Pre-emptive Moves Against Speculation*

Speculators have never been popular, and they may never have been as unpopular as they are today. Increasingly they are blamed for fluctuations in commodity prices, particularly in energy prices, even though a market lacking speculators to take the other side of price hedging transactions for physical market players would arguably be one that would be much more volatile.

Two of the most important functions of futures markets are the transfer of risk and price discovery. In a well‑functioning futures market, hedgers, who are trying to reduce their exposure to price risk, will trade with someone, generally a speculator, who is willing to accept that risk by taking opposing positions. By taking the opposing positions, these traders facilitate the needs of hedgers to mitigate their price risk, while also adding to overall trading volume, which contributes to the formation of liquid and well-functioning markets.

However, the traditional speculative hypothesis stating that profitable speculation must involve buying when the price is low and selling when the price is high, has come under strong criticism. The critique originates from the observation that prices and non-commercial positions in energy commodities have been moving together since 2002.  Accordingly, it is argued that excessive speculation by institutional investors caused energy prices to diverge from their fundamental values.

In order to combat excessive speculation and prevent market manipulation, the US CFTC, under the mandate given by the Dodd Frank Act, proposed on 13 January, 2010 hard position limits on commodity futures, options and swaps positions of speculators. Critics argued that there has yet to be a credible study which links the run up in commodity prices to trading strategies of speculators. However, the Commission justified its proposed rule as follows: “The Commission is not required to find that an undue burden on interstate commerce resulting from excessive speculation exists or is likely to occur in the future in order to impose position limits. Nor is the Commission required to make an affirmative finding that position limits are necessary to prevent the sudden or unreasonable fluctuations or unwarranted changes in prices or otherwise necessary for market protection. Rather, the Commission may impose position limits prophylactically, based on its reasonable judgment that such limits are necessary for the purpose of “diminishing, eliminating, or preventing” such burdens on interstate commerce that Congress has found result from excessive speculation”. 

In seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the Commission proposed a two-stage approach for hard position limits as preventive medicine for excessive speculation. In the first stage, the Commission will take over the existing spot-month limits set by exchanges. For example, NYMEX has a 3 000 contracts hard position limit for spot month NYMEX WTI, which now becomes the federal position limit. In the second stage, the Commission will make its own determination on the spot-month limit, any single-month and all-months-combined position limits across different trading venues once it collects enough data, especially from swap markets. The proposed rules call for spot-month position limits at 25% of deliverable supply. The rules also limit non-spot month and all-months-combined positions to 10% of open interest for the first 25 000 contracts owned by a trader and 2.5% thereafter. Bona fide hedging positions will not be counted towards the limits. Also, if a swap dealer’s counter-party is a hedger or a swap dealer completes a trade on behalf of a bona fide hedger, then the swap dealer might use bona fide exemption for this specific trade and it will not be counted towards position limits.

Proponents have employed several arguments to justify the need for hard position limits on commodity derivatives markets. They argue that hard position limits on speculative activity ensure the effective functioning of the market by minimising price disruption that could be caused by  excessive speculation. They further argue that a hard position limit is necessary to reduce concentration of market share in commodity markets. This will ensure that markets would be made up of a broad group of market participants with a diversity of views, thereby  preventing distortion in market prices. The limit on the concentration of market share is also deemed necessary to cut systemic risk. Finally, they argue that rules‑based hard position limits are preferable to position accountibility levels in that they provide much more certainty as well as preventing arbitrary intervention in the market.

Market participants however have already raised concerns over some issues concerning the proposed rules. Regulators themselves express uncertainty over what the new position limits will bring to the market. As Michael Dunn, Commissioner at the US CFTC, put it “With such a lack of concrete economic evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst, a placebo for one that does.”  Market participants’ main concerns include the folowing:

Lack of clarity on how the Commission reached its proposed position limit formula. The Commission has yet to provide a cost-benefit analysis for its proposed rule. Specifically, the Commission provides no evidence or justification that these limits are necessary to prevent the risks it has identified. 

Hard position limits will severely constrain trading activity which would lead to increased, rather than reduced, volatility. Liquidity in futures markets, and especially in swaps markets, will, it is argued, be unnecessarily impaired. Producers and end users would have a smaller pool of counterparty firms to hedge their price risk with, which in turn increases the bid/ask spread, thereby creating more volatility. The proposed rule can also potentially constrain the size of trading entities. This will lead to market dependence on small speculators as institutional investors would be forced out of the market once they reach their respective position limit. This would lower liquidity and increase trading costs. Higher trading costs would, in turn, force some entities to establish smaller positions.

Classifying long-only index position as speculative will restrict access by many individual investors to commodity price exposure. Index funds aggregate the buying and selling decisions of small investors, who invest in commodities due to diversification benefits as well as a hedge against inflation. It is argued that denying the exemption on index funds position limits precludes small investors from a cost effective means of investing in commodities.

Position limits might drive some participants to other markets. Introducing non-universal position limits creates regulatory arbitrage opportunities as some market participants might move their trading activity to less regulated markets. For example, imposing limits on derivatives positions that Exchange Traded Funds (ETFs) can hold will lead to the creation of physical based ETFs that are not subject to position limits, which would eventually have the potential to distort prices.

Within-class position limits inefficiently constrain liquidity and hence increase the likelihood of large price fluctuations. The proposed rule imposes position limits on the individual classes as well as across different trading venues. For example, consider a market in which the position limit is 1 000 contracts. A speculator who is long in 500 futures contracts and short in 1 250 OTC contracts would have 750 net short positions. This trader would be within the all-months all-class limit; however, he/she would be in violation of the OTC class limit.

Meanwhile, on this side of the Atlantic, the European Commission and the UK's FSA convey two opposite views on hard position limits for commodities. The European Commission's consultation report, in line with the US CFTC, urges the need to consider hard position limits on spot month contracts but position management systems for all other contracts, similar to position accountability levels in US exchanges, which will authorize regulators to demand traders to reduce their positions if needed.  On the other hand, the UK's FSA opposes hard position limits for commodities for both exchanges and OTC derivatives, arguing that a position management system is an appropriate tool to maintain fair, orderly and efficient markets.

*IEA Oil Market report February-2011