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No More Enrons: Derivatives

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REGULATING DERIVATIVES

Enron's "asset-lite" business strategy relied heavily on the use of energy derivatives (financial instruments such as futures, forwards, options, swaps and structured securities which are used to hedge or speculate on the change in value of an underlying asset) and other highly speculative financial instruments. The company created new markets with all kinds of financial instruments related to pollution rights, online credit and even the weather.

Enron used derivatives as part of its scheme to defraud the market through false reporting, manipulation of accounting rules and misrepresentation of income. When the misdeeds were exposed and Enron's credit rating was downgraded, market participants ceased to trade with the company, leaving it without the liquidity and volume that turned bid-ask spreads into earnings. By the time it failed, Enron's derivatives liabilities exceeded $18 billion.

By establishing and running trading markets Enron basically operated as an unregulated financial institution. Financial institutions that broker exchange-traded futures and options are normally subject to some basic soundness and transparency requirements. But Enron and similar over-the-counter derivatives dealers were not. Enron had no capital requirements, no margin or collateral requirements, no licensing or registration requirements, no reporting requirements and no obligation as a dealer to make a market by maintaining bid and ask quotes as "specialists" on stock exchanges are required to do.

Enron's friends in government played a key role in bringing this situation about, particularly when it came to deregulating energy derivatives. As chair of the Commodity Futures Trading Commission, Wendy Gramm helped deregulate Enron's energy-swap operation in 1992. Once the exemption, which sheltered the company from government oversight, was in place, Gramm resigned from the commission. Weeks later, Enron appointed Gramm to its board of directors. Enron compensated Gramm from $915,000 to $1.85 million for her 1993 to 2001 tenure on its board.

In 2000, Senator Phil Gramm (Wendy's husband) co-sponsored the Commodity Futures Modernization Act, a measure deregulating certain kinds of futures trading, including energy futures. The act reduced the level of transparency and the government's ability to monitor exchange-traded derivatives. It completely eliminated any federal regulation of the over-the-counter derivatives market, leaving Enron to operate unsupervised. Attached as a rider to an 11,000-page appropriations bill, the law went through with little scrutiny. (See "Gramms and Enron: A Mutual Aid Society," by Elaine S. Povich, Newsday, February 10, 2002)

Enron's excessive use of derivatives was by no means unusual. As former derivatives salesman and law professor Frank Partnoy suggests in his book, Infectious Greed, derivatives played an important role in most of the major financial scandals of the past decade, including the collapse of Barings Bank, the bail-out of Long Term Capital Management and the Orange County, CA. But the widespread use of these complicated financial instruments by rogue traders and even Fortune 500 companies has created a much greater risk of system-wide collapse. That's why Warren Buffett has described derivatives as "ticking time bombs."

Given their abuse by speculators, most derivatives should probably be banned. At a minimum, all over-the-counter financial instruments such as the derivatives should be subject to the same audit and reporting requirements as other financial instruments traded on the stock exchanges. Reporting requirements make the markets transparent and allow for the detection of serious problems before they become a social crisis. Derivatives dealers should be licensed and registered just like other securities dealers, bankers and traders in exchange-traded derivatives. Regulatory parity would also require capital and collateral-margin requirements that would prevent problems at one firm from causing entire markets to freeze up or melt down.

Related Legislation:

Market Oversight Consolidation and OTC Derivatives Regulation Act (H.R. 1109), introduced by Rep. Peter DeFazio (D-OR).

For More Information:

Derivatives Study Center
Testimony of Prof. Frank Partnoy before Senate Government Affairs Committee (1/24/02)
"Financial Derivatives: Action Needed to Protect the Financial System" GAO Report from May 1994 (GAO/GGD-94-133)

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