Position Limits Continue to Stir Up Controversy
Fanni Koszeg | Bloomberg Law
- Better Markets and CME strongly support position limits for cash commodity swaps to protect markets from excessive speculation by financial industry market participants.
- Financial industry groups firmly oppose position limits and criticized the CFTC for lack of proper market and statutory analysis.
The Commodity Futures Trading Commission (CFTC) adopted its final rule on position limits (Final Rule) last October, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). However, considering the multitude of comments it received, the CFTC decided to treat the published spot-month position limits for cash-settled derivatives contracts on an interim final rule basis in order to solicit additional comments. A wide range of market participants and industry organizations have now submitted comment letters on the subject. The commenting organizations gave conflicting advice depending on their role and interest in the markets. An independent industry organization and certain representatives of futures exchanges supported identical position limits for cash- and physically-settled contracts. On the other hand, financial market participants and their industry representatives opposed any limitations on cash-settled trades and strongly criticized the CFTC for treating the two types of trades as equivalent.
Background—Controversy over Final Rule
All sides criticized the CFTC since it first proposed to establish position limits for certain commodity futures and swaps pursuant to Section 737 of Dodd-Frank. The CFTC adopted the Final Rule with a controversial 3–2 vote and finalized certain parts on an interim final basis. For background on the Final Rule, see CFTC Finalizes Rule on Position Limits, Bloomberg Law Reports® – Derivatives Law, Vol. 2, No. 24 (Nov. 18, 2011). High-profile industry associations have since challenged the Final Rule in court, but the CFTC rejected their motion for a stay of its effective date. The comment letters described below provided another opportunity for these industry associations and others to convince the CFTC to reconsider and reshape certain provisions of the Final Rule.
Interim Final Rule
The CFTC adopted spot-month limits for cash-settled derivatives contracts using the same methodology it applied to physical delivery contracts. The Final Rule sets position limits initially at existing designated contract market (DCM) levels and during the second phase of implementation, limits would be based on 25 percent of estimated deliverable supply. (Cash-settled natural gas contracts have a limit of five times the level of the limit for the physical delivery of other covered commodities.)
Some of the commenters approved of the Final Rule, including the interim final provisions, or asked the CFTC to impose even stricter limits; many re-iterated that the Final Rule should be withdrawn until further studies are completed and, at the very least, position limits for cash-settled derivatives contracts should be significantly less restrictive.
— Arguments in Support of Position Limits
The CME Group Inc. (CME), which includes four separate derivatives exchanges (including the Chicago Mercantile Exchange and the New York Mercantile Exchange), argued that a “policy of higher spot-month limits for cash-settled contracts in any linked market is contrary to the long-standing joint policy of the [CFTC] and the exchanges.” CME went on to analyze the definition of “deliverable supply,” which it believes should be updated by the CFTC, and supply estimates should be increased meaningfully. CME calculated that, given these increased supply estimates, spot-month limits set at 25 percent for both physical delivery and cash-settled contracts would provide sufficient liquidity for bona fide hedgers in both markets. CME concluded that “[it] can think of no reason why parasitic cash-settled contracts require or deserve a higher spot-month limit than the principal physical delivery price discovery contract on which they are based.”
Better Markets, Inc. (Better Markets), an independent industry organization, submitted two comment letters. In its first submission, Better Markets argued that the CFTC did not go far enough in establishing position limits on market participants operating primarily in cash-settled derivatives markets. It emphasized the need to prevent excessive speculation and “the ancillary harms that excessive speculation can cause: destruction of the hedging environment and distortion of the price discovery function.” Better Markets recommended that the CFTC target commodity index traders who—according to its extensive study submitted as an annex to the comment letter—represent a “class of harmful participants.” Better Markets argued that these index funds systematically distort price curves because their speculative trades do not reflect fundamental supply and demand factors, which should properly be determining price curves.
Better Markets’ second submission addressed the question of the interim final spot-month limits. It argued that the current one-to-one ratio between physically settled and cash settled contracts is appropriate and useful in virtually eliminating the risk of classic market manipulation, if not necessarily in preventing excessive speculation. However, Better Markets argued that under a position limit system where a particular trader is allowed to hold both a physically- and a cash-settled position during any given spot month, it makes no sense to have a higher ratio for gas contracts. Therefore, it recommended that the CFTC avoid widening the ratios for any commodity swap contracts.
— Financial Industry Remains Critical
The International Swaps and Derivatives Association (ISDA) together with the Securities Industry and Financial Markets Association (SIFMA) reiterated that they “remain deeply concerned with the [Final Rule], and disagree with premises upon which the [CFTC] has based its adoption of the Final Rule.” They also specifically criticized the interim final spot-month position limits for cash-settled contracts. ISDA and SIFMA demanded that the CFTC withdraw the interim final position limits until “after it has collected and analyzed the data needed to make the statutorily required finding” that (1) excessive speculation exists, (2) limits are necessary to prevent the burden caused by such speculation, and (3) the position limits imposed are appropriate.” The industry associations submitted expert declarations in support of their position to “further substantiate the significant, immediate, and unjustified costs that will result from the [Final Rule].”
The Futures Industry Association submitted almost identical arguments, stating that “withdrawal of the [Final Rule] is the only action that will ensure the [CFTC] does not impair liquidity, efficient price discovery, and the ability of market participants to hedge against risk at a particularly fragile time for the U.S. economy.”
Similarly, the Alternative Investment Management Association (AIMA), representing hedge funds, argued that while positions taken in physically-settled contracts are likely to have some form of direct impact on the market price of the underlying commodity, a position taken in a cash-settled contract “would not be expected, in any meaningful or significant way, to increase or decrease” market prices. AIMA also recommended that the CFTC perform additional market studies and cost-benefit analyses of the Final Rule and, if it concluded that limits are necessary, then it should determine an appropriate ratio higher than the current one-to-one ratio.
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