The Enron Loophole
The Enron Loophole
Mark Jickling
Specialist in Financial Economics
Government and Finance Division
Summary
The Commodity Exchange Act exempts certain energy derivatives contracts from
regulation by the Commodity Futures Trading Commission (CFTC). These exemptions
are popularly known as the “Enron loophole.” Soaring energy prices have raised
concerns about whether the CFTC has enough information about these unregulated
markets to monitor energy trading in a comprehensive manner. The Farm Bill (P.L.
110-234) established a more stringent regulatory regime for electronic trading facilities
that offer contracts that play a significant role in setting energy prices. A number of
other bills in the 110th Congress would impose new reporting or regulatory requirements
on the bilateral energy swaps market, which was not addressed by the Farm Bill. This
report will be updated as legislative developments warrant.
Background
In 2000, Congress passed the Commodity Futures Modernization Act (CFMA, P.L.
106-554), whose central purpose was to set out the conditions under which derivative
financial contracts — instruments like futures, options, or swaps, whose value is linked
to the price of some underlying commodity — could be legally traded in the over-the-
counter (OTC) market, that is, off the futures exchanges that are regulated by the
Commodity Futures Trading Commission (CFTC). The CFMA established three
categories of commodities and made them subject to varying degrees of regulation:
financial commodities (such as interest rates, currency prices, or stock indexes) were
defined as excluded commodities. Excluded commodities can be traded in the OTC
market with minimal CFTC oversight, provided that small public investors are not
allowed to trade. A second category is agricultural commodities; here, because of
concerns about price manipulation, the law specifies that all derivatives based on farm
commodities must be traded on a CFTC-regulated exchange, unless the CFTC issues a
specific exemption after finding that a proposed OTC agricultural contract would be1
consistent with the public interest. Finally, there is a third “all-other” category — exempt
commodities — which includes whatever is neither financial nor agricultural. In today’s
markets, this means primarily metals and energy commodities. The statutory exemption
1 This exemptive authority is in Section 4(c) of the Commodity Exchange Act.
from regulation provided by the CFMA for exempt commodities is commonly known as
the “Enron loophole.”2
What Is Exempt From Regulation?
The CFMA added a new Section 2(h) to the Commodity Exchange Act, exempting
two classes of transactions from most CFTC regulation. First, bilateral contracts between
“eligible contract participants”3 that are not executed on a trading facility4 are exempt
from the Commodity Exchange Act, except for certain anti-fraud and manipulation
provisions. Second, contracts in exempt commodities between “eligible commercial
entities”5 that are executed on an “electronic trading facility”6 are also exempt from most
provisions of the Commodity Exchange Act. Substantial volumes of trading in energy
contracts avail themselves of each of these exemptions.
The Bilateral Swaps Market
In the bilateral swaps7 market, there is no centralized marketplace equivalent to the
futures exchanges like Nymex or the Chicago Board of Trade. Instead, a number of
financial institutions — large commercial and investment banks — act as dealers. They
stand ready to offer contracts linked to commodity prices, taking the other side of their
customers’ positions. The customers include hedgers (producers and commercial buyers
of commodities), other financial institutions, and speculators such as hedge funds and
institutional investors. Eligible contract participants may enter into swaps directly with
each other, but the market is dominated by large dealers partly because of concerns about
credit risk, or the risk of counterparty default.
Very little information is available about OTC commodity markets. The Bank for
International Settlements (BIS) conducts surveys of swap dealers, which probably capture
2 Before its collapse in 2001, Enron Corp. was a pioneer in OTC energy trading and developed
an electronic market (Enron Online) for trading physical and derivative contracts based on a
number of energy products.
3 Defined in the law as financial institutions, insurance companies, broker/dealers, government
units, professional futures traders, and businesses and individuals meeting certain asset and
income thresholds. The presumption is that these are sophisticated traders who do not need the
protections offered by government regulation.
4 “Trading facility” is defined in law as a “facility or system in which multiple participants have
the ability to execute or trade agreements, contracts, or transactions by accepting bids and offers
made by other participants that are open to multiple participants in the facility or system.”
5 These are defined as eligible contract participants (see note 3 above) who (1) deal in the
physical commodity or (2) regularly provide risk management or hedging services to those who
do.
6 Defined as a trading facility (see note 4 above) that operates over an electronic or
telecommunications network and maintains an audit trail of transactions.
7 A swap is a derivative contract economically equivalent to a futures contract. Two
counterparties agree to exchange payments over the life of the contract. The payments fluctuate
according to changes in the underlying commodity’s price, so that the net cash flow is always
positive for one party, and negative for the other.
most of the market, but the BIS data do not break out individual commodities. They
report that the notional value8 of outstanding OTC derivatives on commodities other than
precious metals at the end of 2007 was $8.3 trillion, up from $5.0 trillion in 2005. In
terms of gross market values, the figures were $673 billion in 2007 and $813 billion in
Market value, also called fair value, measures the current worth of a derivative,
based on whether the related cash flows are positive or negative, the time remaining to the
contract’s expiration, and the volatility of the underlying price. At the end of 2007, two
of the largest dealers in energy swaps, Morgan Stanley and Goldman Sachs, reported that
the fair value of their commodity derivatives totaled $41.2 billion and $28.8 billion,
respect i v el y. 10
Electronic Trading Facilities
Since the passage of the CFMA in 2000, an exchange-like market for energy
derivatives has come into being. Trading occurs on electronic platforms among eligible
commercial entities. Under the CFMA, the CFTC had no substantive regulatory authority
over these electronic trading facilities. The markets were required to notify the CFTC that
they were operating and provide very basic information about the owners of the market.
CFTC regulations refer to these trading facilities as “exempt commercial markets
(ECMs).” The CFTC website lists 18 ECMs, 12 of which trade energy contracts. A 2007
CFTC study reported that eight of these were active and suggests that only a single ECM
handled a volume of energy transactions comparable to the regulated exchanges. That
market is operated by IntercontinentalExchange, Inc. (ICE).11
While the ECMs are not subject to reporting requirements under the Commodity
Exchange Act, some information about ICE’s activities appears in the firm’s Securities
and Exchange Commission filings. ICE’s electronic platform offers hundreds of different
contracts, but most of the volume is accounted for by about two dozen highly liquid
contracts in North American natural gas and electrical power and global crude oil.
Trading volume in 2007 for these three commodities was 158 million contracts (natural
gas), 8.3 million (power), and 8.5 million (oil). The notional value of the natural gas
contracts traded was $2.7 trillion, comparable to the Nymex figure of $2.9 billion.12
8 Notional value is the value of the underlying commodity. In derivatives, however, since traders
do not own or purchase the underlying commodity, notional value is merely a reference point
used to calculate gains and losses, which are based on changes in price.
9 Bank for International Settlements, Quarterly Review, June 2008, Table A110.
10 Morgan Stanley, Form 10-K, annual report for fiscal year ending Nov. 30, 2007, p. 95;
Goldman Sachs Group, Inc., Form 10-K, annual report for fiscal year ending Dec. 31, 2007, p.
11 CFTC, Report on the Oversight of Trading on Regulated Futures Exchanges and Exempt
Commercial Markets, Oct. 2007, p. 9. Another ECM, the Natural Gas Exchange (NGX), handles
substantial volumes of OTC contracts, but it is based in Canada and used primarily by Canadian
firms and traders.
12 IntercontinentalExchange, Inc., Form 10 — K, annual report for fiscal year ending Dec. 31,
(continued...)
In the crude oil derivatives market, ICE’s OTC volume appears to represent a much
smaller share of the total market: Nymex traded 150 million crude oil contracts in 2007,
ICE Futures Europe (a regulated exchange in the United Kingdom, owned by ICE) traded
U.S. exchanges have tried to establish a market for electricity futures, but have never
succeeded.
According to the CFTC, the ICE and Nymex natural gas markets are economically
linked and function as a single market. The major traders on ICE are also the major
traders on Nymex. As a result, the CFTC concluded in October 2007 that its capacity to
monitor trading on Nymex was limited and that it needed “further transparency” with
regard to ICE’s OTC market.14 The CFTC made recommendations for legislation that
would extend CFTC oversight to certain electronic trading facilities offering contracts
based on exempt commodities.
Closing the Enron Loophole: The Farm Bill
In late 2007, both the House and Senate considered legislation that generally
followed the CFTC’s recommendations. In May 2008, provisions addressing the
regulation of ECMs were included in Title XIII of the Farm Bill (H.R. 2419) and enacted
as P.L. 110-234.
The Farm Bill amends Section 2(h) of the Commodity Exchange Act to provide for
CFTC regulation of electronic trading facilities that offer “significant price discovery
contracts” in exempt commodities. These contracts are those that “perform a significant
price discovery function,” that is, contracts (1) with a settlement price linked to a
regulated market’s contract, (2) that may be the subject of arbitrage trading involving
exchange-listed contracts, (3) that are traded in sufficient volume to have an effect on
other market prices, or (4) that are used as a reference point for pricing transactions in
other markets. Once the CFTC determines that a contract meets one or more of these
criteria, the electronic trading facility becomes subject to exchange-like regulation.
An electronic trading facility on which the CFTC determines that significant price
discovery contracts are traded will be required to comply with nine core regulatory
principles. The facility will have to
!ensure that contracts are not readily susceptible to manipulation;
!monitor trading in significant price discovery contracts to prevent market
manipulation, price distortion, and disruptions of the delivery or
cash-settlement process;
12 (...continued)
13 Ibid. Contract size varies from market to market.
14 CFTC, Report on the Oversight of Trading on Regulated Futures Exchanges and Exempt
Commercial Markets, Oct. 2007, p. 12.
!establish and enforce rules that will allow it to obtain any necessary
information to monitor trading;
!adopt position limits or position accountability levels for speculators in
significant price discovery contracts;
!provide for emergency authority to liquidate open positions and to
suspend trading in a significant price discovery contract;
!publish daily trading information on price and volume;
!monitor and enforce compliance with the rules of the electronic trading
facility applicable to significant price discovery contracts, including the
terms and conditions of the contracts and any limitations on access to the
market; and
!avoid conflicts of interest and antitrust violations.
These core principles are very similar to the principles that apply to the futures
exchanges, except that the exchanges must comply with additional principles dealing with
protection of small public customers. The Farm Bill does not alter provisions in current
law that limit trading on electronic trading facilities to eligible commercial entities (see
note 5 above), who are presumed to be sophisticated traders who do not need government
protection.
In addition, the Farm Bill requires that trading in significant price discovery contracts
be subject to the CFTC’s large trader reporting system. The CFTC receives daily reports
on all positions that exceed specified size thresholds, and publishes the data in aggregate
form in its weekly Commitments of Traders reports, distinguishing between hedging and
speculative positions.
Is the Loophole Still Open?
The Farm Bill provisions will bring major changes to markets where the CFTC
identifies significant price discovery contracts. They will become self-regulatory
organizations, with formal enforcement responsibilities. The CFTC will have enhanced
authority; not only will it routinely receive data about trading and the positions of hedgers
and speculators, but it will have power to suspend or revoke the operations or regulatory
status of an electronic trading facility that fails to comply with the core principles, fails
to enforce its own rules, or violates applicable CFTC regulations.
There is a question of how far the new regulatory regime will extend, since the key
designation is a significant price discovery contract, rather than market. Could the new
regulations apply to a single contract traded on a market, but not the market as a whole?
In terms of trade data and position reporting requirements, the answer appears to be yes,
but in other areas, it is not clear. Since the electronic trading facility with a single
significant price discovery contract would be required to set up a market surveillance
operation to prevent manipulation, why would it limit that operation to a single contract?
It might enhance trader confidence and improve its competitive position by applying that
surveillance system to all trading.
The Farm Bill does not affect bilateral swaps that are negotiated between two parties
rather than executed on a trading facility accessible to multiple market participants. The
commodity swaps market is large and growing, and it can be argued that the logic that led
the CFTC to call for more regulation of electronic facilities — that such facilities were
economically linked to the regulated markets and used by the same traders — also applies
to the swaps market. The major dealers in commodity swaps also trade on Nymex
(leading Wall Street firms all have seats on the exchange), and it is very likely that major
commercial hedgers, such as oil companies, utilities, and transportation firms, also use
the exchange and swaps markets simultaneously. Speculators, like hedge funds and
investment banks’ proprietary trading desks, constantly seek out arbitrage opportunities
among the various markets.
It is not clear why, if the CFTC expects to benefit from more transparency in the
electronic trading facility market, it would not similarly benefit if new disclosure or self-
regulatory requirements were applied to bilateral swaps. However, in its October 2007
report on exempt commercial markets, the agency concluded that “staff experience in
surveillance of these markets [does] not suggest that the OTC bilateral or voice broker
energy markets exhibit significant price discovery attributes. Thus, their direct impact on
other parties and markets is limited. In addition, the non-standardized form and significant
size and dispersion of these markets would make it extremely costly and difficult to
extrapolate beneficial market surveillance information on a routine basis.”15
Further Legislative Proposals
Several bills before the 110th Congress propose to regulate or otherwise affect the
OTC bilateral energy swaps market. Several bills (H.R. 6330, H.R. 6341, H.R. 6372, and
S. 3134) would remove energy commodities from the category of “exempt commodities”
and place them on the same regulatory footing as agricultural commodities. This would
require that OTC energy contracts be approved by the CFTC before they could be traded.
H.R. 6264 would limit participation in the OTC energy market to firms that deal in
the physical commodities.
H.R. 3009, S. 577, S. 3131, and S. 3202 would impose new reporting requirements
on energy swap dealers and/or other OTC market participants.
Summaries of these bills are available in CRS Report RL34555, Speculation and
Energy Prices: Legislative Responses, by Mark Jickling and Lynn J. Cunningham.
15 Ibid, p. 20.