Prior to the debt markets seizing up, the Bear Stearns bailout, the lack of a Lehman Brothers bailout, TARP, and all the myriad fallout from the credit crisis which led to the deepest and longest recession in a generation, there was deep concern over rising commodity prices. Specifically, the spike in crude oil in the summer of 2008 — up to $147 — led to public outcry and demands for investigations.
As in the past, politicians, analysts and certain market gurus sought out scapegoats, including a favorite in times like these, speculators. This time was different as nearly concurrently with the substantial rise in commodity price, a new player joined the market — the long-only commodity investor.
At the beginning of this century we began to see growth in products that tracked commodity indexes. The Goldman Sachs Commodity Index, or GSCI (now the S&P GSCI), was the most popular, but there were others, including the Dow Jones AIG Commodity index (now Dow Jones UBS Commodity Index) and the Rogers International Commodity Index. These indexes track the performance of a basket of commodities in a rules-based process and were made investable to institutional and retail investors looking to allocate a portion of their portfolio to commodities.
Monies in these funds were invested either directly in the futures markets or in the swaps markets, with the swap market intermediaries eventually using futures to hedge the exposure they provided to the fund.
Commodities, which always have been viewed as a hedge against inflation, entered a bull market at the turn of the century and, with deficits growing throughout the last decade and the value of the U.S. dollar falling precipitously, many investors were looking for such a hedge.
In addition to funds tracking these indexes were exchange-traded funds on individual commodities, such as crude oil, gold and silver. This may have heightened suspicion as one of the charges made against these investments is that they were basically hoarding commodities, forcing prices higher unrelated to the underlying fundamentals. While the argument of hoarding doesn’t hold a lot of water with funds that roll futures positions at the beginning of the month preceding expiration, some of the ETFs actually held the physical commodity backing the investment.
While for many, the controversy over the spike in crude oil faded with the credit crisis and efforts by the Treasury and Federal Reserve to save our banking industry, others were stuck on the notion that speculators were to blame, and once our banking sector moved away from the brink and commodity prices began to rise off the crisis lows, the focus returned to speculators.
Excessive speculation was blamed and restricting or limiting speculative access to the market was viewed by many as a solution.
The authority of the Commodity Futures Trading Commission (CFTC) to set position limits has been an issue debated for a long time. The CFTC has held hard limits in agricultural commodities for many years. For other commodities the exchanges set hard spot-month limits and position accountability levels. The Dodd-Frank Act attempted to end any confusion by addressing position limits. CFTC Chairman Gary Gensler said, "The Dodd-Frank Act expanded the CFTC’s authority to set position limits and also directed us in a more clear way to actually do that and expanded it to [OTC] derivatives as well in something called aggregate position limits…"
Dodd-Frank called for limits in 180 days for energy and metals (that did not have specific CFTC limits) and 270 days for agricultural products. The CFTC missed those deadlines but on Jan. 26 put out a notice of proposed rulemaking.
A common complaint by exchanges during the run-up to the rule proposal was that listed contracts acted properly and that position limits on listed futures would push business to the over-the-counter market and overseas; it would not affect excessive speculation, if it even existed, but simply push speculation to other venues.
Dodd-Frank addressed this by directing the CFTC to propose position limits in physical commodity futures contracts as well as swaps that are economically equivalent to those contracts. The proposal covers 28 exempt and agricultural commodities (see "Limiting exposure"). The exempt commodities are the energy and metals contracts that previously did not have CFTC limits.
In the first step of the rulemaking the Commission will set the spot-month position limits at 25% of deliverable supply for a given commodity. This currently is the procedure in both the agricultural commodities and exempt commodities, but needs to be set by the Commission so it can add economically equivalent swaps to the position limit structure.
Limits on positions in similar cash-settled contracts will be the same for entities with positions in the physical contract. If an entity has no position in the physical contract, cash-settled contract limits will be five times that of the physical.
Under the proposed rules non-spot-month position limits (aggregate single-month and all-months-combined limits) will be set for each referenced contract at 10% of open interest in that contract up to the first 25,000 contracts, and 2.5% thereafter.
That is for the exempt markets. The open interest formula was used in 2005 to set non-spot limits in agricultural markets and the proposal would retain what it calls "legacy limits" in these markets. Legacy limits are those set in 2005 based on 2004 open interest, and would set limits significantly below what they would be if they simply applied the formula based on 2010 open interest (see "Sitting at the kids’ table").
The proposal asks for comments on whether it would be better to adopt the same formula for other markets or to increase the limits to levels requested by the Chicago Board of Trade in an April 6, 2010 petition (that would still fall short of the formula based on 2010 open interest).
This drew a comment from Gresham Investment Management Chairman Henry Jarecki. Gresham operates a long-only commodity-strategy-based fund that previously had been given a No-Action letter from the CFTC granting it limited relief from spec limits. Jarecki wrote,
"This decision strikes me as illogical and unfair. …The proposal would, on one hand, maintain the status quo in the agricultural markets but, on the other, impose new limits in the energies and metals based on a formula that was introduced 18 years ago to set limits on agricultural commodities. …the proposal is unfair because it will put Gresham at a distinct disadvantage to its primary competitors: The large investment banks."
Jarecki says delays in implementation would allow the banks to continue on with their hedge exemption, which could force him to do business with competitors as he would have to enter the swaps market rather than execute in futures.
However, CFTC Commissioner Bart Chilton, perhaps the strongest advocate of limits, says he supports higher limits for agricultural futures, though does not necessarily support simply applying the formula the same way to ag markets.
For many, spec limits were a moot point as swap dealers enjoyed an exemption from them based on a previous rule interpretation regarding financial hedges. Many in Congress supporting limits also supported redefining what constituted a bona fide hedger to strictly commercial hedging of physical market exposure. Congress directed the CFTC to change the definition and by removing the word "normally" from the definition altered the exemption. The new definition of bona fide hedging
"recognizes bona fide hedging for derivatives that are subject to this rulemaking only if such transactions or positions represent cash market transactions and offset cash market risks, as opposed to the acceptance of bona fide hedging transactions and positions as activity that normally, but not necessarily, represents a substitute for cash market transactions or positions."
Basically the rule forces the Commission to look through to the counterparty and if the counterparty is a bona fide hedger then the swap dealer is granted the exemption.
Exemptions for preexisting positions and bona fide hedging aside, the Commission estimates that on an annual basis, the proposed limits will affect 70 traders in agricultural contracts, six traders in base metals contracts, eight traders in precious metals contracts, and 50 traders in energy contracts.
What comes first, the problem or the solution?
While Dodd-Frank specifically addressed position limits there still is a disagreement as to whether the CFTC was mandated to set limits proactively or to do so only in lieu of evidence of "excessive speculation."
Dodd-Frank calls on the Commission to set position limits
"For the purpose of diminishing, eliminating, or preventing such burden [of unwarranted or unreasonable price fluctuations resulting from excessive speculation], the Commission shall…fix such limits on the amount of trading which may be done or positions which may be held…. as the Commission finds are necessary to diminish, eliminate, or prevent such burden."
The wording has allowed for different interpretations with those supporting limits seeing a definite mandate and others an option for the regulator once a definite finding of excessive speculation has been proven. CME Group Executive Chairman Terry Duffy noted in Congressional testimony that
"[Dodd-Frank] indicates that such limits would be ‘unnecessary’ where burdensome excessive speculation does not exist or is unlikely to occur in the future. CME Group’s comment letter on the Commission’s energy position limits proposal discussed at length the absence of any credible empirical evidence of the existence of burdensome excessive speculation or its likely future occurrence."
Several comments on the proposed rule made a similar point but the rule proposal states,
"The Commission is not required to find that an undue burden on interstate commerce resulting from excessive speculation exists or is likely to occur in the future in order to impose position limits. Nor is the Commission required to make an affirmative finding that position limits are necessary to prevent sudden or unreasonable fluctuations or unwarranted changes in the prices or otherwise necessary for market protection. Rather the Commission may impose position limits prophylactically, based on its reasonable judgment that such limits are necessary for the purpose of "diminishing, eliminating or preventing" such burdens on interstate commerce that the Congress has found result from excessive speculation."
The debate over the interpretation is split. Senator Tom Harkin (R-Iowa) in a letter to the Commission stated,
"This language has never been interpreted to require the Commission to make affirmative findings of harm having been caused in order to impose speculative position limits; rather the language compels the Commission to take action to deter and prevent manipulation and other disruptions in market integrity. It does not limit the Commission to acting solely after finding that such disruptions have occurred."
Several other like-minded members of Congress have expressed the same opinion but it is not universal.
More dicey is the treatment of index investors. The change in the hedge exemption could make life difficult for them. In a letter to the agency sent while she was still Chairman of the Senate Ag Committee, Senator Blanche Lincoln talks specifically about not limiting index investors:
"I urge the CFTC not to unnecessarily disadvantage market participants that invest in diversified and unleveraged commodity indexes. ...diversifed, unleveraged index funds are an effective way to diversify their portfolios and hedge against inflation. Unnecessary position limits placed on mutual fund investors could limit their investment options, potentially substantially reduce market liquidity, and impede price discovery."
The difference of opinion in Congress is mirrored at the CFTC. While only one commissioner, Jill Somers, voted against putting the proposal out for comment, Commissioners Scott O’Malia and Michael Dunn expressed reservations.
While addressing the Futures Industry in March, Chairman Gensler acknowledged that some Dodd-Frank rules would be late and bucketed the myriad rules into three phases of implementation: early, middle and late. Duffy recalled this in his recent Congressional testimony and recommended the Commission save position limits for last.
The odd and perhaps dangerous part of the debate over spec limits is that those opposing and supporting it are operating under diametrically divergent realities. Those demanding tight limits believe with an exacting level of surety that speculators are distorting the market, and by some manner of restraining their activity prices would fall, despite the fact that there is no clear evidence to support that position, either in its diagnosis or in its prescription. Those opposing limits see no link or too weak of a link to take action and note that often in such cases the prescribed remedy will exacerbate further the problem it meant to address, as has been the case in the past.
And there is a third camp of folks who believe speculators, long-only funds in particular, probably are affecting price but believe any regulatory fix only would add to the problem.
The Commission has received nearly 12,000 comments, many of which are calling for tight limits but appear to be form letters generated from one source. In fact, a large portion of these letters focus on one commodity, silver, and appear to be generated by a theory making its way through metals-centered websites that a large banking institution, with the help of regulators, is manipulating the price of silver lower, not higher.
The position limit proposal does not go nearly far enough for many of those who believe speculators are manipulating price, which may make it seem — when compared to industry resistance — like the Commission struck the right balance, but its characteristics particularly regarding aggregation rules are extremely complex and will add costs. But the larger issue is that it purports to be a solution to a problem that may not necessarily exist.
Dunn noted at a public hearing on Jan.13 that the CFTC has a mandate to set position limits but added,
"To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive speculation. The task then is for the CFTC staff to determine whether position limits are appropriate. With such a lack of concrete economic evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst, a placebo for one that does."
Twelve thousand comment letters later not much has changed.