Not all regulation is bad. Rules and laws that protect markets and market participants from criminal actions and schemes to defraud are not only necessary from a moral and ethical perspective, without these regulations there would be little faith in markets. Regulation is a lot like wine, a glass each day could have beneficial effects when it comes to general health, but a bottle or more each day is a recipe for disaster.
In the wake of the 2008 financial crisis, the United States and the European Union decided to react by overdosing on regulation. Overwhelming and complicated Dodd-Frank regulations and other new rules chased many market participants in the commodity markets to friendlier jurisdictions. One of the biggest problems with many of these rules is they represent ideology rather than common sense.
The incoming administration of President-elect Trump will likely take a far more proactive and business-friendly orientation to regulation. The United States is on the verge of massive change, a move from ideology to pragmatism which could be good news for business. One of the regulatory agency heads, a Democratic appointee who is the current Chairman of the Commodity Futures Trading Commission (CFTC), is now attempting to rush through a short-sighted Dodd-Frank-inspired initiative. Chairman Timothy Massad's bio is evidence of his political loyalty and dedication to government mandated regulation. Dodd-Frank ordered the CFTC to establish position limits as a primary tool to combat " excessive speculation that has been harming consumers and hindering market integrity." However, on November 8, the future of Dodd-Frank became highly questionable. Rather than respect the will of the nation and the incoming President's agenda, the CFTC Chairman has decided to run a last minute play to approve position limits in futures markets. The move is clearly out of step given the changing political environment, and the fact that agency dictated position limits do not have the support of many industry experts. In his defense, perhaps the Chairman did not hear who won the election and which party controls the Congress.
One of the problems with agencies like the CFTC has been that political ideology rather than a practical approach has driven regulatory fervor in the wake of the 2008 financial crisis. A proactive and sensible common sense perspective to regulation would benefit all market participants. The reactive Dodd-Frank Act has harmed the business environment and competitive nature of the United States on the world stage in the world of raw materials. Commodities are essential staples and they are global assets. Bad regulation only serves to chase business away from U.S. shores. I believe that the last minute rush by Chairman Massad to institute position limits amounts to an ideological play without any cognizance of the political change that has occurred.
The CFTC initiative is flawed
The initiative which is currently in the hands of the other two CFTC Commissioners calls for a cap on the number of contracts any trader can be long or short. Circulating a proposal is often the final move before calling for a vote on an initiative. The CFTC is an agency that is supposed to have five Commissioners who vote on policy initiatives. No more than three of the agency heads can be from the same political party. Right now, there are only three Commissioners, two Democrats and one Republican. It appears that Chairman Massad is attempting to win a 2-1 vote before President-elect Trump assumes office on January 20 to comply with the Dodd-Frank Act.
The Democrats in Congress, led by Senators like Elizabeth Warren (NYSE:MA) and Bernie Sanders (NYSEARCA:VT) have been vocal opponents of speculation. They argue that speculators increase consumer prices and damage the financial system.
Position limits have been in the domain of the exchanges. There are hedgers who often receive exemptions from position limits because of their underlying business. However, the proposed rule that will result in a hard federal-governmental enforcement regulation will take a tremendous amount of autonomy away from commodity exchanges or designated contract markets like the Chicago Mercantile Exchange (NASDAQ:CME) and the Intercontinental Exchange (NYSE:ICE). The position limit initiative sets significant regulations for the swap markets. Limiting flexibility on these, the world's most liquid and prominent markets, could cause business to flee to friendlier and less restrictive jurisdictions. Moreover, setting hard and fast limits for the 28 commodities derivatives that trade on the CME and ICE as well as in the swap markets amount to legislating rules for a global market, which is a leap of faith at the very least.
Many of those trading on the U.S. exchanges are hedging or positioning from abroad. Stricter position limits may chase the largest traders away, causing liquidity to suffer. Commodity exchanges thrive on liquidity. A proactive and effective regulator should always look to support market participants so long as they transact within the rules which should serve as protection against criminal actions. However, limiting position size across the board with a hard and fast rule will limit flexibility. In the world of raw material production, consumption and even trading by merchants and yes, speculators, position limits set in stone could create a national security issue for the U.S. It is possible that the flows of business will move to areas of the world with little or no transparency. We have seen the bulk of the physical commodity merchanting business move to Switzerland and Asia in the aftermath of the Dodd-Frank legislation.
When I traded physical commodities for over two decades, agencies like the FBI and CIA would routinely review raw material flow data to understand economic conditions around the world in producing and consuming nations. Chasing that business offshore from the U.S. has made the collection and analysis of all of this data challenging, if not impossible. Therefore, this position limit rule could jeopardize national security in the future.
Moreover, the Dodd-Frank Act was a piece of reactive legislation in response to the global financial crisis of 2008. Commodity futures and the exchanges had no issues or suffered from no problems leading up to, during or in the aftermath of the crisis. The integrity and smooth operations of the exchanges and their clearinghouse operations have never been in question. The clearing of swap transactions via Exchange margining operations will certainly minimize systemic threats to the financial system. However, position limits in the capable hands of the DCMs as opposed to being dictated by a regulatory agency in Washington DC remains preferable. The CFTC is the regulator of all futures exchanges in the U.S. and the Exchanges have a long and successful history of setting margins, contract terms and position limits. The CFTC sets the framework but the exchanges should have the flexibility to operate and make the rules under the supervision of the regulatory body. Position caps and limits will limit Exchange flexibility and effectiveness and will create another level of bureaucracy.
A new administration will reject this initiative
Chairman Massad must realize that the incoming Administration will swiftly reject the position limit initiative. The Republican CFTC Commissioner, J. Christopher Giancarlo has been a consistent critic of position limits as well as many other regulatory initiatives that have been reactionary, complicated and not supportive of businesses operating in the United States. I have read some the Commissioner's opinions which always refer to the need for a common-sense and proactive solution, with which I wholeheartedly agree.
Meanwhile Representative Mike Conaway, a Texas Republican who chairs the House Agricultural Committee which oversees the CFTC has urged Chairman Massad not to move forward with his position limit initiative writing, " The final supplement the Commission proposed remains far short of a workable rule." However, Democrats in Congress continue to support the CFTC Chairman and want to see the rule pushed through before inauguration day. Senator Debbie Stabenow (NYSE:MI), the ranking Democrat on the Senate Agriculture Committee is supporting the initiative and said, " Position limits are an important tool to ensure Wall Street speculation does not lead to high energy costs for families at home or at the pump." The explanation sounds great and like a crowd pleasure for the voters who put the Senator in office but it is simply false.
The Democrats have pointed to energy speculators buying futures in gasoline, heating oil as well as other commodity products over the years which increase the cost of living for U.S. families. When the pro-regulation politicians begin to sing this song, they totally lose me. The argument is not only wrong; it shows a total lack of understanding of futures markets, speculation and economics. How sad it is that our elected politicians do not understand commodity markets, it is even sadder that the Chairman of the CFTC appears not to understand an important constituency that creates the environment where futures trading and hedging can flourish.
Speculators are as likely to go long as they are to go short
A successful futures market depends on two critical factors, in my opinion. First, the delivery mechanism allows for the smooth convergence of future and physical prices over time. Second, the presence of speculators in a market provides liquidity. Speculators take a financial risk, they go long when they believe a commodity price will go higher and short when they think it will go lower. They buy to sell and sell to buy. Producers often wish to sell when prices are high and consumers wish to buy when prices are low. The speculators and traders tend to trade at all price levels, providing the liquidity necessary for hedgers and others in the business of producing or using commodities to transact.
Moreover, when it comes to speculators, they are as likely to go long as they are to go short. Speculators exist to make money from price volatility which makes arguments like Senator Stabenow's specious. As often as they may be responsible for higher prices which cost consumers money, they are responsible for pushing those prices lower, saving consumers money. However, when speculative selling causes the price of a raw material market to move lower we never hear the cries of speculative intervention in markets. Perhaps the next rule the Chairman will suggest could be a short only rule for speculators.
Position limits are arbitrary
Aside from the fact that hard and fast position limits imposed by a governmental regulatory body are arbitrary, they assume that all other jurisdictions around the world will adhere to CFTC and U.S. government dictated levels. The fact is that in countries like China, the speculative fervor will take up the slack of any onerous regulation that limits the amount of business on U.S. exchanges. There are so many reasons why onerous CFTC-dictated position limits will detract from the effectiveness of U.S. futures markets but perhaps the most compelling reason is that industry in the U.S. is against them.
One of the reasons for the success of futures market in the U.S. has been industry involvement in smart regulation that protects markets and supports the underlying business entities that are market participants and hedgers in the contract markets. The CFTC is a regulatory agency but it can only be effective if it is sensitive to industry needs. When regulation rejects industry opinion and works against its ability to profit, U.S. business becomes less competitive on the world stage and business will naturally move to areas of the world that are more supportive. In early 2016, an advisory committee with industry representatives voted 8-1 against position limits on commodities dictated by the CFTC. The one dissenting opinion from The CFTC's Energy and Environmental Markets Advisory Committee vote said the committee was "stacked" with Wall Street interests. However, two members of the committee who voted against the limits were from the gas and oil producing community, Conoco Phillips and The Natural Gas Supply Association. Another no vote came from a trade association representing electric utilities and two no votes came from the exchanges themselves, the CME and ICE, the ultimate experts in the futures industry. Therefore, five of the votes were hardly "Wall Street interests". Hedgers are the reason for the rise of futures markets and they work because of industry support and involvement in the creation of contract markets. Ignoring industry's desires and arguments is a tragic mistake.
A new regime soon- The last gasp at ineffective regulation that scares business from U.S. shores
It is my hope that the incoming administration will appoint new Commissioners to the CFTC, from both sides of the political aisle, who will favor the interests of U.S. business while protecting the public and other market participants from fraud and other criminal activity on futures exchanges and in swap markets. It is an imperative that appointees understand the underlying commodities business and the importance of these markets to U.S. national security as well as the sourcing of raw materials for our nation. Commodities are finite resources and demographic trends over past decades have increased the competition for raw materials. The United States remains the business hub of the world, partially because the dollar is the most accepted reserve currency. The CME and ICE are the biggest and most influential commodities trading exchanges around the globe. These exchanges attract consumers, producers, traders, investors and speculators which together create a transparent and liquid environment for international commerce. The regulatory environment of the United States can either attract or repel these commodities businesses. Common sense regulation involves an industry sensitive approach. A politically motivated attempt to push agency dictates on position limits through before a change in administrations is short sighted. The argument that politicians and regulators are protecting the nation from evil oil speculators is false and a scare tactic to achieve some eleventh-hour political goals. Leave position limits to the Exchanges, the CFTC is a regulatory body not the operational expert.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.