Streetwise Professor

The CFTC floated its proposal to set energy futures & futures options position limits yesterday.  Here’s the NOPR, and here’s a cheat sheet and FAQ about the proposal.

The result is no surprise to me.  In the weeks leading up to the announcement, many reporters had called to ask for my take on the CFTC’s likely course of action.  I responded that the CFTC would do something, but that the limits it chose would be relatively generous.  The agency was between a rock and a hard place.  On the one hand, Congress clearly expected action; indeed, I strongly suspect that Gensler had to promise that he would act on energy position limits to get the job in the face of skepticism from Bernie Sanders and some others in the Senate.  On the other hand, it eventually dawned on the Commissioners that overly restrictive limits would just drive business to OTC, and perhaps overseas; given that Gensler in particular wants to rein in the OTC markets, this would be an extremely perverse outcome.  So, they did something, but not much.

Which isn’t the best alternative, but it’s not the worst either.  The best alternative would have been to take a principled stand like the FSA, which has remained skeptical on position limits because of the lack of any evidence that speculators distort prices.

Indeed, the entire justification for the CFTC action could be summarized as (with apologies to The Treasure of the Sierra Madre): “Evidence?  We ain’t got no evidence.  We don’t need no evidence.  We don’t have to show you any steenkin’ evidence!”

Don’t believe me?  Well, here’s what they say:

The Commodity Exchange Act directs the CFTC to act prospectively, as necessary, to curb or prevent excessive speculation . . . The CFTC’s notice of proposed rulemaking does not speak to whether there was excessive speculation in the regulated derivatives markets for energy commodities. [From the FAQ.]

The CFTC need not demonstrate that there has been excessive speculation in the regulated derivatives markets for the major energy commodities. [Emphasis added.]

I see.  There is no evidence that speculation has distorted prices in the past, but the Commission feels it is perfectly acceptable to act against the purely hypothetical possibility that it might in the future–even though the logical and empirical basis for the hypothetical is extremely dubious, at best.

A couple of other comments on the proposal.

First, it creates a tripartite classification of market users–bona fide hedgers that use futures to manage physical risks; swap dealers that use the contracts to manage financial risks, and speculators.  Swap dealers can hold positions equal to twice the limit to which speculators are held.  This seems like being a little bit pregnant.  The higher limit is an implicit admission that swap dealers do use these instruments to manage financial risks.  Indeed, many of these risks are transferred from the very same physical market players whom the proposed limits favor as bona fide hedgers.  (Swap dealers offer risk management solutions to physical players, and then lay off some of that risk through the futures markets.)  So then what’s the point on limiting the position swap dealers can hold to hedge their OTC books?  And why is “two” the magic number.

Perhaps this is best seen as a backdoor approach to push trading from the OTC market onto exchanges.  Not a good idea.

Second, some aspects of the proposal are intellectually incoherent.  For instance, (a) there are all month limits, and (b) the limit for cash-settled contracts is five times the limit on delivery-settled contracts for firms that hold only the former.

Now, if you believe that market power manipulation is the problem, and if you believe that delivery settled contracts are particularly susceptible to market power manipulation, then all month limits are unnecessary; a spot month limit would be sufficient to mitigate manipulation.  (It’s wrong, as I showed in a JOB paper some years back, to conclude that cash settled contracts are not susceptible to market power manipulation, but it is a widely held belief.)

So, by choosing all month limits, the CFTC must believe that market power manipulation alone is not the problem; speculation can distort prices in other ways.   But if you believe that (not that you should, but if you do), you should also believe that speculation in cash settled contracts could also distort prices.  (A lot of the hyperventilating about index funds, and OTC markets, is based on the view that people making bets affects the outcome of the race.)  But if you believe that, you wouldn’t privilege cash settled contracts through a much more generous position limit than for delivery settled ones.

Perhaps this incoherence shouldn’t be a surprise.  Given the complete absence of any credible theory or evidence as to how speculation distorts prices to guide policy making, silliness is inevitable.

How will this play out?   Apparently the Commission is quite divided.  Moreover, it has indicated that it will take its sweet time in evaluating comments on the proposal, and may revise it accordingly, stretching the implementation time line.

My guess is that this is a strategic decision.  The Commission at least recognizes that any coherent approach to limits (even if the coherence is based on flawed theories and evidence: I just mean intellectually consistent) must encompass both the OTC markets and the exchange traded markets.  If the Commission wants to, for reasons known only to its members, crack down on speculation generally, acting on the futures markets alone is doomed to failure.  But they are waiting on Congress for authority to act in the OTC market.  Slow walking the proposal gives Congress time to act, and may indeed goad it into action.

In brief: laws, sausages–and CFTC proposals.