London, 11 January 2010

The Commodity Futures Trading Commission (CFTC) looks set to unveil proposed new rules this week that combine higher position limits in energy markets with a more restrictive process for granting exemptions.

The outcome of the CFTC's review is not unexpected. It is a compromise between those who have called for stricter limits to prevent manipulation and excessive concentration (CFTC Chairman Gary Gensler, Commissioner Bart Chilton and several legislators in Congress) and those who warn that tougher limits risk driving business offshore and into unregulated physical markets (Commissioners Michael Dunn and Jill Sommers as well as many within the futures industry).

It represents the only way forward that was politically feasible for the Commission. Maintaining the status quo, as many in the futures industry and investors want, is not an option, given intense scrutiny from Congress and the new public scepticism about the activity of the masters of the universe on Wall Street.

But the Commission has little political cover for a tougher approach, given lack of support from the Financial Services Authority in London, lukewarm interest from the White House, Treasury and congressional committees, and internal divisions among the commissioners.

Whether the proposed rules have much practical impact, or largely enshrine the existing system, depends on how the detail of how the new limits and exemptions are formulated.

The Commission must make crucial decisions in several areas that will have a decisive effect on how the rules shape trading activity:

(1) FIXED OR DYNAMIC LIMITS

Will position limits be set as a fixed number of contracts or a maximum share of open interest for each market participant?

Fixed limits would build on the existing system in both agricultural markets (federal limits set by the CFTC) and energy markets (position limits and accountability levels set by the exchanges). They would be much simpler to enforce and give greater certainty for both the industry and regulators. They would avoid a situation where one market participant with a large share close to the maximum allowable percentage could be forced to cut its position simply because other participants had cut theirs, reducing overall open interest.

But fixed limits would also be somewhat arbitrary and would need to be regularly reviewed and adjusted to ensure they remained appropriate. Set too high, they could allow a few participants to dominate a market when open interest falls. Set too low, they would encourage circumvention with no corresponding gain in ensuring the market remained competitive and diverse.

Linking limits to open interest would make them dynamic and ensure limits evolved in line with changing market conditions. As a market grows and liquidity improves individual participants would be allowed to grow their positions. Conversely, if the market shrinks, positions would have to be reduced in line with lower liquidity.

In practice the CFTC could opt for a blend of the two systems. It might opt to keep the system of fixed limits for the contract nearest to maturity while setting limits for other months in terms of a percentage of the open interest. It could also set fixed limits but base them on current levels of open interest, reviewing and adjusting them periodically in line with changes in the level of interest. Fixed-but adjustable limits might offer the best combination of certainty for market participants with flexibility.

(2) INDIVIDUAL CONTRACT MONTHS

If the CFTC decides to set fairly generous overall limits, it must decide how to prevent the build up of excessively concentrated positions in individual contract months.

Having a claim to barrels of oil under the Nov 2010 contract (CLX0) is not the same thing as having a claim under the Dec 2010 contract (CLZ0). Contracts are not completely fungible. The build up of large positions in certain contract months can distort or threaten to distort the market, even when the position remains a much smaller share of open interest taken as a whole across all contract months.

It was the concentration of positions in certain months that caused problems with the Amaranth hedge fund in 2006 and which triggered the Commission's decision last summer to withdraw position-limit exemptions from two index operators in the CBOT wheat market.

If the Commission decides to raise overall limits, this concentration problem could become worse. At the moment, the Commission and exchanges specify a three-part limit: (a) front month; (b) single month; and (c) all months combined.

In most instances, the single-month limit is quite high compared with the overall total, allowing traders to concentrate a substantial part of their overall position in just one contract.

For example, the limits in CBOT wheat are 600-5,000-6,500 contracts respectively, so a participant can hold as much as 77 percent of its total position in one month. For NYMEX crude, the limits are 20,000-10,000-3,000, allowing participants to hold up to half the total in a single contract.

The CFTC must decide whether to specify fixed or percentage limits for individual months as well as an all months total. If it sets the overall total at a fairly generous level to accommodate the needs of physical hedgers and investors, it must decide whether to set more restrictive totals for individual months to prevent excessive concentration in specific market segments.

In most cases, a more generous overall limit should probably be combined with tighter single-month restrictions that are a much smaller share of the global total than at present.

(3) EXEMPTION-GRANTING PROCESS

The Commission and exchanges currently grant exemptions from position limits for "bona fide hedging transactions and positions" (the detailed requirements are set out at 17 CFR 1.3(z)). They are meant to be limited to "transactions or positions normally represent a substitute for transactions to be made or positions to be taken at a later time in the physical marketing channel" and where "they are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise".

Some exemptions have been granted to a "person [who] owns, produces, manufacturers, processes or merchandises" commodities. But others been given to banks, swap dealers and other financial institutions to offset their positions in commodity indices or index-like products they have sold to clients.

In the past, exemptions have been used to evade position limits that had become too tight over time and could not accommodate the large inflows of investment money into commodity markets. Raising the overall position limits should reduce the need to grant so many exemptions in future.

But the Commission must still decide whether to continue providing an exemption for swap dealers and index operators to offset financial rather than physical exposures. This is potentially the most tricky area. There is no appetite for blocking investors from getting exposure to commodity prices via futures markets.

The Commission will probably want to continue allowing investors to access the market via exchange-traded funds (ETFs) and the various types of index products, but granting lots of exemptions would once again undermine the purpose of the limits. If position limits are to have any meaning, they must be binding on most participants most of the time.

The Commission may decide to raise limits and then refuse further exemptions to index operators. Collectively, investors will be able to take a substantial position, but they may be required to do it via several separate index providers of ETFs rather than just one or two, preserving diversity and perhaps avoiding some of the obvious distortions associated with index rolls that have been evident in the last three years.

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