London, July 2010

There is nothing new under the sun. Arguments about dominant positions in futures markets have not changed much if at all over the last 60 years as a famous court case from the 1970s, citing even older cases, shows.

Anyone following the current disagreement between the U.S. and UK commodity regulators about position limits and dominant positions should try reading "Cargill v Hardin" -- the judgment of the U.S. Court of Appeals for the Eighth Circuit on a squeeze in the CBOT wheat contract back in May 1963. The judgment was rendered in 1971, but it has never been overturned and remains good law, at least in the seven farm-dominated states covered by the court.

The judgment provides an entertaining roadmap on how the squeeze was executed; the judges clearly thought many of the arguments they were presented with stretched credulity. It also sets out a thorough examination of the subsequent legal arguments about whether the futures positions in fact constituted a squeeze and whether it was illegal under the U.S. Commodity Exchange Act.

The court dealt lucidly with issues raised by large open positions in the run-up to a contract's expiry and how those might effect pricing. It noted the unprecedented prices prior to expiry, the record spread between the expiring and next-to-deliver contract, and the large gap between prices in Chicago and on other exchanges.

It also discussed the question of whether the shorts should be held to their delivery obligation. The court concluded: "While the obligation to make or take delivery is a bona fide feature of the futures contract, in reality the futures market is not an alternative spot market for the commodity itself, and indeed the functions performed by the futures market would be severely hampered if it were turned into an alternative spot market.

"Most parties who engage in futures transactions are in no position to either make or take delivery, and if they were required to always make preparations to fulfil their obligations to make or take delivery, the number of persons who could effectively participate in the futures market would be substantially restricted, thus reducing the liquidity and volume of that market.

"The main economic functions performed by the futures market are the stabilization of commodity prices, the provision of reliable pricing information, and the insurance against loss from price fluctuation. The functions can be fulfilled only if both longs and shorts can be assured that they can offset their contracts at nonmanipulated prices.

"If in a squeeze situation, the shorts must be forced either to pay manipulated prices to offset their contracts or in the alternative to bring in higher priced outside supplies which are neither wanted nor needed in the local market, then both the cash and the futures markets will be dislocated".

It ended by observing, "We cannot conceive that any useful purpose would be served by encouraging such conduct in the future." (452 F.2d 1154, paragraph 109) The Eighth Circuit reached a very different view of futures markets from the one currently held by Britain's Financial Services Authority. The FSA is much more relaxed about the effect of dominant positions and does not seem to feel that short hedgers deserve special protection.

In 2009, it issued a report setting out its opposition to imposing position limits in commodity futures markets. It permits dominant positions to be brought to expiry provided position holders comply with any directions from the exchange.

Even so, the judges and lawyers in "Cargill v Hardin" in 1971 presaged almost all the arguments that have been made in the past two years for and against imposing position limits in commodity futures contracts and about how to handle positions close to expiry.

They would probably have been surprised no settled view has emerged in the 40 years since then. But perhaps every generation has to have the debate for itself.

Ends --

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

The views expressed are his own.