COLUMN-Position limits, redux: Kemp

Fri Nov 8, 2013 8:57am EST

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON Nov 8 (Reuters) - The U.S. Commodity Futures Trading Commission (CFTC) is making another attempt to impose position limits on 28 core futures contracts covering agricultural products, energy and metals, after a U.S. court vacated its first attempt due to procedural errors.

The court ordered the commission to use its "experience and expertise" to resolve perceived ambiguities in the law on position limits. The CFTC is now trying to do just that with a much lengthier and more detailed notice of proposed rulemaking justifying its decision, running to no fewer than 459 pages.

As the notice explains: "The commission now undertakes the task assigned by the court: using its experience and expertise to resolve the ambiguity the district court perceived in section 4a(a) of the Commodity Exchange Act." Section 4a(a) is the one that deals with position limits.

EXPERIENCE AND EXPERTISE

In case there is any doubt about the diligence with which the CFTC is approaching its homework, and to try to shelter it from further judicial review, the rulemaking notice refers 21 times to the commission's "experience" and another six times to its "experience and expertise".

The commission reminds readers it has been imposing position limits as a tool to regulate agricultural futures markets for more than 70 years.

"The commission concludes that, based on its experience and expertise, when section 4a(a) of the act is considered as an integrated whole, it is reasonable to construe that section to mandate that the commission impose position limits.

"This mandate requires the commission to impose limits on futures contracts, options and certain swaps ... The commission also concludes that the mandate requires it to impose such limits without first finding that any such limit is necessary to prevent excessive speculation in a particular market."

MAKING A NECESSITY FINDING

However, in case a reviewing court is tempted to disagree and require a necessity finding, the commission provides real-world examples to illustrate why it believes position limits are necessary to prevent deliberate market manipulation or unintended price volatility.

It draws at length from a report into the Hunt Brothers silver manipulation in 1979-80, prepared by the Treasury, the Federal Reserve and the Securities and Exchange Commission, and another report into fluctuations in natural gas prices caused by hedge fund Amaranth in 2006, written by the Senate Permanent Subcommittee on Investigations.

Lest anyone think the commission has not considered all viewpoints and approached the issue with an open mind, the CFTC lists no fewer than 134 academic studies relating to position limits which it has reviewed and evaluated.

INVOKING CONGRESSIONAL POWER

Ultimately, the commission tries to arm itself with the supreme lawmaking authority of Congress. The report begins with the blunt declaration that: "Congress has repeatedly expressed confidence in the use of speculative position limits as an effective means of preventing unreasonable and unwarranted price fluctuations."

Later, the CFTC observes: "Congress (has) conducted several investigations that concluded that excessive speculation accounted for significant volatility and price increases in physical commodity markets," particularly oil and gas.

Not all academic studies agree. But the CFTC invokes congressional power: "Studies that militate against imposing any speculative position limits appear to conflict with the congressional mandate that the commission impose limits ... Such studies also appear to conflict with Congress' determination, codified in the Commodity Exchange Act, that position limits are an effective tool to address excessive speculation."

AN IDEOLOGICAL LITMUS TEST

Position limits are probably the most emotive and polarising issue in commodity regulation. The passion expended on the issue, by both supporters and opponents, is far out of proportion to their practical impact. Instead, limits have become an ideological litmus test of whether someone is a believer in free markets or regulation.

In agricultural markets, position limits have been enforced by the CFTC since the 1930s and are no longer considered controversial.

If eventually extended to energy and metals markets, under the commission's current proposals, their impact on volatility is likely to be modest.

Position limits would help prevent corners and squeezes, as well as the unintentional volatility associated with the accumulation and liquidation of big positions like Amaranth's. But they would not reduce the volatility associated with commodity price bubbles, where a large number of speculators try to trade in the same direction at the same time, driving prices temporarily away from their fundamental equilibrium.

If limits will not be as effective as supporters hope, they are unlikely to be as damaging as opponents fear. Critics have not cited a single real-world instance in which limits have harmed liquidity or prevented a commodity producer or consumer from hedging their risk exposure effectively.

Nor can critics explain why a hedge fund such as Amaranth should have needed to amass positions amounting to 5 percent of all the natural gas consumed in the United States in a year, and why such enormous positions, with their almost inevitable impact on price formation, should not be restricted.

TIME TO BURY THE HATCHET?

The commission's first attempt to impose position limits was invalidated by the U.S. District Court for the District of Columbia on narrow procedural grounds.

The CFTC's own legal team "advised that the odds of winning an appeal were quite good", according to Commissioner Mark Wetjen, who strongly supported an attempt to overturn the judge's ruling by appealing to a higher court.

Nonetheless, the federal court appeared hostile to many of the commission's arguments. Even if the commission can cure the procedural defects that sank its first rulemaking, its second attempt could be vulnerable on other grounds.

So the question is whether the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association, which represent derivatives dealers, will mount another legal challenge.

Position limits, like much of the rest of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, are still bitterly resented among banks and derivatives dealers.

But hopes of repealing the law have vanished with President Barack Obama's re-election and the Democratic Party's continuing control of the Senate. Derivative dealers must contend with the reality that Washington and the CFTC will be controlled by Democrats for the next three years.

Passions may have cooled a little. Many of the largest banks in commodity markets, who were the principal opponents of position limits, have scaled back their operations and sought to mend fences with regulators. Institutional investors, too, no longer see commodities as a growth area that could be hampered by limits.

COMPROMISE OR CONFRONTATION?

The latest position limit proposals contain some significant concessions to the industry.

Proposed limits, especially for energy, would be set at a high level. Spot-month limits for gas and oil could be up to four times higher than the limits currently fixed by exchanges. Limits for other months and all-months combined would also be generous. The proposals contain generous exemptions for hedgers.

The commission's own analysis shows fewer than three traders would have exceeded the proposed overall limits on crude oil during 2011 and 2012, and no traders in natural gas. Rather more traders would be caught in smaller and less liquid markets for gasoline and heating oil.

Many more crude and gas dealers, investors and hedgers would be affected by the spot month limits, but in principle those are less controversial because there is widespread agreement large positions should be limited in the run-up to delivery to prevent corners and squeezes.

For free-market purists, there can never be any justification for limiting position size; the latest version of the proposals must be as fiercely resisted as the first.

But perhaps calmer heads will prevail. The industry could pocket its court win, declare victory, and accept a modified version of the current proposals, safe in the knowledge limits will be set at such a high level they will not constrain normal trading.

The risk if the industry continues to resist position limits tooth and nail is that Congress will have to clarify the law, and the industry might like the answer a lot less. (Editing by Dale Hudson)

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