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I find myself compelled to write this part 2 of my earlier article with several goals in mind. First, I intend to establish that the historical references in the original article are entirely correct. Second, I intend to prove that the fundamental purpose (not being achieved) of the futures market regulatory scheme is NOT to facilitate buying and selling on futures markets, but, rather to tie prices on those markets to real world supply and demand (also not being achieved). Third, and, perhaps, most important, although I am an amateur historian, I am also a professional lawyer, and I am embarrassed to say that I need to correct a serious error in legal analysis that exists in the original piece, even though no commentator pointed it out, lest it send people to seek redress in the wrong venues.

Anyone confused about the historical basis for regulation of the futures markets should note that the “Commodities Futures Trading Act of 1974” is simply the enabling act that created the current Commodity Futures Trading Commission (CFTC). It is not the first, nor the only, attempt to bring honesty to the futures markets, nor is it likely to be the last. The principles and practices set out in the Act have their foundation in earlier legislation. In its day, the 1974 Act represented a well meaning, but futile attempt to reign in manipulative activity. The intent was to reform the previously existing “Commodities Futures Trading Act of 1936”.

Contrary to various naysayers who wrote comments to Part 1, the regulations found in the 1974 Act are very similar to those found in the 1934 Act, especially those that attempt to tie real world supply and demand to the buying and selling of futures contracts. Even though a particular rule may be dated, in the law books, to the 1970s or 80s, that is just because the latest iteration of the enabling statute occurred at that time, and the concept was renumbered into a new section. The fundamental bases for the rules I have discussed are in the agricultural futures markets that existed at the turn of the 20th century.

The basic framework for the current attempt at futures market regulation was not created in the 1970s, or even in the 1930s. It finds its origins in the Grain Trading Act of 1922, which was the first major attempt to rein in mischief-making on the futures exchanges. The 1922 Act was passed into law as a result of decades of complaints from late 19th century and early 20th century farmers. These good folks alleged that manipulators were using abusive short selling tactics to artificially lower grain prices.[1]

The farmers’ complaints were of downside short manipulation, and echo the complaints voiced by modern gold/silver conspiracy theorists. Over time, the farmers were proven correct, and that resulted in legislation regulating the futures markets. In 1922, however, trading firms challenged the law, but the U.S. Supreme Court approved it, ruling in favor of the reforms, writing, in pertinent part, that:

...The act in § 4 forbids all persons to use mails or interstate telephone, telegraphic, wireless, or other communication, in offering or accepting sales of grain for future delivery or to disseminate prices or quotations thereof, excepting the man who holds the grain he is offering for sale…and under such conditions as to reflect the general value of grain and its different grades, and which have been designated by the Secretary of Agriculture as "contract markets.…

The agricultural roots of today’s futures markets are the reason that the CFTC is overseen by the Senate and House agricultural committees, rather than the banking committees. Philip McBride Johnson, a partner in the firm of Skadden, Arps, Slate, Meagher & Flom LLP, whose clients are mostly securities and derivatives dealers, served as chairman of the CFTC from 1981 to 1983, and has written an excellent book which, in Chapter 10, exposes many of the problems he helped to create.[2] The book candidly tells the story of money-influenced politics, and how money was used by commodities dealers and the exchanges to buy lobbyists and, eventually, to buy one regulator for themselves, now known as the CFTC, from Congress.

Given that the CFTC’s origins arise out of a “purchase” of the 1974 Congress, by derivatives dealers, one can better understand why the institution fails in its job on a regular basis. CFTC was born out of the sin of lobbying money. What it has done, however, is convince many traders that it is perfectly legal for commercial entities to engage in massive naked short selling. While the idea is completely false, any attempt to dissuade these people of that erroneous belief, is now met with personal attacks and contempt. Reading some of the tirades in the comments section of my previous article illustrates that point. Thanks to the CFTC, naked short selling, which is exactly what all the enabling Acts were passed to prevent, has become a daily practice. The agency has turned out to be useless, except with respect to regulating small traders who have no political clout.

The actual federal regulations that are supposed to rein in sinful futures dealers are clear. The law provides that it is:

…unlawful…(a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in, or in connection with (1) an offer to make or the making of, any transaction for the purchase, sale or delivery of silver bullion, gold bullion, bulk silver coins, bulk gold coins, or any other commodity pursuant to a standardized contract commonly known to the trade as a margin account, margin contract, leverage account, or leverage contract…[3]

The primary problem exists among the so-called “commercial traders”. This is a classification used by the Commodity Futures Trading Commission (CFTC) for traders who are supposed to use the futures market for bone fide business activities.[4] Unlike more transparent arrangements, such as at the TOCOM exchange in Japan, however, the CFTC is very secretive about almost everything, giving out information in small spoonfuls. This leaves us in the dark and forces us to speculate with respect to exactly what positions are held by whom. CFTC hides behind claims of confidentiality, and makes it very difficult for outside analysts to separate which positions, for example, a firm like Deutsche Bank may hold for its own account, which are being held for the benefit of speculative clients, and which are being held on behalf of other commercial firms, including entities that may be owned, controlled, or closely connected to the reporting bank.

It has been established, however, that big banks are not merely placing trades on behalf of speculative traders. The bank participation report, inadequate though it is[5], indicates that they are also placing large numbers of trades for their own account. The dearth of information flow, from CFTC, however, makes detailed analysis extraordinarily difficult, in the absence of extensive subpoenas. These subpoenas cannot be issued because of the exclusivity of CFTC’s jurisdiction, however, which is a method by which derivatives dealers have insulated themselves from true scrutiny and regulation by creating CFTC.

Hedging of spot transactions, by commercial entities, is a legitimate activity, so long as it is incidental to a regular business involving the commodity being regulated, and, as such, commercial registrants are exempt from position limits. A hedge is defined as a transaction that will protect against loss through a compensatory price movement.[6] In other words, if you have a huge stockpile of gold, you have the right to sell as many short contracts as are needed to protect you from losses, in the event that the metal goes down in price. For example, suppose someone owns a gold bullion shop. If he buys metal but can’t sell it for a few weeks or months, the price may goes down in that time period, and he will be stuck with a loss. So, instead, he sells a short position. If the price goes down, he will collect the difference between the point at which the short was sold and the price he buys it back. If the price goes up, he still has the metal, and will be able to sell it at a higher price, thereby covering losses on the short. If he has hedged correctly, the process allows businessmen to calculate their profits, and thereby engage in commerce dealing with volatile commodities, without going bankrupt from big price changes that they may not anticipate. The commissions and fees, which are the only cost, can be calculated into the cost of doing business, adding certainty to an uncertain business world.

The CFTC, however, encourages a wide drift from the original purpose of the futures markets, and appears to be allowing the commercial entities to do much more than merely hedging their bets. In a report, that the agency alleges arose out of an investigation of complaints of silver short side manipulation, the CFTC stated, in pertinent part:

Commercial traders in NYMEX silver futures are not limited to hedging only NYMEX warehouse stocks. They can hedge any silver price exposure they may have, including NYMEX bullion stocks, bullion stocks held outside NYMEX warehouses, silver held in non-bullion form, new silver production, and derivative and forward positions in other silver markets.

Most of it is true, except for the last part of the last sentence. That is highly misleading because it reflects what CFTC has done to facilitate manipulation on the part of large derivatives dealers, rather than what it is supposed to be doing. The basic problem is that CFTC allows commercial traders to hedge against unverified derivative positions. Not all “derivative and forward positions in other silver markets” are legal hedges. The CFTC explanation ignores this important distinction. Without numerous exceptions and exemptions, which appear to have been granted by the CFTC on the most spurious of grounds, the law only allows for hedging of verifiable physical metal, and, in the case of derivatives, the commercial entity must actually intend to buy the metal for delivery or actually sell it on the spot market. Any other alleged “hedge” is fraudulent, and the naked short sales that arise out of it are illegal.

This restriction to real world spot transactions is not a small matter, given that it is designed to tie the futures markets to the real world supply and demand. A vast proliferation of OTC forward contracts and options defies the imagination. For example, as of 2001, the estimated total value of all gold ever mined in all human history, including that which has been lost in shipwrecks and buried forever in Roman ruins, would be worth about US$4.39 trillion at 2009 valuation of $920 per ounce. Additional gold has been mined since, but the difference is negligible, and my primary purpose is to show you the forest, not the trees. According to the June 2008 semi-annual report, Table 22A of the Bank of International Settlements, the total OTC gold derivatives market amounted to $649 billion, of which $428 billion consists of options. The numbers are probably much higher today. In truth, however, only the tiniest of tiny portion of the world’s total physical gold supply is available to derivatives dealers. At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold. Almost all the rest, is held in the form of jewelry, coins, and small hoards of private gold bars that are not on the market for sale, never will be, and are NOT available to derivative dealers. It is extraordinarily unlikely that $649 billion dollars worth of OTC gold derivatives are backed by physical metal. The disconnection between the availability of real metal and the availability of derivatives is even more extreme in the silver market.

As I’ve said before, the regulations allow commercial traders to offset only physical spot market positions, and are designed to tie real world supply and demand to prices on the futures markets. The tie was part of the reforms enacted back in 1922, but the reform has been subverted by the creation of CFTC in 1974. By failing to enforce this aspect of the law, and allowing naked short selling by commercials, CFTC has not only NOT insured the honesty of the market, but has facilitated corruption of the futures exchanges.

The full Federal Regulation actually provides as follows:

(z) Bona fide hedging transactions and positions — (1) General definition. Bona fide hedging transactions and positions shall mean transactions or positions in a contract for future delivery on any contract market, or in a commodity option, where such transactions or positions normally represent a substitute for transactions to be made or positions to be taken at a later time in a physical marketing channel, and where they are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, and where they arise from:

(i) The potential change in the value of assets which a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising,

(ii) The potential change in the value of liabilities which a person owns or anticipates incurring, or

(iii) The potential change in the value of services which a person provides, purchases, or anticipates providing or purchasing.

Notwithstanding the foregoing, no transactions or positions shall be classified as bona fide hedging unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices and, for transactions or positions on contract markets subject to trading and position limits in effect pursuant to section 4a of the Act, unless the provisions of paragraphs (z) (2) and (3) of this section and §§1.47 and 1.48 of the regulations have been satisfied.

(2) Enumerated hedging transactions. The definitions of bona fide hedging transactions and positions in paragraph (z)(1) of this section includes, but is not limited to, the following specific transactions and positions:

(i) Sales of any commodity for future delivery on a contract market which do not exceed in quantity:

(A) Ownership or fixed-price purchase of the same cash commodity by the same person; and

(B) Twelve months' unsold anticipated production of the same commodity by the same person provided that no such position is maintained in any future during the five last trading days of that future.

(ii) Purchases of any commodity for future delivery on a contract market which do not exceed in quantity.

(A) The fixed-price sale of the same cash commodity by the same person.

(B) The quantity equivalent of fixed-price sales of the cash products and by-products of such commodity by the same person; and

(C) Twelve months' unfilled anticipated requirements of the same cash commodity for processing, manufacturing, or feeding by the same person, provided that such transactions and positions in the five last trading days of any one future do not exceed the person's unfilled anticipated requirements of the same cash commodity for that month and for the next succeeding month.

(iii) Offsetting sales and purchases for future delivery on a contract market which do not exceed in quantity that amount of the same cash commodity which has been bought and sold by the same person at unfixed prices basis different delivery months of the contract market, provided that no such position is maintained in any future during the five last trading days of that future.

(iv) Sales and purchases for future delivery described in paragraphs (z)(2)(i), (ii), and (iii) of this section may also be offset other than by the same quantity of the same cash commodity, provided that the fluctuations in value of the position for future delivery are substantially related to the fluctuations in value of the actual or anticipated cash position, and provided that the positions in any one future shall not be maintained during the five last trading days of that future.

(3) Non-enumerated cases. Upon specific request made in accordance with §1.47 of the regulations, the Commission may recognize transactions and positions other than those enumerated in paragraph (z)(2) of this section as bona fide hedging in such amount and under such terms and conditions as it may specify in accordance with the provisions of §1.47. Such transactions and positions may include, but are not limited to, purchases or sales for future delivery on any contract market by an agent who does not own or who has not contracted to sell or purchase the offsetting cash commodity at a fixed price, provided That the person is responsible for the merchandising of the cash position which is being offset.[7]

I include the entire lengthy legal citation, lest naysayers claim that I’ve taken it out of context. But, simply put, you cannot legitimately or legally hedge against another hedge, which is what the derivatives dealers appear to be doing, and which CFTC seems to be allowing them to do. In order to be a legal “hedger”, you can be a mining company with a reasonable expectation of getting it out of the ground, you can be someone who has just purchased a mining company’s production forward, or you can be a person who has a huge vault, or access to someone else’s huge vault. But, what you cannot be is merely a bank without enough silver or gold to cover short positions, who claims to be “hedging” the risk of yet another bank’s similarly empty OTC vault, or even a bank “hedging” the risk of sovereign gold from the ECB or Federal Reserve, because even though the sovereign gold vault may actually contain metal, if the primary purpose of your relation to that sovereign is not to sell the metal into the spot market, but merely to “cover” short trades on the futures markets, you have engaged in illegal naked short selling.

Actually, when it is not justifying its actions in granting exceptions or exemptions, the CFTC, itself, defines the word “hedging” as “taking a position in a futures market opposite to a position held in the cash market to minimize the risk of financial loss from an adverse price change; or a purchase or sale of futures as a temporary substitute for a cash transaction that will occur later.”[8] You can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future).[9] But one cannot hedge against a derivative unless the counterparty actually has possession of the physical gold or silver, and unless you are intending to take delivery for some legitimate business purpose. Legitimate business activities, however, DO NOT include suppressing gold prices on behalf of various sovereigns. The sovereign may enjoy sovereign immunity, but the market trader acting on their behalf certainly does not. But, even if it did, that would not stop the regulator from barring that manipulative trader from the market, as any honest regulator would do. Beyond this, it is nearly certain that most OTC derivative positions are NOT composed of sovereign physical gold or silver, and acceptance of such positions as “bone fide” cover for short positions, without more, is essentially acceptance of fraud with a wink and a nod.

When a bank tells the CFTC that it is hedging against paper derivatives, if the agency wanted to do its job, it would demand proof that the alleged gold or silver is really being used for something other than offsetting a short position taken on COMEX, and is actually in the counter party’s vault, or has actually been contracted for from a mining company capable of delivering in a timely manner. If the trader cannot prove this, he should be removed from the market or declassified into a speculator, subject to position limits. But, I can find no evidence that CFTC has ever done that, let alone audited a vault in the entire 34 years of its existence.

When a willing regulator creates a situation like this in the world of high finance, corruption and fraud will always follow. The allegations of conspiracy theorists take on new urgency, because they are likely to be correct, at least in part. If the gold really exists, let’s get to the bottom of it, and calm the fears of the market. If it doesn’t exist, commercial so-called “hedgers”, taking short positions in excess of the speculative limits, are committing fraud. Naked commercial short contracts are illegal in the futures markets, and, if the CFTC staff wanted to follow federal regulations, this type of activity would be prohibited. Instead, it takes no action at all, or facilitates the practice.

Subsection (3), titled “Non-enumerated cases”, unfortunately, gives CFTC staff discretion to interpret the law for the benefit of those they wish to benefit. This discretion may be the root of all mischief. The agency can help favored financial institutions by granting unjustified exceptions to the rules. Such exceptions should normally be few and far between. But, banks appear to be allowed to take speculative short positions in gold, and silver, for their own accounts, and for commercial entities they represent, even though the positions far exceed speculative limits. The fact that Deutsche Bank seems to have needed a bailout from the ECB, in order to cover its recent deliveries of gold is simply one example. Common sense tells us that huge bank short positions are not likely to be legitimate hedges, at least as hedges are defined by real regulations, as opposed to how some CFTC staff have managed to contort them.

All of this brings us back to Deutsche Bank. There is now reasonable suspicion and probable cause to investigate whether or not it sold naked short positions[10] in excess of speculative position limits. The problem is finding someone with jurisdiction, willing to do the investigation. In spite of having claimed to do multiple “investigations” of the silver futures industry, CFTC has never mounted a proper investigation of the precious metals market. So, in seeking help, we can count them out. Even if they were willing to launch an investigation, which they probably are not, it would end with no action, and a whitewash of the activities. Yet, short contracts in excess of speculative limits, not covered 100% by physical metal of some kind, are clearly illegal trades.[11] Clearly, something must be done to cleanse these markets before they implode. We cannot leave this situation as we’ve found it. So, what can be done?

My background is primarily in securities law, rather than commodities law, and, as a result, I made an embarrassing error in the legal analysis in Part 1 of this series. The SEC’s potential to be incompetent is held in check by the concurrent and competitive activity of state prosecutors. This was illustrated, most notably, by the actions of Elliot Spitzer, former Attorney General of New York State, who forced important reforms upon Wall Street, when the SEC failed or refused to act. The SEC shares jurisdiction with state regulators, creating a balance of power that has protected investor rights, at least to some extent. The inclusion of ambitious prosecutors within the realm of empowered regulators creates a balance of power that prevents complete control of the regulatory process by big financial institutions.

Back in 1974, the derivatives dealers managed to buy an agency with exclusive jurisdiction over them, and, thereby, they purchased the means to control their own regulation. Many courts, having recognized that they issued an incorrect opinion, a few days after the fact, find that the lawyers for the parties have not brought a motion for rehearing. The court is ethically compelled to rehear the matter “sua sponte”, which is Latin for “on its own motion”, in order to correct itself. There were many naysayers who wrote to critique Part 1. However, none of them pointed to the real error. Instead, they dwelt upon minutiae, complaining about aspects of the article that were essentially correct, but may have contained a technical error or typo. Accordingly, I am forced to correct myself.

I erroneously assumed, without fully researching beforehand, that state prosecutors could step in when CFTC refused to act, as they do in the case of the SEC. That was incorrect, and based upon faulty assumptions. In contrast to the SEC, the financial industry managed to buy an exclusive agency from Congress, known as the CFTC, which is now the only entity allowed to have jurisdiction over the futures markets. State laws protecting consumers and state prosecutors have been effectively neutralized and rendered helpless. Since they appear to control many aspects of the agency, the charade can go on without restraint.

The exclusivity provision that the derivatives dealers bought, are now embodied within 7 U.S.C. 2 (a)(1)(A). It has been used to prevent state laws from protecting the public in commodities fraud cases. In conflict with this, I had been counting on these laws to protect people now. I had hoped to enlist state prosecutors to help. While they, or a private party, could theoretically bring writs of mandamus to force the agency to do its job, trying to force an unwilling federal agency to regulate is a fool’s game. There are some people, within CFTC’s structure, who seem to be trying to push the agency into action. One person whose name comes to mind is Bart Chilton. However, CFTC, as an institution, is not willing to act, and his honest efforts, in the long run, are doomed to failure. Bart Chilton, well meaning though he is, is completely helpless in the face of the bureaucracy of an agency that does not want to do its job. He will, undoubtedly, be fed with a lot of incorrect analysis and information, and his efforts are doomed to failure.

Having identified the disease, however, we can now begin the search for the real cure. The only way to undo the exclusivity purchased by the derivatives dealers, and the control over their own regulation, which came with it, is to get Congress to reverse itself. As I pointed out, earlier, because the futures exchanges started out trading food grains and cattle, Congressional oversight is vested in the House Agriculture Committee and the Senate Agriculture, Nutrition and Forestry Committee. The fact that most of these Senators and Congressmen are from the West and Midwest, rather than from New York and Chicago, gives an edge to the People. This must be a grass roots effort.

Concerned citizens must redirect attention from writing fruitless letters to CFTC, to writing and calling your Congressmen. If Congress passes legislation revoking CFTC’s exclusive jurisdiction, power will immediately pass back to the states, and I can assure you that things will get done swiftly. We would see proper investigation and rapid resolution of egregious abuses if they exist in the manner now being alleged.

Here are the names of the members of Congress who sit on the subcommittee that supervises CFTC. You can easily obtain their addresses on the internet. Note that with the proliferation of emails, it is often more effective to write a snail-mail letter. If the hue and cry of the People’s voice is loud enough, your representatives will hear you above the din of corrupt industry lobbyists.

Write to your representatives in Congress. Although some of the staff probably need to be replaced, the CFTC does not need to be closed down. With respect to regulating small traders who lack political clout, it often does its job. The problematic area is with the big banks and major derivatives dealers. Simply urge Congress to strip CFTC of its exclusive jurisdiction. If we can get a grass roots effort together, sufficient to remove this agency from being an impediment to law enforcement, many willing prosecutors and regulators will step up to the plate, take on the big international banks, and proceed with the challenge of cleaning up America.

Senate Subcommittee on Domestic & Foreign Marketing, Inspection, & Plant & Animal Health

Sen. Max Baucus, Chairman

Sen. Lindsey Graham, Ranking Member

Sen. Kent Conrad

Sen. Mitch McConnell

Sen. Debbie Stabenow

Sen. Pat Roberts

Sen. E. Benjamin Nelson

Sen. Mike Crapo

Sen. Ken Salazar

Sen. John Thune

Sen. Robert P. Casey, Jr.

Subcommittee on General Farm Commodities and Risk Management

Leonard L. Boswell, IA, Chairman

Jim Marshall, GA

Brad Ellsworth, IN

Timothy J. Walz, MN

Kurt Schrader, OR

Stephanie Herseth Sandlin, SD

Betsy Markey, CO

Larry Kissell, NC

Deborah L. Halvorson, IL

Earl Pomeroy, ND

Travis W. Childers, MS

Jerry Moran, KS, Ranking Minority Member

Timothy V. Johnson, IL

Sam Graves, MO

Steve King, IA

K. Michael Conaway, TX

Robert E. Latta, OH

Blaine Luetkemeyer, MO



[1] Chicago Board of Trade v. Olsen, 262 U.S. 1 (1923)

[2] Johnson, Philip McBride - Derivatives - A Manager's Guide to the World's Most Powerful Financial Instruments. (McGraw-Hill 1999 - ISBN007134506X).

[3] 17 CFR § 31.3

[5] The bank participation report lists commodity positions that U.S. and foreign banks, active in the futures and options markets, maintain for their own account. It is not broken down by bank, and it defines “bank” as commercial bank, only. According to an explanation given to me by a representative of CFTC, investment banks, like Merrill Lynch, Morgan Stanley, Goldman Sachs and so on, have never been included in the report. It is not clear whether or not investment bank divisions of commercial banks, like the pre-Bear Stearns investment bank division of JP Morgan Chase have been listed. Nor is it clear how the agency will list the positions of Merrill Lynch, Bear Stearns in the future, now that they have been acquired, but maintained as separately incorporated entities by Bank of America, and JP Morgan Chase, respectively.

[7] 17 CFR 1.3 (z)

[9] Id.

[11] In my previous article, I stated that commercials are required to keep 90% cover by virtue of a loosened standard I found had been created by 17 CFR 31.8. Recently, however, I reread the exact wording of that paragraph. I discovered that the loose standard applies only to “leveraged transaction merchants”. One would hope that such hedgers, who sell contracts exceeding 10 years, will be able to accumulate the missing 10% of metal, during that time period. Other commercials, however, should be held to the higher standard. Other than leveraged transactions, all other hedgers must maintain 100% cover of short positions. The extent to which this is not being done, must be investigated fully, and it can only be done by a full disclosure of the locations at alleged vaulted metal is supposed to exist, mining claims, and should also include unannounced spot vault audits by trusted employees of the regulator.

Source: Did the ECB Save Comex from Gold Default? (Part 2)