By Bart Chilton
There are three commonly referred to loopholes: the Enron loophole, the London loophole, and the swaps loophole. We’ll go over each, one at a time, and get rid of a little of the mystique surrounding them. When I’m done, hopefully you’ll start to see the derivatives markets in a new light, with sharper focus, and more clarity.

Enron Loophole
Let’s start with what is now commonly referred to as the “Enron Loophole,” which was a provision included as part of the 2000 Commodity Futures Modernization Act (CFMA). This provision deregulated part of the futures markets by certain exempting electronic markets from oversight by the CFTC and creating a new category: Exempt
Commercial Markets (ECMs).

As many of you have heard, Enron lobbyists, along with former Senator Phil Gramm, successfully negotiated the final compromise that came out of conference creating this new category. That’s not to assign blame on Senator Gramm, but merely to demonstrate why folks started calling this loophole the Enron Loophole.

Here is the practical side of the Loophole: Jeffrey Sprecher, an innovator on all counts, started the InterContinental Exchange (ICE Futures U.S. based in Atlanta) with a group of investors, who saw this opening to start a new exchange and not have to worry about all the pesky regulations associated with the regulated markets. ICE Futures U.S. has been very successful, though I think Mr. Sprecher, who serves as CEO would tell you they couldn’t have accomplished this level of success if saddled with the same regulatory hurdles that are applied to designated contract markets (DCMs).

CFMA, in this instance, got government out of the way and allowed the dawn of a new era of electronic trading, which has changed our market structure forever. Did Congress overshoot a little and also create an environment where folks like Enron could take advantage of the system? In hindsight, I think so.

And here’s why. Rather than an exhaustive conversation on the inner-workings of Enron Corporation, I’ll use another example of a company that actually took advantage of a light regulatory touch provided by the CFMA: Amaranth. This example is easier to understand, and in my view better demonstrates, the problem the Enron Loophole created and the consequences that resulted.

In 2006, Amaranth attempted to manipulate the natural gas market by taking very large positions on the New York Mercantile Exchange (NYMEX). The CFTC can see activity on a regulated exchange like NYMEX on a minute-by-minute basis. In coordination with CFTC staff, NYMEX realized these levels were very high. NYMEX began addressing the situation by contacting Amaranth and instructing it to promptly liquidate its natural gas positions.

But here’s the rub. Amaranth liquidated its NYMEX positions and bought similar positions on ICE Futures U.S., which by virtue of its classification as an ECM was not something that the CFTC could readily monitor.

In reality, no net liquidation really occurred, and what we’re told by economists today is that the ramifications were costly to consumers. In fact, economists at the Federal Energy Regulatory Commission reported that consumers in California paid up to 30% more for energy the summer of 2006 because of Amaranth’s attempted manipulation.

Smart people disagree on the exact figure, but it is safe to say that consumers were harmed by Amaranth’s actions. Ultimately, the CFTC brought a case and settled with Amaranth for $39 million dollars, but, as I said, not before considerable damage had been done to the public.

These actions by Enron and Amaranth and the consequences were chronicled in a detailed report in 2006 issued by Senator Levin who chairs a Department of Homeland Security Subcommittee. The report also called for a more oversight in this area and urged that the now famous Enron Loophole be closed.

As a regulator, I’m pleased that through the perseverance of several U.S. Senators, the Enron loophole was officially closed with a reasoned and measured legislative response as part of the recently passed Farm Bill.

London Loophole
The second dark market, or loophole, has been commonly referred to as the London Loophole. To paint a broad picture of the regulatory approach in London, it is fair to say that their system is very similar to ours, with a few important distinctions.

In April of this year, I had the opportunity to travel to London to meet with my counterparts and deliver a speech, also on a topic of my choosing. The title of my speech was “The Ancient Art of Glassmaking,” and my objective was to let our friends in London know that I felt strongly in the collaborative efforts international regulators must take to oversee markets in a more transparent fashion.

I raised three specific issues: first, publication of the “Commitment of Traders” (COT) report, which includes data that gives the public a better sense of what is occurring in markets and also serves the CFTC in our surveillance efforts; second, harmonization of our information sharing needs, with a goal of getting as close to real-time as possible; and third, restoration of consumer confidence by strengthening collective enforcement efforts.

In London, the Financial Services Authority (FSA)—the UK regulator for securities, banking, and derivatives—has not seen the need to produce a COT report. Earlier in the year, an FSA official said it was “too costly.” Further the FSA had not taken any enforcement action in eight years.

Here’s why that is important for U.S. consumers. The price folks are paying for gas is directly influenced by the price of a barrel of oil traded in futures markets. The most notable trading for oil occurs on NYMEX in the West Texas Intermediary (WTI) contract, the world’s benchmark contract for oil pricing.

However, NYMEX isn’t the only exchange trading a WTI contract. ICE Europe in London has an identical contract that settles off the NYMEX price and is arbitraged by traders everyday. In short, the two are interdependent, and the activities of either market can be felt on both sides of the Atlantic. This “look-alike” contract is what folks are referring to when they talk about our second dark market, the “London Loophole.”

The foreign trading is referred to as “dark,” because the U.S. regulators don’t have a sufficient statutory or regulatory window into trading activity on the foreign market, even though that trading affects domestic markets. CFTC PAGE 5 OF 7
Without divulging anything confidential, I can tell you that theoretically a trader could have the maximum number of positions in the NYMEX WTI contract and have more than that number on ICE Europe’s “look-alike” contract.

That doesn’t mean that there is anything illegal going on. It doesn’t mean that there have been attempts to manipulate the market. It doesn’t even mean that anyone who has held large positions in both markets has manipulated the market. However, up until a few months ago, we were not receiving the needed information to even see if there might be a problem of one trader holding large positions on both exchanges.

Large trader positions on ICE Europe who are trading the WTI look-alike contract are important information for us to have here in the United States.

This is information that I feel is critical due to the increasing global nature of these markets and the fact that our protection of U.S. consumers must now stretch well beyond our own borders, an effort that I’m proud the CFTC is not only undertaking, but leading.

Last week, I was able to deliver welcoming remarks to a group of international regulators that traveled to the U.S. to learn firsthand from our staff experts at the CFTC about our regulatory system. I talked to them about how a trader’s computer is, in a sense, a time machine. Traders can wake up in the middle of the night, on the other side of the world, and arbitrage between different markets. And they do. Is that a bad thing? No, but again it is critical that we get the regulatory framework in place to handle this new environment and that means strong coordination with regulators across the globe.

I’m pleased to say that the relationship with our counterparts in U.K. has improved greatly, and that the international conference we hosted last week is an example of our bridge building efforts with other countries like India, Brazil, Japan, and China to name a few. With this strong coordination comes the confidence that the problems presented by the “Enron Loophole” won’t result with the “London Loophole.”

While we are undertaking a regulatory fix to get needed information, and are now receiving information from the UK, efforts are also underway in Congress to address the London Loophole in our commodities law. In fact, leaders in both the House and Senate have proposals to make sure we avoid any disasters and protect American consumers. Both the House and Senate have recently debated these measures and garnered bipartisan majority support, though falling short of passage on procedural technicalities. I’m told that Congressional leaders in the House and Senate are spending August discussing how to overcome procedural hurdles so that the London Loophole and our final loophole can also be closed permanently.

Swaps Loophole
Which leads me to our third and final dark market—the Swaps Loophole. This loophole deals with transactions performed in excluded “over-the-counter” markets, many of which are called, simply, swaps.

These swaps transactions are mainly conducted by institutional investment banks that broker deals between commercial and non-commercial traders. Swaps dealers are granted hedge exemptions from the CFTC so that they can narrowly tailor deals between sophisticated entities to meet their business needs and manage their business risks. Over-the-counter activity now comprises 2/3rds of the trading volume in the U.S.; regulated exchanges comprising the other 1/3rd of futures trading activity.

The issue comes as speculators have increased their participation in the futures markets, primarily through swaps dealers, in an unprecedented fashion. In fact, at least $250 billion dollars has come into these markets in the last several years and the question that many people are asking is whether or not that influx of capitol is having an influence on the prices of oil and other commodities.

I’ve had the opportunity to discuss this issue with a lot of really smart people and I can tell you that a lot of them disagree.

Personally, I don’t see how $250 billion dollars doesn’t have a thumb-on-the-scale effect on prices. That’s an astronomical amount of money invested in commodities as an asset class—a new type of investment strategy in the futures markets and different approach applied to commodities trading. But, again, a lot of smart people disagree about the impact.

In total candor, I’ll admit that the only thing I feel comfortable telling you is that I simply don’t know what impact this new investment is having; which as a regulator makes me nervous. I’ll also tell you that I feel strongly that it merits further investigation so we fully understand what, if any, effect it may have on the price consumers are ultimately paying at the pump.

There are several factors affecting gas prices, but this is one area where we certainly must improve our understanding.

My view is that adding transparency in this area and providing the CFTC with the discretion to take action, if warranted, would be a good thing. It would allow us to have a window into what’s going on in certain over-the-counter contracts—not to outsource this activity overseas, but take action if needed. (Bart Chilton is Commissioner, CFTC, Speech at Michigan Agri-business Association)