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:
   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 (
   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.
   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.
   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)

Spotlight falls on London commodity regulation

July 9, 2009

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

    By John Kemp
    LONDON, July 7 (Reuters) – As the Commodity Futures Trading Commission (CFTC) contemplates toughening position limits and oversight of U.S. commodity markets, the spotlight is shifting to the weaker regulatory regime overseen by the Financial Services Authority (FSA) in London [ID:nN07310607].
   Until now, criticism of London has centred on the so-called “London loophole”, which allowed U.S.-based commodity traders to amass positions in U.S. commodity contracts on exchanges registered in London rather than at home to avoid position limits and reporting requirements in the United States.
   Commodity traders could evade position limits and reporting on the New York Mercantile Exchange (NYMEX) light sweet oil and heating oil contracts by building up additional positions on the London-registered lookalike contracts on the Intercontinental Exchange (ICE).
   The loophole has been largely closed following a “voluntary” agreement between the CFTC, FSA and ICE last year. The FSA and ICE agreed to implement position limits on commodity contracts deliverable in the United States on the same basis as limits applied in New York. In return the CFTC agreed not to seek jurisdiction and continue to allow trading from terminals in the United States under existing “no action” letters.
   But closing the London loophole is unlikely to be enough to silence criticism about the standards applying in London commodity markets. The problem is not the FSA’s (voluminous) regulations but the growing gap between what’s written on paper and what happens in practice. It has left everyone (regulators, market participants and customers) unsure about what is allowed and what is not.
   It stems from competing visions about the appropriate role for regulation in commodity markets. Historically, these markets were assumed to be dominated by knowledgeable “professionals” who could be expected to look after themselves, rather than “retail” investors. So a light touch regime which prevented obvious abuses (such as fraud) was all that was required.
   As the level of participation by retail investors and less knowledgeable customers (such as pension funds) has increased, expectations about the level of regulation have risen. Increasingly, rules developed for equity markets have been applied (in slightly modified form) to commodities — with an emphasis on treating customers fairly, preventing insider trading and prohibiting “market abuse”.
   In most cases though, the rules contain a carve out allowing behaviour to deviate from published norms as long as it is in line with “accepted market practices”. The clash between historically accepted practices and what the rules now theoretically say has become an enormous source of confusion about what is and is not permitted.
   To take one example: the execution of large orders on or close to the close of the market and the declaration of a settlement or daily valuation. Established equity market practice puts a special onus on clients, brokers and traders to ensure large or unusual orders executed at this time do not cause, or appear to cause, manipulation or price distortions. Trading in the run up to the close is especially sensitive and subject to heightened scrutiny. Actions which appear designed to “support” closing prices are clearly forbidden.
   But the situation is far less clear cut in commodity markets. Many clients want to achieve closing prices since these are used to mark positions to market and to settle hedging programmes. So much trading is concentrated in a relatively narrow “window” ahead of the close and declaration of daily valuations. The large amount of liquidity concentrated in this short period attracts further trading from those needing to execute large orders.
   With this late trading activity there is a widespread temptation and open market talk about attempts to “support” or “hammer” the close. But does this constitute market abuse? It clearly contravenes the written regulations. But equally clearly it is in line with accepted market practice. So it falls into a grey area. It seems to depend upon the (unobservable) intentions of the market participant.
   Equally contentious is the question of how to deal with large long positions which dominate the market nearby or over certain sections of the forward curve also remains contentious. Such positions would clearly be considered abusive in equities, and the U.S. Treasury has warned bond market participants it will hold them to a high standard of behaviour if they do the same in U.S. government securities. But the position in commodities is more equivocal and the source of perennial controversy [ID:nL7149027].
   The FSA requires commodity brokers to submit “suspicious transaction reports” (STRs) where they suspect their clients or others are engaging in activity that could amount to market abuse. But in an update sent to regulated firms in September 2008, the FSA noted it had received only a “handful” of STRs related to commodities out of 700 across all markets, and said it would have expected a greater number. Firms have come under pressure to increase the number of STRs.
   The lack of STRs highlights industry uncertainty about what constitutes the level of “reasonable suspicion” needed to trigger a report; what are accepted practices; and how to define misuse of information cases compared with other markets.
   Uncertainty is compounded by the FSA’s decision to devolve frontline market regulation to the exchanges themselves, retaining only a supervisory and second-tier function for itself. While exchange operators have tried to separate their business function (which involves maximising volumes) from their regulatory one (policing market behaviour), there is an inevitable tension.
   More importantly, it has left the FSA with a dearth of expertise on commodity matters. Commodities are a very small part of the regulator’s remit. The institution has failed to build up the specialist personnel, knowledge and market contacts it needs to be able to take its own independent view and cross-check the information it is receiving from the exchanges and their members.
   In an ideal world, the business and regulatory functions would be separated. Exchanges would run themselves as pure commercial enterprises, with regulation transferred to the FSA. The FSA itself would clarify its fundamental approach – either reverting to the traditional light-touch system and abandoning the pretence of equity-like regulation, or making the new regulatory system real by taking a tougher line on previously accepted market practices.
   In reality, this sort of change is too ambitious; it runs counter to too many vested interests. But a useful start would be for the FSA to increase its own expertise in this area, strengthen its market contacts and conduct more direct surveillance and supervision, while making clearer what “market practices” remain acceptable and which ones are consigned to history.
   (Edited by David Evans)