London, 15 January 2010

The U.S Commodity Futures Trading Commission's proposed position limits for the big four energy markets (WTI crude oil, Henry Hub natural gas, U.S. heating oil and U.S. gasoline) are a compromise. They give the industry most of what it wanted while enacting useful, if generous, limits designed to prevent markets becoming excessively concentrated in future.

The Commission has sidestepped the controversial question of whether excessive speculation contributed to the spike in oil and other commodity prices in the first half of 2008. The Commission notes that the Commodity Exchange Act directs it to act proactively to curb or prevent excessive speculation. It does not need to make a finding as to whether it has actually occurred in the past. The threat that it could happen in future is enough.

By avoiding an analysis of what caused the price spike, the Commission is trying to avoid getting bogged down in an issue that has exposed divisions among the commissioners themselves, as well as with the chief economists' department and other regulators such as Britain's Financial Services Authority (FSA). Commission Chairman Gary Gensler is trying to build a pragmatic consensus around a relatively generous limit regime without waiting to settle the academic debate about what drives the formation of futures prices.

CONCENTRATION, NOT SIZE

The Commission has shifted the thrust of its reforms away from curbing the absolute size of positions towards ensuring the markets remain free from excessive concentration.

Position limits for all months other than the spot month will now be linked directly to the size of the market. Market size will be measured by open interest during the previous calendar year as reported in the weekly commitment of traders reports and adjusted by the Commission each year for changes. Linking position limits to open interest ensures they are dynamic and grow in line with the underlying liquidity.

For highly liquid markets such as crude oil and natural gas, the Commission's proposals would actually raise position limits substantially from current levels, most of which are more theoretical than real because the exchanges have granted so many exemptions from them to facilitate ordinary business as volumes have grown.

* In general, the all-months-combined (AMC) limit will be set at 10 percent of the first 25,000 contracts of open interest, plus 2.5 percent of the remaining open interest over 25,000 contracts. The single-month limit will be set at two-thirds of the AMC total.

* Bona fide commercial hedgers will continue to receive an unlimited exemption for hedging inventory or anticipated purchases or sales of the physical commodity, but subject to a CFTC audit to confirm the exemption is being used to hedge rather than speculate.

* Swap dealers will no longer be able to obtain a bona fide hedging exemption. Instead a new "limited risk management exemption" will be created for them. It will be capped at twice the normal limit (20 percent of the first 25,000 contracts and 5 percent on all open interest above that level -- with the single-month limit again set at two-thirds of the total).

The new rules effectively limit individual speculators to no more than 2.5 percent of the market and swap dealers to no more than 5.0 percent. It will not capture "ordinary" positions, only those of exceptional size.

The CFTC claims the limits would currently affect only 10 large traders across the four energy markets, and even they will be allowed to apply for further exemptions.

The reform is basically sensible. Large positions are not a problem per se. They only become a cause of concern when they account for such a high share of the market that they confer pricing power. So focusing on concentration rather than the number of contracts is a useful improvement. The reform ensures limits will be updated regularly to keep pace with changing market conditions while remaining predictable (they will change only once a year or so).

SINGLE MONTH LIMIT A MISTAKE

The one area where the Commission is probably making a mistake is setting the single-month limit so high in relation to the all-months combined total. NYMEX currently sets single-month limits for both natural gas and crude oil at just half the all-months limit; even that may permit positions to accumulate dangerously in certain segments of the curve. The CFTC's proposals would lift the share from half to two-thirds.

The decision is understandable. The Commission has come under pressure from swap dealers -- many of whom operate commodity indices that concentrate positions in just one or two forward months. But it should rethink this area. Concentration in one or two months has created problems in the past. Amaranth's positions gave it as much as 50 percent of the open interest in certain contract months, even though its share of the overall natural gas market was much lower. Similarly, the Commission last year withdrew position limit exemptions given to Deutsche Bank and another index operator for CBOT wheat and corn, in part because of the buildup of massive positions in specific forward months with limited liquidity.

The Commission needs to ensure the market remains free from excessive concentration throughout the length of the curve, and that requires tougher, not laxer, limits at the single-month level. Coupling a rise in the all-months limit with a rise in the share that can be held in a single month is courting disaster. If swap dealers want to run very large positions in excess of the normal speculative limits, they should be obliged to spread those positions more evenly along the curve to ensure they do not create distortions at any point along it.

KEEPING PLAYERS HONEST

The Commission deals sensibly with the question of how to ensure complex market participants (who may be hedging inventory, operating indices on behalf of clients, and taking speculative positions on their own account) do not abuse the hedging and risk-management exemptions.

Any positions hedgers or swap dealers claim under exemptions will be set against their normal speculative limit. If swap dealers also claim a hedging exemption, this will count against their limited risk management exemption.

So once a hedger or swap dealer has used an exemption to go over the normal speculative limit, they will not be able to take any speculative positions. Once a swap dealer has used a hedging exemption to go over their risk-management limit, they will not be able to claim risk-management exemptions. This system of "nesting" the limits should prevent the system being gamed.

A GOOD TEMPLATE FOR LONDON

The Commission's proposals will not satisfy purists who believe that speculation should be forced back to the margins of the market. But after a year of doom-laden pronouncements about the risk of driving business offshore or into unregulated physical markets, the Commission has produced a set of sensible and workable proposals that will not inconvenience regular market users.

It has thrown down the gauntlet to Britain's FSA to produce sensible proposals of its own. Despite being much criticised for its "no touch" approach to regulation during the boom years, the FSA appears to have rapidly reverted to type. Reform proposals published last month bore all the hallmarks of an agency that has been thoroughly captured by the industry it is supposed to regulate. Much of the text appeared to have been written by industry associations.

The FSA rejected the idea of position limits out of hand. But while absolute limits could restrict liquidity, it is not obvious that concentration limits of the sort the CFTC is proposing are a bad idea. Is it really outrageous to suggest no participant in what is supposed to be diverse market should have a position of more than 2.5 percent or 5.0 percent of the outstanding contracts?

In setting itself against this approach, the FSA seems to be taking a dogmatic and ideological stand for the right of market participants to amass huge shares of the market (reaching 20, 30 or even 40 percent in some cases), then hoping that it will not cause distortions or manipulation.

Gary Gensler's CFTC has produced a thoughtful reform that will help ensure markets remain free from distortion. Britain's FSA should take note.

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John Kemp is a Reuters columnist. The views expressed are his own