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The Wall Street Journal: Without Borders Global Exchanges Security Risk

Without Borders
Global Exchanges
Pose a Quandary
For Securities Cops

Nymex’s Squabble With Rival
Over U.K. Rules Spotlights
Issues for NYSE Merger
A Dinner Proposal Falls Flat
June 5, 2006; Page A1

As financial markets grow more electronic and international, a big question looms: Who should regulate them? More bluntly: Who’s in charge if there’s a market meltdown?

That issue is now in the spotlight as the operator of the New York Stock Exchange sets plans to merge with Euronext NV, creating the first trans-Atlantic linkup of stock and derivatives markets. To understand how messy the regulatory questions can get, take a look at the dispute swirling around an electronic trading network known as ICE. Based in an Atlanta office park, it matches buyers and sellers of energy contracts around the world.

For more than five years, ICE (IntercontinentalExchange Inc.) has chipped away at the 134-year-old New York Mercantile Exchange, a traditional market where brokers and traders in giant Manhattan pits use hand signals and shout orders to each other. In February, ICE took aim at Nymex’s signature product — a futures contract on West Texas Intermediate crude. It quickly captured 25% of that market.

Nymex claims ICE owes much of its success to a regulatory quirk. Thanks to its purchase of a London petroleum market, where ICE later shut down the trading floor, ICE is overseen by regulators in the United Kingdom, not the U.S.

ICE says the British oversight is proper, since energy products are global and the U.K. has sophisticated regulators. Nymex and its backers in Congress have cried foul. They call it “regulatory arbitrage” — shopping for a more lenient regulator. Unlike U.S. rules, the U.K. rules that govern ICE’s futures business don’t impose limits on the size of positions, or have the same stringent reporting requirements on super-large trades that govern Nymex traders. Nymex wants a “level playing field,” says James Newsome, the Nymex chief executive.

Right now there’s no formal legal framework for regulating exchanges that cross national borders. Regulators around the world are scrambling to establish ties and figure out how to proceed. The process isn’t easy: Most regulators aren’t only national officials, they tend to be nationalistic, believing their rules are better than those of other countries.

In recent months, U.S. regulators have engaged in a flurry of discussions with their counterparts in other countries. Securities and Exchange Commission Chairman Christopher Cox, who has said that exchange consolidation is “inevitable,” has begun consulting with rulemakers in countries ranging from the U.K. to South Korea to China.

In Europe, cross-border mergers have already prompted regulators to collaborate. A big spur has been Euronext, a Dutch holding company that operates exchanges in London, Amsterdam, Paris, Brussels and Lisbon. Each country’s regulators handle domestic-only issues, but they have formed a “college” of regulators from the five nations to handle cross-border issues and harmonize some trading rules.

Executives at the NYSE and Euronext say little will change at the grassroots level in how markets are regulated under the new combined holding company. European companies still will list their shares for trading on the European exchanges that are units of the new combined company. Those European exchanges will still be overseen by individual national European regulators, which cooperate but are still technically separate. In the U.S., the SEC will still oversee the NYSE but won’t have a direct say over Europe, except in that it will oversee the parent company since it will be headquartered in New York.

Still, regulators are planning adjustments — more sharing of information, for example — to prepare for the first major trans-Atlantic exchange deal, according to NYSE officials who have spoken with regulators in recent weeks. One senior regulator in the U.S. compared the cooperation with that seen between different state regulators who have different agendas but often work together under an umbrella group, the North American Securities Administrators Association.

Electronic commodity trading networks are a particularly thorny case for regulators. They have no physical presence, like a trading floor. They play in global markets such as oil and gold. In the U.S., the Commodity Futures Trading Commission, created in 1974 to oversee commodities futures and options markets, has wielded a relatively light hand in dealing with overseas markets that have some operations in the U.S. Congress has renewed and expanded the agency’s mandate several times but never spelled out when a “foreign” exchange’s activity would subject it to U.S. oversight, giving the agency wide berth to make rulings case by case.

The CFTC’s chairman between 2001 and 2004 was none other than Mr. Newsome, who has a Ph.D. in agricultural economics. In his current job as head of Nymex, Mr. Newsome is urging the CFTC to regulate ICE’s latest petroleum futures offering. As CFTC chairman, however, he welcomed international competition. During his reign, the CFTC staff issued a number of so-called no-action letters, giving foreign exchanges the green light to expand into the U.S. with home-country regulations intact.

One of the beneficiaries of Mr. Newsome’s free-market regime was an engineer named Jeffrey Sprecher. In the mid-1990s, he was a power-plant developer based in Newport Beach, Calif., looking for a way to sell power. He says he concluded it should “be done on a computer, because I was an engineer and we were in the computer age.”

In 1997, he bought a company that he wanted to use to improve trading in electricity and natural gas, which he viewed as an unorganized regional patchwork. He later retooled it into an energy exchange that eventually became ICE. It helped big players, ranging from oil companies and utilities on one side to banks and speculators on the other, match over-the counter orders on a dizzying array of contracts.

As others, such as Enron Corp. and Dynegy Inc., scrambled to set up similar electronic trading platforms, Mr. Sprecher, now 51 years old, lined up 13 major investors, including Royal Dutch Shell PLC, BP PLC and Morgan Stanley.

One potential investor that didn’t bite was Nymex. In early 2000, Mr. Sprecher pitched his plan for an electronic commodities market to the Nymex board at a dinner meeting. It began cordially but ended almost as soon as he finished his pitch. “They literally had me escorted out the door,” says Mr. Sprecher of the incident. Current and former Nymex officials confirm the meeting was tense, but say Mr. Sprecher wasn’t escorted out. One recalled he was asked to leave.

ICE and Nymex initially competed only indirectly. Nymex traded regulated futures contracts — the standardized and easily tradable agreements to buy or sell a financial asset or commodity on a fixed date in the future. ICE grew in the vast, largely unregulated over-the-counter market where large utilities and power providers trade complex contracts tied to everything from natural gas to electricity.

Then ICE started to expand internationally. In 2001 it bought the petroleum exchange in London where Brent crude-oil futures are traded. The London exchange already had one no-action letter from the CFTC back in 1999, letting it put electronic trading terminals in the U.S. while still falling under U.K. regulation.

In 2002 and 2003, the London exchange, later renamed ICE Futures, made several amended requests to the CFTC to expand its U.S. presence while remaining under U.K. rules. The agency — still under Mr. Newsome’s leadership — granted these requests.

In recent years, the CFTC has allowed non-U.S. exchanges to make electronic systems available to customers in the U.S., while allowing foreign regulators to be the primary supervisors, essentially outsourcing the regulatory function. However, as Nymex points out, some foreign entrants have been subject to U.S. regulation. Those include Eurex, the German- and Swiss-owned derivatives exchange, which formed Eurex US, under CFTC oversight, to launch trading in U.S. Treasury bond and note futures in early 2004.

The agency is “in the cross hairs of policy crosscurrents that we need to reconcile,” says Reuben Jeffery, chairman of the CFTC. “These issues of globalization and competition, born of seamless technology, they are ‘now’ issues and will only grow in significance in the years to come.”

In 2005, ICE shut down the physical trading floor in London and went all-electronic. With revenue and profit rising quickly, ICE went public on the Big Board last November at $26 a share, and closed at more than $39 a share in its first trading day. ICE was trading at $54.77 in 4 p.m. composite trading Friday.

Fast-rising crude-oil prices and volatile natural-gas prices also were helping Nymex post record volumes. In early 2006, with ICE Futures already dominating crude-oil contracts in London, Mr. Sprecher announced plans to take direct aim at Nymex’s West Texas crude-oil futures. Unlike Nymex’s contract, the ICE version can’t involve delivery of actual oil, just cash settlement of each contract tied to the price of West Texas crude.

In January, ICE applied for CFTC permission to have the West Texas Intermediate contracts regulated the way all of its ICE Futures business is regulated, by Britain’s Financial Services Authority. ICE’s CEO, Mr. Sprecher, says that it would be cumbersome to have two sets of regulators.

Nymex claims the U.K. regulations, including no limit on the size of positions investors can take, are an incentive for some big hedge funds to abandon Nymex for ICE. ICE responds that the market doesn’t need position limits because its contracts guarantee a settlement in cash instead of physical delivery of oil like Nymex’s.

To Mr. Sprecher, the regulatory squabble is in large part an effort by Nymex “to slow us down.” Nymex says that’s not true and points out it picked up its argument about ICE’s U.K. regulation only after ICE shut down its London-based floor, which made the jurisdiction of U.K. regulators seem questionable.

In a five-page letter to the CFTC in late January, Nymex general counsel Christopher Bowen argued that WTI crude oil “is a U.S. product,” drilled and produced in the U.S. and distributed throughout the U.S. He added that the settlement price used by ICE Futures was based on the Nymex settlement price.

Also weighing in at that time was Sen. Charles Schumer, the New York Democrat and member of the Senate banking committee. Sen. Schumer wrote to CFTC Chairman Jeffery of his “grave concern” about allowing ICE to escape oversight by U.S. regulators. “In today’s high-priced energy environment, it is imperative that these crude oil futures contracts be traded in an environment with proper protections,” Sen. Schumer wrote, “to avoid creating an environment for speculators to purchase unlimited crude oil contracts potentially driving the price of oil up to $100/barrel or higher.”

In response, ICE argued that the West Texas Intermediate contract is based on a “globally traded commodity.” ICE also argues that U.S. and British regulators have extensive information-sharing agreements. CFTC officials agree, and say that they have a strong working relationship with their U.K. counterparts, and have ready access to trading data.

On Jan. 31, the CFTC staff approved ICE’s plan to offer the West Texas contract, but the CFTC told both ICE and Sen. Schumer that it would review the matter, and review the entire “no action” letter process that allowed ICE’s expansion.

In a special closed meeting on May 3, the full five-member commission made the unusual decision to tell the CFTC staff to begin a thorough review of what is a “foreign” board of trade and what is a U.S. entity. It also scheduled a late-June public hearing.

Meanwhile, ICE Futures also recently started offering electronic versions of other contracts that are traded on the Nymex floor, including heating oil and unleaded gasoline.

But the biggest fight is still over crude. At an industry conference in mid-May, Nymex’s Mr. Bowen described a hypothetical situation in which 90% of trading in West Texas Intermediate futures gravitates to ICE, from about 30% today. “In the event of a market meltdown, would there be sufficient access to market surveillance and enforcement capability?” Mr. Bowen asked.

On the same panel, ICE’s general counsel, Johnathan Short, sniffed at the Nymex objection. “It’s technology arbitrage rather than regulatory arbitrage,” he said, adding that Britain’s Financial Services Authority is hardly a lax regulator.

The remark was a dig at Nymex’s slower pace in embracing electronic trading. Nymex has been spending heavily on technology lately. In early April, it announced a tie-up with the Chicago Mercantile Exchange to put its main products on the Chicago exchange’s Globex electronic trading system, beginning in mid-June.

Still, its main products — from its benchmark 1,000-barrel crude-oil contracts to its precious-metals contracts — are traded mostly in the pits at Nymex in lower Manhattan. To some big Nymex traders, the physical trading pits are paramount in a crisis, as traders seek the safety of large liquid markets and perhaps the comfort of seeing their counterparts face to face.

At the energy industry’s annual conference in Boca Raton, Fla., earlier this year, Mr. Newsome spoke about Nymex’s technology investing. Sitting on the same dais, Mr. Sprecher made hand motions, mimicking the buy and sell signs of floor traders, suggesting that was the extent of Nymex’s “technology.”

Write to Bernard Wysocki Jr. at [email protected] and Aaron Lucchetti at [email protected]

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