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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. 

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)

from Rolfe Winkler:

Markets need rules

NEW YORK, July 9 (Reuters) - Why are free marketers so afraid of rules? As regulators take a fresh look at the commodity markets, Wall Street and its defenders are again panicked that regulators will overreach.

No doubt regulation, when excessive, can be problematic. But energy markets are so totally unfettered, they can benefit from tougher rules, especially when it comes to transparency and excessive speculation.

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