By John MacKenna
Four years after passage of landmark commodity trading reform legislation that New England Fuel Institute pursued aggressively, market volatility has been in decline and large banks are exiting the commodity markets. But the reforms are far from secure, and energy prices remain unreasonably high.
President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, launching a series of reforms to the nation’s financial markets. Congress had passed the legislation in response to the financial collapse of 2008, which was caused in part by under-regulation of the markets for derivatives, including commodity futures and swaps.
NEFI had already been lobbying intensely for commodity markets reform for years before the subprime mortgage crisis triggered the 2008 meltdown. “We had part of the ‘Enron Loophole’ successfully closed in 2008, but we did not have the stomach to tackle the entirety of the unregulated swaps market until after the financial crisis, which was caused by the swaps market,” said NEFI Vice President of Government Affairs Jim Collura.
Political will for reform was strong after the financial crisis, enabling Congress to pass the Dodd-Frank Act. The inclusion of Commodity Trading reforms under Title VII of that Act was an essential victory for NEFI and its allies in the Commodity Markets Oversight Coalition (CMOC), an alliance of associations representing commodity-dependent industries in agriculture and transportation.
Collura explained the importance of Dodd-Frank. “It required over-the-counter (OTC) swaps to be cleared, created price transparency and provided the Commodity Futures Trading Commission (CFTC) with new authority to prosecute manipulation. All of those rules are done and are being enforced, and it has had a measurable impact.”
Dodd-Frank authorized the CFTC to set up new exchanges for previously unregulated swaps called “Swap Execution Facilities” or “SEFs.” These exchanges went live in just the last seven months and have been “a huge success,” he said. “Their share of the market has grown, and over-the-counter swaps are now being cleared on those platforms, enabling market participants to see what swaps dealers are charging others for the same products.” One of the purposes of this requirement was to drive down hedging costs by allowing greater price transparency. This transparency also allows the CFTC to collect swaps market data and monitor for fraud or intent to manipulate prices.
Dodd-Frank also provided the CFTC with new tools to police against fraud, manipulation and disruptive trading and to prosecute such activity. The CFTC has dramatically stepped-up enforcement activities in the four years since Dodd-Frank passed, Collura said. In the three years following Dodd-Frank’s passage the CFTC has filed 283 enforcement actions, more than the previous six years combined.
Wall Street Fights Back
The years since Dodd-Frank became law have seen a mix of success and frustration for market reformers. In one piece of good news, large banks are stepping back from the commodity markets, according to a recent report by Bloomberg.
“The commodity markets are not as profitable as they were, and the banks are facing a lot of new regulatory barriers,” Collura said. “I think part of the explanation behind it is also the work that we’ve done in making the futures and swaps markets more transparent and our work with the Federal Reserve, which has recently begun questioning the proper role that large banks play in the physical commodities space.”
Marketers have also seen a decline in commodity price volatility since the passage of Dodd-Frank, although the exact cause is hard to decipher, according to Rich Larkin, President of Hedge Solutions. “It’s not quite clear what the impact Dodd-Frank has had on the volatility in the commodity markets, specifically energy futures like crude oil, ULSD and gasoline. There is no doubt that implied volatility has seen a significant decline since 2008. We are currently at or near all-time lows for historical volatility; a measurement that impacts options premiums and indicates a calmer, more orderly market.
“Articles have been written and analysts have hypothesized that the new regulations have forced the banks to exit the commodity space for now,” he added. “Recently, they’ve pointed to Morgan Stanley’s sale of its physical energy business to NGL this spring as a sign that more stringent capital requirements inherent in the Dodd-Frank regulations have forced the banks out of the commodity space. On the flip side, skeptics will say that the recent calm is simply the result of a change in the macro view. Lower volatility only temporarily discourages the commodity space as an attractive place to park assets, but give it time and the monies will once again flow back into this space. Only then will we see the true impact of the bill once it is fully implemented and time provides a clearer picture.”
While some elements of the reform legislation have not yet taken effect, most of the provisions have been implemented, according to the NEFI Vice President. “We have accomplished much of what we set out to do. We made sure the markets were transparent and that rules are being enforced. We made sure the CFTC can prosecute manipulation and fraud, and that is being done to great success. But we also wanted to make sure that the influence of speculative activity was limited, and that is still a big question mark. Folks that profit from speculating in commodities are fighting to preserve their exemptions and see that limits are not imposed on energy trading.”
The frustrations have been caused by financial interests and their allies in Congress, who have dug deep into their bag of tricks trying to stymie reform at every turn. “In Washington there is a turn of phrase that lobbyists use: Legislate, regulate, litigate, legislate, and this is typically how policy goes through,” Collura explained. “Congress writes the legislation, the regulators implement it, and they are challenged in court. Whichever side loses, they push for new legislation to reverse the loss.”
The implementation of position limits on speculators has followed this well-worn path. Position limits were stripped from the energy markets and from over-the-counter swaps trades by the Congress as part of the Commodity Futures Modernization Act of 2000, known to most as the “Enron Loophole.” In the Dodd-Frank Act Congress acknowledged the harm this caused, including the role of speculation in the commodity price bubble of 2007-2008. In response lawmakers required the CFTC to re-impose position limits on energy futures and in the OTC swap markets.
In October 2011, the CFTC approved a final rule on position limits, but Wall Street trade groups led by the International Swaps and Derivatives Association (ISDA) challenged the rule in U.S. District Court and prevailed, with the court vacating the rules and remanding the issue back to the CFTC. But rather than await new legislation, the CFTC rewrote the position limits regulations themselves to address the court’s concerns. The Commission is currently working on a final proposal.
“We believe the CFTC is not only responsible for ensuring transparent and accountable markets, but also that the price discovery function of the markets – which very much impacts the price of diesel fuel, heating oil, and all commodities really – is working,” Collura said. That is why after years of fighting, NEFI continues pushing for this important rule. Without it , there’s no assurance that prices set by these markets are truly reflective of supply and demand. “That was the mission NEFI and its allies set out to accomplish, so until meaningful position limits are back in place, our job remains unfinished.”
NEFI and its coalition allies must remain vigilant to protect the gains made in Dodd-Frank and ensure the implementation of effective position limits and other reform measures, according to Collura. “Those reforms have been under attack since the 2010 election. A lot of folks who came to D.C. then were funded by Wall Street, and they had promises to keep,” he said. “If it wasn’t for us, they would have been successful [in rolling back reforms.]”
“We have had to fight continuously, and we have been successful. We have also built key alliances on the Senate side, so we can make sure that bills that come out of the House that threaten reform will die in the Senate. If we gave up after Dodd-Frank passed and said, ‘We won. Let’s move on’, all of these accomplishments would have been reversed.”
In addition to fighting the promulgation of new regulations, pro-Wall Street members of Congress have also kept the CFTC underfunded. “They are using the power of the purse as an opportunity to put handcuffs on the CFTC to enforce rules,” Collura said. With the exception of this year, Wall Street allies in Congress have sought to cut the Commission’s budget every year. “The CFTC is now responsible for a multi-trillion-dollar market, and their funding really has not changed much since the law was enacted. They don’t have the staff or the technical resources to fully implement these new rules, even rules against manipulation and fraud. They need qualified folks to pore over data and make sure there is no manipulative or disruptive activity. As the need for resources grows, the willingness to provide it has unfortunately decreased in Congress, ” he added.
Reversing the Dodd-Frank reforms could expose the U.S. economy to a repeat of the 2008 collapse, while increasing market volatility and unwarranted price spikes. “Do we want to go back to where we were before 2010, when opaque and completely unregulated derivatives resulted not only in the biggest bubble in commodities in history but also a housing bubble and the worst financial crisis and employment markets since the Great Depression?” Collura asked. “I’m not sure anyone would want that.”
Wall Street interests are going to great lengths to thwart reform. When CMOC was hiring for a lawyer to prepare a court brief in support of position limits, they had to look well outside the Washington, D.C., area. Every firm in the Capital had a conflict of interest because at least one lawyer doing some kind of work for Wall Street interests or was at least trying to attract their business, he said. “We ended up having to hire a firm out of Birmingham, Alabama,” the NEFI Vice President said.
CMOC, the NEFI-led pro-reform coalition, has scaled back its activities and now convenes by phone monthly or quarterly, but members are always ready to provide “air support” when NEFI asks, according to Collura. “Most recently the House of Representatives began work on a CFTC reauthorization bill that includes harmful provisions designed to stymie new trading rules,” Collura said. “We activated our coalition list and rallied our allies to the cause. The bill passed but not overwhelmingly, which will help us defeat the bill in the Senate.”
Will Prices Fall?
One question that NEFI members have asked is why oil prices have not declined as the CFTC has implemented its reforms. “We have more transparency and all the other rules in place, and the CFTC is policing manipulation and fraud. By most accounts the markets are more stable than six years ago. With all this happening, why aren’t prices lower?” Collura said. “That is a complicated question, and members have the right to wonder.” Part of the explanation could be the fact that the rules for position limits in commodities are not done yet. Turmoil in the Middle East and elsewhere could also be keeping prices high, he noted.
Effective oversight of the commodity markets is essential for keeping energy prices in check, but there are other factors of similar importance, too, according to the NEFI Vice President. “The key to lower energy prices is, first, lifting barriers to domestic production; second, insuring proper investment in energy infrastructure and ensuring movement of energy around the country; third, making sure prices are reflective of supply and demand and that hedgers like our members can cost-effectively manage price risks through the derivatives markets; and fourth, making sure there is a healthy regulatory and tax environment and that members are not overly burdened by red tape. You have to go after all four. You can’t ignore any one of them if you are serious about bringing affordable energy to consumers.”
It is difficult to predict how speculative position limits, when implemented, will affect pricing, according to Collura. The CFTC is now proposing near-month trading limits of 25 percent of deliverable supply for an individual trader, which NEFI considers too high. NEFI has submitted comments urging the CFTC to work closely with end-user advisory groups to set limits for each commodity and review them periodically to ensure their effectiveness. The association has also called for the implementation of aggregate position limits, which would restrict the combined positions of all traders in any market, but the CFTC has indicated that aggregate limits might not be enforceable.
Position limits would be most effective if implemented in both U.S. and European exchanges, but European regulators have balked at setting limits. “You need to have other markets with the same sets of rules, and they have to be strong,” Collura said.
NEFI has asked that the CFTC restrict access to U.S. markets to participants from countries with similar position limits. “There is a major legal argument over whether the CFTC has the right to require dual regulations and require companies to be subject to the same rules,” he explained.
Another important reform will be added in the months ahead when the ‘Volcker Rule’ takes effect, barring commercial banks from speculating in the financial markets. “Once Volcker is implemented, banks won’t be able to speculate with people’s Federally-insured deposits, such as the cash they keep in their checking and savings accounts,” Collura said.
The financial interests might seem to have the upper hand, given their financial advantages, but Collura sees strength in NEFI’s position as well. “We may not have the financial wherewithal they have, but we have the moral upper hand because our members are small businesses and provide an essential commodity that is vital to consumers,” he said. Unreasonably high and volatile energy prices also have a ripple effect through other sectors of the economy. “Airlines don’t benefit when jet fuel increases ticket prices. The same is true for trucking: When diesel prices get unreasonable, truckers pay more and everything they transport goes up in price. Therefore, this is more than just a fight to lower gasoline prices or home heating costs, it is a fight to ensure a more stable and competitive U.S. economy. That’s a win-win for everyone.”