Thursday, November 24, 2011

Regulation beyond Mandate?*

In a contentious 3-2 vote on 18 October, the US CFTC Commissioners approved final rules on federal speculative positions limits on commodity futures, options and swaps positions of speculators for 28 commodities. These include NYMEX natural gas, crude oil, gasoline and heating oil, along with a number of metals and grains contracts.

In seeking to prohibit excessive speculation and its possible effect on price volatility in futures markets, the Commission adopted a two-stage approach for hard position limits as preventive medicine for excessive speculation.  The main features of the final rulemaking include:

·    Spot month limits, effective sixty days after the term “swap” is defined by the Commission, which is expected in December 2011. In the first stage, the Commission will take over the existing spot-month limits set by exchanges. In the second stage, the Commission will make its own determination on the spot-month limit based on the 25% of estimated deliverable supply. The spot-month limit will be adjusted biennially for agricultural contracts and annually for energy and metal contracts. That is to say, the earliest adjustment to energy contracts spot month limits based on estimated deliverable supply can be made in the first quarter of 2013.

·     Non-spot-month and all-months-combined position limits for legacy agricultural contracts will go into effect sixty days after the Commission defines the term “swap”. For non-legacy agricultural, energy and metal contracts, the position limits will be effective after the Commission receives one year of open interest on swaps data. Thereafter, non-spot month and all months combined position limits will be adjusted every two years based on the previous two years’ open interest. The rules call for limits on non-spot month and all-months-combined positions up to 10% of the sum of futures, cleared and uncleared swaps open interest for the first 25 000 contracts owned by a trader and 2.5% thereafter.

·       The cash-settled natural gas contract will be subject to spot month and non-spot month position limits set at five-times the limit that applies to the physical delivery natural gas contract. 

·      Bona fide hedging positions will not count towards the limits. Exemptions for bona fide hedging transactions have been broadened to include certain anticipated merchandising transactions, royalties, and service contracts in the final rulemaking. Hedge exemptions need to be approved by the Commission, rather than the exchanges. 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.

·     The final rule requires quarterly position visibility reporting requirements for traders exceeding a non-spot month position visibility level in energy and metal contracts.

Proponents 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 rule-based hard position limits are preferable to position accountability levels, in that they provide much more certainty as well as preventing arbitrary intervention in the market.

In his support for the final rule, Chairman Gary Gensler argued that position limits have served to curb or prevent excessive speculation and its impact on prices. However, as pointed out by Commissioner Scott O’Malia in his statement of dissent, nine-legacy agricultural contracts, which are subject to spot month and non-spot month position limits, were not spared record-setting price increases. Chairman Gensler further argued that the Commission received more than 15 000 comments on the position limit rule, most of which were in favour of hard position limits. Nevertheless, most of these comments came from a letter writing campaign organized by silver advocacy group without any substance. Commissioner O’Malia suggested that there were only 100 substantive comments letters, some of which were not even taken into account during the final rulemaking. Commissioner O’Malia and Ms Jill Sommers further iterated market participants concerns over the inadequacy of cost benefit analysis, restrictive interpretation of bona fide hedging, lack of clarity on how the Commission reached its proposed position limit formula, possibility of reduced trading activity which would lead to increased, rather than reduced, volatility; and possibility of international or physical/cash settled regulatory arbitrage.

Commissioner Michael Dunn’s vote eventually determined the outcome of the rule-making. In his opening statement, Commissioner Dunn presented his views on speculation and its effect on commodity prices. He clearly stated that “No one has proven that the looming spectre of excessive speculation in the futures markets we regulate even exists, let alone played any role whatsoever in the financial crisis of 2008. After we implement position limits, in all likelihood, the prices of heating oil and gasoline will not drop precipitously as some have strongly suggested. Airline tickets will not be cheaper and the food you buy at the grocery store will be the same price. Investments in precious metals will continue to rise and fall unpredictably. Things will remain relatively the same, except for those who use the markets we regulate to provide the very resources we all need. For these farmers, producers and manufactures, position limits, and the rules that go along with them, may actually make it more difficult to hedge the risks they take on in order to provide the public with milk, bread and gas. The role of the futures market is price discovery, not price setting. If we limit participation in these markets through position limits, producers may receive inaccurate market signals when making production decisions. If this occurs, the prices we all pay for our groceries and to heat our homes may become more volatile. Position limits may actually lead to higher prices for the commodities we consume on a daily basis.” And finally he said “My fear is that position limits are, at best, a cure for a disease that does not exist or a placebo for one that does. At worst, position limits may harm the very markets they are intended to protect.”

After stating all his concerns, Commissioner Dunn voted in party line to support final rule-making simply because it is required by the law, as he said. However, this view is challenged by market participants as well as two dissenting Commissioners, Ms Sommers and Mr O’Malia. They argue that the Commission overreached its mandate by arguing that the Act clearly states that the Commission should adopt position limits if the Commission finds that position limits are “necessary to diminish, eliminate or prevent” the burden on interstate commerce caused by excessive speculation. They further argued that the Commission still did not have qualitative or quantitative criteria of what is meant by excessive speculation.

The debate over the position limit rule may continue further. Market participants might challenge the final rule based on whether the Commission overreached its mandate by pre-emptively setting a position limit on commodity derivatives contracts, on the almost non-existing cost-benefit analysis in the final rulemaking as well as insufficient consideration of some of the comments letters which the Commission was obliged to take into account. Some argue that substantive comments letters as well as Commissioners  Sommers, O’Malia and Dunn’s statements could be used by opponents to challenge the final rule on position limits.

*IEA Oil Market Report-November 2011


  1. I disagree with Commissioner Dunn's stated reasoning for supporting the speculative limits rule. Based on his rationale, limits should be imposed on all futures and swaps regardless of whether there is evidence of their being susceptible to excessive speculation. That is, if Commissioner Dunn believes the law requires speculative limits, it requires them for all contracts not merely those selected by the Commission. The only basis for excluding contracts other than the 28 is evidence that they are not susceptible to excessive speculation. Since that evidence was not provided, then Commissioner Dunn should have voted against the rule unless it was modified to include all contracts.

  2. Jim, I totally agree with you. Did you see ISDA's press statement on why they have resorted to the courts? Their arguments are in line with what I put in my blog's last paragraph.

    They argued that:

    1) The majority of the CFTC found they were required to create position limits. We read the statute to mean that position limits should be put in place when the CFTC found them to be necessary and appropriate. The CFTC made no such finding. Indeed, one of the yes votes warned the limits might do more harm than good.

    2) Despite a torrent of comments and numerous studies by academic and government bodies, the CFTC ignored the evidence in proceeding with the rule. Agencies are required by administrative law to consider comments.

    3) There really was no cost-benefit analysis. We’ve seen this before and it is very unsettling, especially when this is also required by law.

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