11/07/2014 12:27 pm ET Updated Jan 07, 2015

A Matter of 'National Security' (and Beer)

Congress approved the Dodd-Frank Wall Street Reform Act in response to world financial calamity. Though delayed and diluted, the reform legislation has led to substantial improvements in consumer protections such as new requirements for regulation of swaps contracts. So those who seek to undo any of the popular reforms would need a pretty good excuse. Commissioner Christopher Giancarlo of the Commodity Futures Trading Commission (CFTC) offered this reason for a newly proposed rollback: national security.

"National security" is at stake, he said at a Commission meeting Nov. 3, referring to a tongue twisting issue involving "embedded volumetric optionality." Giancarlo, the newly confirmed Republican on the commission, which regulates the high-risk derivatives market, explained himself with a story. He recently visited a Kentucky aluminum smelter. They sell aluminum to many firms. Some make beer cans; some make US fighter jets. The Kentucky firm competes globally for such business.

To power the plant, the aluminum smelter buys energy. Often, it buys energy for actual future delivery in contracts called "forwards." Forwards are subject to conventional trade law. Disputes are settled in court. If, however, these contracts contain provisions that allow for options, such as the option to sell to another buyer on an exchange and could be used for speculation, they legally become known as "futures." Then these energy contracts are regulated by the CFTC.

Being regulated by the CFTC, according to Giancarlo, is such a competitive disadvantage that it would threaten the existence of the Kentucky smelter. That means no Kentucky-made aluminum for US fighter jets. That means no US fighter jets. And that would mean no "national security." Actually, Giancarlo didn't itemize the damage to the overall US fighter jet supply, but he did invoke national security. As such, surely he exaggerates.

Volumetric optionality simply means that an options contract to purchase commodities allows the purchaser to receive a varying amount of the underlying product. The prevailing CFTC guidance allows such an agreement to be considered an "unregulated contract" only when the volume may be affected by physical factors beyond either party's control--for example if a fire destroyed half the trucks needed to transport the commodity.

What the industry seeks and what the CFTC is now proposing is to release more contracts from oversight by broadening the definition of "optionality." The newly proposed language provides that a unregulated "forward" contract "must be primarily intended . . . to address physical factors . . . that reasonably influence demand for, or supply of, the nonfinancial commodity." In other words, if a Minnesota power plant needs less natural gas owing to a mild winter, the forward option can provide that they purchase less than the maximum under the contract, and such a contract would no longer be subject to regulation by the CFTC.

By excluding these types of contracts from CFTC oversight, experts are concerned this arena might become an alley for bad actors who thrive in the dark. Think Enron. Enron exploited a 1993 loophole that arguably wreaked havoc with consumer energy prices. It's not clear what games a modern-day Enron might play with the proposed exclusion from CFTC oversight of the volumetric optionality forward. But lack of oversight has invited manipulators before.

CFTC Commissioner Sharon Bowen shares this concern and invokes the same historical misadventure. In comments at the Nov. 3 meeting, she noted, "In 1993, one Commissioner [well known financial reformer, Sheila Bair,] cast the lone dissenting vote. . . . She argued that exempting energy derivatives from regulation would . . . leave the public unprotected. Today's proposal seems to go farther.. . . . Whereas with an exemption, there is the ability to later tailor it to fit the precise needs of the market and the public, there is no turning back from an exclusion."

Be careful of broad exclusions, Bowen warns. Better to allow temporary exemptions, where the CFTC can more readily reverse course if necessary. Instead of the permanent volumetric optionality exclusion, Bowen urges the commission to finalize its proposed revocable exemption for what it calls "trade options." Trade options would still include the ability to accept varying volumes of a commodity while keeping these contracts within CFTC oversight by requiring disclosure. Users of the trade option exemption must simply complete an annual form listing name of firm, name of commodity, and amount of commodity delivered in the previous year.

Such accountings would hardly be a burden for a Kentucky aluminum smelter. It's a "much clearer and cleaner approach," concludes Bowen. The exemption would leave markets less inviting to a new Enron because of disclosure while providing for national security and beer.