Regulating
‘Excessive’ Speculation
The regulatory gap between the two main energy markets worldwide, NYMEX and ICE, is likely to
be substantially reduced if new regulation is passed in the United States.
By Carlos Blanco & Anita M. Herrera
AFTER A NINE-MONTH investigation, the US Senate issued a report 1
that focused on the activities of two hedge funds, Amaranth and
Centaurus, during 2006. The report’s main conclusion is that Amaranth
was attempting to manipulate the futures markets by taking large posi-
tions in natural gas derivatives in New York Mercantile Exchange
(NYMEX) and IntercontinentalExchange (ICE) before losing over US$6
billion after their trades soured in September 2006.
Until recently, calls for increased regulation on energy derivatives
transactions could not be easily justified. Even though hedge funds and
other investors in energy and commodity markets have been routinely
blamed by politicians and other pundits for the price increases as well as
... the empirical evidence has been mixed regarding
the role of speculators in energy markets
the temporary periods of high volatility experienced in recent years, the
empirical evidence has been mixed regarding the role of speculators in
energy markets. For example, academic studies have not concluded that
increased speculative transactions in energy markets reduce or increase
the amplitude of price fluctuations around equilibrium levels. On one
side, speculators may exhibit herd behaviour at times and may have an
impact in terms of amplifying price trends. However, for speculators to
Trading Illustration
10 SEPTEMBER 2007 COMMODITIES NOW
stay in business, they have to buy low and
sell high and as they trade against each
other, they can not all be long or short.
The current disparity in regulation
between NYMEX and other exchanges
such as ICE results from the “Enron loop-
hole” inserted in 2000 into the US
Commodity Exchange Act. The ‘loophole’
refers to a provision requested by Enron
and others that created electronic energy
exchanges, such as ICE, that are exempt
from oversight by the Commodity Futures
Trading Commission (CFTC) because only
qualified participants may trade on these
exempt exchanges. As a non-regulated
exchange, ICE is not subject to certain
CFTC requirements such as the market
surveillance program, even though that
may soon change.
Regulated exchanges and traders are
required to report end-of-day positions for
traders above certain thresholds set by the
CFTC. Additional reports provide overall
trading information that enable the CFTC
to identify discrepancies with the large
trader reports. However, with the growing
role of electronic exchanges in the world
of energy trading, the effectiveness of the
CFTC’s market surveillance program to
identify manipulation and misconduct
through daily “large trader reports” has
been called into question in recent years.
The main reason is that the CFTC only has
access to incomplete information.
Although the CFTC may selectively make a
“special call” to request trading informa-
tion from non-regulated exchanges,
including over-the-counter transactions 2,
non-regulated exchanges are not – as a
rule – required to provide any information
that would justify making the “special
call” in a timely manner to allow the CFTC
to take preemptive measures with regards
to excessive speculation.
Therefore, the information regularly
received by the CFTC may not be particu-
 REGULATION
Figure 1: Amaranth Positions Before & After NYMEX Directed it to Reduce Positions
Before:
For example, the report states that, “on August 8th NYMEX instructed Amaranth to reduce its NYMEX positions in the
September and October futures contracts. Amaranth complied with the NYMEX order but increased its positions in the
related ICE swap contracts, thereby maintaining – and even increasing – its position and risk profile for those months.”
Sources: NYMEX, ICE.
larly useful for analysing energy deriva-
tives market activity because no routine
information is obtained from the non-reg-
ulated markets, such as ICE. The CFTC
market surveillance program relies on a
system of timely data in order to preserve
the markets’ hedging function and price
discovery role.3 As the CFTC asserts: “Only
• Although Amaranth was technically a multi-strategy hedge
fund with positions across asset classes, by 2006 it had devoted a
large fraction of its risk capital to natural gas trading.
• Natural gas has offered hedge funds a potentially alluring
combination of scalability and volatility, and so has attracted a
number of non-traditional financial participants during the past
three years, including Amaranth once other arbitrage opportunities
had become less lucrative.
• Commodity derivatives markets are relatively small compared
to global asset values, so it is possible for even one large hedge fund
to overwhelm these markets. This arguably happened with
Amaranth’s large-scale natural gas trading.
• The US regulatory umbrella, covering energy trading, has had a
noteworthy gap in coverage. The exchange-traded futures markets
are explicitly regulated by the CFTC and the physical natural gas
markets are explicitly regulated by the FERC. But over-the-counter
energy derivatives trading, until now, has not been subject to the
same regulatory scrutiny. It was on such platforms that Amaranth
carried out a substantial fraction of its trading.
• Unlike the LTCM crisis, counterparties did step in quickly to
assume Amaranth’s positions, which immediately stabilised the
natural gas market.
• At the time of Amaranth’s implosion, the reason that there were
not worries of wider systematic failure is that Amaranth’s core risk
positions were not similar to those held by the international money-
center banks. In the case of LTCM, its positions were highly
correlated to those held by money-center banks, meaning that
LTCM's distress would become everyone’s distress.
Hilary Till, EDHEC Risk and Asset Management Research Centre.
12 SEPTEMBER 2007 COMMODITIES NOW
After:
by properly identifying and aggregating accounts can the surveillance
staff make a thorough assessment of a trader’s potential market impact
and a trader’s compliance with speculative position limits.”4
Currently, as the Senate report concludes, there are two critical regula-
tory flaws. The first is that NYMEX, as well as the CFTC, are limited in
their ability to determine whether traders’ positions are too large
because it has no regular access to traders’ positions on ICE. Second,
even if NYMEX or the CFTC requires a trader to reduce its positions, the
trader can shift its positions to ICE where the positions will not be mon-
itored. Amaranth moved its natural gas positions to ICE in August 2006
when NYMEX ordered it to reduce its positions in two contracts nearing
expiration for delivery in September and October 2006 (Figure 1).
ICE refutes the conclusions of the Senate report calling for additional
regulation by responding that it has instituted a large trader report for
the CFTC.5 The CFTC used its “special call” authority in October 2006 to
obtain information from ICE regarding clearing member position data
for cash-settled contracts that were based on NYMEX natural gas con-
tract prices. However, special calls are typically issued after the fact and
the CFTC emphasises that such special calls are not issued to conduct
regular market surveillance of ICE.6
NYMEX, as well as the CFTC, are limited in
their ability to determine whether
traders’ positions are too large
On July 25th 2007, the CFTC charged Amaranth and Brian Hunter, its
former natural gas trader, with attempted manipulation of the natural
gas futures market based on information the CFTC subsequently
received regarding Amaranth’s natural gas swap positions on ICE. The
complaint alleges that Amaranth intended to lower the price for the
March and April 2006 NYMEX natural gas futures by selling off their
large NYMEX futures position just before the last day of trading in the
previous month. Amaranth’s swaps on ICE were based on the NYMEX
natural gas futures price determined by the trading before the end of
the previous month.7 The day after the CFTC filed its charges, the
Federal Energy Regulatory Commission (FERC) exercised its anti-manip-
ulation enforcement authority by issuing a show cause order to
Amaranth and traders Brian Hunter and Matthew Donahoe. Amaranth
 REGULATION

and the traders have 30 days to show FERC why they should not be sanc- Removing the Enron loophole as well as
tioned with civil penalties and forced to disgorge profits totalling increasing disclosure requirements on ICE
US$291 million for trades in February, March, and April 2006.8 and other unregulated exchanges are the
most likely first steps. Any additional
The regulators now face the challenge of increasing measures will require carefully review and
evaluation to ensure that the cure of
the effectiveness of their oversight activities without
increased regulation is not worse than the
forcing market participants into unregulated disease caused by market failure •
bilateral OTC markets
Carlos Blanco, Ph.D. is Managing
Director of Black Swan Risk Advisors, LLC.
Ultimately, ICE may need to participate in the CFTC large-trader
He is also a lecturer on Risk Management
reporting system so that the CFTC can assess the potential market
at the University of California, Berkeley
impact of large speculative positions. The regulators now face the chal- and a faculty member of the Oxford
lenge of increasing the effectiveness of their oversight activities without Princeton Programme.
forcing market participants into unregulated bilateral OTC markets. E: carlos@blackswanrisk.com
Anita M. Herrera, President of OTC Legal
Footnotes: LLC., is an energy and derivatives lawyer
1 “Excessive Speculation in the Natural Gas Market” Staff Report (with additional minority
staff views). Permanent Committee on Investigations. United States Senate. 2007 based in Washington, DC. OTC Legal and
2 7 U.S.C. § 6g(d). Black Swan Risk Advisors provide risk
3 Commodity Futures Trading Commission, “Backgrounder: The CFTC's Large-Trader management, regulatory, compliance,
Reporting System”, CFTC website: www.cftc.gov/opa/backgrounder/opa-ltrs.htm transactional tax solutions and
4 Commodity Futures Trading Commission, “Backgrounder: The CFTC's Large-Trader
Reporting System”, CFTC website: www.cftc.gov/opa/backgrounder/opa-ltrs.htm
documentation services, including master
Section 4a(a) of the Commodity Exchange Act authorises the CFTC to establish speculative agreements for trading energy
limits on commodity futures contracts. commodities and derivatives.
5 ICE Rejects Amaranth Criticism. Financial News, 25 June 2007.
E: aherrera@otclegal.com
6 See CFTC letter to Senator Jeff Bingaman, February 22, 2007, pp. 3, 7.
7 US Commodity Futures Trading Commission Charges Hedge Fund Amaranth and its Reference:
Former Head Energy Trader, Brian Hunter, with Attempted Manipulation of the Price of Blanco, C. ¶ Herrera, A., “Lessons from
Natural Gas Futures, CFTC Press Release 5359-07, July 25, 2007. recent hedge fund liquidations”.
8 Commission takes preliminary action in two major market manipulation cases, FERC The Risk Desk, April, 2007.
News Release, July 26, 2007.

Rolf & Nolan