Testimony of

Richard R. Lindsey, Director,

Division of Market Regulation

Before the House Committee on Banking and Financial Services,

Concerning Regulation of the Over-the-Counter Derivatives Market

and Hybrid Instruments

July 24, 1998

The Securities and Exchange Commission (“SEC” or “Commission”) appreciates the opportunity to express its views on issues relating to the federal regulation of transactions involving over-the-counter (“OTC”) derivatives and hybrid instruments.1 These issues involve significant questions of public policy that require the attention of Congress, members of the financial regulatory community, and interested industry participants.

Benefits of OTC Derivative Instruments

It is widely recognized that OTC derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of Am erican capital markets. In fact, U.S. markets and market professionals have been the global leaders in derivatives technology and development.

OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates. Because of the range of benefits these products offer, the OTC derivatives market has grown significantly during the past two decades.

The growth in activity involving this market has come, in part, as a result of the careful approach to regulation taken by Congress and by U.S. financial  regulators. That approach has focused on promoting legal certainty for OTC derivative transactions and encouraging the development of sound

industry practices.2 That approach has also relied on building consensus among U.S. financial regulators through their participation in the President’s Working Group on Financial Markets.
Concerns Regarding the CFTC Concept Release on OTC Derivatives

The recent concept release on OTC derivative instruments issued by the Commodity Futures Trading Commission (“CFTC”) represents a significant departure from the careful approach taken by the SEC and other regulators to the OTC derivatives market.3 In its concept release, the CFTC raises the possibility of applying a comprehensive regulatory regime to transactions involving swaps and hybrids as a condition for exempting such products from the requirements of the Commodity Exchange Act (“CEA”). Such a regulatory regime would necessarily be based on the CFTC’s conclusion that swaps and hybrids are futures contracts or commodity options and, as such, are subject to CFTC jurisdiction under the CEA.

Chairman Levitt joined the other members of the President’s Working Group – Treasury Secretary Rubin and Chairman Greenspan of the Federal Reserve Board – in objecting to the issuance of the CFTC’s concept release, citing grave concerns about the possible consequences of the CFTC’saction.4 In particular, these concerns focus on the risk that the CFTC’s action may increase the legal uncertainty concerning swaps and other OTC derivative instruments and, thus, destabilize what has become a significant global financial market. Uncertainty created by the CFTC’s concept release and concerns about the imposition of new regulatory costs also may stifle innovation and push transactions offshore.

Any consideration of the issues facing the OTC derivatives market, such as legal certainty, the concerns of industry participants, and the role of U.S. financial regulators, must begin with an examination of how this market has evolved and which products are involved in the bilateral transactions conducted between market participants. A convincing argument has not been made that developments in the OTC derivatives market since 1994 – when the members of the Working Group last testified before Congress on this market – or since 1995 – when the SEC and CFTC worked with the Derivatives Policy Group to develop a framework for voluntary oversight of OTC derivatives – merit the CFTC’s consideration of a vast, new scheme to regulate this market. Indeed, questions relating to what kind of regulation, if any, is appropriate for this market are ones that should not be addressed by an agency acting under a statute intended to govern only exchange trading in futures and commodity options.
Swaps

In its concept release, the CFTC sets out a broad regulatory agenda for regulating the OTC derivatives market and implies that the CFTC has jurisdiction over this market. We disagree with the CFTC’s approach. First, this approach necessarily involves examining the extent to which swaps may be futures subject to regulation under the CEA. On this issue the SEC has been clear – traditional swaps that are not traded through a multilateral transaction execution facility are not futures and are not subject to regulation under the CEA.5 This view is shared overwhelmingly by the industry.

Second, as Secretary Rubin, Chairman Greenspan, and Chairman Levitt suggested in their joint statement, we have serious doubts as to the CFTC’s authority to regulate OTC markets. The CEA provides for the regulation of exchange-traded futures, making off-exchange futures transactions illegal under the statute. Nowhere in the CEA has Congress articulated an intent that the CFTC regulate off-exchange markets, nor has Congress established standards for the protection of the public interest should the CFTC assert jurisdiction over these markets.

Moreover, the CEA should not be used as a foundation on which to build a system of regulation for the OTC derivatives market. Because of the difference in goals between exchange markets for futures and OTC derivatives markets, the CEA should be interpreted as providing for exclusive CFTC jurisdiction only over futures contracts that are traded on an exchange. For example, it is critically important to prevent manipulation of exchange markets that perform a price setting function. The OTC derivatives market does not set the price of underlying cash commodities. This difference should be acknowledged in the regulation of these two markets.

Third, we disagree with any plan by the CFTC to regulate the OTC derivatives market through exemption. In enacting the Futures Trading Practices Act of 1992, Congress gave the CFTC broad exemptive, not regulatory, authority regarding OTC swap transactions.6 Congress granted this authority to the CFTC without making any determination regarding the status of swaps and other OTC derivative instruments under the CEA. We disagree with the potential exercise by the CFTC of its exemptive authority as a means to regulate areas that have not been determined by Congress to fall within the CFTC’s authority. This is very different from the exercise by an agency of its exemptive authority to provide regulatory relief

in circumstances where the agency has clear jurisdiction over the activities or products that are subject to the exemption.

Moreover, regardless of the characterization of these instruments under the CEA, both the plain language of the CEA and the legislative history

indicate that Congress did not intend for the CFTC to use its exemptive powers to establish a new regulatory regime for the OTC derivatives market.

Notably, Section 4(c) of the CEA places certain conditions on the exercise of the CFTC’s exemptive authority. These conditions include the requirement that any exemption be in the public interest, that exemptions be limited to transactions that would be effected between persons meeting the definition of “appropriate persons,” and that exempted transactions not have a material adverse effect on the ability of the CFTC or any contract market to discharge its regulatory or self-regulatory abilities under the CEA. Beyond these general requirements, Congress did not direct the CFTC

to impose substantial additional requirements as a condition for exercising its exemptive authority, choosing instead to allow the CFTC to either exempt transactions unconditionally or on stated terms or conditions.

Given the willingness of Congress to allow the CFTC to exempt transactions without imposing conditions beyond those contained in Section 4(c), it is unlikely that Congress anticipated that the CFTC would establish exemptive conditions that, in effect, would require compliance with a new, comprehensive regulatory scheme for conducting off-exchange transactions. In fact, Congress specifically reserved for itself issues of regulatory policy relating to the OTC derivatives market. As stated in the Conference Report for the Futures Trading Practices Act of 1992, the purpose of giving the CFTC broad exemptive powers was to provide “a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development (could) proceed in an effective and competitive manner.”7 The objective was legal certainty for swaps, not expansive regulation of an evolving market.
Hybrids

The CFTC’s concept release also raises significant concerns regarding the current exemption for hybrid instruments contained in the CFTC’s Part 34 rules.8 Hybrid instruments are depository instruments or securities products, such as debt or equity securities, that have one or more commodity-dependent components with payment features similar to commodity futures or commodity option contracts. Under the CFTC’s Part 34 rules, such instruments may be exempt from regulation under the CEA if the sum of the commodity-dependent values of the commodity-dependent components of the instrument is less than the commodity-independent value of the commodity-independent component.

In its concept release, the CFTC indicates that some experienced practitioners have stated that the definition of hybrid instrument under the Part 34

rules is complex and difficult to understand and apply. We believe that the current definition is working well and that the mathematical computations

required under the definition are generally well understood. However, if industry representatives believe that the Part 34 rules are difficult to apply, we

would be interested in working thoughtfully with the industry, bank regulators, and the CFTC to address those concerns.

More generally, it seems the CFTC is proposing to substantially narrow the scope of the current hybrid exemption. In addition, the exemption’s

availability would depend on compliance with a scheme of regulation that would be implemented based on the CFTC’s exercise of its exemptive

authority. It is important to recognize that all hybrids are already regulated as banking or securities products. Where the commodity-dependentvariables are not paramount, there is no need to add another layer of regulation under the CEA.

Concerns of Market Participants

The CFTC’s suggestion that swaps and hybrid instruments might be futures or commodity options – derivative products regulated under the CEA – represents a significant departure from traditional views about the status of swaps and hybrids under the CEA. A conclusion to this effect would be of great concern to participants in the OTC derivatives market who have long considered the CFTC’s current exemptions for swaps and hybrids to be non-exclusive safe harbors from regulation under the CEA. Consistent with this view, market participants believe that a broader range of swaps and

hybrids than those described in the exemptions – such as products based on equity securities – also are not subject to regulation under the CEA. If

swaps and hybrids in general are considered to be futures or commodity options, as the CFTC suggests, concerns will be raised not only that the CFTC might restrict its existing exemptions, but also that contracts executed outside the terms of these exemptions might be deemed illegal off-exchange contracts in violation of the CEA. Fears regarding the legality of swaps and hybrid instruments could seriously disrupt the derivatives market.

The SEC’s “Broker-Dealer Lite” Proposal In contrast to the CFTC’s actions, which have raised concerns about legal uncertainty and the imposition of new regulatory costs on participants in the OTC derivatives market, the SEC’s OTC Derivatives Dealer, or “Broker-Dealer Lite,” proposal is intended to reduce the regulatory burdens faced by broker-dealers that conduct an OTC derivatives business. 9 Under the SEC’s current regulations, firms that effect transactions in OTC derivative instruments that are securities (such as OTC options on government securities) must register as broker-dealers and comply with the

SEC’s capital and margin requirements. In some instances, these regulatory costs have resulted in firms dividing their activities, placing

non-securities activities in separate, unregistered affiliates located in the United States, and conducting their securities activities abroad.

In proposing special rules for a limited class of broker-dealers, called “OTC derivatives dealers,” the SEC recognized that, in some instances,

fragmenting a firm’s OTC derivatives business may hinder its ability to manage risk and compete for business. If adopted, the proposed rules would

provide U.S. securities firms with greater flexibility in structuring their OTC derivatives activities by allowing them to conduct transactions involving

both securities and non-securities derivative products through one entity. It should be emphasized here that flexibility is the goal. The proposed rules

would reduce, rather than increase, the regulatory impediments to doing business.

Registration as an OTC derivatives dealer would be a voluntary alternative to registration as a fully regulated broker-dealer under the SEC’s current rules. Modified capital rules would be applied to these registered dealers, under which they would be allowed to use value-at-risk models for determining market risk charges. OTC derivatives dealers would also be subject to the more flexible margin provisions typically applied to banks.

This would make it more economical for the OTC derivatives dealers to conduct transactions involving both securities and non-securities OTC derivative products in the same place. However, this entire structure would be optional, including the determination as to which, if any, instruments a dealer chose to place in the separate entity, along with its securities OTC derivative products.

The SEC’s “Broker-Dealer Lite” proposal does not expand the SEC’s jurisdiction, nor does the proposal claim that OTC derivative instruments generally are securities. Under the proposal, OTC derivatives dealers can opt to trade a wide range of derivative products; of these, the SEC can only regulate securities transactions engaged in by the OTC derivatives dealer. This does not represent any change in the exercise of the SEC’s jurisdiction. Moreover, any activity involving futures transactions by an SEC regulated entity would remain subject to the CFTC’s exclusive jurisdiction – as is the case today.

In short, the SEC’s proposal for OTC derivatives dealers is intended to promote market development and innovation and encourage dealers to keep business in the United States. It also is, in effect, a laboratory in which the SEC can test the operation of new concepts, such as value-at-risk, in a controlled environment, before introducing them into its rules for all broker-dealers. The OTC derivatives market has grown substantially in recent years, and this growth is indicative of the strength and vitality of U.S. capital markets. In contrast, conclusions drawn from the CFTC’s concept release raise concerns regarding legal uncertainty for OTC derivative instruments and the imposition of new regulatory costs. These concerns may stifle innovation or push transactions offshore.

The Working Group’s Request for Legislation

As noted earlier, the growth in the OTC derivatives market has resulted, in part, from the careful consideration of market issues and consensus

building among financial regulators. To address the legal certainty concerns raised by the CFTC’s concept release, Secretary Rubin, Chairman

Greenspan, and Chairman Levitt have requested a temporary legislative response to provide Congress and the regulatory community time to

consider the important public policy issues raised by activities in this market.10 The request was not made lightly, but was necessary to prevent any

perception that the U.S. regulatory system imposes an unreasonable amount of legal uncertainty on transactions in the OTC derivatives market, and

to avoid litigation that could increase this uncertainty.

In particular, the requested legislation would require the members of the President’s Working Group to study the OTC derivatives market to evaluate

whether any additional safeguards are warranted. The scope of the study would be OTC derivative instruments, including swap agreements, and

hybrid instruments. Following completion of the study, the President’s Working Group would develop recommendations, as may be appropriate, for

changes in statutes, regulations, and policies to improve operation of this market and to enhance legal certainty for swap agreements and hybrid

instruments. The legislation would require the President’s Working Group to submit a report to Congress describing the study and setting forth any

recommendations.

Because of the importance of legal certainty to market participants, the legislation would also maintain the regulatory status quo by imposing a

temporary moratorium on the CFTC’s ability to restrict its current exemptions for hybrid instruments and swap agreements. More specifically, the

legislation would require that prior to the enactment of legislation reauthorizing the CFTC, the CFTC would not be permitted to promulgate any

proposed or final rule, regulation, or order – or issue any interpretive or policy statement – restricting or regulating activity in any hybrid instrument or

swap agreement currently eligible for exemption under the CFTC’s regulations. The legislation would also provide legal certainty to derivatives based

on non-exempt securities.
Financial Derivatives Supervisory Improvement Act

In an effort to address legal certainty concerns in the OTC derivatives market, last month Chairman Leach introduced a bill, entitled the “Financial

Derivatives Supervisory Improvement Act of 1998.” Like the legislation requested by the President’s Working Group, this bill would impose a

moratorium on the CFTC’s ability to restrict or regulate swaps and hybrid instruments, and would call for U.S. financial regulators to conduct a study

of the regulation of the OTC derivatives and exchange-traded derivatives market.

Under the Leach bill, this study would be conducted by a new Working Group on Financial Derivatives, which would be chaired by the Secretary of

the Treasury and would include the Board of Governors of the Federal Reserve System, the SEC, the CFTC, the Office of the Comptroller of the

Currency, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation, and the Federal Reserve Bank of New York. While we agree

that a study of OTC derivatives markets is appropriate, we believe that the study should be conducted by the President’s Working Group in its current

form.

As constituted, the President’s Working Group represents a diverse and balanced group of regulatory bodies. The four agencies that make up the

Working Group are those having a principal interest in the operation of the OTC derivatives market, and bring to the group perspectives relating to

the relationship of this market to securities and futures regulation, as well as the operation of the nation’s banking system. Adding more bank

regulators to a group formed specifically for the purpose of addressing derivatives issues would make the operation of the group more cumbersome,

without adding points of view not already represented by the Department of the Treasury and the Federal Reserve Board. Moreover, the additional

agencies that would participate in the proposed Working Group on Financial Derivatives already participate, as appropriate, in the discussions of

the President’s Working Group.
SEC–CFTC Merger

In connection with recent discussions regarding regulation of the OTC derivatives market and hybrid instruments, the idea of a merger of the

Commission and the CFTC again has been raised. While a merger of the two agencies might make sense in certain ways, the benefits of such a

union may not be as immediate or dramatic as its champions might expect.

The cost savings associated with a merger may be limited, because the new combined agency would still need to retain operating divisions to oversee each of the regulatory areas within its jurisdiction, such as corporation finance, investment management, the securities markets, and the commodities markets. It is true that merging the Commission and the CFTC would streamline regulatory oversight, reduce jurisdictional uncertainties, and eliminate some administrative costs, but we must take care not to be distracted from the urgent business before us today. Calming the OTC derivatives market is our top priority.

A merger of the Commission and the CFTC would entail a substantial commitment of time, money, and resources, both for Congress and the two agencies. Accordingly, the Commission is wary of the costs and distractions of an agency merger at this time.

Conclusion

In short, the CFTC’s concept release raises important policy questions that should not be addressed by the CFTC alone, but rather require the attention of Congress, members of the financial regulatory community, and interested industry participants. The OTC derivatives market is a rapidly growing and extremely vital global market that crosses jurisdictional boundaries among the regulatory community. The legislative proposal put forward by Secretary Rubin, Chairman Greenspan, and Chairman Levitt recognizes the need to protect the market from unreasonable and potentially harmful legal uncertainty, while also providing the time needed to allow the President’s Working Group to study the issues raised by activities in the OTC derivatives market and to develop, as a group, appropriate recommendations to Congress.

The Commission appreciates the opportunity to offer its perspectives on the OTC derivatives market, and to re-emphasize its serious concerns with the CFTC’s concept release and the damaging consequences that concept release could have on this market. The President’s Working Group should be provided with the opportunity to carefully study the OTC derivatives market and to analyze the current regulatory structure. The Commission and its staff welcome any questions on these issues that the Committee may have, and look forward to continued discussions with Congress, the President’s Working Group, and industry representatives on these important issues.
Footnotes

-[1]- The Commission’s staff also has participated in developing draft legislation recommended by the President’s Working Group on Financial Markets to revise the banking and bankruptcy insolvency laws. This proposal clarifies the treatment of certain financial contracts upon the insolvency of one of the parties to a transaction, and this will reduce systemic risk. The Commission believes that it is important to strengthen netting arrangements and provide certainty to the treatment of financial contracts when an institution becomes insolvent, and looks forward to the enactment of legislation that achieves these goals and strengthens our financial markets.

-[2]- See, e.g. , Derivatives Policy Group, Framework for Voluntary Oversight (Mar. 1995). The Derivatives Policy Group was comprised of principals representing six major U.S. securities firms, specifically, CS First Boston, Goldman Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers, and Lehman Brothers.

-[3]- Commodity Futures Trading Commission, Concept Release on Over-the-Counter Derivatives, 63 FR 26114 (May 12, 1998).

-[4]- Joint Statement by Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan Greenspan and Securities and Exchange Commission Chairman Arthur Levitt, dated May 7, 1998.

-[5]- Letter dated Jan. 4, 1993 from Jonathan G. Katz, Secretary, SEC, to Jean A. Webb, Secretary, CFTC, commenting on CFTC proposed rules regarding the regulation of swaps and hybrid instruments.

-[6]- P.L. No. 102-546; 106 Stat. 3590 (1992). Using the exemptive authority granted to it under the Futures Trading Practices Act of 1992, the CFTC promulgated rules under Part 35 of its regulations exempting certain swap transactions from the provisions of the CEA, other than provisions prohibiting fraud and manipulation. 17 C.F.R. Part 35.

-[7]- H.R. Rep. No. 102-978, 102d Cong., 2d Sess. 81 (1992).

-[8]- 17 C.F.R. Part 34.

-[9]- Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940 (Dec. 30, 1997).

-[10]- See Letter dated June 5, 1998 to The Honorable Newt Gingrich, Speaker, U.S. House of Representatives, from Robert E. Rubin, Secretary,

Department of the Treasury, Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, and Arthur Levitt, Chairman, Securities

and Exchange Commission.

http://www.sec.gov/news/testimony/testarchive/1998/tsty0898.htm

A Few Speculators Dominate Vast Market for Oil Trading

By David Cho
Washington Post Staff Writer
Thursday, August 21, 2008; A01

Regulators had long classified a private Swiss energy conglomerate called Vitol as a trader that primarily helped industrial firms that needed oil to run their businesses.
But when the Commodity Futures Trading Commission examined Vitol’s books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel. Even more surprising to the commodities markets was the massive size of Vitol’s portfolio — at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.
The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. Other CFTC data showed that a significant amount of trading activity was concentrated in the hands of just a few speculators.
The CFTC, which learned about the nature of Vitol’s activities only after making an unusual request for data from the firm, now reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency. That figure may rise in coming weeks as the CFTC checks the status of other big traders.
Some lawmakers have blamed these firms for the volatility of oil prices, including the tremendous run-up that peaked earlier in the summer.
“It is now evident that speculators in the energy futures markets play a much larger role than previously thought, and it is now even harder to accept the agency’s laughable assertion that excessive speculation has not contributed to rising energy prices,” said Rep. John D. Dingell (D-Mich.). He added that it was “difficult to comprehend how the CFTC would allow a trader” to acquire such a large oil inventory “and not scrutinize this position any sooner.”
The CFTC, which refrains from naming specific traders in its reports, did not publicly identify Vitol.
The agency’s report showed only the size of the holdings of an unnamed trader. Vitol’s identity as that trader was confirmed by two industry sources with direct knowledge of the matter.
CFTC documents show Vitol was one of the most active traders of oil on NYMEX as prices reached record levels. By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil — about three times the amount the United States consumes daily. That day, the price of oil spiked $11 to settle at $138.54. Oil prices eventually peaked at $147.27 a barrel on July 11 before falling back to settle at $114.98 yesterday.
The documents do not say how much Vitol put down to acquire this position, but under NYMEX rules, the down payment could have been as little as $1 billion, with the company borrowing the rest.
The biggest players on the commodity exchanges often operate as “swap dealers” who primarily invest on behalf of hedge funds, wealthy individuals and pension funds, allowing these investors to enjoy returns without having to buy an actual contract for oil or other goods. Some dealers also manage commodity trading for commercial firms.
To build up the vast holdings this practice entails, some swap dealers have maneuvered behind the scenes, exploiting their political influence and gaps in oversight to gain exemptions from regulatory limits and permission to set up new, unregulated markets. Many big traders are active not only on NYMEX but also on private and overseas markets beyond the CFTC’s purview. These openings have given the firms nearly unfettered access to the trading of vital goods, including oil, cotton and corn.
Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.
CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets.
CFTC leaders have argued that speculators are not influencing commodities’ prices. If any new information arises during the agency’s examination of swap dealer activity, officials said they would report it to Congress.
“To date, the CFTC has found that supply and demand fundamentals offer the best explanation for the systematic rise in oil prices,” CFTC spokesman R. David Gary said, reading a statement that had been crafted by agency officials. “Regardless of their classification . . . the CFTC’s market surveillance group scrutinizes daily the positions of all large traders, both commercial and non-commercial, to guard against market manipulation.”
Victoria Dix, a spokeswoman for Vitol, declined to answer questions. The firm, through Dix, released a statement that stated only that it had not been contacted by the CFTC about the reclassification of its business and that its trading status remained unchanged. CFTC officials said they do not typically contact firms that are reclassified.
On its Web site, the firm says it has $100 billion a year in revenue and describes its thriving global energy-trading business.
For most of the past century, regulators put limits on financial actors to prevent them from dominating commodity exchanges, which were much smaller than the bond or stock markets. Only commercial operations, such as farms, airlines, manufacturers and the middlemen that handle their trading activities, were allowed to buy nearly unlimited quantities. The goal was to allow these businesses to minimize the effect of price swings.
The first major change to this regulatory framework occurred in 1991, when Goldman Sachs, through a subsidiary called J. Aron, argued that it should be granted the same exemption given to commercial traders because its business of buying commodities on behalf of investors was similar to the middlemen who broker commodity transactions for commercial firms.
The CFTC granted this request. More exemptions soon followed, including one to the Houston-based energy trader Enron.
“When the CFTC granted the 1991 hedging exemption to J. Aron (a division of Goldman Sachs – villain again ?), it signaled a major shift that has since allowed investors to accumulate enormous positions for purely speculative purposes,” said Rep. Bart Stupak (D-Mich.) Now, he added, “legitimate businesses that hedge and take physical delivery of oil are being trampled by the speculators who are in the market purely to make profit.”
A second turning point came when Congress passed the Commodity Futures Modernization Act of 2000. The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the “Enron loophole,” saying Enron played a role in crafting it.
In the months after the act was passed, private electronic trading platforms sprang up across the country, challenging the dominance of NYMEX.
“Investment banks had been frustrated with the established exchange because they really were never able to get control of it,” said Michael Greenberger, a law professor at the University of Maryland and a former staff member at the CFTC.
The most successful of the private platforms was InterContinental Exchange, or ICE, founded by Goldman Sachs, Morgan Stanley and a few other big brokerages in 2000. ICE soon opened a trading platform in London, allowing its founders to trade vast quantities of U.S. oil overseas without being subject to regulation.
The exemptions for swap dealers and the development of overseas markets allowed big brokerages to open the door for more hedge funds, pensions and big investors to move into commodities.
In the coming years, commodity investments by funds could grow to $1 trillion, veteran hedge fund manager Michael Masters said in testimony before the Senate earlier this year. In an interview, he said this trend could raise commodity prices for everyone in the coming years and “have catastrophic economic effects on millions of already stressed U.S. consumers.”
Meanwhile, commodities have been good business for big Wall Street brokerages. Its commodity trades helped keep Goldman Sachs profitable during the credit crisis, said Richard Bove, a banking analyst at Ladenburg Thalmann.
“Business is lousy right now,” Bowie said of Goldman Sachs. “Commodities and currencies are clearly the strongest business they have right now.”
In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in U.S. oil contracts overseas in Dubai. Goldman Sachs and Vitol are among the major investors in this new exchange.
 
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