CFTC review process – thinking about the eventual outcome

July 29, 2009

Several people have asked what I think will be the eventual outcome of the US Commodity Futures Trading Commission (CFTC)’s review of position limits and hedging exemptions in energy futures markets.  My guess is that the review will result in only fairly minor changes.

The most likely changes to emerge from it are probably: 

(a)  CFTC rather than exchanges will set position limits and be responsible for granting exemptions. 
(b)  Position limits will apply on an aggregate basis that will cover an entity’s positions across all exchanges and OTC.  To enforce this system, CFTC will demand data on OTC positions and on positions that are “near to” those on markets it regulates (ie Significant Price Discovery Contracts). 
(c)  Position limits on contracts close to expiry may be “hardened” to become fully binding (with few or no exemptions other than for physical hedgers intending to make or take delivery). 
(d)  Position accountability levels on contracts further away from delivery may be hardened somewhat but unlikely to become absolutely binding.  CFTC will almost certainly demand more documentation and proof to back up claims that they being held for “bona fide hedging” purposes. 
(e)  CFTC may revisit the classification of traders as commercial/non-commercial.  For firms with both hedging and trading operations, it may require the two to be separated out for reporting and regulating purposes.  The system would then regulate positions rather than entities. 

Changes that are NOT likely to happen: 

(a)  CFTC is unlikely to withdraw the hedging exemption from swap dealers and index funds entirely.  This would in effect bar many pension funds and others from using commodities as an asset class to diversify etc.  It is possible that the CFTC might condition the hedging exemption for swap dealers on the nature of their counterparties (ie a swap dealer who has sold swap contracts to a commercial enterprise can hedge them without limit in the futures market, but limits would apply if the counterparty was a pension fund or hedge fund).  But even this is very unlikely for the same reason as above — it would essentially shut down commodities as an asset class.  It is more likely that the CFTC will contine to allow swap dealers to claim a hedging exemption — PROVIDED they can show the position is being managed on a passive basis — AND with suitable documentation. 
(b)  CFTC unlikely to impose binding limits on the total position that can be held across all months without generous exemptions. 

If true, then any changes in the regulatory regime will be fairly incremental.  Funds will continue to have reasonably unrestricted access to the market and appetite for commodities is unlikely to diminish.  Commercial hedging will not be hampered. 

London MIGHT gain a slight competitive advantage if CFTC goes ahead with limits while FSA does not. But on the basis of the above analysis, any advantage would be very slight.  So the distribution of trade volumes between London and the United States would probably NOT be affected significantly. 

Given the limited changes the CFTC is contemplating the FSA could probably hold its current position.  It depends on how far the CFTC eventually shifts from its “no evidence” of speculative impact on prices.  If the CFTC simply says the situation is unclear, the FSA could probably hold the current line, and argue that London’s “dominant position” management system provides a similar level of protection to the position limits.  If the CFTC moves further and says there has been some indication of a speculative impact on pricing, the FSA would probably have to move somewhat.  But given the limited changes contemplated in Washington, any changes in London would be modest.  More should become clear when the CFTC releases its statistical review, promised for next month.

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