CFTC report urges expansion of oversight to exempt markets

Oct. 24, 2007
The US Commodity Futures Trading Commission has requested oversight authority over some contracts and products in unregulated electronic trading venues known as exempt commercial markets.

Nick Snow
Washington Editor

WASHINGTON, DC, Oct. 24 -- The US Commodity Futures Trading Commission has requested oversight authority over some contracts and products in unregulated electronic trading venues known as exempt commercial markets (ECMs).

The request came Oct. 24 in a report to Congress hours before the House Agriculture Committee's General Farm Commodities and Risk Management Subcommittee's scheduled hearing on reauthorization of the Commodity Exchange Act (CEA), which governs the CFTC (OGJ Online, Oct. 23, 2007).

"This report is designed to provide recommendations that strike a delicate balance between the appropriate level of market oversight and transparency while promoting market innovation and competition to ensure that these markets remain on US soil," said CFTC Acting Chairman Walt Lukken, who was scheduled to testify before the House subcommittee.

CFTC said the report's legislative recommendations include establishing the following for certain ECM contracts which serve a significant price discovery function:

-- Large trader position reporting, comparable to existing reporting requirements that apply to contracts on regulated exchanges. "A large trader reporting system would enable the Commission's market surveillance staff to monitor positions on a daily basis to detect and deter possible manipulative schemes," the report said.

-- Position limits or an accountability level regime, comparable to those that apply to similar contracts on regulated exchanges.

-- Self-regulatory oversight to detect and prevent manipulation, price distortion, and disruptions of the delivery or cash settlement process.

-- Emergency authority to prevent manipulations and disruptions of the delivery or cash settlement process. This could include emergency authority to alter or supplement contract rules, liquidate open positions, and suspend or curtail trading in any contract that serves a significant price discovery function, the report indicated.

CFTC said it also intends to establish an energy markets advisory committee to hold public meetings on issues affecting energy producers, distributors, market users, and consumers. It said it also plans to work closely with the Federal Energy Regulatory Commission to educate and develop best practices for utilities and others who use New York Mercantile Exchange (NYMEX) settlement prices as hedging vehicles and benchmarks for pricing their own energy products.

The commission issued the recommendations after holding a day-long hearing Sept. 18 examining the statutory and regulatory structure governing ECMs, especially those with energy contracts. Witnesses included representatives from regulated and unregulated exchanges, industry associations, and consumer groups.

The Government Accountability Office also examined the CFTC's oversight authority and practices and issued its own report and recommendations Oct. 19.

In its report, CFTC said ECMs developed after the Commodity Futures Modernization Act of 2000 (CFMA) amended the CEA and replaced the existing futures trading supervisory framework with a risk-based tiered structure in which the level of regulation was tailored to the type of market and risks associated with it.

It noted that while there are small start-up ECMs, others have taken on characteristics of regulated markets. "Of particular note to [CFTC] staff is the development by the Inter-Continental Exchange (ICE) of a 'look-alike' natural gas contract with a settlement price linked to the settlement price of the [NYMEX] natural gas benchmark futures contract," it said.

Such a linkage increases the possibility that ICE's unregulated contract serves a major price discovery role and could provide an incentive to manipulate the settlement price of the regulated NYMEX contract, the CFTC report said.

Market disparities
CFTC further said that while many witnesses at the Sept. 18 hearing testified that the CFMA's tiered regulatory structure has been successful and should not be eliminated, others expressed concern over disparities between regulated and unregulated exchanges. They suggested that such disparities make markets more susceptible to manipulation and put regulated exchanges at a competitive disadvantage to ECMs, which offer virtually identical products.

"Generally, most witnesses believed that some changes to the ECM provisions may be appropriate, as long as they are prudently targeted and do not adversely affect the ability of established ECMs to innovate and grow," the report said.

CFTC considers the current level of regulation appropriate when an ECM trading contract's volume remains low and its prices are not relied upon to a great degree by other markets. But when such a contract matures and begins to serve a price discovery function for commodity transactions in interstate commerce, it warrants some increased oversight to deter and prevent price manipulation or other market integrity disruptions, the report continued.

The commission report said a determination that a contract serves a price discovery function should be based on its having a trading volume high enough to affect regulated markets or become a trading benchmark and either influence other markets and contracts through a linkage or be materially referenced by others in interstate commerce "on a frequent and recurring basis."

ICE Chairman Jeffrey C. Sprecher applauded the CFTC report. "The spirit of the recommendations is largely consistent with the views we have expressed in several testimonies this year. Such a solution recognizes and addresses the complexities of [over-the-counter] markets and preserves the significant economic and utility benefits of a properly functioning market," he said in an Oct. 24 statement.

ICE adopted daily position reporting in its primary OTC markets a year ago, Sprecher said. "The concept of position accountability and 'self-regulatory-like' authority would provide ICE with the ability to take action in its markets if necessary. We will continue to engage in a dialogue with regulators, the industry, and Congress and look forward to effectively resolving this long-standing matter," he said.

Contact Nick Snow at [email protected].