One of the most frightening scenes from the financial crisis unfolded in the staid environs of the Commodity Futures Trading Commission’s Washington offices, where the regulators charged with monitoring derivatives trade gathered together the heads of commodity trading from recently shamed Wall Street giants like Goldman Sachs and Morgan Stanley.
The CFTC was a comparatively sleepy DC institution before the financial crisis brought the role of unregulated or lightly-regulated derivatives markets to light at the same time that oil prices were sticking well above $100/barrel, in seeming defiance of the cratering global economy. The scary part wasn’t the meeting of bankers and regulators, or even the terrible office lighting that contributes to the feeling of vague hopelessness bureaucratic buildings often engender.
The scary part was that the regulators – charged with overseeing what was coming to light as trillions of dollars in market activity – had almost no idea what they were dealing with. Their questions continued to move farther and farther away from the specifics of trading activity to the basics of market function; how exactly did energy trading desks operate, they wanted to know? What was the relationship of the oil futures market to the physical price of gasoline?
How could the very people appointed to oversee these markets have so little idea of what was going on? The scale of any individual problem was buried in the obviously overwhelming lack of understanding of what was happening in these markets on a day to day basis. The regulation that would eventually emerge in the wake of that hearing and others like it was designed to improve transparency, but a fundamental logical flaw remained ingrained in the relationship.
In regulating markets, everything that isn’t illegal is traditionally just market activity. And monitoring market activity in commodities – which, unlike equities, are often traded and priced entirely away from public exchanges – is incredibly difficult and complicated, especially when the regulator doesn’t have a clue to how that trading even works. Even with access to data hugely expanded, trading experts say that CFTC commissioners would have a hard time explaining how their markets functioned without relying on anecdote rather than data.
That means regulators often need to find something illegal just to husband the resources necessary to figure out how something works.
That dynamic is at play in the oil and biofuels markets right now, where EU investigators are, in actions closely monitored by their US counterparts, raiding oil companies in search of evidence of manipulation of energy prices. Linked to both unresolved allegations of price manipulation by a high-profile former employee of a price reporting agency (PRA) and the internal energy sector debate over the methodologies used by different PRAs, the investigation of trading and price reporting activity at companies that include Shell, BP and Statoil is a perfect example of a fishing expedition.
Energy traders privately say that the statement by Total CEO Christophe de Margerie is probably closest to the truth: “The system isn’t perfect but that doesn’t mean there’s price fixing.”. Trillions of dollars in energy prices are still set every day in processes largely invisible to regulators, who are increasingly jumpy about the return of systemic threats to the global economy.
Yet again, regulators are forced to accuse before they examine. There is surely a better way.
In the US, the CFTC – which, to use Donald Rumsfeld’s phrase, is now more aware than before of its ‘known unknowns” and “unknown unknowns” – is trying to take a more collaborative approach to shedding light on opaque energy trading.
The Commission has issued more requests for information and comment, partially propelled by its writing of Dodd-Frank rules and partially following the example of their colleagues up the road at the Federal Energy Regulatory Commission. FERC staffers have never seen a NOPR (notice of proposed rule making) they didn’t like, and the process of formally gathering comment instead of launching an investigation, while unwieldy, has prevented another Enron-level failure in the still-Balkanized US power sector.
The Dodd-Frank rules require an increased level of trading through exchanges, and the CFTC is still worried that exchanges of swaps for futures may be circumventing the intent of that rule to improve market transparency and stability. But rather than raid anyone’s desk yet, the regulators went out with a call for help from the industry, seeking to better understand what they didn’t yet.
That terrifying hearing in the wake of the financial crisis may have just taught the Gensler-era CFTC something.
The entire energy trading sector would benefit from a less antagonistic and paranoid approach, one in which markets can still innovate and adjust to changing circumstances while regulators can still oversee and guarantee equal access. Perhaps the next chairman (or chairwoman) can craft the right compromise.
Author’s Note: Peter Gardett was previously employed by a price reporting agency, and covered the CFTC, FERC and the Wall Street banks as a financial journalist.
