The Functions of Derivative Markets and the Role of the Market Regulator

Dr. Sharon Brown-Hruska, Commissioner
U.S. Commodity Futures Trading Commission

2006 Planalystics GasBuyer Client Conference

New Orleans, Louisiana

May 18, 2006

Thank you very much Paul for inviting me to New Orleans to have the opportunity to address you today. I should also credit Commissioner Nora Brownell of FERC, who introduced me to Paul and suggested that my frequent calls for risk management by commercial energy consumers would not be lost here. It is refreshing to meet representatives of so many significant companies that recognize the importance of hedging. I would also provide my support for the comments made by Chairman Fields that encouraged utilities to hedge energy price risks. In my view, prudent risk management is the best way to decrease the volatility of cash flows and to ensure that entities can innovate and focus on their primary enterprise, whether that is manufacturing or farming or power generation.

I am also pleased to return to New Orleans where, as Paul mentioned, I spent some years on the faculty of Tulane University. Like many who love this city, I felt a profound sense of remorse when the impact of the hurricanes began to unfold and continued to be revealed. More on point for my remarks today, however, I have always appreciated how critical the natural gas and other energy markets are to Louisiana and this region. The hurricanes also played havoc with these markets, particularly last fall and into the winter heating season. They were a critical explanatory factor in the record high natural gas prices we saw last December, and concerns about continued disruptions during the coming hurricane season have contributed to higher volatility and more extreme seasonal spreads being reflected in futures markets prices.

Before I get too far along, I should note that the views I express in my remarks today are my own and do not necessarily reflect the views of the other commissioners or the staff of the CFTC. I enjoy coming to conferences like this because of the opportunity it gives me to meet individuals like you who are dealing with risks in the marketplace. It often surprises me how many companies do not seek to manage commodity price risk. As mentioned, before coming to the CFTC, I was a professor of finance and risk management and derivatives markets, including futures and options markets, were my primary areas of study and teaching. Now as a regulator, my focus has been redirected somewhat in that I focus on how to protect and manage these markets to assure that they continue to function properly and effectively. It is also my desire to see these markets innovate so that they can provide market users like you with the tools you need to manage risks.

What I will talk about today are the functions of futures markets and what we do at the Commission to ensure that the markets function properly. Futures markets really serve two important functions. First, they allow hedgers to shift unwanted risks from themselves to other market participants who are willing to take it on. So, for example, if I am an exporter and I do not want to carry currency risk from my sales of products abroad, I can go to the futures market to hedge that risk. By doing so, I can concentrate on the business of selling products overseas and not have to worry about whether exchange rates are rising or falling. On the other side of those futures contracts, may be other exporters or importers who have the opposite currency risk that I face, or it may simply be a speculator, a hedge fund or a pension fund that wants to acquire the currency exposure that I want to shed. Hedging is important because it allows individuals and businesses to operate more efficiently. The futures regulatory scheme has developed with a purposeful bias toward protecting hedger’s interests, both on the supply and the demand side.

The second function of the futures market is that of price discovery and this also receives our attention as regulators. It is this function of the futures market that I would like to consider at some length today because of the focus on energy prices and the role markets, like the futures markets, play in determining those prices. In the course of hedging or speculating in futures contracts, market participants bring information to the markets. A participant who collects information on expected weather patterns and its effect on commodity prices—for example the impact of wet weather in the Midwest during the planting season, or the potential of a hurricane to close oil operations in the Gulf of Mexico—brings that information to the future markets every time he trades. When there exists an imbalance in views between those who think prices will rise and those who believe it will fall, prices will react accordingly until a new equilibrium price is reached. In the end, those who bring the best information regarding market fundamentals to the market will be financially rewarded for their efforts.

Price discovery is important on a number of levels. On one level, it is important because futures prices are often used by various industry participants to set the prices for the commodities they are buying and selling. In agriculture, as well as other sectors of the economy, it is quite common for a transaction to reference the futures price as the basis for a purchase or sale. For example, corn in Iowa may be quoted in terms of x number of cents above or below the Chicago Board of Trade futures price. Gas buyers often utilize the NYMEX monthly settlement prices to determine prices for swaps and physical transactions. Both sides are willing to reference such a price because they believe that the price is determined in a liquid, efficient and, importantly, transparent market. In this sense, the market represents a neutral agent in the sales negotiation. Compare that to something like the purchase of a car, where the sales agent is typically much more knowledgeable about the true value of the car he is selling than the purchaser is. So, futures prices can serve as an important means to facilitate commercial activity.

But in fact, the price discovery process that takes place in futures markets plays a much larger role in the economy than simply facilitating transactions. We know that prices allocate resources in the economy. Specifically, when prices of a particular good are high relative to other goods, we consume less of those goods and where possible use more of the cheaper goods or commodities. In part, this is what Adam Smith was referring to when he talked about an invisible hand guiding individuals to assure the best interests of the community at large.

Futures markets not only provide the prices that guide current consumption and production decisions, but because they trade out over extended periods of time, they aid in planning for future consumption and production decisions and guide intertemporal allocations. For example, looking at the current prices of December natural gas contracts over the next several years, we see that the December 2007 contract in the series peaks at about $11.00 per million Btus. Thereafter, the price of the December contract falls steadily through the 2011 contract where the current price is about $8.50 per million Btus. This tells us that the market expects that either production increases, imports of liquefied natural gas, conservation or a combination of these and other factors will conspire to lower future natural gas prices. Having this kind of collective forecast can be extremely helpful to producers and consumers in making plans involving the use of natural gas. Thus, we see that futures markets can be a veritable treasure trove of information that can be used to guide our activities.

From the perspective of a government regulator, I believe it is important that this function be protected so that the price signals being sent to the market accurately guide consumption and production decisions. As for what can happen when price signals are distorted or ignored, I like to tell the story of a kingdom that had the simple desire to be self sufficient in wheat production. There was only one problem. The country was a desert and fresh water was scarce. But while the country had little water, they had a lot of oil, and oil was valuable. So they sold the oil at high prices and subsidized farmers to produce wheat at up to eight times the world price. With such prices guaranteed for their wheat, farmers could afford to put in expensive irrigation systems and pump precious water into their fields. In the end they were successful. By 1984/1985, Saudi Arabia became a net exporter of wheat. Of course, this success came at a high cost. Agricultural demand for water, which represented about 90 percent of total water demanded in the country, greatly reduced the availability and quality of water in the kingdom. In effect, Saudi Arabia, through its agricultural subsidy program, undervalued its water and has struggled with the risk of running out. And as Ben Franklin said, "When the well's dry, we know the worth of water."

To me, this story suggests that we must be careful of how governments manage and regulate markets. For the past couple of years we have faced high energy prices. As often happens when a commodity’s price rises or falls precipitously, there are calls by consumers, producers, politicians and any number of other groups to do something about prices. Such calls to do something may be warranted if they deal with the root cause of the problem, which more often than not lies in the physical market conditions of the commodity in question—i.e. low production, high demand, transportation problems, etc. The markets are usually simply reflecting these problems.

Unfortunately, however, calls to do something often focus on the markets and on limiting trading in some way. Sometimes the call is to place limits on how far prices are permitted to move over a defined period of time. At other times there are calls to place limits on the amount of trading that certain individuals and entities—usually speculators—can do.

The concern that I often have with these proposals is that they make assumptions that may not be supported by the facts; they may be haphazard in their effect on market participants; and worst of all, they may distort the price discovery process, thereby masking the true problems in the marketplace, thus exacerbating the problem we are trying to fix.

As an illustration, consider the effect that price limits may have on the markets. The rationale for price limits is that if markets are overheated or irrational, such limits will give participants a chance to catch their breath and begin trading anew in a more rational fashion. On its face, this seems sensible. The problem is what happens if our assumption is wrong and the markets are not irrational? In that case, closing the futures markets shuts all traders, including hedgers out of the market. It also precludes speculators and market makers from exiting positions, thereby placing a financial strain on the clearing system. And closing the markets shuts down the price discovery process, which as I have noted has implications for the broader economy. So when it comes to considering market constraints such as price limits, we must be careful that the solution to our perceived problem does not exacerbate it.

At the CFTC, we appreciate the value and role that the futures markets play in the economy and make it a priority to assure that the markets are fair and do their job in discovering prices. The main way that we accomplish this is through our market oversight and surveillance programs. The market oversight staff continuously monitors the terms and conditions of contracts being offered by the exchanges and considers underlying market factors that may affect the functioning of a contract. For example, staff will look at the expected level of deliverable supplies and market infrastructure at the delivery points of a contract to assure that conditions do not exist that would allow a contract to be easily cornered or squeezed. If such conditions should exist, the staff will work with the exchanges to develop remedies to the situation.

Once contracts are trading, the market surveillance program of the Commission bears the responsibility for monitoring trading activity. The market surveillance section employs a staff of about 45 economists and analysts who continuously monitor activity on the futures exchanges. The heart of the program relies on what we refer to as the Large Trader Reporting System. This system captures the end-of-day position of every trader who has a reportable position. For example, the reporting level for natural gas is 200 contracts. That means that every trader in the natural gas market that has a position that is equal to or greater than 200 contracts will have his position reported to the Commission. While the reporting levels are fixed from one day to the next, they are adjusted periodically to assure that the CFTC captures from 70 to 90 percent of all positions in a particular market.

Using these reports, the surveillance staff looks for unusual concentrations or the coordination of trading by groups of traders who may be attempting to manipulate the markets. The surveillance staff will also focus on the largest of the traders in the markets as trading nears expiration to assure that the markets are liquidating in an orderly fashion. For example, if the staff notices that a large trader is holding onto a position and not liquidating, they may contact the trader to find out his intentions. Is the position a hedge or a speculative trade? Does the trader have the capacity to make or take delivery? Does it make economic sense to hold the position?

In addition to collecting this information and contacting traders in the markets, the staff routinely reports its findings to the Commission. Every week, the staff identifies those contracts deserving the most attention and briefs the Commission on activities in the markets. As you may well guess, over the past couple of years the oil and gas markets have garnered the most attention. Other contracts that have involved close monitoring were the expirations of some of the treasury-note futures contracts due to wide spread between the contract coupon rate and the actual rates, and price movements in the cattle markets around the announcements of mad cow disease in Canada and United States.

During the weekly surveillance briefings, the staff presents an analysis of current market conditions, including physical market activity related to such things as storage and usage figures, imports and exports, production expectations, weather forecasts—whatever information may be important to understanding current price trends in the markets. Also, they will review the large trader reports and present any other relevant information regarding the intentions of the major players in the markets. With the growth of hedge funds and other large speculators, the staff has also continued to closely track activity to ascertain what impact these participants individually and as a group may be having on the markets. To date, the staff’s findings have shown that these large speculators tend to support liquidity in the markets rather than having a detrimental impact on price movements.

But surveillance is really just the first line of defense in the marketplace. Wherever money is involved, there will of course be those who would like to take advantage of the situation. When participants attempt to manipulate the market or otherwise interfere with the pricing process, the CFTC maintains an enforcement program to prosecute wrongdoers. Back in 2002, we found it necessary to move aggressively to protect the markets from false price reporting and the intentional manipulation of natural gas price indexes. The false price reporting that was taking place involved natural gas traders who were attempting to influence the value of reported price indexes published by various trade publications. Because these indexes were being widely used by industry participants, as well as traders in the natural gas futures markets, these traders hoped to influence the value of the indexes so that trades or contracts based on those prices they were entering into would be positively affected.

When news of the false reporting got out, there was a very negative effect on the over-the-counter market because the price discovery and transparency mechanisms relied upon by many—in particular index reporters—could no longer be trusted. In fact, a good deal of trading activity moved to the regulated exchanges where the markets were generally free of these abuses. Even more significant, the Commission had an interest in protecting the price discovery process of the futures markets because these published prices indices were a part of the information base that traders relied upon in making trading decisions in the futures market.

The end result was that the Commission held to account numerous companies and individuals who false reported, manipulated, or attempted to manipulate natural gas prices. Since 2002, we have investigated over 40 major energy companies and a number of individuals for alleged violations. Thus far, the Commission has filed over 20 actions and collected over $300 million in civil monetary penalties. In cooperation with the FERC and the Department of Justice, the Commission took action under provisions of the Commodity Exchange Act to penalize those entities and individuals who took part in the misreporting.

In the end, the goal of the CFTC is to assure that fair and competitive markets exist—it is not and it should never be to influence price outcomes unless it is to stop a manipulation of the market. I firmly believe that by assuring that markets are efficient and that those participating in them are assured they are getting a fair shake, it allows the markets to innovate and offer new products to its customers. And judging by the number of new contracts and trading structures we are seeing offered in the marketplace today, and the explosive popularity and volume of these contracts, the confidence in the markets has been restored reflecting the overall feeling that these markets do offer a fair game.

One area where we have observed some novel products is with respect to weather derivatives. I had the chance to sit down last week to talk with Paul Corby to learn more about Planalytics and what they do for their customers, and I found it both fascinating and impressive. Paul also shared with me some of the materials Planalytics produces on hurricane forecasts. We have always known that, in the physical commodities, weather often plays a critical role in pricing. For agricultural commodities, rain and temperature combinations typically make the difference between bumper crops and low prices, on the one hand, and production shortfalls and high prices, on the other. In the energy markets, cold winters drive up the price of natural gas, while a cool summer can put an equal chill on the market.

Thus, we know that weather plays an important part in commodity prices and individuals and firms can in essence hedge their exposure to weather through the use of commodity futures. But we have also seen a growth in derivatives that allow hedgers to directly hedge weather through weather derivatives. The Chicago Mercantile Exchange, for example, lists derivatives based on temperatures for various cities around the U.S. and abroad. These contracts typically have payouts tied to variations in heating or cooling degree days in these cities. Other weather derivatives have been based on rainfall totals over select periods. I find the development of these types of contracts fascinating as financial engineers have been able to more precisely identify risks and thereby design contracts that more precisely target risks that hedgers and risk managers want to eliminate. The markets for these derivatives also give us better information about the particular risks we face.

Another area which has seen the development of novel products is event markets. Generally speaking, event markets bring together participants to form an opinion about the expected outcome of a certain event. These markets were pioneered at the University of Iowa in the early 1990s when they developed a market in presidential election results. The idea back then was to give students an opportunity to learn how markets operated by allowing them to trade presidential candidates using real money. The prices for candidates reflected the market’s assessment of the likelihood that a particular candidate would win. To date, the Iowa Electronic Markets has proven quite prescient in predicting political races.

Since then other groups and companies have taken an interest in developing these types of markets as a way of gathering information regarding the likelihood of a certain event occurring. Events might be the likelihood of a hurricane striking a specific area, a movie exceeding a specific box office take, a new product attaining a certain level of sales. Longitude, in its venture with Goldman Sachs, offers a market that allows users to take positions based on their expectation of the natural gas and crude oil inventory statistics. In essence, these markets would rely upon the price discovery function that markets typically perform so well and as I have described today. Whether they also provide a hedging function like futures markets and should be similarly regulated has perplexed the Commission and the staff are continuing to consider issuing guidance as to whether these markets fall under its jurisdiction or not. Needless to say, that determination will have a great effect on these nascent markets. For this reason, I would reiterate my earlier point that regulators must be very circumspect about the impact their policies can have on markets and their vital utility to the public.

Thank you for the attention you have given me today. As I said at the outset, it is my pleasure to be here and I welcome any questions you may have.

Last Updated: April 18, 2007