Institute for Agriculture and Trade Policy
Comments for the U.S. Commodity Futures Trading Commission Hearings on the Trading of Energy and Energy Derivatives, ("Energy Hearing Comments")
Steve Suppan, Senior Policy Analyst, ssuppan@iatp.org
Institute for Agriculture and Trade Policy
August 12, 2009
Time is probably our greatest threat. The longer it takes for the recovery to begin, the greater the likelihood of serious damage to US strategic interests […] Statistical modeling shows that economic crises increase the risk of regime-threatening instability if they persist over a one to two year period.
Dennis Blair, Director of National Intelligence, Testimony to the Senate Select Committee on Intelligence,
February 12, 2009
The Institute for Agriculture and Trade Policy (IATP) is a 501c3 organization headquartered in Minneapolis, Minn., with an office in Geneva, Switzerland. IATP, founded over 20 years ago, works locally and globally to ensure fair and sustainable food, farm and trade systems. IATP is grateful for the opportunity to comment on CFTC rulemaking, enforcement actions and legislative recommendations to enable commodity futures exchanges to contribute to the orderly functioning of markets that are crucial to food and energy security. In order for global economic recovery to be sustainable, and not a repeat of the bubble and bust economy of the past decade, fundamental reform of CFTC rules and futures trading practices is urgent. To avoid the political instability about which Director Blair testified, the economic recovery must not be threatened by another round of excessive speculation and extreme price volatility in commodity futures markets.
On February 2, IATP submitted testimony to the U.S. House of Representatives Committee on Agriculture concerning the Derivatives Markets Transparency and Accountability Act of 2009, (Derivatives Act) subsequently passed by the Committee
1. We noted that excessive speculation and the resulting extreme price volatility in agricultural futures contracts made it difficult for many farmers and ranchers to forward contract, as rural bankers were unable to assess price risks with enough certainty to loan money to country elevators and other first points of sale. By June 2008, when commodity futures prices began their historic collapse, agricultural supply chains were facing a financial crisis and many farms and ranches suffered a cash flow crisis that endangered their ability to plant crops and feed livestock. Food and energy riots, due to unaffordable or unavailable food and energy commodities, broke out in at least two dozen developing countries, already suffering from skyrocketing food and energy import bills and less than the critical three month minimum of hard currency reserves.2 We supported Section 3 of the Derivatives Act, which would close the "swaps loophole" by requiring the CFTC to establish aggregate speculative position limits in concert with the recommendations of the Position Limit Advisory Groups stipulated in Section 6. We reiterate here our support for aggregate position limits applied to all trading venues and for the Advisory Groups. These position limits, together with the measures proposed in Section 3 to prevent regulatory arbitrage, if enforced by an adequately budgeted and staffed CFTC, will help reverse the deregulation and de-supervision that has lead to systemic violations of the Commodity Exchange Act.
Since the House passage of the "American Clean Energy and Security Act" (ACES) on June 26, it has become all the more urgent for the CFTC to establish and enforce aggregate speculation position limits. Sections 340–360 of
ACES provide the legislative authority for the CFTC to regulate the trading of carbon emissions permits and offset credit derivatives. Although the CFTC has said that it is committed to "ensuring emissions market integrity,"
3 without aggregate speculative position limits on carbon futures, the carbon market "weight of money" from unlimited speculator positions will induce extreme price volatility that could dissuade investments towards a low carbon economy. The legislative design of primary carbon trading assumes that carbon prices will trend upward as government reduces the number of pollution permits granted and annually increases their initial legislated price. According to the U.S. Congressional Budget Office (CBO), "the price increases would be essential to the success of a cap-and-trade program because they would be the most important mechanism through which businesses and households would be encouraged to make economically motivated changes in investment and consumption that reduced CO2 emissions."
4 The cap-and-trade legislative provisions of ACES suffer from short comings too numerous and complex to analyze here. To take but one example, as Michelle Chan testified on March 26 to the House Committee on Ways and Means5, the difficulty of verifying the GHG reduction claims of offset project developers could allow carbon derivatives investors to take profits well in advance of verification. And, we would add, there is nothing in ACES to prevent offset project developers from trading carbon derivatives—a conflict of interest similar to the many that have plagued financial markets for more than a decade. The short-selling of carbon derivatives alone, anticipated in ACES (Section 352) and unrestricted by position limits, would tend to undermine the legislated structure to increase carbon prices. "Successful" short-selling could drive down carbon prices sufficiently to prevent cap and trade from making any demonstrable contribution to the ACES-mandated reduction of Green House Gasses. In light of ACES, the Derivatives Act and the Obama administration proposal to regulate Over the Counter Trading, the CFTC should organize hearings in the fall to consider the issues involved in regulating primary and derivative carbon markets and CFTC’s capacity to regulate such markets.
In May, IATP joined the Commodity Markets Oversight Coalition (CMOC). We have helped draft and signed on to June 3 and August 5 letters to the Congressional leadership and an August 5 letter to CFTC Chairman Gary Gensler.
6 We wish to draw attention to two related issues in the August 5 letter to Congressional leadership. Under the subtitle, "‘Dark Market’ Trading Is A National Security Risk," the CMOC points out that the "dark markets" of private party to private party trades not only expose the financial system to unreported counterparty risks, but to malevolent trading practices that could disrupt U.S. energy supplies and pose a national security threat. Continued regulatory and legislative inaction to allow OTC trading in these "dark markets," makes the U.S. vulnerable, in a way—not unlike the vulnerability of at least 40 developing countries—to political instability due to the economic crisis. Director of National Intelligence Dennis Blair, in his February 12 presentation to the Senate Select Committee on Intelligence emphasized that the economic crisis, triggered in part by financial services industry deregulation and de-supervision, had displaced Al-Qaeda as the number one U.S. national security threat.
7 It has been suggested that greater transparency in the reporting of OTC trades will enable the CFTC to effectively regulate the "dark markets" that compete with the standardized trades of publicly regulated commodity exchanges. The CFTC is currently debating criteria for the "customization" of OTC trades, which together with a return to prudential capital requirements for all parties involved in the OTC trade, would make the "dark markets" somewhat less opaque. We fear that while CFTC and financial services industry lawyers debate whether a new financial product fits CFTC "customization" criteria, continued OTC trading in the "dark markets" could give rise to further rounds of excessive speculation, and in the case of malevolent traders, expose the United States to a national security threat in its energy markets.
We agree with Michael Masters, in his June 4 testimony to the Senate agriculture committee: "Wall Street will try to shift the debate to standardized vs. customized in order to avoid clearing [trades on transparent and publicly regulated derivatives clearing organizations]. Congress has the responsibility to make clearable vs. non-clearable the right standard."
8 Masters rightly proposes a high regulatory burden of proof and a much higher margin requirement for a trader to justify the need for an OTC contract. He poses the question that we believe that Congress and the CFTC should pose and answer: What kind of financial product has price risks so opaque and difficult to assess that not one derivatives clearing organization would accept the product for trading? Transparency is a good disinfectant for the design of toxic assets that many banks still carry on their books. But that transparency should not be the mere reporting to the CFTC of the opaque financial products of "dark markets." Instead regulation should put a heavy burden of proof on those traders to show the market efficiency and social utility of products whose risks are so difficult to assess.
Satyajit Das, a financial market analyst, has written, "Relatively simple derivative products provide scope for risk transfer. But increasingly complex and opaque products are used to raise risk and leverage and circumvent investment restrictions, bank capital rules, securities and tax legislation."
9 Das doubts that U.S. and EU regulatory and legislative remedies proposed thus far to regulate OTC derivatives trading will be effective. We hope that his well-documented and reasoned grounds for skepticism will not be further supported by weak CFTC reforms. As Director of Intelligence Blair observed in his testimony to the Senate, time is not on our side, not just for economic recovery, but for financial services reform to make the recovery sustainable. Reform proposals that prevent the trading practices that have lead to excessive speculation and its economic and social consequences are much preferred over regulatory priorities that result in prolonged litigation. Hence, we welcome Chairman Gensler’s support for establishing and enforcing aggregate speculative position limits.
10 However, we doubt that his proposal to focus CFTC resources to investigate the market share of commodity futures market participants will yield timely results for regulatory reform. And because time is of the essence, it is essential to prioritize—for implementation and enforcement—the most efficient means for preventing excessive speculation. Setting and enforcing aggregate speculative position limits should take priority over CFTC studies on market share concentration and referrals to the Department of Justice for possible violations of anti-trust laws. The U.S. government does not have a good track record of enforcing anti-trust laws and laws governing anti-competitive business practices. Indeed, in 2006, the Inspector General of the U.S. Department of Agriculture reported that the USDA had lacked the capacity for more than a decade to investigate and refer cases to the Department of Justice for violations of the Packer and Stockyards Act and other laws on anti-competitive agribusiness practices.
11 The new head of the Department of Justice division on anti-trust matters has indicated a willingness to prosecute commercial law violators. However, over the past decade many such cases have perished due to the increasing use by the courts of summary judgments, verdict set-asides and rules of procedure that exclude relevant evidence. Given the overwhelming political and legal war chests of the financial services industry, pursuit of a market concentration framework for regulating the commodities futures markets does not seem to be a cost-effective strategy nor the best regulatory tool to prevent excessive speculation. IATP recommends that Chairman Gensler focus CFTC resources on the prevention of excessive speculation and extreme price volatility. Neither the CFTC nor physical hedgers nor public interest groups have the luxury of time to fight the financial services industry on a legal battlefield where it has overwhelming advantages.
The Institute for Agriculture and Trade Policy wishes to thank the CFTC for the opportunity to comment on the complex issues addressed by this hearing. We look forward to working with the CFTC to restore the price risk management and price discovery functions of commodity futures markets, while allowing speculators to provide an optimal amount of liquidity needed to clear the trades among physical hedgers.
Notes
1 Testimony for the U.S. House of Representatives Committee on Agriculture, Subcommittee on General Farm Commodities and Risk Management hearing on the draft "Derivatives Markets Transparency and Accountability Act of 2009" http://www.agobservatory.org/library.cfm?refid=105090
2 "Commodities Market Speculation: The Risk to Food and Agriculture," Institute for Agriculture and Trade Policy, November 2008, at "ensuring
emissions market integrity," at http://www.iatp.org/iatp/publications.cfm?accountID=451&refID=104414 3 Rafael Martinez, "CFTC Market Surveillance of CO2: We are committed," Energy and Environmental Markets Advisory Committee, U.S.
Commodity Futures Trading Commission, May 13, 2009 at http://www.cftc.gov/stellent/groups/public/@aboutcftc/documents/file/eemac051309_martinez2.pdf 4 Douglas W. Elmendorf, "The Distribution of Revenues from a Cap-and-Trade Program for Co@ Emissions," Congressional Budget Office,
Testimony before the Committee on Finance, United States Senate, May 7, 2009 at 8. 5 http://waysandmeans.house.gov/media/pdf/111/chan.pdf
6 http://www.tradeobservatory.org/library.cfm?refID=106535; http://www.tradeobservatory.org/library.cfm?refID=106619; http://www.tradeobservatory.org/library.cfm?refID=106620
7 http://www.dni.gov/testimonies/20090212_testimony.pdf
8 "Testimony of Michael Masters before the Committee on Agriculture, Nutrition and Forestry, United States Senate," June 4, 2009 at 8. http://
agriculture.senate.gov/ 9 Satyajit Das, "How to design derivatives that dazzle and obfuscate," Financial Times, July 8, 2009.
10 "Opening Statement of Chairman Gary Gensler, Commodity Futures Trading Commission Hearing of the Commodity Futures Trading Commission," August 5, 2009 at http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/genslerstatement080509.pdf
11 http://www.usda.gov/oig/webdocs/30601-01-HY.pdf
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