Public hearing discusses whether CFTC should have a greater role in regulating exempt commercial markets.

On September 18, 2007, the U.S. Commodity Futures Trading Commission (CFTC) held a public hearing to discuss whether CFTC should have a greater role in regulating exempt commercial markets (ECMs). An ECM is an electronic trading facility that operates largely outside of the CFTC’s supervision, if access is limited to sophisticated commercial traders that trade exempt commodities (such as energy commodities, metals, chemicals, emission allowances and wood pulp) on a principal-to-principal basis. The CFTC hearing was organized in response to recent alleged manipulation of U.S. natural gas markets by hedge fund Amaranth Advisers LLC and Energy Trading Partners, LP, a Texas-based owner of pipeline assets and natural gas storage facilities.

Earlier this summer, the U.S. Senate published a staff report on excessive speculation in the natural gas market, in which it concluded that New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) are functionally equivalent markets, and that, although gas traders use both of these markets, NYMEX and ICE are regulated differently. Namely, NYMEX is regulated by the CFTC as a designated contract market (DCM) subject to registration and core principle requirements concerning preventing manipulation, self-regulation, reporting, and ensuring fair and equitable trading, the financial integrity of transactions, and access to trading information. ICE is essentially unregulated as an ECM, due to the application of the so-called "Enron loophole" (i.e., Section 2(h)(3) of the Commodity Exchange Act). The provision authorizing ECMs in the Commodity Exchange Act was adopted in 2000 by Commodity Futures Modernization Act as a result of Enron and other over-the-counter traders’ lobbying efforts.

During the September 18 hearing, the CFTC solicited views from the staff of the CFTC (economists, market surveillance and general counsel), regulated commodities exchanges (such as NYMEX and CME), exempt commercial markets (such as ICE and Chicago Climate Exchange), end users (such as manufacturing companies that use natural gas) and industry groups (such as Consumer Federation of America, the Futures Industry Association (FIA), Managed Funds Association (MFA) and ISDA).

The views expressed during the hearing fall generally into two categories. On one hand, the staff of the CFTC, regulated commodities exchanges, consumers groups and certain end-users variously advocated for leveling the playing field between regulated exchanges and the ECMs, closing the "Enron loophole" by requiring reporting of positions, imposing limitations on excessive trading (i.e., speculation), and either abolishing entirely or requiring the registration of the ECMs. Alternatively, they variously advocated adopting a more targeted approach of carving out energy commodity contracts from the exempt category and requiring that once a certain contract traded on the ECM becomes a price discovery benchmark, that contract must be subject to the same regulatory restrictions as a similar contract traded on a DCM, for example, NYMEX or CME.

On the other hand, the ECMs—FIA, MFA and the ISDA—advocated that removing Section 2(h)(3) (i.e., the "Enron loophole") from the Commodity Exchange Act will dramatically curb innovation in the U.S. derivatives markets and thus defeat the purpose of the CFMA, will make entry into these markets prohibitively expensive and will cause the exodus of over-the-counter derivatives markets from the United States. They also advocated that there is no overwhelming evidence that there was market failure in the first place and, accordingly, that the proposed regulatory intervention is necessary.

As the recent Senate and CFTC hearings demonstrate, some form of regulatory action likely is inevitable. Senator Feinstein (D-CA) has renewed her efforts since the collapse of Enron to pass legislation to improve oversight of the energy markets. Likewise, on September 17, 2007, Senator Carl Levin (D-MI) introduced a bill (S. 2058) (Levin Bill) expressly designed to "close the Enron loophole," and to bolster confidence in the energy commodities markets by restoring the CFTC’s authority to monitor and control the largely unregulated ECMs.

Under the Levin Bill, energy trading facilities, a new subset of trading facilities that would otherwise qualify as an ECM under current law, will be required to meet similar regulatory standards as traditional futures markets, like NYMEX. These requirements range from registration, basic internal compliance controls and anti-fraud provisions, to specific and enforceable position and trading limits, as well as recordkeeping and reporting. Essentially, the Levin bill seeks to subject all energy trading facilities to the same level of scrutiny as currently exists for fully regulated contract markets, i.e., DCMs. The Levin Bill also introduced a new defined category of a commodity, the "energy commodity," which includes sources of energy, crude oil, gasoline, heating oil, diesel fuel, natural gas and electricity, or results from the burning of fossil fuels, including carbon dioxide and sulfur dioxide. Further, to prevent the possibility of U.S. energy over-the-counter markets migrating overseas, the Levin Bill requires that contracts in energy commodities for delivery in the United States, but executed on a foreign boards of trade through U.S. domestic terminals, must be reported as well. Finally, the Levin Bill specifically authorizes the CFTC to request position and trading information relating to energy commodities entered into under Section 2(g) (the swap exclusion) and Sections 2(h)(1)-(2) (exempt commodity exemptions).