London, 7 September 2011: Reuters

London's commodity exchanges may be compelled to set limits on the maximum number of contracts traders can buy or sell in metals, energy and agricultural products, according to the latest draft of a directive to be proposed by the European Commission this autumn. The latest draft of an amendment to the Markets in Financial Instruments Directive obtained by Reuters, shows Britain's regulators, exchanges and trade associations losing their battle to head off the threat of position limits despite frantic lobbying.

Unless there are significant last-minute changes, the contours of the proposed directive will broadly follow the outline demanded by France's President Nicolas Sarkozy in limiting positions taken via commodity derivatives.

The draft would align the EU regime with regulatory practice in the United States, a significant victory for US Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler, who has been battling criticism his own reforms will cause US firms to lose business to more lightly regulated European rivals.

ARTICLE 50(a)

Britain has secured some limited objectives in the negotiations. National regulators will not be forced to set hard position limits on commodity contracts. The draft directive stipulates only that regulators must be given the power to "limit the ability of any person or class of persons from entering into an instrument including by introducing non-discriminatory limits on positions or the number of such derivative contracts per underlying which any given class of persons can enter into over a specified period of time, when necessary to ensure the integrity and orderly functioning of the affected markets" (Article 50(a) (1)(g)).

It does not say that regulators must use these powers. Britain's regulators are likely to keep them in reserve. But even that is further than they wanted the draft to go. The article also requires regulators must have authority to intervene in a more ad hoc manner by requesting any person "to subsequently take steps to reduce the size of the position or exposure" (Article 50(a)(1)(f)).

Regulators in London are hostile to using position limits as a tool for ensuring markets remain orderly and preventing abuse, as they explained in a position paper on "Reforming OTC Derivative Markets" published in December 2009.

In that paper, they argued "Whilst UK Authorities are not opposed to regulators having the option to set limits as one tool to help combat market manipulation, the adoption of such a policy would be a departure from the approach taken across all financial derivative markets in the UK and is not necessarily the best means of combating manipulation".

"In adopting such a policy the UK Authorities are concerned there would be an expectation for regulators to use position limits, and we do not think this is conducive to achieving the most effective regulatory outcome".

ARTICLE 47(a)

In other areas, Britain's defeat is starker. Regulated commodity exchanges will be required to establish and enforce their own position limits, in line with technical standards to be developed by the new European Securities and Markets Authority (ESMA): "Member States shall ensure that regulated markets ... relating to a commodity or an underlying ... apply limits on the number of contracts which any given market members or participants can enter into over a specified period of time, or alternative arrangements with equivalent effect, to be imposed in order to: (a) support liquidity; (b) prevent market abuse, or; (c) support orderly pricing and settlement conditions" (Article 47(a)(1)).

In a nod to London's concerns about singling out speculators for less favourable treatment, there is a requirement for limits to be imposed in "transparent and nondiscriminatory" manner. There is an apparent escape clause for "alternative arrangements with equivalent effect" to position limits and a power to confer "exemptions".

The provision for alternative arrangements might allow Britain to retain its preferred position management system as a substitute for hard exchange-set limits, but it will require some fast talking, because the draft is fairly clear that fixed limits are its preferred option here.

It states that regulated markets "shall specify clear quantitative thresholds such as the maximum number of contracts persons can enter, taking account of the characteristics of the underlying commodity market, including patterns of production, consumption and transportation to market".

ESMA will "develop draft regulatory technical standards determining the limits on the number of contracts which any person can enter" in a bid to ensure "uniform application of position limits in the Union".

It is far from clear Britain's preferred position management system is "equivalent" in its effect to the sort of limits envisaged elsewhere in the EU -- or could survive normal statutory construction, which requires a court to give effect to all the provisions in a law.

COT REPORTING

The draft directive would require exchanges publish aggregated data on the long and short positions of various categories of traders, patterned on the weekly commitments of traders reports in the United States (Article 47(b)). London's exchanges have already made progress in this area. Intercontinental Exchange ( ICE) has been reporting information for inclusion in the weekly CFTC reports on its WTI contract since 2009 as part of a deal with U.S. regulators.

More recently, ICE started publishing information on its main Brent contract and NYSE Liffe has promised something similar on its soft commodity contracts, after the cocoa rumpus in July 2010.

In most markets, however, transparency remains poor compared with the United States. The obligation to publish weekly data on the commitments of traders would mark a big step forward.

OTHER REPORTING

Even more important is the requirement for national regulators to notify ESMA of any position limits they impose under Article 50(a)(1)(g) or ad hoc instructions to reduce position sizes under Article 50(a)(1)(f). The notification requirements are set out in Article 56.

National authorities must also communicate to ESMA position limits or alternative arrangements used by exchanges so a summary can be published centrally. There is no requirement to communicate enforcement actions related to these exchange-set limits and other arrangements, but in time this is also likely to reported to ESMA.

Information on limits and enforcement is crucial. The area is currently opaque, which makes it impossible for outsiders to assess whether the regulatory regime is working effectively to maintain orderly markets and prevent abuse. In at least one instance, an exchange has admitted enforcing an "unpublished" position limit on a major commodity contract, because of concerns about liquidity in the underlying physical market, which is hardly satisfactory.

In response to a Freedom of Information (FoI) request from Reuters, Britain's Financial Services Authority (FSA) earlier this year admitted it had not used its authority to order a trader to close or reduce positions between January 2010 and March 2011.

Instead, exchanges exercised their position management powers at least once, but the FSA could not say how many times, since it did not keep information on the subject. Far more transparency about regulation is crucial to upholding public confidence and will be needed to satisfy ESMA that position limits or alternative arrangements are appropriate and effective. Overall, if the draft is adopted in its current form, it would move European commodity regulation in a sensible direction.

It defers a showdown over Britain's preferred position management approach until ESMA takes a view on whether it is an effective alternative, allowing everyone to claim a partial victory. But the drift is clearly in the direction of fixed limits with exemptions.

Position limits would become the EU's default approach to commodity market regulation. Britain's position management regime might survive -- but only if regulators and exchanges can convince the EU it really does offer an equivalent degree of protection against disorderly markets, squeezes and abuse.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.