Streetwise Professor

Bart Chilton has come out in support of a position “point” plan that would permit the CFTC to monitor trader positions, investigate positions larger than pre-set “points,” and vote to require traders to reduce any such positions.  As a result, it appears that this interim plan will go forward.

In some respects, this is better than hard limits, but many issues remain.  The proposal gives the Commission considerable discretion, and discretion can be misused and abused.

Here are several open questions.

First, what conditions would permit the ordering of a position reduction?  Must there be some showing of a market disruption?  In the language of the CEA, must the Commission show that the position in question represents “excessive” speculation?  How would that be defined, and what criteria would be used to evaluate whether it has occurred?  Must the Commission show that the position has caused “unwarranted” price fluctuations?  Or must the Commission merely show that the position has the potential to cause such unwarranted flucutations?  (“Bart doesn’t like it” shouldn’t be sufficient to justify a required reduction.)  If not, what is the statutory basis for the authority?

Second, what evidentiary burden must the CFTC meet to support any order to reduce a position?  That is, what evidence must the CFTC produce to support a finding that the position has caused a disruption/unwarranted price fluctuation (or has the potential to do so)?

Third, what recourse does the affected trader have to an order to reduce his position?  Can he appeal the decision?  To whom?  Can the trader get injunctive relief?

With respect to this third question, there’s an interesting case from 1979:

On Thursday, March 15, 1979, the Commission, pursuant to this section, issued an order to the Board of Trade of the City of Chicago (Board of Trade) to suspend all trading in the March 1979 Wheat Futures Contract (Contract) for the following day, Friday, March 16, 1979. The order stated that the Commission had reason to believe that an emergency within the meaning of Section 8a(9) of the Act existed with respect to the Contract in that significant transportation and warehouse facility shortages had caused a major market disturbance which prevented the market from accurately reflecting the forces of supply and demand. The order additionally specified that the Commission had reason to believe that there existed a threatened manipulation or corner in wheat as a consequence of this market disturbance and as a result of the combined long open positions maintained in the Contract by a small number of speculative traders.

. . . .

The Board of Trade complied with the Commission’s order, and all trade in the Contract was suspended on Friday, March 16. Throughout that day Board of Trade officials and the Commission communicated with each other concerning further trading in the Contract. On that Friday afternoon the President of the Board of Trade advised the Commission that under its own rules it had declared an emergency in the Contract and that trading would be limited to “liquidation only (except new sales for delivery only).”2 In response to the Commission’s inquiry concerning what reasons the Board of Trade intended to announce for issuing the order, the President of the Board of Trade stated that the true reason was the shortened trading period remaining due to the one day suspension of trading ordered by the Commission.3 After the Commission notified the Board of Trade President that such a reason was unacceptable, the Board of Trade issued its order which stated that “various factors” led to the conclusion that trading in the Contract should be limited to liquidation only.

That same evening the Commission issued a supplemental order. The supplemental order recited that the Commission continued to believe that an emergency existed with respect to the Contract, and that further action was appropriate. The Commission ordered the Board of Trade to:

(1) immediately terminate all trading in the Contract on March 19, 20, and 21, 1979, the three remaining trading days in the Contract;

(2) permit deliveries of wheat to be made in fulfillment of current open positions in the Contract through the last day permitted for delivery under the rules of the Chicago Board of Trade at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979; and

(3) settle all positions in the Contract remaining open as of the close of business on March 30, 1979, at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979.” (App. 5a)

On the next day, Saturday, March 17, the Board of Trade instituted this action in the district court seeking review of the Commission’s March 16 supplemental order. The complaint asserted that the Commission’s order was arbitrary, capricious, an abuse of discretion, not in accordance with law, and in excess of the Commission’s statutory authority because no emergency existed within the meaning of Section 8a(9) of the Act. The Board of Trade’s complaint sought an injunction restraining the Commission from enforcing its March 16 supplemental orde

Could a trader ordered to reduce a position initiate a similar action?

In my opinion, there is a legitimate reason for emergency authority (although I have argued frequently that ex post deterrence is superior to a market intervention) in cases of manipulation.  Given the inherent vagaries of the idea of “excessive speculation,” however, I have serious concerns about giving the Commission discretion to intervene selectively in order to force individual traders to reduce positions when manipulation is not suspected.  Any such authority should be constrained.  The Commission should be required to set out a coherent rationale for any such intervention; provide evidence that but for such intervention the existence of said position would cause prices to diverge substantially from the competitive level justified by fundamentals; offer the target of such action the opportunity to present contrary evidence; and permit review by a court.

Absent such protections, the market would be at risk to arbitrary actions based on flaky theories that have not been subjected to serious empirical test.  This would create an unnecessary regulatory risk.  Moreover, political economy factors could further distort the exercise of this discretion, as some traders (or other interested parties) may attempt to influence the Commission to take action against market rivals, or to bail out traders caught on the wrong side of the market.  Given the political and popular frenzy that sometimes accompanies big price movements, such perverse outcomes are well within the realm of possibility.  Indeed, I argued in my 1995 JLE piece on self-regulation that fear of such opportunistic intervention was a major reason why exchanges in the past failed to pass rules permitting the exchange to force traders to liquidate or take other actions that would potentially influence market prices.  I think these exchanges were on to something.  The CFTC should ponder that.