The Regulation Pendulum Swings Back

The CFTC plans to hold hearings into revoking the exemptions they had previously given to investment firms which removed limits on the amount of assets they could hold in physical commodity markets. This exemption, called ‘Bona Fide Hedging’, circumvented a 1936 law which protected price discovery by limiting the involvement of speculators. It allowed true hedgers, producers and speculators to participate in the same market without anyone bullying the others.

Before the Great Crash of 1929 the US financial market was largely unregulated. You could say that compared to today’s market it was the wild wild west. As a consequence of the crash a lot of sensible regulations and government oversight was instituted. But most of those sensible and necessary rules were removed as the power of absolute free markets took hold. The pendulum is now swinging towards more regulation. All we can do is hope that it doesn’t swing too much and the regulations that are put in place are useful.

The danger is that politicians will make hedge funds or any speculator into a scapegoat to score cheap points. If the limits are too restrictive, then it will reduce liquidity. But as long as we can go back to the simple rules that worked for 50+ years, I think we’ll be fine.

I don’t think that anyone can look at the underlying supply of crude oil, which has been plentiful and without interruption and then look at the demand side, which has been waning and find any justification for the kind of price swings that we have seen recently. In less than two years, we’ve seen a barrel reach $145, then crash to $33 and then rise 50% to $70! All the while, no fundamental change whatsoever has occurred in either the demand side or the supply side.

Although I believe we should let markets work, when you have speculators controlling more oil than all the commercial oil held in storage in the US combined with the US government’s Strategic Petroleum Reserve… then things are clearly out of whack. The only reason this was allowed was because the CFTC gave exemptions to OTC swap dealers who needed to hedge their own exposure through the futures markets. Due to the size and amount of their OTC transactions, the needed to take mammoth positions.

It isn’t entirely clear what the CFTC will do but the hearings coming up will provide an answer. As usual, expect the FIA to push for less regulation. One possible solution would be more transparency. The CFTC will improve the detail in its weekly CoT report by reporting swap dealers positions separately.

The result will probably be less volatility, which is not that great if you’re a trader. But if the consequence is having a sane and healthy commodity market which will provide a foundation for a stable economy, then I’m all for it.

Finally, there was a rogue trader from PVM who pushed the futures price higher by an extra $2 recently and caused a $10 million loss. But that is not even chump change compared to the size of the oil market. If there was a ‘Nick Leeson’ type trader out there who was responsible for the run up in crude oil, it would let Goldman Sachs and other investment banks off the hook.