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| Statement of the New York Mercantile Exchange Before the United
States House Subcommittee on General Farm Commodities and Risk Management |
| Presented by Neal Wolkoff, Executive Vice President and Chief Operating
Officer, New York Mercantile Exchange |
| 06/19/2003 |
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Mr. Chairman, my name is Neal Wolkoff. I am the Executive Vice President
and Chief Operating Officer of the New York Mercantile Exchange, Inc. ("NYMEX"
or the "Exchange"), which is the world’s largest forum for
the trading and clearing of physical-commodity based futures contracts,
including energy and metals products. NYMEX is a federally chartered marketplace,
fully regulated by the Commodity Futures Trading Commission (“CFTC”
or the “Commission”). On behalf of the Exchange, its Board of
Directors and members, I want to thank you and all the members of the subcommittee
for the opportunity to participate in today's hearing. The subcommittee’s
invitation stated that the purpose of today’s hearing was to consider
testimony concerning the Commodity Futures Modernization Act of 2000 (“CFMA”).
Congress displayed bold leadership with the CFMA, which was a landmark piece
of legislation that revised the Commodity Exchange Act (“CEA”)
in the most significant revisions of the last quarter-century.
The Exchange’s comments and observations today will focus on our experiences
as an entity that is regulated under two CFMA regulatory categories. We
will also consider how the post-CFMA regulatory scheme has held up in the
face of major developments in energy markets in the last two years. Among
other things, we will analyze possible responses to the issue of faulty
data submitted to price reporting and indexing services. While going somewhat
beyond the focus of the CFMA, we also would like to address briefly the
interplay between state and federal regulation of physical energy markets.
Finally, we will close by considering whether it is premature at this juncture
for Congress to undertake any whole-scale revisions of the CEA
NYMEX’s Operation as a Designated Contract Market and as a Derivatives
Clearing Organization When the CFMA was passed by Congress in late 2000,
NYMEX had been an exchange for nearly 130 years and had grown to become
the world’s largest exchange for futures trading based upon energy
and precious metals
When the CFMA was enacted in December 2000, it amended the CEA by creating
a number of alternative regulatory tiers applicable to trading facilities
to replace the prior “one size fits all” regulatory approach.
In general, the various regulatory tiers reflect different levels of regulation
based upon the types of products to be offered by the trading facility and
the participants who would be eligible to trade on the facility. In addition,
Congress created a new statutory category of derivatives clearing organization
(“DCO”) and also codified a set of regulations specifically
applicable to DCOs. The separation of the regulation of trading facilities
from the regulation of DCOs confirmed that DCOs could operate as part of
a trading facility or operate independently as a stand-alone entity.
With respect to these regulatory tiers for trading facilities, Congress
grandfathered existing futures exchanges by allowing them to be designated
in the contract market regulatory tier, the highest level of regulation,
without needing to undergo a lengthy application process. Congress followed
the same approach in grandfathering existing clearing organizations as DCOs.
Consequently, when the CFMA first went into effect, NYMEX continued its
business operations by offering open outcry and electronic trading forums
pursuant to the contract market regulatory tier. The Exchange continues
to run our businesses in that same regulatory tier today.
We do so for a number of reasons. The overwhelming majority of our market
users are commercial or other institutional companies seeking to use the
Exchange’s markets to meet their price discovery or hedging needs
in energy and metals products. Notwithstanding their status as sophisticated,
knowledgeable commercial entities, most of our market participants have
expressed a strong desire to conduct their business in a fully and well
regulated marketplace where the rules are applied consistently and assertively,
and prices are transparent. The upheavals in the energy sector following
the collapse of Enron have served as a reminder of the importance of market
transparency and sensible regulation. Within the CFMA’s highest regulatory
tier, where we operate, the legislation has effected a return to regulation
for the purpose of market integrity, while removing layers of prescriptive
rules which failed a reasonableness test when viewed in the context of costs
and benefits. Prior to the CFMA, regulation exacerbated an uneven playing
field between domestic and international markets operating in this country,
and imposed competitive constraints on Exchanges because of prior approval
requirements for rule and contract changes even where few, if any, substantive
regulatory concerns were present. The Exchange recognizes that the transparency
of NYMEX prices, and the integrity of our markets, make NYMEX a visible
and reliable benchmark for energy pricing that is vital to our economy.
Consequently, we believe that as a public market the contract market level
of regulation is appropriate for the Exchange’s established contracts,
where NYMEX provides a broad public benefit. The visible and highly competitive
daily transactions of energy futures and options on the Exchange provide
a true world reference price for the commodities traded. In addition, although
NYMEX is a marketplace for commercial participants in the energy realm to
hedge risk and discover prices on large volume transactions, the benefits
of this marketplace accrue to the consumers of energy who receive prices
based on open and fair competition.
Within the Designated Contract Market (“DCM”), or highest, tier
of CFMA regulation, the Exchange has benefited from the ability to effectuate
operating rules without lengthy written submissions, and to introduce market
oriented changes to contracts without undue processes for approval. Probably
the most important observation to make about the contract market regulatory
tier concerns the CFMA’s replacement of very detailed prescriptive
regulations with principles-based regulation, i.e., core principles. Congress
in its wisdom made clear in the CFMA that regulated entities shall have
reasonable discretion with respect to the manner in which they will comply
with the core principles.
The CFTC has embraced the substance of the legislative changes that eliminated
burdensome procedures in favor of common sense review, and shown an orientation
toward protecting market integrity without the trappings of excessive paperwork.
NYMEX has thrived in this new CFMA environment, and thanks Congress and
the CFTC for its very positive steps to make the domestic regulated futures
industry more robust and competitive than it has ever been. As a result
of the change in regulatory approach under the CFMA, we have found that
the Exchange now has substantially greater flexibility with respect to how
we comply with regulatory standards than was true in the pre-CFMA environment,
even though the contract market tier involves the highest level of regulation
The Exchange especially appreciates having the ability to submit new products
and rules to the CFTC on a self-certification basis, and then make those
changes effective on the next business day. Streamlining the product submission
process has benefited our market users greatly by allowing NYMEX to bring
new products to market much more expeditiously. Accordingly, the Exchange
commends Congress on providing NYMEX and the other regulated markets with
this new level of flexibility in the CFMA concerning how we operate our
business lines on a day-to-day basis.
It is also our sense that use of a principles-based approach regulation
is a more pragmatic and effective means for regulatory agencies to monitor
effectively rapidly changing industries and markets. In other words, use
of the core principles approach provides flexibility to regulators as well
as to regulated entities.
In addition to operating as a DCM, NYMEX also provides clearing services
as a registered Designated Clearing Organization or DCO. Like the DCM, the
CFTC fully regulates the DCO’s conduct and rule set. As a brief bit
of background, NYMEX’s clearinghouse provides the processing functions
to assure the correct assignment of trades, but most importantly the clearinghouse
provides a financial guaranty for all transactions executed on the Exchange,
and also for those transactions executed off-Exchange but accepted by a
NYMEX clearing member firm for clearing through the clearinghouse. The clearing
function protects market participants against counterparty credit risk,
which is simply the risk of failure of either one of the two parties to
a transaction (the buyer or the seller) to pay such funds as they become
due to his or her counterpart as a result of the trade. At NYMEX, the clearinghouse
is operated as another division or department of the Exchange. Through a
system of cross guarantees among the brokerage firms and banks that comprise
NYMEX’s clearinghouse, credit risk is mitigated for each participant,
because financial performance is generally guaranteed by the Exchange and
backed by its clearing members (although market users maintain a limited
credit exposure to the futures commission merchant carrying their account).
Customer funds are held by the Exchange and its clearing members in trust
accounts, which are segregated from the exposure and funds of the clearing
firm or the Exchange itself.
The core principles for DCOs included in the CFMA largely codified the prudent
and reasonable standards that the CFTC had informally applied to clearing
organizations in prior years; thus, the current application of these core
principles to NYMEX in its status as a DCO has not noticeably affected the
Exchange’s day-to-day clearing operations. NYMEX recognizes that the
ongoing operation of a clearinghouse necessarily entails some concentration
of financial risk. Accordingly, the Exchange is continually reexamining
its operations and procedures to develop the strongest possible financial
oversight and surveillance systems.
NYMEX has also taken a number of steps in recent years to further enhance
the financial strength and integrity of the clearinghouse. Just last month,
NYMEX consolidated into one fund the two guaranty funds that had been maintained
separately (as one of several sources of financial backing) for transactions
on the NYMEX Division and the COMEX (metals) Division. As a result of this
consolidation, the NYMEX guaranty fund has roughly doubled to its current
size of approximately $128 million. As part of this change, the Exchange
also increased the amount that could be assessed from Clearing Members in
the event that the Guaranty Fund would be exhausted. Another major enhancement
to the Exchange’s clearinghouse that occurred last month was the addition
of $100 million in default insurance that is also now available as a source
of financial backing. The Exchange has also raised minimum working capital
requirements for NYMEX Clearing Members to $5 million, although most clearing
member firms handling public customer business have far more capital than
the minimum.
NYMEX specializes in understanding the peculiar risks associated with metals
and energy, and our internal risk management procedures involve strict oversight
to regularly evaluate risk, and to treat the financial integrity of the
marketplace as a much higher business priority than building trading volume.
Margins are established to collateralize fully the risk of a position without
regard to the impact such costs might have on trading participation. A host
of safeguards, layer upon layer, are imposed by the Exchange, and overseen
daily by the CFTC, to carry out our responsibilities.
The Exchange was pleased to obtain recently a AA+ credit rating from Standard
& Poors, largely in recognition of our regulatory procedures and thoroughness
in our market oversight. In other words, we view the issuance of this credit
rating as tacit recognition of the experience and expertise that NYMEX has
developed over the years in energy and metals risk management.
While some might question whether the shift by a few regulated markets to
a for-profit status could hypothetically affect the extent of a regulated
entity’s self-regulatory efforts, the Exchange’s experience
would indicate that shifting to a for-profit status instead elevates the
importance of effectively addressing reputational risk. This is particularly
the case for institutions where a level of regulation has come to be associated
with the institutional brand. NYMEX’s status as a de-mutualized for-profit
company has only heightened the transparency with which the Exchange operates.
NYMEX files regular reports with the SEC, and has a duty to disclose publicly
any material adverse information. Any event that NYMEX allows to call into
question its commitment to excellence of its market management will be known
and widely disseminated, to the detriment of its members, who are also shareholders
(NYMEX does not have public shareholders). Post-CFMA Energy Market Developments
There have been quite a series of challenging situations in energy markets
in the last several years, and some observers have suggested that these
events may have implications for the CFMA . A partial list of such challenges
might include electricity price spikes in various markets, the financial
meltdown of Enron and the resultant impact of that crisis on the energy
merchant sector, the waves of disclosures regarding so-called “round-trip”
or “wash trades” executed on less regulated markets, the additional
disclosures regarding inaccurate reporting of price data to various price
reporting services, and the periodic volatility in specific markets, such
as the run-up in oil prices prior to the war with Iraq. NYMEX’s various
regulatory safeguards allowed the Exchange to maintain solid footing during
these very challenging periods. The Enron meltdown may serve as an instructive
example. In the early stages of Enron’s difficulties in the fall of
2001, some observers feared that Enron’s substantial position in the
OTC marketplace could pose serious problems for a significant number of
OTC market participants. However, Enron’s counterparties realized
the risk in being paired against a company in ever-worsening condition and
made alternative arrangements, including transferring positions to the NYMEX.
During that same period, NYMEX market surveillance functions, using established
tools such as large trader reporting, position limits, and position reporting,
alerted staff to potential problems. To address issues arising from the
Enron situation, the Exchange implemented a number of measures:
§ Margin requirements (cash required as a guarantee of fulfillment
of a futures contract) on natural gas contracts were increased.
§ Approval was sought from, and granted by, the CFTC for the use of
EFS (“Exchange of Futures for Swaps”) instruments for natural
gas to allow market participants to migrate their positions from the OTC
marketplace to NYMEX.
§ NYMEX implemented policies to reduce exposure to Enron’s credit
risk by NYMEX traders. Indeed, as the measures were enacted, the Exchange
witnessed a remarkable “flight to quality,” as market participants
moved to the NYMEX where financial performance is largely guaranteed by
the safety and soundness of a federally overseen clearinghouse.
Episodes like the Enron failure heighten the awareness that NYMEX is a relatively
safe haven, and that the benefits to doing business on a regulated marketplace
hold great appeal, or should, to any corporation with credit or price exposure
to energy. We believe that corporate boards and treasury offices should
become more involved as a matter of their fiduciary obligations to their
employees and shareholders to learn about the differences between regulated
and unregulated marketplaces.
Chief among the lessons to be taken from the Enron bankruptcy is the value
provided by the federally chartered, regulated commodity marketplace in
supplying market oversight and credit enhancement. The ability of market
participants to move from largely unregulated trading platforms to the Exchange,
where transparency, liquidity, and market oversight are the watchwords,
proved to be of critical value in avoiding broad ranging disruptions as
Enron’s problems became known.
NYMEX Clearing Services for Transactions Executed Off-Exchange
NYMEX not only operated safely during this volatile period, but thanks to
the flexibility permitted under the CFMA, NYMEX has been able to serve this
battered market segment with necessary services to stabilize the many affected
businesses, and avoid disruptive corporate or cash market meltdowns. By
opening our clearing system – under the regulatory supervision of
the CFTC – to transactions executed off-Exchange, NYMEX has been able
to provide ongoing cash market liquidity, because participants who previously
could not transact business with each other because of credit constraints
could now do so.
The Enron meltdown set in motion a number of ripple effects throughout the
energy merchant sectors for natural gas and power. The financial weakness
of such a large market participant brought new focus and concern to the
financial strength of other energy firms and to the issue of counterparty
credit risk. In the post-Enron environment, a number of other energy trading
companies who had amassed significant debt saw their credit ratings and
stock prices tumble. As concerns regarding counterparty credit became more
severe, a liquidity crisis began to develop in these markets. Energy firms
clearly needed to find new mechanisms and solutions to mitigate these credit
issues.
In response, NYMEX took advantage of the broader scope of clearing activity
provided by the CFMA to DCOs and initiated a new clearing service in May
2002. The CFTC deserves tremendous credit in cooperating to allow this valuable
new service to start, using its new authority for flexible regulation to
approve a new and innovative service while taking prudent steps as a careful
regulator to preserve a maximum of systemic integrity. This service allows
cash market participants who have established a business relationship with
a NYMEX Clearing Member to submit energy transactions in specified products
to NYMEX for clearing. As part of this clearing process, the off-Exchange
contracts would be extinguished and, in their stead, futures positions would
be carried at the clearinghouse by their Clearing Members that would be
thus subject to the same protections afforded to other futures contracts,
such as daily marking to market.
The Exchange’s clearing services have clearly responded to a real
business need, and over the last year, our clearing services have achieved
a reasonable level of acceptance and usage by the business community. We
currently have over 200 companies registered to use this program, and we
have now cleared more than 3 million contracts in this new program. The
contracts cleared include a broad array of natural gas and natural gas basis
contracts as well as a number of financially settled power contracts. We
hope to continue to meet the needs of market users by gradually expanding
the scope of this service over time.
Cash Market Energy Price Reporting and Price Indices
There is now a broad consensus among energy market users that there is a
real crisis of confidence regarding the reliability of energy price indices
and generally the validity of prices reported by cash market participants
in certain energy commodities. For example, a March 2003 report issued by
the Federal Energy Regulatory Commission’s (“FERC”) Western
Markets Task Force concluded that employees of several energy firms had
reported false price information to publishers of price indices. The CFTC
has also taken enforcement actions in this area, for example, recently entering
into one settlement with a major trading firm. That case involved allegations
of attempted manipulation and false price reporting and the settlement included
among other sanctions a $20 million fine. Similar CFTC enforcement actions
may follow in the weeks and months ahead.
Enforcement actions aside, both regulators and energy market participants
alike have begun to search for new procedures and market mechanisms to address
the current crisis of confidence in energy price formation processes. The
CFTC and FERC jointly sponsored a conference held in April on this subject,
and FERC, the CFTC and the National Association of Regulatory Utility Commissioners
will be sponsoring a follow-up conference, on June 24, 2003, on energy price
formation and price indices for natural gas and electricity. One proposal
that seems to be taking hold would entail firms acting as price validation
services who would conduct external audits of energy prices submitted to
energy price index providers. NYMEX has suggested that this type of function
would be most amenable to a regulatory structure under which a regulatory
agency such as the CFTC or FERC delegated oversight responsibilities to
another entity (or group of entities). This approach, which is usually referred
to as the self-regulatory organization or SRO approach, would result in
the SRO or SROs being responsible for a number of duties in areas such as
auditing, compliance, rulemaking, and standardization of formats.
The Exchange believes that the SRO model offers the prospect for a real
world solution to the current problem, but this model need not entail excessive
governmental regulation. In designing a SRO structure for this purpose,
NYMEX generally favors a cost-conscious, pro-market approach. Thus, the
Exchange would suggest that the SRO model should permit a number of qualified
entities to be designated as an SRO to promote market competition in providing
this service to energy markets.
Role of Federal and State Governments in the Regulation of Gasoline Markets
The Exchange would also like to include a few brief comments regarding another
current energy industry topic: the requirements applicable to gasoline sold
in the Northeastern region. To be clear, NYMEX as an institution is completely
price neutral; on each business day, there is an equal number of contracts
bought as well as sold on the Exchange, and we do not have a vested interest
in the profits or losses of either side of the market to the detriment of
the other side. NYMEX also does not take a position on the environmental
impact of ethanol or MTBE, and we do not prefer or advocate the use of either
additive to gasoline to fulfill the current federal requirements for oxygen
standards in Reformulated Gasoline (RFG). NYMEX’s concern is to see
uniformity of grade and quality standards governing RFG specifications across
the New York Harbor region which, as a marketplace, is one contiguous region
despite distinctions in state borders.
At this point in time, New York State is set to implement a ban in New York
on all gasoline with MTBE commencing on January 1, 2004. By comparison,
New Jersey will permit its continued use. Meanwhile, Congress is considering
a comprehensive energy bill which, if adopted, would end the oxygenation
requirement for gasoline in this region sometime in 2004. In effect, MTBE
would largely disappear from the scene, and ethanol would not be required
in reformulated gasoline in the New York area. In other words, there is
the prospect of intervening federal action prior to the January 1, 2004
start of the New York ban that would render New York’s MTBE ban at
the state level unnecessary. However, until Congress takes action, the industry
needs to prepare for a scenario where one kind of gasoline is restricted
in New York but otherwise available in New Jersey. Gearing up for this possibility
of a two-tier type of regional market involves significant costs to our
market users, planning and preparation costs that would become moot by Congressional
action in this area.
Premature Revision of the Commodity Exchange Act
Over the last year or so, some have suggested that it would be useful to
clarify the scope of the CFTC's anti-fraud and anti-manipulation over certain
products and markets, and have further suggested a need for greater transparency
and public accountability for certain markets within the CFTC's jurisdiction,
particularly if such markets begin to serve a price discovery function.
While NYMEX is generally supportive of these policy goals, we also take
note of the extensive number of investigations now underway by the CFTC.
Several of these investigations have resulted in complaints being filed
and also settlements involving significant fines. When Chairman Newsome
appeared before this subcommittee two weeks ago, he noted that there “may
well be” additional complaints filed in the near future. Accordingly,
we believe that the best public policy approach would be to defer Congressional
consideration of amendments to the CEA until the CFTC has had an opportunity
to complete its ongoing matters. At that time, a clearer picture should
emerge as to whether there is a need to amend the CEA.
We are also appreciative of Chairman Newsome’s concern that a general
reopening of a major statute like the CFMA can result in unintended consequences,
including mischief by special interests to dilute certain regulatory safeguards
while others are being strengthened. At this time, the marketplace, including
shareholder groups, and federal investigators, regulators and prosecutors
have provided many of the benefits sought last year through an amendment
of the statute. We believe the time is not at hand for another reopening
effort.
In addition, by deferring consideration of possible CEA revisions until
a more appropriate juncture, Congress would also be allowing exchanges and
clearing organizations further opportunity to make business decisions on
a voluntary basis as to how best to serve their customers, rather than having
such decisions be made on the basis of regulatory directives. There is basis
for believing that the ordinary operation of free markets may well bring
about a number of benefits and services to market customers, such as use
of portfolio margining for a broader array of products.
Once again, Mr. Chairman, thank you for the opportunity to participate in
this important discussion. |
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