London, 8 November 2009 

Chairman Gary Gensler and his fellow commissioners on the Commodity Futures Trading Commission (CFTC) face tough decisions in the next few weeks, with a looming, self-imposed December deadline for deciding new position limits and rules on hedging exemptions in energy markets.

The Commission may surprise its fiercest critics by launching a review that will raise limits on some of the more liquid contracts such as crude oil and natural gas. 

Setting Federal Limits 

The CFTC appears committed to imposing federal position limits on energy markets and setting stricter rules for granting hedging exemptions.

Gensler has noted that the law states the Commission "shall" set limits and has no discretion in the matter. He has praised limits as a means to prevent excessive concentration and ensure markets reflect a diversity of views. And if limits are to be effective, bona fide hedging exemptions will have to be fewer and policed more rigorously.

The Commission is poised to wrest authority for setting limits and granting exemptions back from the exchanges. In future, it will set them itself, bringing practice in the energy markets into line with agricultural contracts, where the CFTC rather than exchanges already sets limits and grants exemptions.

Commission staff have already begun to scrutinise hedging exemptions in the agricultural markets more closely, revoking exemptions granted to Deutsche Bank and one other index operator. Similarly tough scrutiny is likely when the CFTC takes over the management of energy exemptions.

How Much Tougher? 

The commissioners are more divided and uncertain on other issues, including the level of the limits; whether to continue giving exemptions to banks and other institutions that use futures to hedge financial as well as physical exposures to energy prices (for example index operators and managers of exchange-traded funds); and how far to push the CFTC's authority into physical commodity markets.

The Commission is under intense pressure from the industry not to restrict access too severely or risk business migrating to less heavily regulated markets in London and elsewhere.

Several banks have warned they are ready to shift the investment focus to physical oil and other commodities (which the CFTC does not regulate). There is mounting interest in tailored commodity indices that invest in futures contracts which are not deliverable in the United States (and which again escape the CFTC's jurisdiction).

No Political Cover 

The CFTC has little political cover for a tough clampdown:

• Regulators in London appear content to maintain a light touch, so tough limits in the United States risk being circumvented in a re-run of the regulatory arbitrage that undermined banking regulation earlier in the decade.

• The White House and U.S. Treasury Department are distracted by other issues. Commodity market regulation has sunk far down the list of priorities.

• Legislators show lukewarm interest. Senators Bernie Sanders (Independent, Vermont) and Maria Cantwell (Democrat, Washington) continue to press for tough limits and exemptions, but both are marginal on this issue. Lawmakers with more influence, such as House Financial Services Committee Chairman Barney Frank, are more worried about maintaining the competitiveness of U.S. banks and show little appetite for an aggressive clampdown.

• The CFTC continues to come under the jurisdiction of the House and Senate agriculture committees (a legacy of the time before 1980 when the most important futures markets were in farm products). The Commission's committee overseers are more concerned with fixing convergence problemsin the Chicago Board of Trade (CBOT)'s troubled wheat futures contract rather than position limits in crude and heating oil.

Like the rest of the administration's financial reform agenda, the question of position limits and exemptions has lost momentum over the last six months as the financial system has stabilised and attention has turned elsewhere.

Commission Retreats 

Chairman Gensler has been on a speaking tour in recent weeks to build support for effective limits, as well as mandatory clearing for over-the-counter derivatives. In a thoughtful speech last month, he argued "we must ensure that the risks generated by the financial sector are never allowed to push us so close to the brink again the worst financial crisis in 80 years demands the most comprehensive regulatory reform."

He went on to argue "Some have articulated a false choice between stronger regulation on the one hand and a free market on the other. Rules improve markets, however, by enhancing efficiency and integrity. Traffic lights require you to stop your car, but they also ensure that traffic is orderly and efficient. They reduce risk for every person on the highway."

But Gensler cuts an increasingly lonely figure. Even CFTC Commissioner Bart Chilton, who was the earliest policymaker to call attention to the impact of index and other investments on commodity prices, and has consistently argued for tougher limits and fewer exemptions, appears to be backtracking in the face of industry lobbying.

Chilton continues to argue for limits, including on the "massive passive" positions of the index funds, in line with current practice in the agricultural markets.

But in a recent speech, and interview with Reuters, Chilton emphasised "the bar should be set high enough so that we do not chill legitimate business activity and unintentionally create incentives for offshoring and dramatic increases in OTC activity." Limits should be generous initially and could always be ratcheted down later.

Chilton's over-riding priority -- "do no harm" -- is a call for a cautious, status-quo preserving approach. Other commissioners, such as Michael Dunn, appear even less inclined to trigger a confrontation with the industry.

The Final Outcome 

The most likely outcome appears to be a set of binding position limits set by the Commission for all energy contracts, applied on a fully consolidated basis to on-exchange and off-exchange markets where the commodity is delivered in the United States and performs a significant price discovery function.

Many more commodities will be brought within the Commission's remit. The Commission is already looking at a range of OTC power markets. Limits will apply to both active speculators and operators of passive commodity index funds. Exemptions will be harder to obtain and the Commission is likely to require much more documentation to show the position is indeed being used passively to "hedge" a price exposure, both when the exemption is first granted and on a continuing basis.

But the Commission will probably continue to accept that  swap dealers' exposure to index funds gives them a legitimate claim to be "hedging" and allow them to obtain carefully structured exemptions.

The present system combines fairly low limits with generous exemptions to a wide range of players. In this Looking- Glass World, the rules appear tough but are actually lax. In future, the CFTC may raise the limits substantially, especially for some of the more liquid contracts such as crude oil and natural gas, but then grant fewer exemptions.

By raising limits, the CFTC would avoid driving business offshore or into less transparent markets, and reduce the pressure to grant ad hoc waivers, while maintaining at least some control over market concentration, and improving transparency and predictability.

Ends --

By John Kemp, Thomson Reuters columnist. The views expressed are his own

Key speeches by Gensler and Chilton:

www.cftc.gov/ucm/groups/public/@newsroom/documents/speechandtestimony/opagensler-15.pdf

www.cftc.gov/ucm/groups/public/@newsroom/documents/speechandtestimony/opachilton-28.pdf