From the June 01, 2011 issue of Futures Magazine • Subscribe!

The spec limit debate

Hedge exemption

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."

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