London, 17 December 2010

The U.S. Commodity Futures Trading Commission (CFTC) will miss its end-January deadline for adopting a final rule on position limits -- but Chairman Gary Gensler is slowly winning the war of attrition with Wall Street lobbyists to impose comprehensive restrictions on position sizes and reduce market concentration.

The Commission has made some strategic concessions -- delaying the finalisation of all-months limits until it has gathered more data on the size of over-the-counter swaps markets; abandoning the controversial crowding out provisions; and clarifying its proposals for aggregating positions and interpreting the independent account controller rule. Postponing adoption of the final regulation has sparked fears from strong advocates of limits such as CFTC Commissioner

Bart Chilton that changes are being fatally undermined by stalling tactics and the fierce lobbying to create numerous loopholes so the exceptions and exemptions swallow the general rule.

On balance, those concerns appear unfounded. Gensler has surprised his critics and turned out to be the most effective chairman in decades, winning vast new powers for the agency and all the major battles he has picked so far.

Gensler has made some technical concessions in response to comments received. But when it is eventually adopted, the final rule will largely follow the contours he set out at the start of 2010 and achieve his stated objective of ensuring markets remain diverse and free from excessive concentration.

GRINDING AHEAD

To understand just how far Gensler has transformed the debate, it is worth recalling objections raised during the statutory consultation on his initial proposals held between January and April this year:

(1) On behalf of the dealers, the Futures Industry Association (FIA) denied the CFTC had any authority to impose limits unless it could prove empirically that they were "necessary" to diminish, eliminate or prevent excessive speculation. The implied threat was to contest the whole rulemaking in court.

Gensler has neutralised this risk by persuading Congress to include an explicit instruction to set limits in Section 737 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (PL 111-203), removing any uncertainty and ambiguity about its authority in this area.

(2) Opponents suggested the CFTC should not press ahead with limits on organised futures and options markets until it had clear authority to regulate OTC swap contracts, or risk pushing volumes into markets over which it had less control. Jurisdiction concerns were raised by CFTC Commissioners Scott O'Malia and Michael Dunn and might have prevented the Commission assembling a majority to adopt a final rule imposing limits.

Gensler has met them by getting Congress to give the CFTC explicit new authority to regulate OTC markets. Section 737 makes clear the CFTC should set "aggregate position limits" on positions whether held as futures, options or swaps, if they are economically equivalent or show significant price linkage, arbitrage or material price reference with a regulated contract market.

(3) Opponents raised the threat unilateral limits would cause trading and price discovery to migrate overseas. Section 737 directs the CFTC to "strive to ensure" foreign boards of trade impose comparable limits and limits will not cause price discovery to shift to foreign venues.

Here too Gensler has made progress. Britain's Financial Services Authority (FSA) remains opposed, but the CFTC has negotiated "no action" agreements imposing limits on contracts offered on foreign boards of trade equivalent to U.S. contracts or related to physical settlement in the United States and offered electronically to participants in the United States.

Gensler has outflanked the FSA by forging close links with European regulators. New proposals issued by the European Commission this month show strong influence from the United States and convergence with the CFTC's approach. Crucially, the Commission's proposals would give the new European Securities and Markets Authority power to set "ex ante position limits" as part of a system of enhanced position management.

Prompted by Gensler, regulators are very aware of the potential for regulatory arbitrage and determined to resist efforts to divide and rule them.

PHASED ROLL OUT

Position limits will be introduced in two stages. In stage one, the Commission will effectively take over the existing spot-month limits set by futures exchanges, transforming their status from exchange rules into federal law. This is essentially a holding step to economise on data requirements and comply with instructions set out in Section 737 while the CFTC obtains better data, especially on swap markets, to enable it to fix limits for other months and all months combined (AMC) accurately.

In the second stage, the Commission will make its own determination of deliverable supplies and fix spot month limits at 25 percent of this level for physically settled contracts and 125 percent for cash settled ones (where the risk of a squeeze is smaller). It will propose all-months limits based on the formula outlined earlier this year -- 10 percent of open interest for the first 25,000 contracts and 2.5 percent thereafter.

The CFTC has ditched its intensely controversial crowding out proposal, but only because it is no longer needed to ensure limits are effective. Instead of the three-way classification proposed earlier (hedging transactions with an unlimited exemption; limited risk management exemptions up to twice the normal limit; and all other speculative and market-making transactions subject to the ordinary limit) the CFTC will now use a straightforward two-way classification (hedges with an unlimited exemption; all other transactions subject to the normal limit).

As directed by Congress, the CFTC has adopted the "look through" approach to hedging exemptions. Dealers will be able to claim hedging exemptions where their counterparty itself benefits from a bona fide hedging exemption, ensuring exemptions for end-users are not neutered by position limits imposed on their dealers.

But hedging exemptions are only available for physical exposures. Section 737 makes clear hedging must involve physical exposure and not general trading book or portfolio risks. Speculators, market makers and commodity index operators will no longer be able to claim exemptions as price-risk managers. The much tighter definition seems to have convinced the CFTC crowding out provisions are no longer needed to preserve the integrity of the rule.

The CFTC will adopt a more generous interpretation of the independent account controller rule and aggregation. Firms with an ownership stake of more than 10 percent in a non-financial entity can obtain an aggregation exemption for that entity's positions provided the stake is passive and they do not participate in management decisions. The independent account controller exemption will remain but only if the positions are demonstrably independent.

FIERCE OPPOSITION

Despite these concessions, exchanges and the industry generally remains strongly opposed. There is still some effort to reopen the issue of whether there should be limits at all, by lobbying the incoming Republican majority in the House of Representatives and wavering commissioners on the CFTC itself.

But it is unlikely to have much effect. Limits are enacted in statute and the law itself is unlikely to be changed for at least two years while the Democratic Party controls both the Senate and the White House.

Much opposition seems to stem from a philosophical objection to any form of regulation rather than concrete concerns about the actual impact. The CFTC estimates only a relatively small number of traders will be impacted by the all-months and single-month limits in agricultural commodities (80); base metals (25); precious metals (20) and energy (10).

More traders would be impacted by spot limits in energy (40) though fewer in farm goods (70); base metals (6); and precious (8). The CFTC is probably comfortable with that; the aim is to keep big positions away from the delivery period where they have the biggest potential to cause distortions.

Large positions can still benefit from hedging exemptions if there is a genuine physical exposure so the eventual number of positions caught will be smaller.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.