Commentaries

Keeping Wall Street’s hands off the collateral

The idea of prohibiting derivatives dealers from reusing and redeploying the trillions of dollars in collateral they’ve taken in from trading parnters is gathering steam.

Earlier this week, I advocated an outright ban on this Wall Street practice called rehypothecation. I noted that one of the flaws with the Obama administration’s plan for regulating derivatives is that it’s silent on the issue of whether derivatives dealers can continue to reuse the collateral they get as guarantees on trades anyway they see fit. 

In the Lehman Brother bankruptcy, one of the big unresolved issues is tracking down collateral Lehman took in as guarantees on derivatives trades and then used as collateral for its own transactions.

Last week, Gary Gensler, chairman of the Commodities Futures Trading Commission, sent a letter to a number of congressmen urging changes in Obama administration’s derivatives plan. One thing Gensler advocated was a measure that would require derivatives dealers to segregate customer collateral in seperate accounts just the way futures dealers must do. Gensler says doing so would make it easier to deal with the failure of a derivatives dealer.

And now Americans for Financial Reform, an umbrella group of nonprofits, municipalities and union, has sent a letter to Sen. Chris Dodd, chairman of the Senate Banking Committee, endorsing much of what Gensler has called for including the segregating of customer collateral. The group’s letter refers to both Gensler and my column in noting:

The rehypothecation of a customer’s collateral makes the unwinding and returning of these “escrowed” funds to traders in bankruptcy proceedings almost impossible, thereby adding fuel to the fire that instititutions involved in complex financial transactions are “too big to fail.”

Now, I should point that a recent IMF report notes that since the Lehman Brothers bankruptcy more customers have requested that their collateral be segregated.  (A hat tip to Zerohedge.com for pointing this out to me). But memories are short and in time this change in behavior could revert back to form.

Back into the mists of time with the CFTC

  This is not the first time that the CFTC has considered the issue of “excessive speculation” and position limits.     In the wake of the Hunt Brothers silver scandal, Congress directed the Commission to submit a report on the events in the silver market (see timeline below, reproduced from the CFTC website).     The CFTC also considered the broader question of whether “unchecked speculation” could pose a danger to markets.  On that occassion the Commission concluded:    “It appears that the capacity of any contract market to absorb the establishment and liquidation of large speculative positions in an orderly manner is related to the relative size of such positions, i.e., the capacity of the market is not unlimited. Recent events in the silver market would support a finding that the capacity of a liquid futures market to absorb large speculative positions is not unlimited, notwithstanding mitigating characteristics of the underlying cash market.” 

“Establishment of Speculative Position Limits,” 46 Fed Reg. 50938, 509040 (October 16, 1981).     So the Commission has considered these questions before.  Last time, it concluded that position limits were necessary to safeguard the effective functioning and price discovery mechanism of the market.    What seems to have happened since then is that the Commission was (gradually) persuaded to change its view as part of the broad thrust away from government regulation and towards “self-regulation” that dominated policymaking in the 1980s and 1990s.  Seeing little point in the position limits themselves, the CFTC was comfortable granting an increasing number of exemptions to them.    Now the pendulum is swinging back.  For a full discussion of the issues now before the Commission, most people could do worse than go find the relevant entries in the Federal Register for 1980-81.    History most definitely rhymes, even if it does not quite repeat exactly. 

CFTC TIMELINE   March 28, 1980—After careful consideration of a host of market factors, the CFTC votes not to use its emergency powers to order a suspension of trading in silver futures as prices plummet.

May 29, 1981—As required by Public Law 96-276, the CFTC transmits to Congress a report on events in the silver market during late 1979 and early 1980, and on issues involving futures contracts on financial instruments.

September 8, 1981—The CFTC adopts a comprehensive set of regulations to govern exchange-trading of options on futures contracts under a controlled and monitored three-year pilot program.

October 16, 1981—The CFTC adopts Regulation 1.61 (now part of CFTC Regulation 150, 17 CFR 150) requiring exchanges to establish speculative position limits in all futures contracts.

CFTC review process – thinking about the eventual outcome

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. 

CFTC lifts lid on large commodity positions

   By John Kemp    LONDON, July 29 (Reuters) – Data presented to yesterday’s public hearing on energy markets show the U.S. Commodity Futures Trading Commission (CFTC) and exchanges have granted so many exemptions from hard position limits and soft position accountability levels that the traditional position-limiting system has become meaningless.    CFTC chairman Gary Gensler noted that exemptions have become so numerous they risk “swallowing the rule”. There’s no danger, the rule has disappeared without trace. The scale and frequency it has been broken has seen to that.    It’s clear from the figures that traders’ positions can be big enough to raise the risk of distorting prices which set fuel costs across the globe.    Gensler’s slide presentation provided the first comprehensive insight into how exemptions have been used — giving detailed data on the number of times limits have been exceeded since mid-2008 for the Big Four energy contracts on NYMEX (crude oil, natural gas, heating oil and RBOB gasoline).      Last week (July 21) there were 37 exemptions in force in the crude contract for an average of almost 5,700 lots (5.7 million barrels of crude oil), and 43 exemptions in force for natural gas for an average of 2,930 lots (29.3 trillion BTUs or 28.5 billion cubic feet).    These were exemptions from spot-month limits (contracts approaching expiry and therefore most vulnerable to squeezes or settlement failure). They take no account of exemptions in force for contracts further out along the curve.    For the 12 months between July 2008 and June 2009, 43 traders received dispensations from the single-month limit on the NYMEX crude contract, exceeding the notional limit by an average of 10,000 contracts (10 million barrels) and with excursions lasting an average of 87 days. In other words, it was routine practice to run positions in a single month at twice the notional “accountability level” set by the exchange.    For natural gas, 26 traders received dispensations from the combined all-months limit, and exceeded it by an average of 32,000 lots (311 billion cubic feet) (four times the usual limit) with excursions lasting an average of 80 days at a time.    Positions on this scale utterly defeat the objective of setting limits.    As Gensler noted, the CFTC’s avowed aim has always been “to ensure that markets were made up of a broad group of diverse participants with a diversity of views. The intent was to avoid the concentration of positions of any single party”.    “In 1980, the CFTC reiterated its goal to prevent market concentration. In its rulemaking, the Commission stated that ‘a trader’s net position has a continued effect on price, and if sufficiently large can become a perceptible market factor’”.    “Speculative position limits serve to decrease the potential for positions to influence the general price level”.    But massive exemptions have produced the opposite effect. For NYMEX natural gas, the CFTC data shows 13 traders had positions amounting to more than 10 percent of the open interest in a single month at some point over the last year, 4 traders had positions over 20 percent, and 3 traders had positions over 30 percent. With this much concentration, price setting is hardly the result of a “diversity” of views.    For the CFTC, the policy question is whether to make minimal changes to the process for setting limits and granting exemptions to restore public confidence in the system’s integrity, or be more aggressive and try to use tighter limits and more narrowly drawn exemptions to reduce the average position size and cut concentration levels.    (Editing by David Evans)

CFTC prepares to recant speculators’ influence

– John Kemp is a Reuters columnist. The views expressed are his own –

Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.

Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year’s oil price spike, according to a report in the Wall Street Journal.

While it might seem a minor shift in emphasis, it is a radical reversal of the Commission’s previously stated view that there was “no evidence” that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.

The position was stated most forcefully by CFTC Chief Economist Jeffrey Harris in testimony to the House of Representatives’ Agriculture Committee in May 2008 (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/harris-fenton051508.pdf).

It was repeated in September 2008 in the CFTC’s “Staff Report on Swap Dealers and Index Traders” and again this year in a joint report with the United Kingdom’s Financial Services Authority (FSA) on commodity regulation for the International Organisation of Securities Organisations (IOSCO).

The Commission’s view has come under pressure from sceptical legislators as the scale of speculative positions in commodity markets and the number of exemptions the Commission and exchanges have granted have been revealed. Congressional anger threatened to derail Gensler’s confirmation. The price of allowing him to take office seems to have been a promise to take a tougher approach.

CFTC review leaves everything to play for

– 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)

Your new consumer watchdog

The Obama administration just released draft legislation for its newly proposed Consumer Financial Protection Agency. The 152-bill would create a five-member commission with the power to make rules and issue subpoenas. 

The new agency’s primary mandate will be to push for greater fairness by mortgage lenders and credit card issuers. That’s important stuff. But sadly, the agency’s mandate appears limited. There’s no discussion in the agency’s enabling legislation that would specifically permit it to look at things like life settlements, structured settlements or structured notes.

The agency would have the power to coordinate with the SEC and CFTC to make sure that there is “consistent regulatory treatment of consumer and investment products or services.” For purposes of this new agency, an investment product is one that “competes directly with, a consumer financial product or service that is subject to the jurisdiction of the Agency.”

That’s pretty vague stuff. But it doesn’t look like this new agency is meant to come up with a broad definition of a “consumer financial product.” Again, just think mortgage and cards.

And that probably means it’s up to the SEC and CFTC to focus on those more exotic investment products. Oh brother.

from John Kemp:

CFTC needs to provide more detail ….

The problem is that no one knows what Gensler means about using "aggregated position limits" to curb excessive speculation.    At the moment the CFTC gets NYMEX data (compulsorily) and ICE data (on a "voluntary" basis).  It wants to obtain information on OTC positions as well, but would need additional legislative authority and systems to achieve it.    The real question is what does CFTC mean by "aggregated" positions and "limits" on them:    (1) Does aggregation stop at NYMEX+ICE, or will it extend to NYMEX+ICE+OTC?  Is CFTC prepared to include OTC contracts which are similar, but not identical, to exchange contracts (in terms of the deliverable commodity) and therefore exert an influence on exchange prices?    (2) What does it mean by limits?  Market participants already routinely exceed the soft non-binding "position accountability levels" on NYMEX alone.  Adding in other positions on ICE and OTC will not make any difference, UNLESS the CFTC intends to harden enforcement of the non-binding accountability levels.  Is the Commission preparing to harden the limits and make them more binding?    Gensler's comments do not take the discussion forward unless the Commission provides some more detail on what it means.

from John Kemp:

CFTC’s Gensler calls for “aggregated position limits” to curb excessive speculation

15:30 02Jun2009 RTRS-CFTC CHAIRMAN GENSLER BACKS U.S. REGULATION OF OTC DERIVATIVES MARKET, AGGREGATED POSITION LIMITS

15:30 02Jun2009 RTRS-GENSLER SAYS CFTC NEEDS "NEW AUTHORITIES" TO BRING TRANSPARENCY TO OTC DERIVATIVES MARKET

15:30 02Jun2009 RTRS-CFTC chief says US regulatory reform is urgent

    WASHINGTON, June 2 (Reuters) - The new chairman of the Commodity Futures Trading Commission told senators on Tuesday that broad U.S. regulatory reform is necessary and called for regulation of over-the-counter derivatives.

    In testimony to a Senate Appropriations subcommittee, CFTC Chairman Gary Gensler, on the job for a week, also endorsed aggregated position limits as a way to prevent excessive speculation.

    "The CFTC, along with the administration and other financial regulators, is committed to working with Congress on broad regulatory reform," said Gensler. "This is particularly true for the markets that the CFTC currently regulates and the markets that may soon come under our regulation."