My original take on the CFTC energy futures position limits was that they were sufficiently generous so as to not represent much of a constraint on most market participants. Upon further thought, I concluded that the “crowding out” provisions that would (a) limit swap dealers to double the spec limit, and (b) preclude those benefitting from the hedge exemption from speculating, or acting as swap dealers are landmines that could inefficiently constrain the operations of the futures markets as risk shifting and price discovery tools.
Christopher Doering of Reuters picked up on this phrase, and found others concerned about the same issue. In effect, the rule will segment the market, creating ghettoes for hedgers, swap dealers, and speculators.
There are good economic reasons to believe that some hedgers might be able to compete effectively as swap dealers, or can speculate in addition to hedging. (Indeed, as Working pointed out eons ago, hedging is really just speculating on price relationships.) Moreover, some swap dealers might have hedging needs, or can efficiently supply speculative capital to the market. The 2x limit on swap dealers is also problematic. Why 2x? Why not 3.14159x? This limitation could constrain the ability of some swap dealers to achieve efficient scale, and may indeed have the perverse effect of shifting business to less well capitalized market participants.
What is truly scary is the “rationale” for this limit offered by that noted industrial organization economist, and expert on scope economies, CFTC commissioner Bart Chilton:
CFTC Commissioner Bart Chilton, a strong proponent of position limits, was unapologetic, arguing exemptions have given too much flexibility to players without stakes in the physical commodity.
“There should be zero patience for trading on your own book, if you have an exemption,” Chilton told Reuters, defending the new proposal as a safeguard against the impact of large traders roiling markets by making risky bets for their own accounts.
“Perhaps, if our proposal goes into effect, some will have to choose a business model,” he said. “Are they a speculator, a swaps dealer or a hedger? Part of the problem we have had over the years is that some wanted to be everything to everybody.”
Loaded with deep economic insights, that. “There should be zero patience for trading on your own book, if you have an exemption”: a purely conclusory, unsupported, assertion. Hedgers with substantial physical market information are often the most profitable speculators.
“Part of the problem we have had over the years is that some wanted to be everything to everybody.” What does that mean, even? Given the nature of information and information flows, it is quite understandable that there are complementarities between speculative, physical, and customer-facing (e.g., swap dealing) trading functions. This is a highly competitive market, and one would expect that if there are complementarities that reduce costs, one would observe–as we do–some firms exploiting them.
Siloing physical market, speculative, and customer-facing activities precludes market participants from exploiting any complementarities. If the complementarities didn’t exist, specialized firms would dominate in practice. The success of multi-function firms in a competitive environment suggests that these combinations offer efficiencies. There are no obvious regulatory constraints (e.g., price controls, rate of return regulations) that are (inefficiently) encouraging the evolution of integrated, multi-function firms.
Regulators throughout the government–in the US, but elsewhere too–are repeatedly substituting their judgments regarding efficient market structure for those of the participants in highly competitive markets. Moreover, like Commissioner Chilton, their rationales for their judgments are often shockingly superficial, not to say ignorant, and fail to engage let alone answer fundamental economic questions. It would be nice, if at least sometimes, regulators flogging particular proposals to change market structures could provide a coherent critique of why incumbent market structures are inefficient, and how the proposed regulation would remedy these inefficiencies–without introducing even worse ones.