Streetwise Professor

January 23, 2011

Massive Fail

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 9:13 pm

I have written a comment letter about the CFTC’s proposed rule on position limits, which I will submit tomorrow.  A draft is here.  It’s fairly long, so I’ll summarize it here.

I have said repeatedly that it is imperative for the Commission to identify the specific problems that it believes position limits will mitigate, and how they will do so.  Creditably, in its NOPR, the Commission does set out specific ways in which large, concentrated positions can inefficiently destabilize markets.  It is best described as a Hunt Brothers scenario, in which a levered player takes a large concentrated position in a market.  Such a leveraged player may be forced to liquidate, and the liquidation of such a large position can cause extreme price moves, and perhaps, pose a systemic risk.

Fair enough.  I’ve written about the Hunts in the past, and have made similar points. So that is a danger.  But crucially, the CFTC does not identify any other ways in which large positions can cause “unwarranted” price fluctuations, which is the basis for its position limit mandate.  Therefore, per the CFTC’s own analysis, its position  limits should focus on addressing a reprise of the Hunt situation.

But the major problem with the CFTC proposal is that it will constrain the trading of many market participants who in no way pose the dangers that neo-Hunts would.  That is, the proposed limits are over-inclusive.

In particular, they will constrain trading by exchange traded funds (ETFs) which are (for the most part) unleveraged.  Indeed most ETFs are completely collateralized.  Moreover, even if an ETF is big, it is different than a single trading entity like the Hunts because ETF trades are driven by the decisions of thousands of ETF investors.

In other words, ETFs are nothing like the kind of speculator–and the only kind of speculator–the CFTC has identified as a danger, but they will suffer collateral damage as a result of the CFTC’s limits.

They will not be the only innocent casualty.  Many other “massive passives”–such as pension funds–will also be affected, even though they do not pose the risks that the Commission uses to justify the imposition of limits.

The problems with the proposal don’t end here.  In particular, although “crowding out” is not explicitly in the new proposal (in contrast to the Commission’s proposal of January 2010), the new proposal has a feature that is just as pernicious, and just as inane: the “within-class” limit.

Due to the powers granted by Frank-n-Dodd, the CFTC now has the power to regulate positions in both OTC swaps and futures, whereas before it only had authority over the latter.  The Commission proposes to create two classes of positions: the futures class and the OTC class.  It proposes several limits imposed on the classes collectively and individually.  For one of the limits, the two classes will be netted against one another, and any speculator must have a net position for all months and a single month that are less than or equal to the speculative limit.  But in addition, each speculator’s OTC position must be smaller than the spec limit, and its futures position must also be smaller than the spec limit.

Here’s the problem.  Assume for simplicity that the limit is 100.   Consider a swap dealer who is short 150 swaps to customers, and hedges this using 150 futures.  This complies with the across-class limit, because it nets out to zero.  But it violates the futures class and the OTC class limits.

This feature therefore limits the ability of intermediaries–swap dealers–to hedge risks.  It is effectively a tax on swap dealers, and will reduce liquidity in the swap market.

There are reasonable grounds to suspect, based on the past statements of some Commissioners, that this is a feature rather than a bug from their perspective.  In my opinion, however, it is flat wrong.  OTC market making is a legitimate activity, and OTC deals (hedged by exchange transactions) are often the most economical way for some market participants to take on the investment or speculative positions they desire.  There is no reason to penalize this activity the way the proposed rule does.

Indeed, by limiting liquidity the rule threatens to exacerbate large price moves in response to shocks.  Prices have to move more in less liquid, less flexible markets in order to accommodate big shocks.  Stifling liquidity through the within-class rules is therefore counterproductive.

I would also note that the Commission provides no economic justification for this restriction.  In particular, it doesn’t even try to show how this restriction addresses the Hunt Problem that is the sole substantive justification for the limits in the first place.

The Commission also fails to justify the size of the limits it proposes, which approach 2.5 percent of open interest for large markets.  To put things in perspective, the Hunts’ position was over 25 percent of the market at times.  So maybe 25 percent held by a single leveraged trader poses a risk: how does that justify a  2.5 percent limit on everybody, including non-leveraged traders who are in fact agents for myriad individuals making independent trading decisions (e.g., ETFs)?

The Commission also fails to recognize that its limits could drive business into the physical markets, thereby distorting prices producers receive and consumers pay.  This is perverse, given that the ostensible purpose of the limits is to prevent and diminish such distortions.

In sum, the non-spot month limit proposal is fundamentally defective.  It identifies a problem, and then identifies a blunderbuss-like “solution” that will hit a lot of trading activity that does not and cannot cause this problem.

The spot-month limits are flawed too, because they are logically inconsistent.  The proposal limits caps spot-month delivery-settled derivatives positions at 25 percent of deliverable supply, but does not explicitly place a cap on the amount of deliverable supply a speculator can hold.  The proposal caps cash-settled positions at 5 times the delivery settled limit, i.e., 125 percent of deliverable supply, and also permits the holder of cash-settled positions to hold 25 percent of deliverable supply.

Spot month limits can be justified as a means of preventing corners.  Well, corners can be carried out by holders of cash-settled positions as well as delivery-settled ones.  Indeed, that happened a lot in the Brent market in the 90s and early-00s, and may in fact be happening right now.  Somebody can manipulate a cash-settled contract by buying excessive quantities in the cash market, driving up prices, and thereby artificially inflating the settlement price of the derivative.

If the objective of the limits is to prevent market power manipulations in both cash-settled and delivery-settled markets, the limits are logically inconsistent.  The delivery-settled limit implicitly assumes that it is possible to distort prices by accumulating less than 25 percent of deliverable supply.  Well, you can do that with the cash-settled contract, and then get a profit on a position that is five times larger.

In sum, the position limit proposal is a good example of bad regulation.  It inflicts harm on “massive passives” (perhaps intentionally) even though this type of trader does not pose the only threat that the Commission has identified: this is a massive fail.

I should also note that the proposed rule provides not a word of justification of the widespread view that speculation caused the price spikes of the 2007-2008 period, or is causing the current runup in commodity prices.  It certainly provides no evidence.  But such price spikes are routinely evoked in Congress, the press, and even in statements by Commissioners, as evidence of the need for such limits.  Since the Commission apparently does not have the confidence in such a belief to include it as a justification for limits in the formal proposed rule, this should play no role in deliberations over the rule going forward.  To do so would be to play bait-and-switch.

Instead, the rule should be evaluated solely on the basis of its efficacy and efficiency in addressing the specific problems with speculation that the Commission has identified.  When this is done, it is clear that the rule is grossly excessive because it impedes legitimate conduct that poses none of the risks that the Commission believes warrant regulation.  The rule should therefore be rejected, and if replaced at all, replaced with something that is targeted at the specific ill that the Commission has diagnosed.

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  1. I agree the proposed regulations regarding position limits and changing the exemption-status for swap dealers is poorly conceived. My main issue/concern is the unproven allegation that “excessive speculation” has been or will be a problem. In a market where every contract traded is an agreement between buyer and seller, how is it possible to prove “excessive speculation” ? Further, who is speculating more “excessiely”, the buyer or seller? I fully agree the proposed changes, if approved, will only result in more physically-backed swaps compounding the already tight supply in a number of markets (e.g. grain, oilseeds, and cotton). Bart Chilton, the CFTC’s main cheerleader for more strict limits, should be called to testify in Congress to both prove “excessive speculation” has existed and provide data for the net harm. If he can’t provide such credible proof, the media should stop giving him a podium to further his crusade and this proposal should die a natural death. In my latest edition on Morrison On The Markets, ‘CFTC vs. The Market’,I provide a few facts to balance the argument of those who favor these regulations.

    Comment by ken morrison — January 24, 2011 @ 6:57 am

  2. […] This post was mentioned on Twitter by CMEGroup, Mr Top Step. Mr Top Step said: RT @CMEGroup: The @StreetWiseProf takes a look at the newly proposed position limits from the @CFTC […]

    Pingback by Tweets that mention Streetwise Professor » Massive Fail -- — January 24, 2011 @ 6:58 am

  3. Bart Chilton will disagree with you. He said that no one can hedge because there is too much speculation!

    Comment by Jeffrey Carter — January 24, 2011 @ 7:05 am

  4. Unfortunately for Mr. Chilton, the facts don’t support his opinion. According to the CFTC’s own weekly data, there are 40% more commercials reporting corn futures positions now vs. 1 year ago (568 vs 406 last year). By comparison, the number of money managers (pure speculators) have risen 24% (160 vs. 129). In Nymex Crude Oil, the # of commercials reporting weekly positions to the CFTC is also higher than 1 year ago, 106 vs. 102 with money managers 118 vs. 113 last year.

    As the commercial says, everybody is entitled to their opinion but there’s only one set of facts. The media needs to do a better job of pressing Chilton for the facsts to support his wild opinions.

    Comment by ken morrison — January 24, 2011 @ 7:23 am

  5. @Jeff–re having Bart Chilton disagree with me: (a) I’m used to it, and (b) I would worry about my analysis if he actually did agree with me.

    The ProfessorComment by The Professor — January 24, 2011 @ 12:09 pm

  6. You could introduce Chilton testimony as supporting your defense. Like George Costanza in Seinfeld, just do the opposite!

    Comment by Jeffrey Carter — January 24, 2011 @ 2:42 pm

  7. Suppose, price of oil is, say, around $50 per barrel.
    Goldman Sucks starts buying thousands of contracts of oil.
    Buying by Goldman increases demand.
    Price of oil goes up.

    On the chart the uptrend is clearly visible.
    Now Goldman analyst makes news by saying that price of oil will reach, say, $100 per barrel.
    Now speculators arrive and drive prices still higher.

    The result?
    Oil, which was selling at $50 per barrel, now is sold at $100 per barrel.
    Refineries pay twice more than they could or should.
    The higher costs are passed on to the consumer.

    Why should I pay more for gas?
    Just because some blood-sucking Goldman traders want to make a nice living?
    It’s hidden tax. It must be if not outright prohibited, it must be at least severely restricted.
    Goldman should have no business to suck money and blood out of me.

    My opinion is based on introductory economics, – supply and demand, and equilibrium price.
    I doubt very much that with advanced economics the opposite can be proved.

    It’s not a free market or price discovery.
    It’s a casino where big players can move prices both up and down simply because they have a lot of money.
    It’s a parasitic activity.

    It’s bad enough that the Left is accusing corporations in all sins, real and imagined.
    Litigation, taxes…
    So corporations pack up and move to Asia.
    20 or 30 years from now America will be corporation-free wasteland, populated only parasitic futures traders who no longer can manipulate markets simply because the Chinese have more money.

    It’s time for this country to think about high-tech, and not about sucking blood out of the people with futures trading.

    Comment by Michael Vilkin — January 24, 2011 @ 10:14 pm

  8. My only comment would be to change the title of the post from “Massive Fail” to “Epic Fail.” Kids like that word right now.

    Comment by Scott irwin — January 25, 2011 @ 9:20 am

  9. Hi, Scott–the “massive” in “massive fail” is aimed at Chilton’s claim that “massive passives” are distorting prices. Both adjectives are quite apt, though.

    The ProfessorComment by The Professor — January 25, 2011 @ 12:47 pm

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