By John Kemp
LONDON, Sept 28 Even before new position limits on energy contracts like crude and natural gas come into force on October 12, the U.S. Commodity Futures Trading Commission (CFTC) has taken an increasingly aggressive approach to enforcing the existing limits on agricultural items like cotton, wheat and soybeans.
In the last week alone, the CFTC has imposed civil monetary penalties and disgorgements totalling nearly $2.5 million on JPMorgan, Australia and New Zealand Bank, and a China-based individual, Weidong Ge, to settle accusations they breached federal speculative limits on cotton (all three respondents), wheat (ANZ) and soybean oil (Weidong Ge).
It brings the total number of settlements this year to five, up from three in 2011 and just two in the five years between 2006 and 2010, according to records published on the Commission's website.
The CFTC's actions have targeted some of the largest and most prominent banks, brokers and hedge funds in the business.
Earlier in September, the Commission penalised Citigroup for breaking limits on wheat. In February, it took aim at hedge fund DE Shaw for violating limits on soybeans and corn. Last year it went after Merrill Lynch (cotton), Newedge (live cattle) and Daniels Trading (rough rice).
Under the current system, the CFTC sets federal position limits on the number of contracts any trader can amass in the spot month, any other month, and all months combined, for nine agricultural commodities (corn, oats, soybeans, soybean oil, soybean meal, cotton, wheat, hard red spring wheat and hard winter wheat) (17 CFR 150.2).
For energy, exchanges like CME Group and Intercontinental Exchange (ICE) set their own hard limits in the spot month and softer accountability levels for other months. But the CFTC is set to begin enforcing federal limits on the spot month from October 12 and will introduce limits on other months and all months combined in future.
The new limits on energy contracts are being challenged in federal district court by the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA). But the judge has so far refused to grant a preliminary injunction to prevent them going into effect.
In January, the CFTC rebuffed a request from ISDA and SIFMA to postpone implementation until the lawsuit is resolved. The industry may file a further request for delay before the limits go into effect in the middle of next month, citing practical problems of complying with them.
The upsurge in enforcement appears to be the result of a deliberate decision to get tougher and send a signal to market participants that both the Commission and exchanges will adopt a zero-tolerance approach to any trader whose position exceeds the limits.
In recent months, ICE has circulated repeated reminders to its members that position limits must be observed at all times and apply on an intra-day basis.
Some breaches appear unintentional. Penalising JPMorgan for holding a net short position in excess of the federal cotton limit "on several days between September 16 and October 5, 2010", the CFTC explained the bank "held positions in excess of the speculative position limits as a result of an inadvertent deficiency in its newly created automated position limit monitoring system."
JPMorgan had successfully applied for a hedging exemption permitting it to hold a bigger net long position. But it did not have a similar exemption on the short side. Unfortunately "the automated monitoring system did not differentiate between the different applicable long and short side position limits" according to the settlement order.
"After learning of this deficiency, JPMorgan utilized a manual position limit monitoring procedure pending correction of the automated monitoring system. Despite adoption of this manual position limit monitoring procedure, JPMorgan violated its short-side speculative position limit on several occasions."
The bank has corrected the automated system and is implementing enhanced internal controls, including retraining of relevant employees. Still, the mistake has cost it $600,000.
In the case of Weidong Ge, and Sheenson Investments, the CFTC alleges position limits were exceeded on several occasions in 2009 in the soybean oil contract and again in 2011 in cotton.
In January and February 2011, Sheenson and two other companies in which Ge had a substantial interest (Chaos BVI and Chaos HK) at times exceeded the single month cotton limit of 3,500 contracts by as much as 599 contracts (17 percent) and the all-months limit of 5,000 contracts by up to 389 contracts (8 percent).
In February and again in July 2011, the combined positions of Sheenson and Chaos were reduced below applicable limits after the CFTC's Division of Market Oversight contacted the companies. Nonetheless, the CFTC has ordered Ge and Sheenson to pay a civil monetary penalty of $500,000, and disgorge $1 million of profits.
NO MORE NICE GUY
Following the spike in oil prices in 2008, the CFTC was heavily criticised for handing out a plethora of hedging exemptions in the form of "no action" letters from Commission staff to banks and other institutions wanting to run large futures and options positions as part of the rapidly growing commodity index business.
For many years, the derivatives industry appeared to play "cat and mouse" with the Commission on limits. In theory, all exchange-traded futures and options contracts in the United States were subject to some form of limit. In practice, the exemptions were so many, and enforcement so weak, that the limits were largely illusory.
The Commission has since taken a much tougher line. "No action" relief from federal limits on soybeans, corn and wheat granted to two funds in 2006 was revoked in August 2009.
At the time, CFTC Chairman Gary Gensler warned, "I believe that position limits should be consistently applied and vigorously enforced."
The Commission has subsequently been embroiled in an escalating row with banks, brokers and investors over whether it has statutory authority to extend federal limits from agriculture to energy. It culminated in an unprecedented legal challenge by ISDA and SIFMA in December 2011, asking the U.S. District Court for the District of Columbia to block them as "arbitrary and capricious," unsupported by evidence or proper cost/benefit analysis.
Many in the industry remain openly contemptuous about limits. "Position limits are, at best, a cure for a disease that does not exist or a placebo for one that does. At worst, position limits may harm the very markets they are intended to protect."
Those words were spoken by then-CFTC Commissioner Michael Dunn - who has since become a senior policy adviser to law-and-lobbying firm Patton Boggs and non-executive chairman of the Depository and Trust Clearing Corporation's new Swap Data Repository. But the sentiments are held even more strongly by many in derivatives markets.
The legal challenge is still pending. In the meantime, however, the ramped up enforcement process is meant to signal limits should be taken seriously. Non-compliance with existing limits on farm contracts will result in tough penalties. If and when limits on energy contracts go into effect, they will be strictly enforced.
The CFTC clearly expects market participants will err on the side of caution and ensure their positions remain well-within the caps at all times. If dealers can spend millions of dollars developing high-frequency trading systems, they can develop systems to ensure individual trades do not exceed permitted limits in real time.
It is an aggressive and uncompromising approach. But having tried to weaken and block position limits at every stage, clogging up the rulemaking process and challenging it at every step of the way in the courts and Congress, the banks and trade associations cannot be surprised the CFTC is determined to crack down to restore respect for the rules.