of the Act, which excludes electronic

trading facilities.

Senator CRAPO. As I see it, both of you agree that Section 2(g),

in the way the Act should be drafted, the Section 2(g) should not

exclude these transactions from the fraud and manipulation provisions. Your disagreement is whether it does or not, am I correct in

that?

Mr. NEWSOME. Yes. Certainly, when we look at exempt markets,

I believe that we should have—I think that we do have the proper

anti-fraud, anti-manipulation authority. If there is question about

that, then clarification, I think, would be helpful.

Senator CRAPO. Mr. Erickson.

Mr. ERICKSON. Senator, I would just add that I think it would

be important to just cement the idea that fraud and manipulation

authority apply and attach to the exempt commodity transactions.

What you raise may be a distinction that I previously had not seen.

For transactions energy products, by dint of being an energy product and exempt, fraud and manipulation authority ought to attach,

no matter if you are trading a swap or some other kind of overthe-counter product.

Senator CRAPO. All right. Mr. Erickson, I apparently do not have,

or maybe we just got a copy of the latest version that you have

been working on of Senator Feinstein’s proposal, but I have not

read it yet. The latest copy that I read does actually repeal the exempt commodity provisions, and if I understand it correctly, it

would then subject all of these transactions to full coverage by the

CFTC and trading on the commodities exchanges. That is not what

you are suggesting we should do, is it?

Mr. ERICKSON. No. That, I think, is a debate that is taking place

a little bit at the hearing today about whether one, two, or three

classifications of commodity are appropriate. I am comfortable with

the idea of the three categories. The idea of the exempt category

was really to make sure that fraud and manipulation attached

across the board. That is not the case. I have not seen this legislation. I would be surprised if it completely took out any references

to exempted categories, but I will be happy to take a look at it.

Senator CRAPO. All right. Thank you very much.

32

Senator LUGAR. Thank you. Do you have further questions, Senator Miller?

Senator MILLER. No.

Senator LUGAR. Senator Fitzgerald, do you have further questions of these witnesses?

Senator FITZGERALD. I do. I was wondering about record keeping,

whether under current law the online energy and metals trading

platforms are required to keep records and are those records available to the CFTC, either of you?

Mr. NEWSOME. I will start. No, there are no record keeping requirements to the section that you are referring to. Do companies

keep records? Obviously, they do. As we look at clarifying antifraud, anti-manipulation authority, I think we need to look at all

activities that could make sure that the Commission has a strong

enforcement program and approach to dealing with fraud and manipulation. To my knowledge, I do not believe—— Senator FITZGERALD. They are not required to keep the records,

so we could see a bunch of wash trades between these online energy or metals trading firms, and they are not required to keep any

records, so even if there was a lawsuit by somebody, there is no

statute that requires them to keep records. They could just shred

any written records they have and destroy computer records. Do

you think that is the case? Mr. Erickson, would you care to comment?

Mr. ERICKSON. It is the case, and it is something that is not required under our Act. Presumably, depending on how you are otherwise—regulated, if you are a publicly held company, there may

be some prohibitions on that.

My concern with the wash trading is that there are a lot of different aspects to wash trading. You have the accounting issue. You

have the fraud on investors that the SEC would be looking at. With

wash trading on these electronic exchanges, it gives people the ability to send false price signals. A lot of these markets are being

viewed by thousands of market participants and these transactions

are going across these lines potentially and sending a false price,

and that is not precluded under the Act as it is written and there

are no reporting requirements or other paperwork requirements to

require their keeping those. Yes, the answer is they——

Senator FITZGERALD. I grew up and still live outside the Chicago

area. Every day, I can open my papers and I can find out the price

of a September corn contract or a September pork bellies contract

or soybean contract and I can find out the volume of trades on our

exchanges in Chicago. Is there anyplace that I can find the same

volume price and open interest information for online energy and

metal trading firms? Would either of you care to answer that?

Mr. NEWSOME. That information is not widely available, and currently, it is not required to be made transparent. As you know, the

Commission has the authority if it makes the determination that

these markets serve a price discovery function to require transparency and there are several markets that we are looking at now

to make that determination.

We had some of this discussion a few moments ago and I would

like to go back, if I may, Senator Lugar, and discuss this with Senator Fitzgerald about transparency. There is no question that genVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
33

eral transparency in marketplaces is a good thing. This goes toward some of the front-end regulation that is being talked about,

and whether or not in these markets, is required transparency a

good thing.

I am not going to argue either side of that today, but simply

point out that these markets are very different than the standardized markets that you just referred to from Chicago. Some are

small, some are illiquid, certainly many are non-standardized. You

are talking about a completely different set of, or a different type

of information than you would receive on the standard markets in

either Chicago or New York, and what kind of impact will that

have?

The fact that it is non-standardized, that there are differences in

size, differences in terms, differences in condition, differences in

counterparty risk, could even the release of that information lead

to distortion to some of our standardized markets because of the

differences in standards? I do not know that, but I think it is something that we need to look at and something that I think we need

to realize when we just talk about transparency in general.

Senator FITZGERALD. Is there any self-regulatory function that

these excluded energy and metals trading online platforms have?

I mean, what SRO function does the Intercontinental Exchange

provide? Does anybody know?

Mr. NEWSOME. To my knowledge, none.

Mr. ERICKSON. None that I am aware of.

Senator FITZGERALD. OK. Now just finally, I guess, if we were to

eliminate the exclusion for online trading of energy and metals derivatives contracts or swap contracts, that does not mean that we

would be regulating these online platforms in the same way we

regulate a facility like the Board of Trade in Chicago or the

NYMEX in New York. They could become DTEFs, right, which

would be subject to a mid-tier level of regulation, is that not correct?

Mr. NEWSOME. Yes, sir. Still, through the CFMA and as we move

forward, I still think it is as important now as it has been to look

at the nature of the product, the type of facility, and who is trading

the product in order to determine the proper regulatory scheme,

and you are correct, they could move into a lesser-regulated——

Senator FITZGERALD. Right now, they are excluded from any category. They do not have heavy. They do not have middle. They do

not have light. They do not have any.

With that, thank you both very much.

Senator LUGAR. Thank you very much, Senator Fitzgerald.

I just have a final question. I am intrigued. Mr. Erickson, you

pointed out that the lights really went out in the Enron market.

Describe what that means. Who was still left in the market and

who won and lost in that situation? In other words, most of us have

not had an experience in which a market that had considerable volume and a lot of money, the lights just went out, as you suggested.

What happened, and describe at least the final day of that.

Mr. ERICKSON. I really think for a lot of this, Senator Lugar,

time will fill in many of the gaps in the details that we have. I just

personally think it is striking and shocking, really, that you could

have an event like that where a marketplace is just gone. That is

34

why I look at this from the perspective that we really dodged the

bullet. We had this period of 3 weeks where the operations were

able to continue.

Senator LUGAR. In other words, the Dynegy situation you described that allowed traders who were in this market to

disengage—— Mr. ERICKSON. Exactly.

Senator LUGAR [continuing]. That is, to close their positions,

sometimes at losses or whatever, but to get out. They were not

there when the lights went out.

Mr. ERICKSON. Exactly.

Senator LUGAR. But, now, somebody was. Who was there when

the lights went out?

Mr. ERICKSON. I have made a couple of unfortunate statements

in various public places and I think that we are all under the impression that virtually everyone did have the opportunity to exit.

I made that statement to a group of pretty good-sized energy companies in Texas about a month ago and was quickly taken to task

for making that statement with a few folks saying that they were

not so successful as I might otherwise have presumed and that

they had just delayed taking several million dollars in losses for a

period of months.

I do not know the scope of it, but I think that we were able to

dodge a bullet. It was just luck in this case. To the extent something like this happened again and we did not have some willing

buyer out there, people may have just been left in that market and

unable, really, to trade out, and that concerns me.

Senator LUGAR. I will not argue the transparency thing. Mr.

Newsome has made a very good case that we need to take a look

at all the source of that issue.

This Enron market strikes me as something that was not very

transparent. As a matter of fact, even though some of us knew that

such a thing existed, what was going on in there concerning not

very transparent—now, some would argue, no need to be. You have

sophisticated people. They were aware of their risks and so, therefore, back in the back room if people are being clobbered, that is

their tough luck.

The dilemma is, of course, when huge sums of money are taking

place like this, some of the people had other stockholders, had some

public consumers that were behind them, why, there are some implications for people other than these sophisticated persons. They

were not operating as individuals, I suspect, most of them, with

their own net worth in these markets. This is what I am worried

about, is the fallout. Something that was meant for people who

were very sophisticated but in their operations, others are caught

in the wake of this.

I have no idea who was there, and that is why I was just simply

curious. You say most, somehow, given the Dynegy, scrambled and

got free of it and reported their losses, hopefully by this time, do

not have bookkeeping problems of their own, describing what they

were doing back there in the markets. This is something that, it

seems to me, between the Commission and the committee, we have

to grapple with, not that that was the end of Enron. Lots of other

things happened before. Our particular piece of the situation we

35

take seriously, derivatives, commodities regulation. We really want

to make certain we perfect as much as possible the Act that we

were all involved in a while back, and so that is the purpose of my

querying this.

We thank both of you very much for your testimony. Both Chairman Harkin and I have allowed members of the committee as

much time as they needed, and likewise you, because it was very

important that this be a part of our record as we are literally consulting together in the midst of a public hearing. We thank you for

coming.

Mr. ERICKSON. Thank you, Senator.

Mr. NEWSOME. Thank you, Senator.

Senator LUGAR. The chair would like to call now our second

panel that will include Mr. Randall Dodd, Director of the Derivatives Study Center; Mr. John Coffee, Professor of Columbia Law

School; Mr. Neal Wolkoff, Executive Vice President of the New

York Mercantile Exchange; Mr. Ernest T. Patrikis, Senior Vice

President and General Counsel from American International

Group, Incorporated, International Swaps and Derivatives Association, ISDA; and Mr. Richard Green, Chairman of Aquila, Incorporated, of Kansas City, Missouri.

Gentlemen, unlike the more permissive regime that has operated

in this committee this morning thus far, let me ask each one of

you, if you can, to summarize your testimony in 5 minutes. We will

not be rigid on that because in some cases, that may be impossible.

Given the hour and, likewise, retaining the attention of members,

we would like to hear from each one of you ad seriatim and then

have opportunities for rounds of questions as committee members

might desire.

Mr. Dodd.

STATEMENT OF RANDALL DODD, DIRECTOR, DERIVATIVES

STUDY CENTER, WASHINGTON, DC

Mr. DODD. Thank you very much. I wanted to start by saying I

am very honored to be here today and I want to be able to provide

my insight into the nature of derivatives markets and to also offer

an economic analysis that will probably help us better understand

what should be the proper level of regulation in these markets.

Now, unfortunately, though, we are being brought together today

by a large number of problems that have cast a pall over our financial markets. Some of these are sort of bad apples—executives, accountants, auditors, financial analysts, people reporting in the

media, but there are also a lot of bad non-apples, failures in our

accounting rules, our financial reporting rules, but also failures in

the way we have used derivatives.

I would like to focus on the role of derivatives today because I

think that we need to solve the problem of the way we treat overthe-counter derivatives in order to solve the problems with these

accounting rules. In fact, I do not think it is going to be possible

to solve accounting, auditing, and financial reporting problems

without more transparent derivatives markets, and I believe we

cannot expect to maintain safe and sound and orderly trading markets for commodities and for other financial instruments until we

have the same basic rules applying to over-the-counter derivatives

36

markets as we have with banking, security, and insurance. Let me

elaborate on those points in order to justify them.

The over-the-counter derivatives markets, as we know, have

grown rapidly in the last 20 years. Chairman Harkin mentioned

that they are now $111 trillion worldwide, quite a bit of that here

in the U.S. It is now multiple times the size of our GDP.

If you compare these markets to the size of our securities markets or banking markets or insurance markets, they certainly rival,

if they do not exceed, them. Today, derivatives are very much the

fourth leg of the table that might be thought of as comprising our

financial system. However, unlike the other legs of the table, banking, securities, and insurance, there are no regulations substantially regarding these over-the-counter derivatives markets, aside

from some semantic difficulties we have seen in trying to define

that subset of them known as exempt commodities.

The reason derivatives have grown so much is because they provide two very important economic functions, that is, price discovery

and risk shifting or hedging or risk management. They have also

grown because they provide some unproductive uses, some downright nefarious uses, and we have had those highlighted to us due

to the failure of Enron. We have seen that they can be used to hide

debt, hide losses, fabricate income, conduct wash trades, to manipulate markets. They also can be used to avoid taxes. They can also

be used to avoid or outflank the regulations that apply to banking,

securities, and insurance. We have seen how they can fabricate a

loan by using, for example, offsetting forward contracts in natural

gas. Also, prepaid swaps have done the same thing.

We need a regulatory framework that encourages their use for

risk shifting and for price discovery while prohibiting their use for

these unproductive, if downright nefarious, activities. That is the

goal here today and I am hoping to help in doing that.

Given that these derivatives markets are large, they are an important part of the economy, and might I add also they are an especially important part of the energy industry. Our $600 billion use

of energy every year involves a large number of derivatives contracts. We do not know exactly, of course, because there are no reporting requirements and so there is no hard data on the amount

of derivatives, over-the-counter derivatives in energy products or

metal products.

However, I did take the opportunity a few months ago to estimate the size of Enron’s derivatives book. Enron alone had at the

end of 2000, the last year they reported, $758 billion worth of derivatives in energy products on their books. Now, you add to that

Duke, Dynegy, Williams, El Paso, Aquila, the others, and you have

the size of an energy derivatives market in the U.S. that is multifold the size of this $600 billion use of our energy, so those markets

are very important.

Because they are important, it is important that they work efficiently. The conditions for these markets working efficiently are

that, one, the prices are transparent, that everyone can see them.

Everyone can also see market volume, open interest, and the like.

Also, that large traders’ reporting data is given to the government

authority so that we can detect and deter manipulation.

37

Transactions in these derivatives instruments should also be conducted in a way that is orderly, where markets do not just freeze

up, they do not just suddenly stop trading, where there are not excessive price movements. After all, that is the way we treat the

New York Stock Exchange and that is the way we treat our other

exchange-traded instruments.

Last, derivatives instruments should have proper credit management practices. Derivatives dealers should have capital. Derivative

instruments should have collateral attached to them that is adequate for the risks that are involved in those transactions.

Now, those are what is needed for an efficient working market

that is tied to this key energy and metal and other financial markets in our economy. Yet, we do not see that actually occurring in

the market today. The private sector has not produced market

practices that are consistent with those needs for an efficient market, and that why I think it is so good that we can come here today

to talk about what might be the remedies for this problem, and I

would like to propose in the brief time I have remaining three basic

remedies to this problem.

The first one is to establish registration and reporting requirements for over-the-counter derivatives. Anyone dealing, selling,

participating in the transaction should be registered. They should

have a background check to make sure they have not been convicted of fraud or embezzlement. If you get convicted of securities

fraud, you are barred from that industry for life as a securities

broker, but tomorrow, you can go get a job working for Dynegy, El

Paso, or Williams, and that is a tragedy. Also, the institutions

should be registered so we know who they are.

Finally, they should also have reporting requirements. Enron

and the like had no reporting requirements as a derivatives dealer.

We know very little about them. We can only infer a little bit, what

we get from their quarterly and annual statements. They should

also report their large trader positions to the government so that

we can detect and deter manipulation and other market problems.

In addition to registration and reporting, the second thing we

need is collateral and capital requirements. Enron had no capital

requirement as a derivatives dealer, even though they were a large

financial institution. Similarly, for that matter, GE and some of

these other near-financial institutions also have no capital requirements. It also would apply to the El Paso, Williams, and the others.

As a result, when Enron fails, the effect is not buffered and instead

is felt immediately by other participants in the industry and, in

fact, other firms throughout the economy, and today we have this

pall over our entire financial market.

In addition to capital is collateral requirements. The organized

futures exchanges, such as NYMEX, have margin and their clearinghouse has capital and that is why when Enron failed and this

market started to melt down, there was a flight to quality, and

where did they flee to? They flew to the high-capitalized, well-margined markets in the NYMEX and they were able in some cases to

get out of Enron and into that market to protect themselves from

credit failure or performance failure on their derivatives contracts.

If it were not for that flight to quality, for having a safe harbor of

where to go, surely the consequences would have been much more

38

difficult. To avoid the deeper problems in the future, we need to

start thinking and establish today about how to adequately

collateralize these contracts.

In addition to reporting and registration requirements, capital

and collateral requirements, last would come what I would consider

orderly market rules, and these would require the derivatives dealers to act as dealers do in other markets, which is to maintain liquidity by posting bid and ask prices throughout the trading day.

It is used in the over-the-counter market for U.S. Government securities. It is even required there. It is used on the stock exchange

as the specialists maintain bid/ask prices. It should also be the case

for over-the-counter derivatives dealers in order to maintain an orderly market and market liquidity.

We should also have spec limits and we should also have excessive price movement limits, again, just as we do in the New York

Stock Exchange and the other futures exchanges. This will help

make these markets more efficient. It will help prohibit the unsavory, nefarious, unproductive uses that we are witnessing today,

and I think it will go a long way to try to solve the problems that

have been highlighted by the failure of Enron and the subsequent

calamities that we have seen in our financial markets. Thank you.

Senator LUGAR. Thank you very much, Mr. Dodd.

[The prepared statement of Mr. Dodd can be found in the appendix on page 90.]

Senator LUGAR. Mr. Coffee.

STATEMENT OF JOHN C. COFFEE, JR., PROFESSOR, COLUMBIA

LAW SCHOOL, NEW YORK, NEW YORK

Mr. COFFEE. Thank you again for inviting me. I want to briefly

address three questions. First, will the Feinstein amendment

produce undesirable uncertainty, and my answer will be no. Second

question, do we need greater transparency in the energy derivatives market, and my answer will be yes.

Third, the question I think we really should be focusing on in

most detail, are there any aspects of the Feinstein amendment that

might produce undesirable or unnecessary restraint on future competition within this industry, and my answer here is yes, there

might be. The amendment is a good answer, a workable answer,

but probably not the optimal answer. There is some over-regulation

in it that is not necessary for its basic core purpose.

Now, let me remind you of something you already know, but I

think the record should set this forth clearly, the 2000 Act was precipitated by a turf war between the SEC and the CFTC, and as a

result of that, there was suddenly a serious question about the

legal status of swaps and the possibility that the longstanding 1993

swaps exemption might be repealed suddenly. That sent a friction

of fear across Wall Street and the President’s Working Group understandably recommended that financial derivatives be deregulated to the extent they traded over-the-counter.

Now, the President’s Working Group, as you all know, did not extend that recommendation beyond financial derivatives, and in a

very simple sentence, we ought to state the rationale for that,

which Senator Fitzgerald has stated and you have also repeated,

but it should be fully in the record. The position of the President’s

39

Working Group is that financial derivatives are not vulnerable to

manipulation, corners, or swaps because they have infinite supply,

whereas physical commodities are vulnerable to corners and swaps

because there is finite supply, and that has always got to be your

polestar when you come back to exempt commodities.

If there is a physical commodity or there is something that is in

finite supply, there is a potential for manipulation, and the most

important thing to take from Senator Feinstein’s very succinct testimony this morning was that there has been a wave of wash

transactions and they raise the strong inference, the strong smell

that there is a manipulative intent in someone’s mind. Investigations will tell us later who did it, and I raise no charges, point no

fingers, but if you get those many wash transactions, someone has

improper purposes someplace and you have to respond to that.

Now, let me go back to the three questions that I raised. First,

is there going to be undesirable legal uncertainty if the Feinstein

amendment were passed? Well, I think not because the SEC is now

out of the picture. There is no possibility again that we will have

a swap being alternatively characterized as a future by one agency

and an option by the other agency because the SEC’s jurisdiction

has been taken away.

The issue that comes up in this area is whether or not the exchange traded facility, ETFs, deserves to be regulated on a totally

different basis than the futures exchange. Now, as a generalize, I

would start out this analysis by looking at the status of Nasdaq

and the New York Stock Exchange. They differ in the same way

that the electronic traded facility, the ETF, differs from the futures

exchange. One has open outcry, one is electronic. They are different

in the same way that our current energy market is different with

two kinds of trading institutions. Both Nasdaq and the New York

Stock Exchange are regulated the same way when it comes to

transparency, reporting, and disclosure, and I think that, again,

should be the polestar. There are relevant differences. Nasdaq is

not yet an exchange. They have the same obligations when it comes

to fraud disclosure reporting obligation.

There has been an issue raised about whether the overlap of the

FERC and the CFTC will also give rise to undesirable competition

or undesirable uncertainty, and I would have to point out that the

FERC and the CFTC are very different agencies with very different

regulatory missions. Thus, they should overlap. The CFTC is basically an investor protection agency and the FERC is basically concerned with consumer protection. It is not safe to cut one agency

back when the other agency’s jurisdiction begins because they are

trying to protect different constituencies and they have different

priorities.

The second question, is there a need for greater transparency?

Again, I think that the Feinstein testimony this morning pointed

out that there is a huge volume of wash transactions, and what is

the motive for a wash transaction, the dominant motive? Maybe

not the exclusive motive, but the dominant motive is to send a false

price signal, a false price signal that signals either that there is demand at a particular price level or that there is market depth and

liquidity at that particular price level, and that is a signal that can

distort not only the market that the signal is entered into but the

40

other market. The fundamental question is, why do we have to regulate a market full of only sophisticated participants, and the answer is because false signals can be sent from that market that

have an externality, that create an externality, because they affect

other markets.

Again, as a generalist, let me take you back very quickly to 1987

and the Brady Commission, which was one of the most authoritative studies after the 1987 stock crash of how markets operate,

and they developed the one market concept. There was an issue

about whether certain transactions in stock index futures in Chicago destabilized the New York Stock Exchange and what they concluded was that there was a realistic scenario that when information was suddenly suspended from Chicago and you no longer knew

what was happening in the stock index future market, that that

could send a wave of fear and change trading behavior on the floor

of the New York Stock Exchange.

This concept from the Brady Commission carries over today.

There is one market and we have two functional substitutes. We

have futures exchanges and we have electronic trading facilities,

and while I think both should survive, both should be encouraged,

they should be allowed to compete fairly, we have to recognize that

signals from one market will affect both markets. We have to have

integrated functional regulation that treats them similarly to the

extent there is a danger of deception and a danger of lack of transparency, because transparency affects the other market, as well.

Last question, is there a danger of over-regulation? I heartily endorse the transparency, the disclosure, the reporting requirements.

The burdens of that kind of regulation are small, the benefits are

great, and the injury to other participants is enormous because the

lack of transparency affects other markets. There is always that externality.

I am more concerned about some other areas that I think are

necessarily adopted. For example, the net capital rules, I do not

think that the net capital rules should be imposed on the electronic

trading facilities. I do not think that serves anything like the same

purpose of ensuring disclosure. The net capital rules are basically

there from the broker-dealer history to protect retail customers

against the danger of broker insolvency because brokers hold

money and property.

I am not sure we have the same need to protect paternalistically

the users of electronic trading facilities. Now, I have used that just

as an illustration. There is a certain amount of over-breadth in the

proposals and I think the core idea of ensuring that there be greater transparency, greater disclosure and regulation is necessary,

vital, and fairly low-cost, but I think there is some excess regulatory baggage that at least should not require a priority and it

could deserve some further examination.

At this point, I will stop and take any questions that you later

want.

Senator LUGAR. Thank you very much, Mr. Coffee.

[The prepared statement of Mr. Coffee can be found in the appendix on page 130.]

Senator LUGAR. Mr. Patrikis.

41

STATEMENT OF ERNEST T. PATRIKIS, SENIOR VICE

PRESIDENT AND GENERAL COUNSEL, AMERICAN

INTERNATIONAL GROUP, INC., INTERNATIONAL SWAPS AND

DERIVATIVES ASSOCIATION (ISDA), NEW YORK, NEW YORK

Mr. PATRIKIS. Thank you, Senator Lugar. I would like to start off

by saying that every morning when I get up, I wonder what disgusting new story will surface from the deeds of certain members

of corporate America. I joined AIG 4 years ago after a 30-year career at the Federal Reserve Bank of New York. I was the No. 2 officer of the bank. In moving to the private sector, I asked myself,

how would it stand up compared to working at the Fed as far as

ethical matters were concerned, and to date have not found that a

problem, but I find all of us tainted by what is going on in the marketplace today.

That is much of the theme of the statement that we have submitted to you this morning. The horrendous activities generated by a

few represent a failure of corporate governance and ethics. It would

not be accurate or fair to blame Enron or any of the lapses of business morality on the over-the-counter derivatives. A better question

is, what is wrong with business school curriculums?

Your inquiry is timely. You should be asking the questions you

are asking. We appreciate Senator Feinstein’s concerns about what

happened with electricity and natural gas trading in California. At

ISDA, we believe the case has yet to be made that regulation of

OTC swaps in privately negotiated derivatives as futures is warranted. While I am not an expert in derivatives or in energy trading—perhaps I know enough to get myself into trouble—I have

read accounts of energy trading activities in the press but have

learned over the years not to believe all that I read.

I understand that the FERC and the CFTC, which, in our opinion, has ample authority to address fraud and market manipulation with respect to non-financial derivatives, has several investigations underway. I hope that the committee awaits the results of

those investigations before deciding on a legislative course.

Of course, there are many questions surrounding energy trading.

Some of these relate to California’s electricity and natural gas deregulation regime and how it may well have invited traders to take

advantage of it through proper and improper means. One key issue

here is whether improper activities involved any use of over-thecounter derivatives as opposed to cash-settled spot trades.

In any event, the major issue you have posed is whether the

CFTC has the authority to deal with fraud and market manipulation that might involve OTC non-financial derivatives. That question has been best answered by the Chair of the CFTC this morning. At ISDA, we share that view. We believe the CFTC has that

authority. However, if it is ultimately determined that it does not,

then we will work with you on legislation to provide the appropriate agency with that authority.

You are probably asking yourselves, why does ISDA oppose legislation that would regulate OTC derivatives as futures? The answer

is that it would result in less liquidity in the marketplace and

would create new uncertainties. As the members of the President’s

Working Group on Financial Markets have pointed out, OTC derivatives are a valuable risk management tool used all over the

42

world. They are a form of financial insurance, spreading risk or

loss to those who can best bear it.

Businesses that are now carrying on activities that would in the

future subject it to regulation may well stay away from markets

that they now use to hedge risks, or they might shift risk management activities offshore. These non-financial derivative markets are

not public retail markets similar to those of the futures exchanges,

where futures style regulation is needed. These markets are composed of sophisticated participants. If there is a lack of liquidity in

some of the energy markets today, it probably does not result from

the lack of regulation but is a market, including rating agency, response to the fact that trading profits do not make up for lack of

capital or that more capital is needed to cover trading risks. We

need more, not fewer, participants in these markets.

It is not clear to me that the legislation proposed would address

the alleged electricity and natural gas trading abuses. Futures regulation for these OTC derivatives will not stop fraud. Indeed, as I

recall it, several past infamous cases of market manipulation involved significant use of futures exchanges.

In closing, the Commodities Futures Modernization Act is about

18 months old. It has brought needed certainty to the OTC derivatives market, not through deregulation but codification. This has

made it possible for businesses and other OTC derivative users, including governments, to better manage their risks.

It assisted in the Enron situation. Enron counterparties did not

walk away from their trades. Your work on the Commodities Futures Modernization Act and support of bankruptcy legislation

aided the markets to work as well as they could in a difficult situation. In addition, even though Enron was the largest bankruptcy to

date, it did not lead to systemic failure in the markets.

Let us give the FERC and the CFTC the opportunity to finish

their work before we conclude that legislation is the answer. Thank

you.

Senator LUGAR. Thank you very much, sir.

[The prepared statement of Mr. Patrikis can be found in the appendix on page 138.]

Senator LUGAR. Mr. Wolkoff.

STATEMENT OF NEAL L. WOLKOFF, EXECUTIVE VICE

PRESIDENT, NEW YORK MERCANTILE EXCHANGE,

WASHINGTON, DC

Mr. WOLKOFF. Mr. Chairman, thank you for allowing me to be

here today. Thank you for holding the hearing. My name is Neal

Wolkoff. I am the Executive Vice President and Chief Operating

Officer of the New York Mercantile Exchange. The NYMEX has the

world’s largest regulated energy marketplace, and as far as precious metals, I can say the same thing.

For myself, my career in commodities regulation and market operations goes back 22 years, initially as a trial attorney with the

CFTC’s Division of Enforcement, and for the last 20 years specifically working in the areas of energy and metals marketplaces. I

will do my best to distill that 20 years into the 5-minutes permitted

to me. If I go over, feel free to cut me off.

43

A little bit of context is very helpful because there has been an

awful lot said today, all of it obviously well meaning, but much of

it incompatible.

To start with, swap transactions or unregulated over-the-counter

derivative transactions are their own instrument. Nobody is saying

that they should be treated like futures transactions. Nobody is

looking for them to be put into the same box as regulated futures

transactions.

A little bit of history, prior to the CFMA being adopted, in the

early 1990’s, I believe it was 1991, as a result of a case involving

a Brent transaction which threw legal uncertainty into the energy

cash marketplace, the CFTC adopted the energy swap exemption,

which the NYMEX supported and we are big believers in liquid

and competitive cash markets, and that includes over-the-counter

swap transactions.

In 1993, to provide legal certainty to all swaps, including financial swaps, the CFTC adopted what was called Part 35, and Part

35 set forward standards for what participants could appropriately

participate and also established that swap transactions could not

be standardized and, likewise, could not be cleared, which were two

distinctions that were made with the exchange traded world.

The CFMA then effectively overrode Part 35, and I think Professor Coffee established perfectly sound reasons why that took place.

It excluded financial swaps from CFTC oversight, which was consistent with the President’s Working Group. It allowed for standardization in energy and metals contracts, which was consistent

with what the marketplace had been evolving to, and it permitted

the clearing of energy and metals derivative transactions because

following Long Term Capital and various other near misses, there

was a belief that perhaps clearing was not something that should

be withheld from the over-the-counter market but encouraged.

Those were generally pretty good things. Part 35 applied prohibitions against wash trading. It made fraud impermissible as far as

swaps, and it outlawed manipulation if conducted via swap transactions, all very straightforward and simple. There was no confusion until the jurisdictional dispute came into effect, none of that

having anything to do with energy and metals.

The CFMA with respect to energy and metals swaps removed the

prohibition on wash trading and, in fact, it created regulatory uncertainty, as we heard the two commissioners, the chairman and

commissioner Erickson before with respect to the application of the

anti-fraud and anti-manipulation rules on those over-the-counter

markets.

Much about the CFMA has been beneficial and forward-looking

in a number of respects, but it is important to note that by permitting metals and energy swaps to become standardized and traded

on electronic trading systems, the law enhanced the roles of those

over-the-counter markets in price determination of very important

strategic commodities, which metals and energy clearly are. Transactions previously had been individually negotiated and tailored to

the needs of the two parties. The resulting price was both hard to

compare, as suggested before, because the transactions themselves

were so different, and there was no vehicle to publicize the transaction price to the wider marketplace.

44

Electronic transactions provided that vehicle and standardization

allowed the comparison of transactions so that parties could easily

see what a particular standardized instrument was trading for. It

was not dissimilar in particular from the price dissemination function that a regulated exchange has.

In doing some very good things, however, there were some regulatory black holes that were created, and I will not get into the history of how the law was adopted. It was recognized that there was

some particular perhaps carelessness. It would not be the lesson in

civics that I would want my small children following.

Under the CFMA, certain markets, including, for example, the

Enron Online system—which is still in business, the assets of that

system are now used by USB Warburg and many of the same traders and management is now working for USB—falls outside of the

definition of a trading facility and it is clearly outside the CFTC’s

regulatory powers.

Other markets that operate in the new regulatory tier called exempt commercial markets, they do not have transparency to the

broader marketplace. You need to actually be a member or an active participant in order to have the screen. Yet, they serve a vital

price discovery function because the participants are generally the

larger users, producers and merchants of the particular commodity

and they are using these systems to determine what their price

should be. The CFTC, without doubt, does not have effective tools

to conduct oversight of these markets or to deter wrongdoing or

punish wrongdoing once it is uncovered.

The CFMA, finally, removed the prohibition on wash trading,

which previously under Part 35 applied to all of these transactions,

and it is hard to imagine what public benefit would accrue for companies freely being allowed to wash trade under commodities law.

I have scratched my head on that quite a few times and it is still

not apparent.

How can Congress fix these problems? Clearly, I am here supporting the Feinstein amendment. Perhaps there may be some

tweaking on capital provisions, but I think that is a very small

item. The Feinstein-Fitzgerald amendment is pragmatic, it is moderate, and it is narrowly tailored. It preserves legal certainty for

swaps. It still exempts transactions from prescriptive regulation. It

does not tell companies what to do and how to do it. It tells them

that if you do things in a fraudulent or manipulative way, you can

be punished for that. That is not saying, do it this way but not another way. It is not prescriptive regulation. That is very important.

Importantly, as well, it provides the CFTC tools to ensure accountability and transparency and to deter misconduct.

It seems difficult to understand why we would want to have educated people and attorneys argue, and eventually argue in front of

a judge, an argument similar to how many angels are on the head

of a pin. Does the CFTC, in fact, have jurisdiction over this transaction but not over that transaction, not really depending on the

nature of the trade but where the trade occurred? Those are the

kinds of technicalities that I think people find outrageous when

there is wrongdoing but there is no clear avenue of investigation

or punishment. That is not good deterrence and that is not effective

for an appropriate market.

45

With the Feinstein amendment, it provides for an application

clearly across the board of anti-fraud and anti-manipulation rules

and the prohibition against wash trading is clearly and evenly applied across the over-the-counter market that remains regulated.

In fact, we believe that the Feinstein-Fitzgerald amendment

should be enhanced and improved in one regard, and that is that

the CFTC should have discretionary authority to create certain

self-regulatory obligations on the part certainly of the larger centralized electronic systems that are playing a key and important

role in price determination. Otherwise, the burden to surveil the

market and enforce rules would fall entirely on the CFTC, which

is a resource drain to government regulators.

The commercial platforms, in our view, should stand behind not

just the technology of their systems, but the integrity, as well, and

we have provided specific language to Senator Feinstein’s office in

this regard.

Last, I would just like to conclude, why does NYMEX care about

this issue? As stated before, we have been unambiguously supportive of the various swap exemptions since the early 1990’s. A liquid

over-the-counter market gives business to NYMEX. It is good for

us. It is good for competition. It is a pro-competitive move. What

these markets have lately done to themselves, unfortunately, is not

pro-competitive. It is not good for the marketplace. It is not good

to NYMEX.

It is a bit scary, in fact, when you consider that under recent

electricity deregulation, the generation has been taken away from

the utilities and provided to the merchant class, which, as said before, has now lost $188 billion of market capital during the last

year. They are controlling power generation. This is a bit of a

frightening world here at this point.

Does this bill solve everything? No, it does not solve everything.

Is it a good step forward to what it intends to solve? Yes, it is, and

we heartily support it. Thank you, Senator.

Senator LUGAR. Thank you very much.

[The prepared statement of Mr. Wolkoff can be found in the appendix on page 152.]

Senator LUGAR. Mr. Green.

STATEMENT OF RICHARD C. GREEN, CHAIRMAN, AQUILA, INC.,

KANSAS CITY, MISSOURI

Mr. GREEN. Thank you, Chairman Lugar and members of the

committee. As Chairman of Aquila, I appreciate the opportunity to

testify today and want to emphasize that I am speaking for Aquila

today and not anyone else in our industry. You should understand

that Aquila is an integrated energy and risk management company

based in Kansas City, Missouri, with customers and operations

across the United States, Canada, Europe, New Zealand, and Australia. We own traditional investor-owned utilities in Missouri and

Kansas, Colorado, Nebraska, Iowa, Michigan, and Minnesota. We

also own and operate generation, transmission, distribution, and

gas storage facilities.

Until recently, we were very active in the energy trading business, both in electricity and natural gas. In fact, we were in that

business from its inception 17 years ago, rising to be consistently

46

the nation’s No. 2 or No. 3 trader in natural gas or electricity. Recently, we initiated a restructuring that included a significant

downsizing of our trading operations for both electricity and gas

due to the tightening credit and capital requirements for energy

traders.

I have three main points that I want to make today. First, it is

clear that the Enron collapse has had an enormous impact on

shareholders and employees of energy trading companies, irrespective of the company’s track record or its soundness. A crisis of confidence exists, especially from rating agencies and capital markets.

Second, I need not tell this committee how valuable derivatives

have been for agriculture. Derivatives are no less important in the

energy industry. The loss of a substantial portion of energy traders

will ultimately have an adverse effect on energy supply and prices

as competition diminishes.

The third point that I want to make is that it is critical for bodies such as this committee to work quickly to remove uncertainty

from the markets, to make corrective remedies where warranted,

and to allow the energy industry to get back to the business of

building critically needed infrastructure. The entire energy sector

has experienced a state of upheaval since the California energy crisis and the Enron bankruptcy. The troubling effects of these events

have expanded to affect all energy traders, even those who had

nothing to do with either the California market or Enron’s inappropriate practices.

My company withdrew temporarily, but significantly, from the

California markets in the fourth quarter of 2000. We saw instability in the market, which made the level of risk to participate too

high. Moreover, we did not engage in the kinds of improper accounting or trading practices for which Enron has become notorious. We played by the rules. Yet, we as well as many others were

swept up in the same wave of uncertainty and lack of confidence

that has resulted in credit downgrades and investor flight. Consequently, a substantial portion of the trading industry has reduced their trading activities or withdrawn altogether.

The Commodities Futures Modernization Act of 2000 was a significant step forward for financial market development. Its primary

act was to provide legal certainty for the over-the-counter or off-exchange derivatives markets. Congress provided the legislation necessary to enable companies to actively engage in transactions with

derivative products, to manage their price risks, and provide stability in their business.

We at Aquila do not believe that the current CFMA led to the

crisis in the industry. We are not sure that one can put the responsibility on the wording of any specific Federal law. Today, we believe that the Act gave ample authority to address fraud and market manipulation. However, we are here to decide whether the current law should be modified, given the current situation.

We believe that restoration of public confidence in this industry

does require revision in the current law. The current business climate, not just in energy, is, frankly, perilous. The difficulties are

both structural and psychological. The country as a whole has been

distrustful about business ethics, financial reporting, accounting

practices, and the use of financial instruments, such as derivatives.

47

Companies have gone out of their way in annual reports to say that

they do not use derivatives. Credit agencies, in response to the

Enron collapse, are exercising heightened scrutiny of energy companies using business practices that were perfectly acceptable only

3 months ago.

You have a right, and perhaps an obligation, to ask, does the activity of energy traders add value to the marketplace and do energy

initiatives matter? The answer is, yes. Derivatives have been

shown to be a critical factor in investment and growth of the economy. By utilizing futures, options, swaps, Aquila and companies

like it are able to take price risks from someone who does not want

it and distribute it to someone who will accept it. The use and

value of derivatives in the energy industry is no different than the

more mature industries like agriculture and banking.

Chairman Harkin earlier asked about how these derivatives affect people. Well, here are a couple of examples. Aquila has a custom derivative product called the guaranteed bill that a Midwestern regulated utility offers to its residential customers that

provides for a fixed monthly bill on natural gas with no surprise

adjustment at the end of the period.

Another example of the benefits of customized derivatives is our

contract with the Sacramento Municipal Utility, which provides

them power or cash when there is insufficient rainfall for their hydroelectric generation to operate. This allows the Sacramento utility to protect its customers from rate increases to cover the costs

of purchasing last-minute power at high prices on the open market

during periods of drought. These benefits need and should continue.

We urge this committee to take action to quickly put remedies

and safeguards in place to help restore the confidence in the beneficial reliance on energy derivatives. To that end, we at Aquila especially appreciate Senator Feinstein’s willingness to listen to industry concerns as she moved forward with her proposal. S. 1951

ensures that information necessary for review and oversight by the

CFTC to do its job is provided on a timely basis. We support Senator Feinstein’s latest version of her bill as it provides the necessary safety nets to restore public trust while not impeding the

dynamics of the marketplace.

These proposed changes in the current law will increase transparency through better and more detailed reporting of transaction

data, give the appropriate regulatory agencies abundant and unambiguous authority to investigate anti-fraud and anti-manipulation

tactics that have been so critical in destroying investor confidence,

and require for bilateral dealer markets the use of value-at-risk

models, or in very limited circumstances and where the Commission determines the risk demands it, the application of minimal

capital requirements. These measures will provide the openness

and accountability so that we start the task of rebuilding confidence in the energy trading industry.

I have talked a great deal about public trust, the importance of

instilling it. I know that this committee will do what it can to restore certainty in the marketplace and provide protection for consumers. However, it will be up to corporate America to behave in

48

a way that earns the public trust. Thank you for the opportunity

to appear before this committee.

Senator LUGAR. Thank you very much.

[The prepared statement of Mr. Green can be found in the appendix on page 164.]

Senator LUGAR. I want to thank each one of you for extraordinary testimony, and by unanimous consent, all of the testimony

you have offered in prepared form will be made a part of the

record, in addition to comments that you made this morning. This

abbreviated testimony was a desire to make sure all could be

heard.

Let me just at this point defer to my colleagues. We are going

to have a roll call vote on the Senate floor, I understand, in about

3 minutes’ time, and that will probably effectively bring to a conclusion the hearing this morning. Before that occurs, let me call

first of all on Senator Fitzgerald.

Senator FITZGERALD. Thank you. Mr. Patrikis, I gather you are

from the International Swaps and Derivatives Association.

Mr. PATRIKIS. I am a Director of the Association, yes.

Senator FITZGERALD. I have been reading the prepared testimony

during the course of this hearing and I wanted to ask you some

questions about it. You state in the prepared testimony a very good

case for legal certainty in the financial derivatives industry, but I

do not think anybody is arguing about the need for legal certainty.

Everybody agrees that there is that need and nobody wants to undermine that. However, in non-financial commodities, such as energy or metals trading online, do you not think it is reasonable to

have a prohibition in the Act against wash trades?

Mr. PATRIKIS. What we heard today was that the CFTC believes

that it already has jurisdiction to deal with that. If that is the case,

as the Chairman of the CFTC said, I agree with him. Wash trades

are bad——

Senator FITZGERALD. Well, we had, I would say, substantial conflict on that. Mr. Erickson said he did not believe they do and Mr.

Newsome was not quite so sure.

Mr. Coffee, you are a law professor. Do you think the CFTC right

now could pursue an online energy exchange for wash trades? Is

there that——

Mr. COFFEE. There is a regulatory hole. If 2(g) is read with a

plain meaning analysis, it says there is no authority over someone

who falls in 2(g). There could be issues about whether Enron online

truly qualified as an electronic trading facility. I am not saying litigation could not try to fight at the edges as to whether you fell

within 2(g). If you fall within 2(g), the plain meaning says there is

no authority.

I understand Mr. Erickson’s position. Commissioner and chairman Newsome was a little bit more equivocal, and I am not sure

I fully understand the basis for his position.

Senator FITZGERALD. Mr. Patrikis, you agree wash trades should

be banned, that they should not be legal.

Mr. PATRIKIS. Correct.

Senator FITZGERALD. You think they should be banned?

49

Mr. PATRIKIS. No, I think they are banned. If the issue is—we

get back to the same question again. If they already are subject to

the authority—— Senator FITZGERALD. They are banned on the NYMEX or the

Chicago Board of Trade. Everybody agrees with that. I have been

looking through the Act, trying to find someplace where the CFTC

would have authority to go after a wash trade on Enron Online,

now owned by USB Warburg, or on the Intercontinental Exchange.

I do not find it. You just had a distinguished law professor say he

does not see it. Mr. Wolkoff, do you believe that the CFTC has that

authority right now?

Mr. WOLKOFF. No. It is unambiguous. Under the rules preventing wash trading, specifically state that they apply to futures

transactions, the Part 35 prohibition, which was explicit in applying wash trading prohibitions to swaps. That language has been removed in 2(g) and 2(h). Regardless of which section you believe

Enron Online or any of these other facilities falls under, the wash

trading provision is conspicuously not there. It is simply not there

and you cannot imply a statutory prohibition when the statute expressly excludes the prohibition.

Senator FITZGERALD. Now, given that confusion, Mr. Patrikis,

what is the problem with making it clear that the CFTC, for example, could go after and pursue enforcement actions against people

engaging in wash trades on these online energy and metals exchanges?

Mr. PATRIKIS. I said in my statement this morning that if the

CFTC does not have authority to go after these trades, it should

have the authority. The difference is, does it have the authority?

I go with the Chairman. I work for a chairman. I like to follow that

chairman. We have heard the Chairman of the CFTC speak. I assume he has a general counsel who is helping him. He thinks he

has the authority.

I say, first, let us wait and see what the abuses are. Has it involved swaps or does it involve cash spot trades, and then see if

he has the authority he has. He says he has the authority. We

think he does. I am not an expert in this area of the law, but he

speaks for the Commission.

Senator FITZGERALD. I have an article from the Chicago Tribune

right here talking about wash trades and saying that they have occurred in the online energy industry. It seems clear enough for the

Chicago Tribune, which is a very careful newspaper. They say that

wash trades are used to inflate numbers on both sides. They serve

no other economic purpose. They have a chart here, one company

selling a power contract to the other company at a certain price

and that other company selling it right back to the first seller at

the same price, returning the power. Also, both sides are recording

revenue from these sales.

The Tribune asks, why do it? They say companies could use

these sales to inflate their numbers, making the companies appear

bigger than they really are. Then they ask, is it legal? They say,

because the wholesale energy market is not regulated, such transactions appear to be legal. Similar sales, however, are prohibited

in regulated financial markets. Now, according to the Chicago Tribune, I am saying that this is the Chicago Tribune saying this—I

50

have not independently verified it—but they say CMS Energy Corporation, Dynegy, Inc., and Reliant Resources took part in wash

sales.

It seems to me we have a lot of people saying this is going on.

Why not let us just make it crystal clear that the CFTC has the

authority to ban these wash trades? Is there any public benefit to

wash trades? Does anybody want to defend wash trades?

[No response.]

Senator FITZGERALD. Nobody wants to defend it. It seems to me

that one of the reasons I understand the NYMEX’s volume has

been going way up is that people are migrating away from these

unregulated companies, companies that have no regulation at all.

People do not want to participate in that now after all the disclosures have come out about abuses in wash trades in the energy

market, and I do not even think it is in the long-term best interest

of companies such as the Intercontinental Exchange to fight some

simple level of regulation that would bring some transparency and

some ability to ban practices that everybody seems to agree should

be illegal, like wash trades.

I wonder if Mr. Wolkoff could address what has happened to the

NYMEX’s volume recently.

Mr. WOLKOFF. For the first 6 months of this year, our energy volume is up about 30 percent, and due to a number of factors, but

one of which clearly has been the loss of market confidence in overthe-counter markets. Notwithstanding that, I think that for the

long-term health and well-being of the market, it is not a positive

that there is a loss of confidence in the over-the-counter markets

and I do not think it is a positive going forward for market competition and I do not see it as an ongoing positive for the NYMEX

to have this situation.

Senator FITZGERALD. I could actually argue that you should

maybe be arguing on the other side, let us not close this loophole,

because you are benefiting from it. All this business is migrating

from the wild West over to where customers have some confidence

that there is some ability on the part of regulators to ban fraudulent practices and to have some price discovery.

Senator LUGAR. Senator Fitzgerald, let me just interrupt for a

moment, if I may, to recognize our colleague, and then we will

come back.

Senator Crapo.

Senator CRAPO. Thank you very much. I would like to just get

into a couple of quick issues. One of the allegations that is very

regularly thrown around here is that the Enron collapse is somehow attributable to the failure to properly regulate derivatives, and

I have asked most witnesses we have had before us on this issue

if they are aware of any evidence of that fact. Is anybody on the

panel aware of any evidence, and I am not talking about this argument about impact on prices in the market in general of improper

uses of swaps or whatever, but is anybody on the panel aware of

any evidence that shows that the Enron collapse is attributable to

the derivatives market?

Mr. DODD. I can offer an explanation. If you look at, first, the

role that derivatives were used to hide the debt, hide the losses and

fabricate income, and generally distort their balance sheet and fiVerDate 11-MAY-2000 09:28 Apr 10, 2003 Jkt 086213 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 86213.TXT SAG1 PsN: SAG1
51

nancial reports in a way that caused the larger market to lose confidence in Enron, I think in the first act, they played a very critical

role in undermining that market confidence and sending Enron

into deep trouble.

Now, when that happened and people ceased to trade with Enron

Online because no one wanted as a counterparty an entity whose

credit rating was in a great deal of doubt because their past reporting was not what they thought it was, and when people——

Senator CRAPO. So——

Mr. DODD. Just one last point, please, sir. I am sorry. When people ceased trading with Enron Online, then they lost liquidity.

They no longer made their income as a dealer. They no longer

earned their bid-ask spread. That was the remaining profitable

part of the corporation, and then they no longer had a profit source.

Then when their credit rating did drop and they were hit as sort

of being super-margined, by having to come up with more collateral

for their derivatives contracts, that was, in fact, the day they declared bankruptcy because that is when they could no longer feasibly operate and the lights went out on the trading platform.

Senator CRAPO. You are testifying that Enron’s use of derivatives

contracts is what allowed Enron to distort its financial picture?

Mr. DODD. Yes. They used them in conjunction with the special

purpose entities to hide debt. They moved it into these special purpose entities, as you recall, right, and showed that they sold the

products for an exaggerated price, and then they used the swaps

to then pay back the Enron parent a profit from the transaction,

so they reported that as income. They also borrowed money, as we

saw in this case with the insurance companies, from J.P. Morgan

Chase——

Senator CRAPO. Now were those, what we are seeing here, called

the illegal swap transactions or the wash transactions?

Mr. DODD. They were legal, and I think that is one of the problems, that it is not just a matter of bad apples but we have some

bad rules.

Senator CRAPO. Legal or not, were they wash transactions that

you are talking about?

Mr. DODD. Some of them were, some of them were not. It goes

beyond wash transactions because it was not even with another entity. It was just, if you will, within Enron, between the parent and

the——

Senator CRAPO. Well, that is my point. If you are saying that a

derivatives transaction was used in one of these other relationships

that you are talking about, I mean, a regular contract that we all

learn about in contract law in law school could have been used, as

well. Does the fact that you can find a totally legal derivatives

transaction involved in the Enron circumstance, does that mean

that the derivatives transaction itself was suspect?

Mr. DODD. I do think it was an unproductive use of the derivatives contract to avoid financial reporting rules to disclose their

debt from their investors, and in that regard, I do think the derivatives were critical——

Senator CRAPO. I am having a hard time seeing how a derivatives contract could be used to avoid financial reporting rules.

52

Mr. DODD. They used them not to avoid the rule. They used them

to outflank the rule, if you will, because they moved their debt into

the special purpose entities. They disclosed some of the losses by

moving those into the special purpose entities through these derivatives trades. Then to cap it all off, they sold their stock to some

of these special purpose entities to enable the special purpose entity to pay off a profitable swap they did back to the parent Enron

and they reported that as income.

Senator CRAPO. Mr. Patrikis has been trying to get in here. Let

us let him—— Mr. PATRIKIS. It is a little difficult to conclude that swaps caused

Enron’s collapse.

Mr. DODD. I did not say caused.

Mr. PATRIKIS. Well, are a major contribution.

Mr. DODD. I said they were used——

Mr. PATRIKIS. I would like to continue testifying.

Senator CRAPO. Certainly. Go ahead.

Mr. PATRIKIS. That the firm lacked profit. It had losses. It made

acquisitions. It could not afford it. It had debt. It could not cover

its debt. It did everything it could to hide the debt. It used a variety of sources to do it. I do not think swaps was a major contribution to that. The company had a good name. It was able to sell off

these SPEs to parties who were dealing with a good name. That

is the source of it.

As to the Enron dealing subsidiary, we heard today, well, Dynegy

saved everybody. As Enron’s trading subsidiary got into trouble, it

was willing to close out trades with counterparties, as is typical in

the case. If we want to know who was hurt by Enron, want the

trading subsidiary, we can go to the bankruptcy court and see that

there were companies who were in the money, who owed Enron

money, they had trades that were favorable to Enron that were not

closed out and they are debtors of the estate. They will be paying

money into the estate. The swap agreement provides for this.

The fact that people were able to close out trades was not due

to Dynegy, it was due to this legislation that this committee has

fostered, including the bankruptcy legislation, that allowed orderly

close-out of trades. That is something ISDA and this committee

have worked on very hard. That the work this committee did

helped facilitate Enron not being a systemic situation.

Now, the companies dealing with Enron were much better off

than we go to long-term capital management because of risk management. The companies in this business have market risk and

credit risk people working. We at AIG do it through our profit centers where there is market risk and credit risk and we do it at the

holding company overlooking it. Those firms manage their risk

well. We had losses from Enron. The losses were containable. The

losses were not material. Why? Because we managed risk.

That is a better part of the Enron story, is how can you have the

largest bankruptcy in the history of the United States and not have

dominoes. It shows, yes, people will make mistakes, people can be

misled, shareholders can be hurt, employees can be hurt, but it was

managed. We can contain it.

Senator CRAPO. Mr. Coffee, you are the law professor here and

so you have been approached several times in questions on that

53

issue. Let me just go to you on this. I realize that there is an investigation underway and we may find more, but based on what you

are aware of at this point, is there any evidence that you can see

that the use of derivatives or swaps by Enron caused its collapse?

Mr. COFFEE. In my judgment, on the available evidence, Enron’s

failure was caused by accounting irregularities and corporate governance failures. There may be some, what I will call spurious

hedging, in which Enron moved assets from its left pocket to its 97-

percent-owned right pocket, but I do not think that that reflects on

the market as a whole. That was self-deception by which Enron

convinced itself and its shareholders that it did not have liabilities

that it really did have, and I consider that to be fundamentally a

corporate governance failure and an accounting failure.

Senator CRAPO. Thank you. I realize my time is running out, as

well. Thank you, Mr. Chairman.

Senator LUGAR. Thank you, Senator Crapo.

Gentlemen, Senator Fitzgerald has indicated that he wishes to

return and ask some more questions. I hesitate to ask you to stay

indefinitely, and I will not do that. We do have a roll call vote underway, so I am going to declare a recess of the hearing pending

the reemergence of my colleague, Senator Fitzgerald. At that point,

he will preside over the meeting as he completes his questioning.

I want to take this occasion again to thank each one of you for

your extraordinary patience. This has been a hearing now of well

over 3 hours, but one that I believe has been productive for our understanding and for that of the public. We will proceed at least as

constructively as we can on the basis of the wisdom you have given

to us.

For the moment, the hearing is recessed, and I will ask the staff

to at least be referees in terms of a reasonable time. I presume my

staff will be back soon. He left that impression as he departed. At

a reasonable time, in the event he does not return, then the recess

should be concluded and the hearing adjourned. I thank each one

of you.

[Recess.]

Senator FITZGERALD [presiding]. Thank you for sticking around.

I just have a few remaining remarks and I think the other Senators are probably headed to the lunch now following our vote, but

I do want to give each of you the opportunity to wrap up your

thoughts on the issue.

I do want to call to everybody’s attention, on July 6, just a few

days ago, in the Washington Post, they reported, ‘‘Energy Firm Re- states by $7.8 Billion,’’ and if I could read you this paragraph, ‘‘Reliant Resources restated its results for a 3-year period during

which the company said it engaged in trades that artificially inflated its revenue by more than $7.8 billion. It said cash-flows, operating income, and net income were not affected. In its filing with

the Securities and Exchange Commission, Reliant said, ’round-trip

trades’ the company engaged in during 1999, 2000, and 2001

should not have been reflected in its revenues or expenses. The

trades added $6.4 billion to the company’s revenue during that period. The company’s revenue also was inflated by nearly $1.5 billion because of how it accounted for four other energy contracts.

Reliant described those deals as swaps.’’

54

Professor Coffee, would you care to comment on what I just read

to you, what implications that has for our discussion here this

morning?

Mr. COFFEE. I would say that the obvious implication of that article is that that company, a publicly held company, must have believed that the CFTC lacked jurisdiction over these kinds of transactions. Now, they could have been right or they could have been

wrong, and I understand that there is a sincere, good faith belief

of some in the CFTC leadership that they do have jurisdiction. The

industry does not agree with them and we once again have legal

uncertainty, and I think the simplest way to resolve that is for

Congress to speak. They could resolve this question much quicker

than would be the process of litigation if the CFTC found an appropriate case to bring.

Senator FITZGERALD. Now, you are a securities law professor, correct? In fact, did I have a textbook of yours? Did you write a——

Mr. COFFEE. There may be. I am co-author of the best-selling securities regulation textbook.

Senator FITZGERALD. How long has it been out?

Mr. COFFEE. It was the first one. It is in the ninth edition now.

It came out in about 1980.

Senator FITZGERALD. Well, I graduated from law school in 1986,

and so that may have been your casebook. I guess you might be

responsible if I do not know enough about securities laws. You

might be partly responsible.

Mr. COFFEE. I am responsible for thousands, then.

Senator FITZGERALD. Clearly, Reliant could have a securities law

problem, possibly——

Mr. COFFEE. Oh, certainly. There is no question that they have

overstated their revenue. They may not have overstated their net

income because this is a wash transaction.

Senator FITZGERALD. Right, but the SEC might take the position

that the revenue and the expenses from those wash trades should

not have been included in their statements, their financial statements.

Mr. COFFEE. Certainly, that is a point that the SEC could raise,

but I thought for purposes of this hearing it seems to me strongly

apparent that the company must have felt that it was not illegal

to engage in wash trades, which is the critical question for this

body.

Senator FITZGERALD. For CFTC purposes. Now, Mr. Patrikis, you

seem vastly outnumbered, I think, based on——

Mr. PATRIKIS. That is OK.

[Laughter.]

Mr. PATRIKIS. My first question really is, is the Washington Post

better than the Chicago Tribune in terms of the accuracy of the reporting? I do not know what ‘‘swaps’’ means in this instance. I do

not know if it is two spot trades back and forth. It sounded like

there were two simultaneous trades the same day. I do not know

enough. I will go to the Financial Times, February 19 of this year,

the need for better financial reporting, the SEC and proposals for

accounting regulatory board will deal with that. It seems to me the

issue like this wash trades also, but the accounting side, public

55

companies doing things like that to puff up the balance sheets. It

is just a despicable practice all around.

Senator FITZGERALD. Do you think this problem could be addressed just by the SEC making clear that wash trades should not

be accounted for on the income statements, and then, therefore,

there would be no reason for a company to engage in wash trades

because you would not get the inflated revenue from the wash

trades?

Mr. PATRIKIS. No, I do not say that. I say that is one reason why

it is bad, and wash trades are bad and the CFTC says it has jurisdiction over wash trades. It is doubly bad.

Senator FITZGERALD. Now, do you think there are any banks, for

example, that engage in interest rate swaps, for example, that

amount to wash trades? Do you think that is going on? That is

really not the subject of the Feinstein bill——

Mr. PATRIKIS. I have never heard of it. I do not know what they

would accomplish. The interest rate in our markets is set in the

Federal funds market. It is the largest free market, outside the

government securities market, in the world, and the only person

who manipulates that market that I know of is the Fed, which presumably does it legally.

Senator FITZGERALD. Would anybody care to comment on that?

Does anybody think wash trades would be going on with

financial——

Mr. COFFEE. It would not be going on with the purpose of trying

to create a short-term spike in the market price. It might occur in

the energy market, but the real motive was not to overstate your

revenue but to create a short-term spike in the market price to affect consumer prices.

Senator FITZGERALD. To establish a price. There would be two

reasons for a wash trade, one to goose your revenues, but two, also

to set a fictitious price.

Mr. DODD. Senator, I think, also, it raises the next question. We

focused a whole lot of our time here just on ascertaining whether

or not the Commission has authority over wash trades. Even once

we have clarified that and established it once and for all, you are

still left with the critical problem of how are they going to enforce

that, and without reporting requirements, they are going to have

a very hard time actually enforcing that prohibition in any effective

way, and I think it is worthwhile pointing out at this juncture,

then, how easy reporting requirements and how costless reporting

requirements are because people that trade derivatives nearly all

through the instant master agreement, they all confirm the trades

through electronic messages between the counterparties.

All that is required to report this vast world of over-the-counter

derivatives transactions is to ‘‘cc’’ the government on the electronic

confirmation messages, and that would give an extraordinarily

cheap and standardized audit trail and paper trail for any supervisor to use to try to detect this activity. You could, if it was properly standardized, just do a computer algorithm to run through the

data to catch trades that occur between counterparties on the same

day at the same price. Those are things that could be made available to regulators for practically nothing.

56

Senator FITZGERALD. Would there be another possibility, and I

will get to Senator Crapo and certainly give him plenty of time.

There are a lot of motivations that people could be opposed to Senator Feinstein and my amendment, but one of the concerns I have

is that with a lack of transparency on online energy trading platforms and metals trading platforms, is it not possible for the customer of that facility to not be getting the best price?

Could I call Enron Online, or USB Warburg Online now, ask

them to pick up a natural gas contract for me at, say, 265? Could

they then go online, and maybe they could buy it at 263 but sell

it to me at 265? I would really never know that I got shaved, would

I, because I have no ability to—there is no transparency in this

market. Would Mr. Wolkoff want to address that?

Mr. WOLKOFF. I do not actually think there is anything illegal

about that. Many participants in the market would simply say that

that is good trading unless there was some sort of a brokerage, a

fiduciary duty between them and you.

It becomes very hypothetical and I think that there are many

possibilities, and part of the problem right now is that without

knowing the realities, people are free to have imagination run wild,

because there are some pretty bad stories that have been confirmed, including the ones you have read, out in the——

Senator FITZGERALD. A retail investor could not go online——

Mr. WOLKOFF. No. The retail investor is prohibited unless they

meet certain asset requirements which bring them into a sophisticated investor category, like $10 million of net worth type of thing.

Senator FITZGERALD. Then could that sophisticated investor call

Enron Online and ask them to buy a natural gas contact for them?

Mr. WOLKOFF. I am not as familiar with exactly how that system

works now, but my understanding of it is that they are not operating in a brokerage capacity. They are operating as a principal in

a market, and so that when you do business on that platform

against UBS, UBS is a buyer or a seller and you, as the

counterparty, are the reverse of that. If UBS is able to sell to you

at a higher price than they have been able to buy from somebody

else, they owed you no obligation to lose money on your behalf.

They are not a fiduciary in that regard. If it were a system where

they are operating as a broker, essentially, where they are taking

orders and then taking obligations——

Senator FITZGERALD. Who is trading on those online energy platforms?

Mr. WOLKOFF. Nowadays?

Senator FITZGERALD. Yes.

Mr. WOLKOFF. Very few. In the past, it was——

Senator FITZGERALD. Well, who would be some of the examples?

Mr. WOLKOFF. Many of the merchant companies. You have the

large——

Senator FITZGERALD. Could you give some examples?

Mr. WOLKOFF. AEP, Aquila, whether on that particular system

or not, you certainly had Enron, you had J. Aaron, you had Morgan

Stanley. These are large participants in the energy world, Dynegy.

I am sure Mr. Green would be more adept at reeling these names

off.

57

Senator FITZGERALD. Mr. Green, you are a part owner of the

Intercontinental Exchange, correct?

Mr. GREEN. Yes.

Senator FITZGERALD. You also trade on that exchange?

Mr. GREEN. To a lot lesser extent today, since we are shutting

down the business, our selling business.

Senator FITZGERALD. You do favor some, even though you are an

owner of the Intercontinental Exchange, you do favor some greater

regulatory oversight?

Mr. GREEN. Oh, no question about it. What we have seen happen

in this marketplace and the colossal breach of trust by corporate

America, we have to start building it back and you do not build it

back by saying, let us wait and see. You start taking steps, and

that is why we are in favor of your amendment.

Senator FITZGERALD. The other owners of the company do not

agree with you, is that correct, and that is why they have Mr.

Patrikis——

Mr. PATRIKIS. No, we do not participate. To the best of my knowledge, my company does not participate in it.

During the break, I talked with someone about it since I did not

understand it, and I will try to give you how I think it works, but

maybe Mr. Green can correct me. Instead of a telephone, we have

a computer facility that allows parties to be introduced to each

other. It replaces the telephone. There is no broker. There is no

intermediary. There are a standard contract similar to the foreign

exchange market or the interest rate swap market. There are some

basic terms that are standardized in it.

In order to go into business, ICE has to file notice of its existence

with the CFTC. It has to tell the CFTC that its owners are not

criminals. It has to make its rules available to the CFTC. The

CFTC has online connection. It has access to the trading platform

for information.

Two counterparties in the marketplace, two of these sophisticated investors are introduced to each other and say, let us do a

deal. Then they go offline and they negotiate the credit terms. Do

I want collateral?

I also think the system has built into it that——

Senator FITZGERALD. They go offline?

Mr. PATRIKIS. They have to then negotiate the credit terms. In

other words, I may require collateral of you. I may require collateral of you if my exposure to you is more than $10 million or $25

million. The credit risk is managed bilaterally, or I think the system has built into it that I just may not do business with a certain

party. I do not like Goldman Sachs. I can say I will not do any

trade with Goldman Sachs because I already have too much credit

risk to Goldman Sachs.

We finish negotiating the terms of the swap agreement. It is the

terms that are the financial terms of the transaction are standardized, but then we go offline. This just replaced the telephone. That

is all it has done, is replaced the telephone and through these

standard terms makes it easier to do business.

My understanding from what we heard from the Chairman of the

CFTC today, if this system, which does not have retail, does not

do clearing, and may not do price discovery, if it becomes a price

58

discovery vehicle, then the CFTC has jurisdiction under the existing rules. I do not know what he was—when he was referring to

what they were looking into, but—— Senator FITZGERALD. What section of the law gives—— Mr. PATRIKIS. I am not an expert on this statute.

Senator FITZGERALD. Now, if two sophisticated principals like

you just described were trading agricultural commodities in an online platform like that, that would be regulated by the CFTC. They

could ban wash trades. What is the public policy rationale for picking out energy contracts, which are also in finite supply, just like

agricultural commodities and other non-financial commodities, and

metals contracts, which metals also have a finite supply, what is

the public policy rationale for this special carve-out for energy and

metals? Why do they get this special treatment?

Mr. PATRIKIS. I, frankly, do not know, and we heard this morning

from earlier witnesses, I do not think there is anyone around that

does, who did the deal. The people who did that transaction had

a motivation. I do not know what it was.

Senator FITZGERALD. Who put the bill together?

Mr. PATRIKIS. Right, in conference.

Senator FITZGERALD. As we had it in Senate committee, it did

not have that special carve-out and somehow, this—— Mr. PATRIKIS. In conference.

Senator FITZGERALD [continuing]. Special carve-out came and it

does not seem to have a father. No one can figure out who did it.

Back to Mr. Green. Have you talked to the other owners of ICE

about this issue, and how many owners of ICE are there? Is there

publicly available information? I know I have seen some reports of

who the owners are.

Mr. GREEN. I would think so. I am not sure. There are maybe

15. I am not really sure.

Senator FITZGERALD. Some banks, some energy companies, right?

Mr. GREEN. Yes, and certainly, and that is why I said in my testimony very clearly I was speaking for Aquila and not beyond that,

because there is not unanimous agreement on how we approach

this situation.

Part of it is an effort to keep the good, positive effect of derivatives going on in the market like what we have done in Sacramento

and what we do with homeowners in the Midwest and their gas

bills, you need an over-the-counter off-exchange market to be able

to put together those derivatives.

Take the Sacramento derivative that we have with that municipal utility. When you talk about putting a package together that

starts to take away rainfall risk and power price risk and a list of

other risks, you need to be able to go over and put all those risks

somewhere else and that takes a complex kind of conversation with

sophisticated players. It is not a simple, standard commodity that

you could do on the NYMEX. There is a need for that.

Now, at the same time, we need transparency and make it open

so you cannot have other things happen, but there is a need for

that, in general.

Senator FITZGERALD. Senator Crapo, you have been waiting patiently, so please, take your time here.

Senator CRAPO. Thank you very much, Mr. Chairman.

59

Actually, you asked the question that was going to be my first

question, although I was going to ask it a little differently, and I

will ask it differently to see if it evokes a different piece of the response.

As I read the Act, and I am trying to learn just what happened

myself when the CFMA was passed, it creates three categories, one

called excluded transactions, which are financial derivatives; one

called everything else, which are exempted derivatives—one is

called everything else but agriculture transactions, and that is

called exempted transactions as opposed to excluded transactions;

and then there is agriculture.

My question is, why was agriculture carved out? Does anybody

know? I mean, agriculture is all by itself——

Mr. DODD. Farmers would not prohibit the bill from passing.

Senator CRAPO. Is that what it was?

Mr. DODD. Yes, sir, I think that is a very succinct answer.

Senator CRAPO. Basically, the agriculture community wanted to

be an exchange-traded market, and had it not been for the agriculture position there, they would have been in the exempted category.

Senator FITZGERALD. Can I clarify that a little bit?

Senator CRAPO. Sure. If anybody can clarify it, I would appreciate knowing.

Senator FITZGERALD. There are three levels. I mean, there is full

regulation like you have at the Boards of Trade in New York and

Chicago. Then there is a middle-tier category for online trading facilities. Then there is no regulation for, like, financial derivatives.

Even if you were to trade agriculture commodities, I think it would

be possible, if you were to trade them online, you would get this

middle-tier regulation.

Senator CRAPO. That is not how I read the Act. Is that correct?

Senator FITZGERALD. All agricultural commodities have to be

traded on—it would be impossible to set them up—Mr. Wolkoff?

Mr. WOLKOFF. My understanding, and it may not be a perfect

understanding, is that agricultural——

Senator FITZGERALD. You could not have the DTEF, in other

words, that——

Mr. WOLKOFF. Agricultural commodities could be traded on a

DTEF but could not be traded on an exempt transaction facility.

The three levels are contract market, which is a regulated change;

a DTEF, which is a hybrid of an unregulated market and a regulated market; and an exempt transaction facility, which is where,

say, the Enron Online and the Intercontinental Exchange fall out.

As an exempt transaction facility, you are not permitted to have

under that exemption agricultural commodities trading. It does not

obligate——

Senator FITZGERALD. OK, but you could trade them on a DTEF,

right?

Mr. WOLKOFF. I believe that is correct, only with certain participants.

Senator FITZGERALD. You could trade them on a contract market,

like the Board of Trade——

Mr. WOLKOFF. I did not hear you. I am sorry.

60

Senator FITZGERALD. You could trade agricultural commodities

on a contract market or on a DTEF but not on an exempt——

Mr. WOLKOFF. That is my understanding.

Senator CRAPO. That would be my understanding. The definition

is really clear for exempt commodities. It is everything that is not

excluded and not agriculture.

Mr. PATRIKIS. One of the reasons is there was no over-thecounter market for agriculture at the time.

Senator CRAPO. They did not want one to become.

Mr. PATRIKIS. The committee did not want one to become.

Senator CRAPO. OK. I guess——

Mr. PATRIKIS. I would like to go back to what Senator Fitzgerald—I have been handed a cite for you, Section 2(h)(4)(D), which

provides for anti-fraud, anti-manipulation, and does give the CFTC

the price discovery authority on——

Senator FITZGERALD. Section 2(h)(4)——

Mr. PATRIKIS. Section 2(h)(4)(D).

Senator CRAPO. That is the one I was looking for earlier today.

Mr. Erickson referred to Section 2(h). I assume that is what he was

referring to.

Let me go on then. I guess the answer to why agriculture is

treated differently is basically that there never was a different

treatment of agriculture and the committee just decided to keep it

that way and the agriculture community wanted it kept that way.

What I am understanding here is that agriculture was treated as

it is now in what I would call the fully regulated category. Then

we created the other two categories, which is financial transactions,

which are commodities which were excluded, and everything else

which was exempted. Am I in the ballpark?

Mr. WOLKOFF. At the risk of further muddying the waters, there

are also a category called forward contracts——

Senator CRAPO. Great.

Mr. WOLKOFF [continuing]. Which are unregulated cash, physical

delivery contracts in which—a very common transaction for agricultural contracts to be traded forward from the planting through the

harvest season, of course——

Senator CRAPO. That would be in the agriculture arena?

Mr. WOLKOFF. Well, it is not a derivative. It is a forward contract, so that is really a physically delivered marketplace that is

unregulated but not covered by either the Feinstein amendment or

the 2(h) section.

Senator CRAPO. All right. From there, then, I am assuming from

what I have heard from every witness today that there is nobody

who is suggesting that we should treat the exempt category or everything but financial transactions and agriculture, that we should

treat that category like agriculture. Does anybody here believe we

should just move the exempt category into the agriculture category?

Senator FITZGERALD. Nobody is for requiring them to be traded

on a board of trade like the Chicago Board of Trade and subjecting

them to the full-blown regulations.

Senator CRAPO. That is what I understand. That is what I wanted to get clarified. OK. We have all these categories, and it is

61

agreed by everybody that the exempt category is a legitimate category that needs to be maintained and we may need to revise——

Mr. COFFEE. I would want to clarify that I think what is really

driving these distinctions is not the nature of the category but the

nature of the trading market. Many of these commodities trade

among very sophisticated parties. Agriculture has classically traded

among farmers who are retail players in these markets, and for

that reason, we wanted to protect and have the highest level of regulation where we know the large percentage of the users of derivatives are people who cannot be called sophisticated financial players.

Senator CRAPO. That is a good explanation. That helps me understand a little better why the agriculture was so distinct. Nobody is

proposing that we move the rest of it into the agriculture-type

treatment.

From there, as I am understanding the testimony today, there

seems to be some pretty solid consistency on the notion that wash

transactions should be prohibited. There is disagreement about

whether there are prohibited or not, but there is really no disagreement about the fact that they should be. Is there any disagreement

about that?

[No response.]

Senator CRAPO. OK. The same thing could be said about the

question as to whether transactions in the exempt category should

be subject to the fraud and price manipulation provisions of the

Act. Any disagreement of that, with regard to that?

[No response.]

Senator CRAPO. Again, there is disagreement as to whether they

already are or are not, but not disagreement as to whether they

should be.

From there, it seems to me that we start to break down. I mean,

there are some other collateral issues that have been raised about

different types of collateralization requirements or reporting and

that kind of thing which may result in debate, but it seems to me

that there is quite a bit of consensus on those basic points. Does

anybody disagree with that?

[No response.]

Senator CRAPO. Now, I have not had a chance to thoroughly review the Act that is being proposed now. The one we debated in

March was distinctly different than the one we are talking about

today, is it not, Senator Fitzgerald?

Senator FITZGERALD. I do not think so. I have not done a sideby-side comparison—it is? It is completely different?

Senator CRAPO. Yes and no.

Senator FITZGERALD. Depending on which side you are on——

Senator CRAPO. The answers are yes and no. Well, it is different

than what I thought it was, and maybe I did not understand it in

March as well as I should have, but I understood in March that

it was different than what I am hearing today it is, and I guess

what I am getting at is if the Act that we are talking about does

nothing other than what I have just talked about, namely make it

clear that wash trades are not legal and make it clear that the

fraud and manipulation provisions are applicable to the exempt

62

category, then I think we may have the ability to come together on

some type of a consensus as to what needs to be done.

I would just say, I am going to have to leave, but Senator

Fitzgerald—— Senator FITZGERALD. I guess I think it is also important to have

some transparency on these markets, in addition to just banning

wash trades, so that people can see the volume and the open interest and just disclosure requirement. It is helpful for the public to

know what the prices are. I do not know if anybody else would

want to comment on that.

Mr. COFFEE. I would suggest that you cannot define fraud as just

boiling down to wash trades. There are other kinds of manipulations, bucket orders. There is a history of various kinds of manipulative games and I think the best prophylactic reform is disclosure,

as you were saying.

Mr. PATRIKIS. Price discovery, if you want transparency, depends

on the market, the standardization, the volume, that you do not

want it to be misleading, you do not want it to destroy the market.

That is the issue. It is not clear with these markets that having

price discovery mechanism in, if they are not at that point——

Senator CRAPO. Is the question—— Mr. PATRIKIS [continuing]. That that will help the market grow.

Senator CRAPO. Is the question then—is this really the conflict?

Mr. PATRIKIS. I think so.

Senator CRAPO. The conflict, then, is whether the disclosure requirements, the price discovery requirements—— Mr. PATRIKIS. Capital.

Senator CRAPO [continuing]. Capitalization requirements or

whatever.

Mr. PATRIKIS. It is the other futures-style regulation raises——

Senator CRAPO. Whether that will impact the market in a negative way and take away the benefit that derivatives now provide

to us.

Mr. PATRIKIS. That we will not have an ICE for some other product, that no one will go to the effort and the expense of starting

that market up. That is the risk. To me, we want to bring more

capital into the market, not set up barriers to bringing more capital

into the market.

Senator CRAPO. Mr. Chairman, I apologize. I am going to have

to leave, but I am very interested in seeing where we can go from

here. At least, if I do not find out that I understand it wrong again

as I leave the room, it seems to me that we have found some areas

where there is not disagreement and I think maybe I am starting

to focus on where the conflict is. Hopefully, from there, we can resolve some of these issues.

Senator FITZGERALD. Thank you. We are going to probably want

to wrap this up. I want to thank Senator Crapo for working hard

to get his arms around this big issue and I am glad not just people

representing Chicago are interested in the commodities futures

issues.

I would like to close with one final thought, that I think that the

opposition to Senator Feinstein and my bill is wrong-headed, that

it is not in the best interest of the people who are opposing it, because I think confidence in the online energy and metals trading

63

platforms might be restored by allowing for some minimal government regulation. In the last few months, business has been migrating away from this completely unregulated area back to the fully

regulated exchanges, and I do not think that Intercontinental Exchange has thought through its best interest on this. I do not think

it is in their long-term interest.

This online industry could dry up in the absence of regulations,

and I would point out that many people were fearful when we

adopted the Securities Act in the 1930’s that it would kill capital

markets. But, in fact, it gave us the greatest capital formation markets in the world, and that the right level of regulation that provides for, largely, disclosure, can be a great source of reassurance

for people who potentially may want to participate in the market.

I would agree that you can suffocate a market by over-regulating

it, but I do not think that the Feinstein-Fitzgerald bill comes close

to doing that. It would actually help the interest of the online energy trading industry.

With that, I want to thank all of you for your time. It has been

a very good discussion. You have all been very patient, waiting

through votes and so forth. Thank you all very much for coming.

This meeting is now adjourned.

[Whereupon, at 1:27 p.m., the committee was adjourned.]

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JULY 10, 2002

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DOCUMENTS SUBMITTED FOR THE RECORD

JULY 10, 2002

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Æ