Click here for CME Group's white paper on position limits in the energy markets.
Click here for EDHEC's study on excessive speculation in the oil futures markets.
Gary Gensler sat quietly while the Futures Industry Association Expo whirled around him. His seemingly calm disposition remained passive when asked about position limits, a hot button topic in Washington D.C. “As it relates to current authority we are taking a serious look at position limits and related exemptions in the energy markets,” said the Commodity Futures Trading Commission (CFTC) chairman, who, it appears, has spent a majority of his time since coming on board at the CFTC eight months ago testifying at Congressional and internal hearings.
Gensler’s stance has been clear regarding hard position limits in energy futures since last summer when he testified before Congress. In fact, the CME Group and the Intercontinental Exchange (ICE) — while both weary of the possible unintended consequences of such limits — seemed so resigned to that fate that they decided to shape the changes rather than fight them.
CME Group CEO Craig Donohue said they were prepared to accept hard limits after providing a detailed warning as to possible negative consequences.
ICE Chairman and CEO Jeff Sprecher stated, “During times that unpopular price signals are being sent by markets, it is often tempting for policy makers to take pro-active steps to address what they perceive to be structural problems in the market. While well intentioned, these measures often fail to achieve their desired objectives.”
This echoed the comments from CME Group, but that is where the two competitors split company. CME Group wants to continue to set position limits and accountability levels and ICE wants the CFTC to have that authority. “Only the CFTC has the placement to view a trader’s positions across all venues to observe true position size — no single exchange or venue is in such a position,” Sprecher said.
During the hearing, Gensler noted that there was a significant distinction between the current position accountability levels and hard position limits (both exchanges administer hard limits on the last three trading days), and has said on several occasions that the current freedom from hard limits is a relatively recent development.
“We have been mandated by Congress to set position limits — this is something that the [CFTC] did with the exchanges in the energy markets through the summer of 2001,” he testified. “It is just eight years ago that this changed. We are taking a serious look whether it is appropriate to protect the public to promote fair and orderly markets to bring position limits in the energy markets as they existed until eight years ago, and as they exist in the agricultural markets.”
BUILD YOUR OWN
With the writing on the wall, CME Group did not want to leave this to chance or to bureaucrats, so they designed their own position limits scheme and revealed it in a white paper
In a precursor to the proposal that could be loosely translated to “let the baby get his way,” CME Group stated, “Although the evidence is clear that speculative positions limits in the energy markets, beyond those already in place, are not warranted, we also recognize that confidence in the futures markets may be undermined by perceptions. Therefore CME Group is proposing the following recommendations.”
The recommendations include: each regulated exchange setting its own position limits for single months, combined and delivery period based on open interest; each exchange administering its own hedge exemption program subject to existing standards until common exemption standards are established by the CFTC; and the CFTC establishing a system for reporting OTC positions and aggregating on-exchange and OTC positions so the combined position could be subject to the limit.
Currently the CME Group’s Nymex and ICE face the same limits for their WTI contracts, which in WTI crude oil include position accountability levels of 10,000 for single-month futures, 20,000 combined and a 3,000 contract hard limit for the last three days of trading in the spot month.
CME Group is proposing a position limit scheme that would be based on the open interest of each exchange. They would set certain hard limits if other markets trading similar energy products agree to adopt comparable programs. “Each exchange and ECM, which is obligated to control excessive speculation, has an obligation under the CEA to set its own limits in proportion to liquidity, volume and open interest.”
CME Group argues that an exchange trading a contract with half the liquidity of a similar CME Group contract — if they faced one industry-wide position limit standard — would benefit from an equivalent limit double that of CME Group. “If Nymex with substantial volume, open interest and liquidity, sets its single-month position limit at 20,000 and an exchange with one-fourth of Nymex’s liquidity, volume and open interest, simply expropriates that number, traders would be able to exploit a position limit of 40,000, when the correct level should have been 25,000, with no more than 20,000 on Nymex and 5,000 on the less liquid exchange.”
ICE doesn’t see it that way. ICE General Counsel Jonathan Short, speaking before the Senate Agriculture Committee in December, said, “Congress and the CFTC should be careful to protect competition by setting aggregate limits across markets and leaving market participants with the choice to ‘spend’ that limit in the venue of their choice.”
Short said the CME Group proposal would “limit competition by inhibiting the development of liquidity in a competing market and locking in the relative market share of incumbent exchanges.”
Even worse for ICE is that under its current no-action letter (that ICE Futures Europe operates under), it is required to follow the position limit regime of CME because they settle their WTI cash settled contract to the Nymex WTI price. A spokesperson for ICE says that would allow CME Group to set levels disadvantageous to ICE. Nymex lists both a physically delivered and cash settled WTI contract but has little volume in the cash-settled contract (ICE only lists a cash contract) and could set a lower level for the cash contract according to the spokesperson.
Going further, ICE maintains that limits should be less restrictive for the financially settled contract. “Where a commodity is physically delivered, position limits make sense. Cash settled contracts settle on the price discovered in the physical markets and don’t represent a claim on the physical commodity; therefor, these positions tend not to be reflected in in the physical price,” the spokesperson adds.
In testimony before the Senate Agriculture Committee, CME Group Executive Chairman Terry Duffy reiterated CME Group’s position, saying, “Legislation should mandate that each [designated contract market] or Swap Execution Facility be required to set its own position limits based on and in proportion to its liquidity, volume, open interest. Any aggregate limits set by the CFTC should not permit free riding exchanges to set internal limits at the level of the aggregate limit, irrespective of the limits it should be setting based on its own liquidity, volume, and open interest.”
Duffy also pointed out that potential limits must include the OTC world. “Language must be added [to current legislation] to ensure that the CFTC refrains from placing hard position limits on regulated exchanges until such time that they are simultaneously placed on the OTC market and foreign boards of trade.”
WHERE’S THE BEEF?
During this process, both exchanges have pointed out that there has been no empirical evidence to support the widespread belief that the price spikes of 2008 were caused by excessive speculation and that the CFTC’s own study released in September 2008 disputes that commonly held notion.
And despite some speculation earlier this year that new evidence would be brought to the fore to support the notion that excessive speculation was responsible, it has not come. The CFTC’s additional aggregated data on commodity markets seems to support previous findings and other studies seem to dispute this as well.
The EDHEC Risk Institute study “Has There Been Excessive Speculation in the U.S. Oil Futures Market?,” written by Hilary Till and released in November, indicates that there was not. Till uses Holbrook Working’s Speculative T-Index (see “Measuring excessive speculation,” page 57) to examine whether outright positioning by speculators and index investors may have been excessive relative to hedging.
The study states in its conclusion: “Within the closed system of the U.S. oil futures and options markets, we find no evidence of excessive speculation, at least not when we use traditional metrics and when we include options positions with outright futures...the balance of outright speculators in the U.S. oil futures and options markets was not excessive relative to hedging activity in those same markets from June 13, 2006, to Oct. 20, 2009.”
EDHEC used the expanded aggregated data from the CFTC, which indicated that the size of index investors — purported to have cause the spike — was dropping, not rising, as crude peaked in 2008 (see “Imagine that,” above).
The data may mean whatever limits are coming may not be as onerous as once feared and perhaps explains why CME and ICE are once again sounding like competitors instead of compatriots.
The ICE spokesperson says that the focus has shifted based on extensive reviews of market positions over the past several months. “It has been more about market concentration and not about speculation because it just didn’t bear out. There was no smoking gun.”
The other, possibly more important, issue being considered has to do with hedge exemptions. Many swap dealers and index funds have been exempted from current limits and accountability levels because they qualify as hedgers. They are hedging a financial position in the futures markets or executing a passive long-term investment approach. Current proposed legislation would create a higher standard for what qualifies as a bona fide hedger. In his testimony, Duffy noted that “a bona fide hedging position would have to be linked to a transaction to be made or position to be taken at a later time in a physical marketing channel. This narrow conception of a bona fide hedge excludes hedging of a wide range of ordinary business risks.”
In its white paper, CME Group states, “Index funds aggregate the buying and selling of many thousands of investors, most of whom are diversifying their investment portfolios and hedging inflation risk.”
In written testimony during this summer’s CFTC hearings on position limits, Henry Jarecki, chairman of Gresham Investment Management (GIM), suggested that if any limits were appropriate they should be applied at the investor level. After all, any investor could invest in the various long only commodity funds and skirt limits while funds like his are simply implementing a passive investment strategy. Seems logical but GIM lost its exemption (GIM operated under a separate exemption granted by the CFTC) a few weeks later.
The CME paper notes, “Denying index funds a risk based exemption from position limits will preclude thousands of small investors from a cost affective means of investing in commodities.”