CFTC set to recommend only minor changes: John Kemp

Thu Jul 30, 2009 8:34am EDT

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

By John Kemp

LONDON (Reuters) - The U.S. Commodity Futures Trading Commission (CFTC) review of position limits and hedging exemptions will probably result in only minor changes to current practice.

While CFTC Chairman Gary Gensler told Reuters Television that "inaction is just not acceptable," none of the issues being examined at this week's hearings is new.

Policymakers have been struggling with the question of how much "speculative" influence should be allowed in commodity markets since the Commodity Exchange Act was passed in 1936, and how to limit it so the activities of investors do not distort pricing for everyone else.


In the last major review, prompted by the wake of the Hunt brothers' attempt to corner the silver market in 1979-1980, the Commission concluded 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" (46 Fed Reg. 50938, 509040, October 16, 1981).

In the wake of the review, the Commission decided limits were the best tool to safeguard market integrity and the functioning of the price discovery mechanism. In 1981, the Commission adopted a formal rule requiring exchanges to establish speculative position limits in all futures contracts (though binding limits were required only for the nearby month; further out exchanges could establish indicative "accountability levels" instead).

Since then the Commission has gradually softened the regime, as part of the wider shift away from government regulation toward "market discipline" that dominated policymaking in the 1980s and 1990s.

As the Commission placed less value on limits, it became comfortable granting an increasing number of exemptions, since many of them were for "passive" index funds rather than "active" speculators such as the Hunt brothers.

Now the pendulum is swinging back. Following the spike in commodity prices during 2007-2008, and evidence that the remaining limits have become effectively meaningless, mainly because so many exemptions have been granted, the CFTC looks set to tighten the regime.

Once again, the favored tool is position limits, and the CFTC shows an awareness that limits can only be effective if exemptions are more restricted than in the past.

But changes may prove more limited than most observers assume. There is no real appetite in the Commission or Congress to take actions that would block investors or large institutions such as pension funds from accessing commodities as an "asset class."


Based on the comments and testimony of the commissioners and interested participants appearing at the hearings the most likely changes to the system are:

(a) The CFTC, rather than exchanges, will set position limits for all contracts in future and be responsible for granting exemptions. This would bring the energy markets into line with current practice for agricultural contracts, which are already subject to federal rather than exchange limits.

(b) Position limits will apply on an aggregate basis across all markets (exchanges and OTC). To enforce this system, the CFTC will demand data on OTC positions and on contracts which are "near to" those it regulates already. The Commission has already begun this process by demanding information on previously exempt contracts which it deems are "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 from delivery may be hardened somewhat but are unlikely to be made absolutely binding. Exemptions will remain available. But the Commission will almost certainly demand more documentation to back up claims that they are being held for "bona fide hedging" purposes.

(e) The Commission will almost certainly revisit the classification of traders as either commercial or non-commercial. At the moment, all of a trader's positions are classified in one category, depending on its primary business interest, which is often unclear. In future, for firms with both hedging and trading/investment operations, it may require the two to be separated out for reporting and regulating purposes.


More radical changes are unlikely. The CFTC is unlikely to withdraw hedging exemptions it has granted to index funds and swap dealers who claim to be hedging "financial exposure" rather than physical positions. Withdrawing them would bar many pension funds and others from using commodities as an asset class, and there is no political or intellectual consensus on this.

For the same reason, the Commission is likely to reject suggestions it should make exemptions conditional upon the nature of the counterparty with whom the swap dealer is trading. Several commentators have proposed exemptions should be available only for swap dealers doing business with a commodity producer or consumer, but not when the counterparty is an investor or pension fund.

The CFTC will continue to allow swap dealers, index managers and others with financial rather than physical exposure to claim exemptions. But it will demand more documentation to support the claim that it is hedging, and may require evidence the position is being managed on a passive basis, separate from any actively managed ones.


Changes in the regulatory regime seem set to be incremental. Commercial hedgers are unlikely to face any significant restriction. Investors will continue to have fairly open access to commodity markets and their appetite for commodities as a portfolio diversifier and hedge against inflation is unlikely to diminish.

As a result, there will be few effects on either the volume of location of trading. Markets based in London might gain a slight competitive advantage if the CFTC presses ahead with limits while the London's Financial Services Authority (FSA) does not. But given the minimal changes that are likely, any advantage will be slight. The distribution of trading between London and the United States would not be affected significantly.

Given the limited changes CFTC seems set to adopt, the FSA may also be able to hold its current policy position (that there is "no evidence" to suggest speculators are responsible for price changes, and large positions are better managed through discretionary rules rather than hard limits). But that will depend on the precise language the CFTC uses when it issues an updated review on the impact of investment money on commodity prices next month.

(Edited by David Evans)

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