Streetwise Professor

CFTC Chairman Gary Gensler gave an extended interview with Reuters on Friday.  A good part of the discussion revolved around budgetary matters, but this gem caught my eye:

The agency likely will stagger deadlines for traders to become compliant with the new regulations — including speculative position limits, Gensler said, declining to give any details about a long-awaited proposal that the agency will unveil in the next month.

Investment funds, which make up as much as quarter of trade in markets like cattle, have already looked for alternative ways to buy commodities, with some buying physical products instead of futures and swaps.

That’s OK by Gensler.

“Congress asked us to do a job, we gotta do what Congress asked us to do,” he said, adding cash markets are not part of his mandate.

Wait just a cotton pickin’ minute.  The whole point about limiting speculation in derivatives markets is that such speculation allegedly distorts prices for the commodities that consumers actually buy and producers actually sell.  That is, that such speculation allegedly distorts cash prices.  Listen to all the crying and moaning and gnashing of teeth about the alleged effects of speculation, and the tales of woe focus on the impact of speculation on cash prices.

I remember distinctly when I testified before Congress on speculation in the summer of 2008: criticisms of speculation at the hearing focused on the impact of derivatives trading on physical commodity prices.  Battling Bob Etheridge of NC took time out from assaulting college students to bewail the plight of trucking companies in his district forced to pay higher fuel prices due to speculation.  The head of the Industrial Energy Consumers of America claimed that chemical producers and others had to pay higher prices for natural gas and crude feed stocks because of speculation in derivatives.

I could multiply these examples by the hundreds, and probably the thousands.  In the 1930s, speculative limits were rationalized as a way of bolstering the prices farmers received on the cash market for their grain.  Suffice it to say that it is beyond cavil that the drive to restrict speculation in derivatives is all about the cash markets.

For Gensler, at this late date, to claim that’s not part of his (or his agency’s) job description beggars belief.  Congress mandated the imposition of position limits for the express purpose of reducing the impact of speculation on cash market prices.  That’s what Congress “asked” CFTC to do.  To proceed with a plan to impose speculative position limits on derivatives, without regard to how said limits could have the unintended consequence of distorting cash market prices is both irresponsible, and at odds with the purpose of the regulation.

Now, obviously, I do not agree with the beliefs underlying the legislative mandate for speculative position limits.  But given that the mandate exists, and that Congress has delegated to the CFTC the authority to implement said limits to achieve a purpose set out in the statute, you’d think CFTC should devise those limits with an eye as to their real effect.  There is now substantial credible evidence that one effect of limits on derivatives will be to shift some activity into the physical markets directly in a way that has more potential for adverse effects on these markets.  It is therefore incumbent on CFTC to take that into account when designing its limits, as otherwise it would impose restrictions that would be directly contrary to the entire purpose of the limits in the first place .

I mentioned the JPM physical copper ETF.  BlackRock just announced another.  This is a growing trend.

Goldman and Standard Chartered argue that physical ETFs should have a limited effect on the market.  In most circumstances, I believe that’s true.  But we’ve seen in the Treasury markets that the limited “float” of some Treasury issues that results from bonds and notes being locked up in pension funds and other buy-and-hold investors can lead frictions that distort prices, and in particular can make it easier to squeeze the market.  Physical ETFs could have the same effect.  Moreover, as a general matter, and as I opined in my original piece on the subject, whereas with derivatives investors can get exposure to particular risks without holding the actual underlying, if physical ETFs are the only way to get exposure to particular commodity price risks, there is an additional constraint that can effect prices as operating under the constraint, to meet portfolio objectives investors may decide to hold inventories of copper that would be released for consumption had investors been able to achieve these objectives through the derivatives market.

At the very least, CFTC should investigate thoroughly the effect of speculative limits on the scale of physical ETFs, and the effect of physical ETFs on the cash markets.  But Gensler’s remark in the Reuters interview makes it evident that he, at least, considers the entire issue irrelevant to the entire position limit exercise.  That’s wrong, and just plain wrongheaded.

You might argue that this development was unintended by the drafters of Frank-n-Dodd.  You can no longer say that it is unanticipated.  Regulators should attempt to determine how market participants will react to their dictates, and plan accordingly.  Saying “it’s not my problem, man” doesn’t cut it.