CFTC's Chilton: We must avoid 'regulatory arbitrage'

Massive Passives

Another market morphing area that we need to be thinking about is the market traders themselves. I call one relatively new group of traders “Massive Passives.” These are fairly non-traditional market participants who are large and have a fairly price-insensitive trading strategy. They get in markets and stay there—for the most part. In the run-up to the financial crisis of 2008, we saw an enormous shift in speculative money coming into futures markets. Over a several year period, roughly $200 billion in speculative money came into these markets—all U.S. futures markets, not just the energy complex. West Texas Intermediate crude oil reached $147.27 a barrel that year. Brent crude got to $145.91. Did these new speculators cause those prices to reach historic levels? I am not saying they were the cause or the culprit. In fact, let me be clear: I do not think they drove prices up nor did they drive prices down. While I am not saying that they were the cruise control on gas or oil prices, I do think they pumped the petrol pedal and prices moved up. They were a part of the price rise. Similarly, when they did get out of the markets, as the economy was melting down, prices decreased.

You don’t have to take it from me, though. Economists at Oxford, Princeton, and Rice universities and many other private researchers say that speculators have had an impact on prices—oil prices and food prices most notably.

But, even as late as last week, some senior exchange officials denied there was any evidence whatsoever that speculators impacted prices. They didn't call the professors idiots or crack pots. Remember the exchange between Lionel, the speech therapist in the movie and the King about smoking? As, King George is lighting up a cigarette, Lionel says, “Please don’t do that.” “I believe sucking smoke into your lungs will kill you.” George says, “My physicians say it relaxes the throat,” and Lionel says, “They're idiots.” The King says, “They've all been knighted.” Lionel says, “Makes it official then.”

Well, these folks aren’t saying the studies out there are bogus or that the professors who worked on them were idiots. They said no evidence existed, as if no studies or papers or quotes existed whatsoever. Well, they are wrong. In fact, two weeks ago I spoke at a Futures Industry Association meeting and listed ten specific cites of studies, papers or quotes that illustrate a link. In fact, there are dozens of other examples. Some of these examples might even come from sources you think unlikely. Here’s one: “We estimate that each million barrels of net speculative length tends to add 8-10 cents to the price of a barrel of crude oil." Any idea where that bit of zealous craziness came from? Maybe Berkley or Oxford? Well no. That came from the March 21st issue of the Goldman Sachs “Global Energy Weekly.” So, folks can make their own decisions about any link between speculators and prices, but to say that there are no studies is simply wrong. I can continue to explain that to folks, but I can’t comprehend it for them.

Consequently, is that what’s going on today, like it may have in 2008? I’ll leave it to you to decide for yourself, but let me give you a little food for thought. There are now more speculative positions in commodity markets than ever before. Between June of 2008 and January of 2011, futures equivalent contracts held by these types of speculators increased 64 percent in energy contracts. In June of 2008, the number of such contracts totaled 617,000. By September of 2010, they were 923,000. And, by January of this year, they had grown to 1,011,000. In metals and agricultural contracts, those speculative positions increased roughly 20 percent or more.

As I’ve said, we need speculators. We all get that. Without them, there is no market. Speculators that contribute to liquid markets can also ensure less volatility. The sheer size, however, of excessively concentrated speculative interests has the potential of moving markets, of influencing true price discovery. That can make life difficult for the commercial hedgers who use markets to manage commercial business risks, and for consumers who rely upon them to fairly price just about everything they purchase.

The U.S. reform law addresses this by requiring mandatory speculative position limits—to ensure that too much concentration doesn’t exist. We were supposed to implement those limits in January, and I’m disappointed that we have not done so. If we had the desire, we could institute limits for the spot month in OTC trading based upon the physical supply. We could put limits in regulated markets. We could have helpful limits in place that could guard against markets being adversely impacted by excessive speculation. We could do that now if we wanted. Unfortunately, we are still a way off. Perhaps we can learn something from the Brazilians on position limits. Brazil boasts the second largest exchange in the Americas. They already have position limits in place and seem to be doing rather well.

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