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CFTC review leaves everything to play for

July 9, 2009

– John Kemp is a Reuters columnist. The views expressed are his own –
   
   By John Kemp
   LONDON, July 8 (Reuters) – The U.S. Commodity Futures Trading Commission (CFTC)’s review of position limits and proposed enhancement of the weekly commitment of traders (COT) reporting system has generated a lot of comment about moves to tighten commodity regulation, but it is not year clear whether the proposals will amount to much.
   At this stage, all the commission is promising is a slightly more detailed breakdown of the categories in the weekly COT report, which will disaggregate positions held by swap dealers, index funds and managed accounts (hedge funds) rather than the current simple dichotomy between commercial and non-commercial traders.
   CFTC Chairman Gary Gensler has also promised to hold public hearings later this month and in August on whether the commission should extend the existing position limits it applies to agricultural contracts to all commodities in finite supply (such as oil, heating oil and natural gas); and whether the current rules for granting bona fide hedging exemptions should be tightened.
   Holding hearings does not commit the CFTC to take substantial action, and it will come under intense pressure from futures brokers and investment banks not to make substantial changes to the current regulatory regime.
   There are three key issues at stake in the review process:
   
   (1) FEDERAL POSITION LIMITS
   At present all commodity futures contracts in the United States are subject to position limits. The commission itself sets limits for agricultural contracts (“federal position limits”). For other contracts, limits are set and enforced by exchange operators under the commission’s oversight (“exchange limits”). In each case, market participants can apply to the commission or the exchange, as appropriate, for permission to exceed the limits where this is needed for “bona fide” hedging purposes.
    The commission will consult on whether it should set federal limits on all contracts, bringing practice in the energy markets into line with the existing system for agricultural contracts. But this is a distinction without a difference. It is just a bit of bureaucratic tidying up.
   There is no evidence federal limits are any more binding or effective than exchange-set ones. The Senate Permanent Subcommittee on Investigations’ recent report on excessive speculation in the wheat market blamed the influx of investment money for the rise in wheat prices, in a market that was subject to federal rather than exchange limits (http://graphics.thomsonreuters.com/ce-insight/EXCESSIVE-SPECULATION-IN-WHEAT.pdf).
   Unless the existing exchange limits are going to be reduced, or the criteria for granting exemptions are tightened, shifting from exchange to federal limits is unlikely to make a material difference.
   
   (2) UPGRADING THE COT REPORT
   The existing commitment of traders report is deeply flawed. Part of the problem is that it divides all market participants into just two categories: commercial users (producers, consumers and inventory holders) who are assumed to be using the market to hedge, and non-commercial users (such as index managers and hedge funds) who are assumed to be investing or speculating. This division is far too crude. Index managers have a much more passive impact on prices than an active hedge fund manager for example.
   So a more detailed breakdown that separated out swap dealers and index managers’ positions would be welcome. The commission already breaks out index positions for some of the smaller agricultural contracts following previous complaints about the distorting effects that large index positions were having in these relatively shallow markets.
   But the real problem with the COT reports is their focus on classifying users rather than positions. At present, the CFTC classifies each user as either commercial or non-commercial depending on the predominant nature of its business, then allocates all that user’s positions to the commercial or non-commercial category as appropriate.
   For example, an airline or an oil company would probably be classified as a commercial user and ALL that company’s trades would be allocated to the commercial category. But that simple allocation process leads to problems where some market participants (such as oil and gas companies with active trading desks) conduct a mixture of hedging and speculative transactions.
   As a result, the existing COT reports overstate the degree of hedging and understate speculation because many of the positions currently in the commercial category are actually speculative positions taken by the trading desks of oil and gas companies, or even physical trading companies that have secured commercial status.
   Unless the COT report is reformed to start classifying positions rather than trades, it is hard to see how the new categories will make it much more useful.
   
   (3) HEDGING EXEMPTION CRITERIA
   The million dollar question is whether the CFTC will tighten the criteria under which it (or the exchanges) grants exemptions to the position limits for “bona fide” hedging operations. The CFTC and NYMEX have been sharply criticised by congressional investigators for granting so many exemptions that the limits have become meaningless.
   But the position is more subtle than many commentators have suggested. Everything depends on what is meant by “hedging”. Gensler’s press statement noted that “Recently, the Commission completed a comment period on whether the bona fide hedge exemption should continue to apply to persons using the futures markets to hedge purely financial risks rather than risks arising from the actual use of a commodity”.
   Exemptions were originally granted to commercial market participants using futures contracts to hedge risks from producing, consuming or storing physical commodities. If the commission restricted exemptions to these categories it would represent a radical toughening of the rules. Exemptions for investment banks and others operating commodity index funds would have to be withdrawn and positions scaled back.
   But most banks and other index operators would argue that they too are hedging. The products they have sold to pension funds and others (usually swap contracts where the bank promises to pay the buyer a return based on the prices of commodities in an underlying basket) leave them with just as much exposure to price risks as producers and consumers of the physical commodity.
   In fact, it was precisely because the commission and the exchanges accepted this definition of hedging that most of the exemptions were granted over the last decade in the first place. Banks and other index operators will argue the commission should continue to recognise this as a legitimate form of hedging. The alternative is that products would have to be withdrawn and investors’ access to commodities as an asset class would be sharply reduced.
   As a result, banks will lobby hard to preserve the “financial hedging” exemption for commodity index operators. If the CFTC accepts this argument, nothing much will change.
   (Edited by David Evans)

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