One of the Commodity Futures Trading Commission’s (CFTC) most colorful commissioners, Bart Chilton, announced last week that he is stepping down soon. Chilton, one of the few commissioners at the CFTC with agricultural experience, has been a rock-n-roll hero of position limits during his term, frequently referring to rock music in explaining his views on commodity derivatives regulation. For example, he referred to position limits—a ceiling on the number of futures contracts a single non-commercial trader is allowed to hold—as “suggested speed limits on a dark desert highway” (a reference to the 1977 Eagles song “Hotel California”).
Chilton’s parting speech noted that the CFTC was “taking it to the limits one more time” (a reference to another Eagles song). This was in direct reference to the CFTC’s announcement that same day of new, rewritten regulations to establish position limits on speculative commodity futures trading. The proposed rules mark an important milestone for the CFTC in its attempts to rein in excessive speculation that can disrupt commodity markets. But in the longer history of the issue, how best to regulate these markets is likely to remain contested.
The rules are aimed at a suite of physical commodities, including agricultural crops, fuels, and metals. The 2010 Dodd-Frank Financial Reform Act requested the CFTC to impose position limits to help reduce volatility in these markets. In its attempts to do so, the regulating agency has faced a storm of criticism and legal action from financial-industry interests who feel that position limits are unwarranted and disruptive of free markets.
Indeed, this is the CFTC’s second try at crafting new rules to impose position limits in recent years. The first version—unveiled in 2011—was successfully challenged in court by financial lobby groups. The International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) disagreed with the CFTC’s interpretation that the Dodd-Frank Act required it to impose position limits. They also claimed that the CFTC did not demonstrate that position limits were justified.
In October 2012, just before the earlier rules on position limits were due to go into effect, the courts ruled in favor of the challengers, preventing reforms from being implemented. The CFTC filed an appeal to the court’s decision, and got right back to work drafting a new version of the regulations, which were finally approved by the last week.
Consistent with its previous version, the proposed rules impose position limits on 28 physical commodities as well as derivatives associated with those commodities. Bona fide hedgers—that is, those traders who are producers or end-users who are in the markets to hedge against genuine risk—are exempted from these limits.
Other exemptions were also introduced, however, and the requirements for parent and affiliate firms to bundle their positions (important for reporting purposes and to determine if position limits have been exceeded) have been eased. The earlier version required firms to aggregate their positions if they owned a 10% or more stake in an affiliate, and that requirement has now been relaxed to those firms with more than a 50% share in an affiliate. This loosening will likely please banks that own a minor stake in commodity firms, as they earlier complained that the 10% threshold was far too low.
In introducing the proposed regulations, the CFTC asserted that it already has congressional power to impose position limits (which it has had since the Commodity Exchange Act was passed in 1936) and restated that the Dodd-Frank bill required it to put new position limits in place.
Still, to ward against another potential lawsuit, the regulator provided over 450 pages of rationale for the proposed regulations. It gives detailed examples of the cornering of the silver market in 1979-80 by the Hunt brothers, and manipulation of the natural gas market in 2006 by the hedge fund Amaranth, as justification for the imposition of position limits.
The CFTC also provides an extensive evaluation of over 134 academic studies on the effect of commodity speculation on price volatility (a review that is much more even-handed and inclusive than the ISDA’s very selective review of literature on its CommodityFACT website). The review revealed mixed views, but as CFTC Chairman Gary Gensler noted, in his view when studies are split about the effects, “it’s better to err on the side of caution.”
The CFTC’s approach, this time around, to show how a lack of limits has distorted markets is a smart attempt to reverse the burden of proof. The onus now is on the lobby groups that seek to challenge the rules to show that the imposition of position limits harms liquidity and prevents hedging.
Although the proposed rules are now on the table, there are reasons to temper one’s optimism going forward. The two most vocal champions of tighter position limits at the CFTC have announced that they are leaving the organization. Gensler had already announced, before Chilton, that he would be departing by end of year.
There is likely to be a fierce battle over the replacements for Chilton and Gensler, and there is every chance that their replacements won’t be as committed to tight rules on position limits. President Obama only just this week announced his nominee to replace Gensler, Timothy Massad, who as a Treasury official was responsible for bailing out the banks following the credit crisis.
Position limits for commodity markets have been a subject of heated debate on and off for the past 100 years. As history shows, regulations on commodity traders have repeatedly been hard fought, later challenged, often repealed, and subsequently brought back again after a crisis in which speculators are viewed with great suspicion. Speculators, in other words, have tried to live “Life in the Fast Lane,” while regulators have been reluctant to “Take it Easy.” Given the winding path of commodity derivatives regulation over the years, and with the promise of a “New Kid in Town,” it is hard to know how significant this latest development will be in “The Long Run.”
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