By Abraham Bailin
When Dodd-Frank was signed into law in July 2010, it marked one of the most comprehensive changes to our financial system since the Great Depression. The Act's primary mandate, "To promote the financial stability of the United States by improving accountability and transparency in the financial system," called to action a multitude of federal agencies, departments, and commissions.
For the Commodity Futures Trading Commission, this meant identifying 30 areas where additional rules required implementation. One such area required that the CFTC implement commodity futures market position limits. The position limits follow the reasoning that decreasing speculative activity will work to curb volatile market swings. In other words, the government is concerned that financial speculators are causing commodity prices to jump around for consumers. As we will discuss, substantive research indicates that the law may not only be off the mark, but could even turn out to be counterproductive.
On Oct. 18, 2011, a divided CFTC passed futures-market position-limit rules. As you would expect, the position limits have been met with substantial resistance from the futures industry. However, it has also received criticism from ranking members of the CFTC.
The recently passed CFTC rules establish federally mandated speculative position limits for 28 core commodities, but in fact position limits aren't new. Exchanges had self-imposed spot-month limits for many years to prevent purely speculative players from cornering or manipulating the markets, which could potentially obstruct real-world use of commodities.
The recent ruling on spot-month limits doesn't mark any major changes. These rules apply to exposure gained through futures, options, and swaps. Spot-month limits, which apply to the period immediately preceding contract expiration and physical delivery of the commodity, are set at 25% of "deliverable supply."
What is new are federally mandated non-spot-month position limits. Non-spot-month limits apply to futures contracts with more than one month until expiration. These new limits stem from the argument that the implementation of position limits will curb price volatility through the prohibition of excessive speculation. As we discuss below, research by major industry regulators and participants has not found any evidence corroborating that argument.
For non-spot-month futures contracts, limits are set according to open interest. A single market participant can hold 10% of the first 25,000 contracts (i.e., 2,500 contracts) and an additional 2.5% of all contracts afterward (i.e., 0.025 x [Total # of contracts - 25,000]). Non-spot-month limits mark a major addition to the position limit regime that already existed under the purview of the exchanges.
The reasoning behind spot position limits is that they prevent a single market participant from cornering and manipulating a physically deliverable commodity. That reasoning does not apply for position limits on non-spot contracts. Holding a majority stake in non-spot futures may allow one to increase prices of that particular futures contract, but it does not allow for manipulation of the price of the deliverable commodity, as it fails to have an impact on the supply and demand paradigm.
Doubts From Square One
Some of the most severe criticisms of the CFTC's recent ruling come on the basis of its lack of concrete data. Over the years, position limits have been consistently turned to by policy makers and regulators in reaction to volatile market swings. In an effort to give this matter a fair hearing, we have attempted to find research supporting the notion that limiting speculative activity within the market is likely to dampen volatility. The search was fruitless.
The risk here is that "speculation" is being conflated with "manipulation" by those who either do not understand or do not appreciate the need for liquidity within commodity futures markets. The two are not the same, and restriction on market participation has the potential to work against Dodd-Frank's mandate, increasing rather than decreasing volatility within our financial system.
In markets where these limits are already high, new regulations provide little to no immediate change to the current market structure; instead they work to prevent stakeholders--the exchanges, investors, and large traders--from appropriately positioning themselves in advance of anticipated market movements. At best, the limits are a harmless solution to a nonexistent problem. At worst, they work to disrupt the efficient transfer of risk from hedgers to speculators across the multitude of currently liquid futures markets.
We are not alone in our skepticism regarding additional limits on position size. The Financial Services Authority & HM Treasury takes a similar stance in the paper "Reforming OTC Derivative Markets: A U.K. Perspective" (2009):
We are of the view that the regulatory focus should be on preventing manipulation... We do not believe, nor have we seen evidence, that a blanket approach through specific position limits is necessarily the most effective way to monitor, detect, and deter manipulative behavior... (Sec. 9.4)
They go further in addressing the relation between position limits and volatility:
In relation to controlling or limiting price movement, we have seen no evidence to suggest that one particular type of market participant has been solely responsible [.] As a result, we do not believe that limiting...by imposing specific limits is a desirable or warranted response to the changing nature of derivative markets. Furthermore, there is no evidence to date which demonstrates that prices of commodities, or other financial derivatives, can be effectively controlled through the mandatory operation of regulatory tools such as position limits. We therefore do not believe these measures would achieve the goal of solving the perceived problems. (Sec. 9.5)
Industry players are raising similar issues this time around. During the CFTC's public comment period, the CME Group took issue with the proposed rules. Looking to get to the bottom of the issue we had a talk with John Peschier, a managing director at the CME Group. Regarding the CME's position on federally mandated position limits he noted, "We do not feel that position limits are necessary. If position limits get too Draconian, they would drive market participants out of the market, which, contrary to the aim of the CFTC's ruling, would increase volatility by decreasing liquidity and decrease transparency for price discovery at the same time."
Other industry officials that have similar concerns include the Futures Industry Association and even a number of CFTC members. Commissioner Dunn went so far as to call position limits a "...sideshow that has diverted resources away from actions to prevent another financial crisis."
Quite possibly the most troubling account is that of the CFTC's former chief economist, Jeffery Harris, in his study on position limits. While at the CFTC, Harris was tasked with studying the effects of speculation on volatile price runups. He published his findings in a paper titled "Do Speculators Drive Crude Oil Futures Prices?" where he concludes:
The increased participation of traditional speculators as well as commodity index traders in the crude oil futures market raises the question of whether these traders predict market prices. The recent increase and eventually fast decline in crude prices has been linked to speculators. Based on our tests, we fail to find that these traders' positions lead prices. Conversely, our results suggest that price changes leads the net positions and net position changes of speculators and commodity swap dealers, with little or no feedback in the reverse direction. (Sec. 4)
The argument for position limits is based upon the idea that speculative activity drives volatile price shifts. However, in one of the most speculatively active futures markets, crude oil, the CFTC has found that price changes drive speculative activity--not the other way around.
Arbitrary Limits: Potential for Rough Judicial Review
There are a host of logistic hurdles associated with the implementation of these rules. Under the aforementioned non-spot-month position limit regimen, a single market participant is able to control a larger percentage of total open interest as the market size and activity decreases.
Consider two markets: one with open interest of 100,000 contracts, and another with 1,000,000. The cap for the smaller market allows a single-market participant to hold a total of 4.4% of the total market, while the cap for the larger market only allows for a 2.7% stake. Intuition would guide us to seek the opposite, to more severely limit a single firm's control of smaller, more easily manipulated markets.
The problem that this may pose for the CFTC ties back to the Administrative Procedures Act. The act requires that all agency decisions be subject to a judicial review. If such a review found the CFTC's limits to be arbitrary and capricious or their process to have been an abuse of discretion, the position limit ruling may be rescinded.
Impacts of Implementation
As mentioned earlier, existing limits are currently set at extremely high levels. Surveying the commodity-focused exchange-traded product, or ETP, space, we don't expect that many if any products will have problems.
We spoke to John Hyland, portfolio manager and chief investment officer of United States Commodity Funds. Hyland manages the largest futures-based single-commodity ETPs on the planet, United States Oil (USO), and United States Natural Gas (UNG). He weighed in on the impacts of the recently passed position limits on the ETP space.
Since USO and UNG invest in single commodities, one might expect them to be prime candidates for flagging CFTC position-limit infractions. Given the size and liquidity of the energy markets, neither comes anywhere near their respective caps. Hyland notes that it may actually be a select few offerings holding baskets of commodity futures that run into trouble with position limits. Based on recent numbers, even the single largest futures-based broad-basket commodity ETP, PowerShares DB Commodity Index (DBC), was using only 50% of its now mandated futures and options allotment in the gasoline and wheat markets.
Matters become exponentially more complicated, however, when applying these new limits to the exchange-traded swaps markets. Hyland notes:
For the CFTC to set final position limits, they will need to know the size of the swap market. Until they complete the swap data repository that won't happen. We may not know what the final limits are until mid-2013, but we know that swap markets for certain commodities are larger than others. For energy markets, the limit could be much higher with the inclusion of swaps. That may not be the case for some of the agricultural markets.
This could cause problems for funds like PowerShares DB Agriculture (DBA). The fund is only half the size of DBC but throws all its weight toward the agricultural sector. Based on numbers taken at the same time as our DBC example, DBA was using over 160% of its cocoa futures contract allotment.
The CFTC has allowed for the application of position limits toward individual offerings, not by the parent or provider. This makes sense; otherwise, providers could run into restrictions with multiple products that operate in the same market albeit with distinctly different strategies.
Exchange-traded notes don't actually hold the futures. However, the underwriting bank of these notes would likely want to hedge their exposure. If the CFTC does not allow for banks to receive exemptions for the position-limit burdens of the ETNs, it's conceivable that some of the largest notes will need to be shut down to save futures position limit capacity for higher-margin businesses like trading desks or investment management.
One major mutual fund that may face serious complications is the PIMCO Commodity Real Return Strategy (PCRIX) open-ended fund. The fund currently has $24.6 billion of assets under management. Despite its participation across the broad spectrum of commodity futures markets, not including the allowance for swap -based exposure, its size potentially stands to set it over its respective limits in several commodities. The existence of clone-offerings does not allow for the exemption of position limits, so this and similar open-end vehicles may have problems going forward. Though the position limitation regulation looks to curb excessive speculation, this fund is a shining example of how non-speculative market participants in the commodity space could be adversely impacted.
The CFTC is also planning to move all swap activity onto exchanges. This will allow them to quantify and monitor their size and allow position limits to adjust accordingly on an ongoing basis. Whether this is feasible is questionable, and implementation may have its own unintended consequences.
While ETPs that hold futures may be unaffected, current swap market participants are not currently required to post substantial liquid margin. Margin will likely be required once their swaps begin going through an exchange and clearing house. This added burden will be passed on to the farming co-op, or the power generation facility, or any user of the markets who doesn't have millions in liquid assets on their books available for a margin call.
The costs of additional capital requirements will ultimately be passed along to consumers. They will result in upward price pressure, though we can't predict to what degree. The bigger cost, however, may be the loss of these financial vehicles completely, as increasingly stringent swap and traditional derivatives market regulation forces market participants to look overseas or cease providing these products completely.
In the end, we hope that the position limits are set high enough to be a non-issue. Even in the case that a select few fund offerings bump into position limits, we don't doubt that other providers will launch competing alternatives to satisfy the demand if it exists. Given the lack of data supporting the reasoning for position limits and the arbitrary levels they seem to be set at, it may be the case that the recent ruling won't make it past a judicial review called for by the Administrative Procedures Act.
It is troubling that the major effects we can see these new position limits having are negative. They stand to detract from the liquidity of markets, in turn increasing volatility. We are afraid that the regulations, as put forth, might cause misallocation of capital throughout the economy. Most concerning, perhaps, is that if the regulation does in fact cause harm, it will harm those it purports to protect (i.e., the small passive investor). These limits stand to obstruct the long-only passive non-speculative investors that gain access through funds, while allowing speculative players, which in most instances are smaller on an individual basis, to continue unabated.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.