US judge strikes down CFTC commodity limits

The recent ISDA challenge to CFTC on commodity limits (discussed here) finally paid off. The nonsense about limits on futures holdings preventing "excessive speculation" that causes outsize swings in commodity prices was struck down in court. Politicians blaming the investment community for problems created by fiscal or monetary policy in the US or abroad never made sense. Grandma's multi-billion dollar state pension fund should not be prohibited from buying a basket of commodities (or investing in a fund that does) to protect against inflation risk. It's just silly.

Academic literature clearly points out that price fluctuations in commodities that had no futures contracts have been just as extreme as those traded on futures exchanges. And funds that take concentrated positions in commodities (such as commodity index funds and ETFs) are not the problem. In fact an OECD paper recently pointed out (see bottom of post) that the participation of index and swap funds in commodity markets may actually reduce volatility - possibly because of added liquidity.

OECD: - An unexpected finding was a negative relationship between index and swap fund positions and market volatility. That is, there is some evidence that increases in index trader positions are followed by lower market volatility. This result must be interpreted with considerable caution. The possibility still exists that trader positions are correlated with some third variable that is actually causing market volatility to decline. Nonetheless, this finding is contrary to popular notions about the market impact of index funds, but is not so surprising in light of the traditional problem in commodity futures markets of the lack of sufficient liquidity to meet hedging needs and to transfer risk.

A US district judge in DC agreed.

FT: - The “position limits” rule was to take effect in two weeks. It would have capped holdings of futures and options for 28 commodities and their derivatives, from crude oil to corn and cocoa, expanding existing limits to contracts for any delivery month.

Robert Wilkins, a US district judge in Washington, said on Friday the CFTC failed to heed instructions from Congress requiring it to determine that its rule was “necessary to diminish, eliminate or prevent” excessive speculation.

OECD paper

SoberLook.com

CFTC coming under pressure to finalize derivatives regulation

Here is an update on the implementation of the Dodd-Frank derivatives regulation (part of the financial reform and consumer protection law) from JPMorgan (see attached document). For active derivatives end-users the clearing requirement deadline seems to be the end of this year. A good number of them are not even close to being ready and the implementation deadline will likely slip once again.

Source: JPMorgan

Of course this is only for products that can be cleared. What happens to derivatives that are not expected to be cleared, at least initially? The CFTC of course is going to impose certain high margin requirements on those (these margins can't be lower than those applied to cleared products.)

But the "non-cleared" margins can't be applied just to US banks because if margins for non-US swaps dealers are lower, US banks will not be able to compete. It means that these margin requirements have to be fairly uniform across jurisdictions, with other regulators playing in the same sandbox. And that's (one of the many areas) where the CFTC is running into difficulties.

IFR: - ... foreign regulators and banks have joined the chorus of disapproval, focusing on the potentially damaging effect margin requirements for uncleared swaps could have.

The most important response to watch for will not be from any individual country’s banking supervisor or US industry group, but from the European Commission’s lead regulator on Internal Market and Services, Michel Barnier.

“We are particularly concerned with potential CFTC margin requirements for swaps that are not cleared through a central counterparty,” Patrick Raaflaub and Mark Branson, the CEO and head of banking regulation at the Swiss Financial Market Supervisory Authority, wrote in a letter to the CFTC in early July. “If such margin requirements are applied to a Swiss-based entity, this may duplicate the requirements and may possibly conflict with international and domestic capital adequacy rules, thereby producing inefficiencies.”

“Due to [this] concern, we cannot exclude that FINMA may have to deny financial institutions permission to supply certain information or grant direct access to U.S. supervisors,” they warned.

That statement could be perceived as a shot across the CFTC’s bows in what could become a power-struggle between international regulators, said a regulatory lawyer in New York. FINMA is implying that it would deny Swiss banks the right or ability to comply with certain US regulations, even if Gensler mandated it. The effect of such a move by FINMA could mean a regulatory stalemate for Swiss banks looking to engage in swaps with US persons or their affiliates after Dodd-Frank is fully implemented in the US, the lawyer said.

This is not a surprise given that the CFTC has trouble regulating futures brokers in the US - which has been its main job. Now they are trying to dictate global regulation on something the agency has little experience with. Even in the US people are beginning to ask questions.

IFR: - The US Chamber of Commerce submitted a letter this month warning Gensler that foreign regulators may feel the impulse to extend the scope of their derivatives regulations back into the US due to the “extraterritorial application of derivatives regulation”. David Hirschmann, the author of the letter, added that an “overly broad” application could put foreign branches of US firms at a competitive disadvantage – criticism US banks have repeatedly raised.

This process has been fraught with problems from the beginning. Zealous, politically motivated, and an inexperienced group has been at this for years, introducing tremendous uncertainties into the implementation process and incremental risks into the derivatives market as a whole.

Enjoy! J.P. Morgan Regulatory Update Slides July 2012

SoberLook.com

ISDA and CFTC are fighting it out over commodity limit rules

Many readers were upset with the Sober Look post from two years ago named Energy speculation vs. hedging - regulate it all, ask questions later. Supposedly oil prices in the summer of 2008 had nothing to do with China’s and India’s rapid growth. It was all speculators. Right.

In fact a 2009 study showed that there is no evidence that futures trading impacts physical commodity pricing. We quote that study again here:

...the results indicate that in recent years the relationship between futures and physical commodity markets for industrial metals was not disturbed by financial investors. Instead, commodity spot prices changes are driven by world economy activity and financial investors are merely responding to these price changes. This conclusion is strongly confirmed by the economic developments in 2008.

But publicity driven politicians and zealous regulators (CFTC) continued on their war path to limit futures position holdings and impose other restrictions. Even without those limits in place, the threat of such action cause distortions in the market place such as ETFs trading at substantial premium to NAV (see Another ETF giving Larry a headache)
Today with the CFTC rules finalized, ISDA and SIFMA (Securities Industry and Financial Markets Association) finally filed a legal challenge to the CFTC’s new rules.

MarketWatch: The Associations believe that the Position Limits Rule may adversely impact commodities markets and market participants, including end-users, by reducing liquidity and increasing price volatility.
…
"The evidence is overwhelming that position limits are, at best, unnecessary and may, at worst, negatively impact commodity markets and users," Mr. Voldstad said. "Numerous studies have been conducted by government agencies and others into commodity price volatility and little, if any, support exists for the idea that speculation causes that volatility or that position limits curb speculation."
…
The Associations have filed suit in federal court in the District of Columbia, alleging that the CFTC:

• Erred in concluding that the Dodd-Frank Act required it to establish position limits without first determining whether they were even necessary; 
• Failed to present a reasoned analysis or consider all evidence in setting position limits;
• Failed to conduct an adequate cost-benefit analysis as required by law;
• Conducted a flawed rulemaking process that prevented commenters from meaningfully participating.

Markets regulation is vital in order to build investor confidence that in turn provides financing to corporations, municipalities, individuals etc. But we need smart regulation, not just what makes for good publicity or sells newspapers.

ICE is asking CFTC to allow CDX and CDS in one account

The CFTC is seeking industry comments on the ICE Clear Credit request for "Commingling" and "Portfolio Margining". As a bit of background ICE (the Intercontinental Exchange) is preparing a platform to clear credit default swaps (ICE would become a "clearinghouse"). It's a slow and tedious process because so many regulatory and "plumbing" (process/technology) issues need to be worked out for CDS.

In their infinite wisdom US politicians have split the regulatory oversight over CDS clearing. Index CDS (such as CDX) are to be regulated by the CFTC, while the SEC is to regulate "single-name" CDS (for example CDS protection on Ford). The rationale here is that the SEC regulates public companies - therefore "single names", while the CFTC deals with futures, many of which are indices. It is quite common for industry participants to have both types in the same portfolio, for example selling protection on one or more single names while buying protection on the index.

Of course neither the politicians nor the two regulators have fully thought this out. After all the futures industry lobby that has been pushing for CDS clearing does not fully understand how CDS is used in practice. Realizing the problem, ICE is trying to get permission to do the following:

1. Keep both single-name and index CDS in a single customer account (separate accounts for different customers of course) in order to allow clients offset gains on one with losses on the other. This is particularly helpful if the strategy is some sort of a spread trade or one type is used to hedge the other.

2. Allow portfolio based margining in this single account. That is if the long and the short CDS have significant risk offsets (short single name CDS vs. long CDX for example), the margin requirement would be reduced. That is the lower the risk, the lower the margin. Obviously there would be the "jump to default" margin charge for each position that can't be "hedged", but portfolio diversification would help reduce that charge.

This is a sensible way to structure CDS clearing and should be permitted. If the CFTC does not accept this request, it will put a significant damper on CDS liquidity, making it that much harder for institutions to hedge credit portfolios and reduce risk.
ICE Exec Summary Portfolio Margining

SoberLook.com

Larry's UNG dilemma

"CFTC is pushing small investors out of the commodities markets!" said Larry. Larry is a small investor who wanted to go long US natural gas and had in the past used "UNG" to do so. UNG is an ETF that is long US natural gas:

The investment [UNG] seeks to replicate the performance, net of expenses, of natural gas. The trust will invest in futures contracts on natural gas traded on the NYMEX that is the near month contract to expire. It is nondiversified.

UNG started trading at a premium to NAV recently, and Larry doesn't want to be the sucker who buys an ETF at a premium. But wait, ETFs (unlike closed-end funds) are not generally supposed to trade at a premium to NAV. From iShares:

With ETFs, Authorized Participants such as specialists on the exchange or institutional broker/dealers can create or redeem shares directly with the fund through an "in-kind" transfer mechanism. APs create ETF units by delivering a basket of securities to the fund equal to the current holdings of the ETF, plus a designated "cash component." In return, the APs receive a large block of ETF shares (typically 50,000 shares in the case of iShares Funds), which investors can then buy and sell in the secondary market.

This process also works in reverse, so if an investor wants to sell a large block of shares of an ETF and there seems to be limited liquidity in the secondary market, the APs can readily take them in and redeem them.

This constant exchange of the portfolio assets for shares of the ETF works to tighten any spread between where the fund trades and it's NAV. As demand increases, more shares are created, while if demand drops, shares are taken out of the market.

Now imagine a situation of increased demand (as is the case with UNG), but the fund can no longer accept "a basket of securities equal to the current holdings", because that basket is the NYMEX natural gas futures contract. UNG, worried about CFTC limiting it's ability to hold natural gas futures, stopped creating new shares (because as it grows it will need to buy more futures). With the supply and demand out of balance, UNG now trades at some 17% premium. UNG can eventually use TRS instead of futures, but it may take time to set that up (and the regulation around TRS remains unclear).

UNG and it's NAV


UNG is Larry's choice because it's quite liquid, but the premium he has to pay forces him to stay away. Larry of course could open a futures account, but futures commissions and minimums are significantly higher (value of a single nat gas futures contract is about $30K).

Of course the reason for this whole dilemma is that CFTC wants to stop Larry and his friends from "speculating" on natural gas markets. That's because speculation is bad and it drives up prices. Larry and his evil gang of speculators have driven prices up this year, but somehow the fundamentals of natural gas oversupply got in their way (with natural gas trading 50% down year-to-date). CFTC, we urge you, please stop Larry before it's too late.


Disclosure: no exposure to UNG

Derivatives trading causing price spikes? Study shows it's just hype.

Following up on our earlier post called Energy speculation vs. hedging - regulate it all, ask questions later, here is a recent study from the Fed that contradicts what some politicians are claiming - that somehow futures trading activity (or what they call "speculation") has a lasting impact on spot prices.

The author, George Korniotis analyzes industrial metals with and without the corresponding futures markets. The chart below from the paper shows the price growth rates for the two types of markets: "traded" and "non-traded".



Here is the summary:

...the results indicate that in recent years the relationship between futures and physical commodity markets for industrial metals was not disturbed by financial investors. Instead, commodity spot prices changes are driven by world economy activity and financial investors are merely responding to these price changes. This conclusion is strongly confirmed by the economic developments in 2008.

Rather than tackling the real issue, which is the US dependence on crude oil, politicians continue to blame derivatives markets for price spikes in energy. They also claim that the same problem exists in other commodities. Maybe they should take a sober look at the evidence to the contrary.

Buying CDS protection could be prohibited

From Epitome Weekly

The climate-change bill passed by the U.S. House would expand federal regulations by banning "naked" credit default swaps (CDS) and requiring over-the-counter (OTC) derivatives to go through central clearinghouses. Further it directs the Commodity Futures Trading Commission to set position limits on energy traders across all markets and brings energy swaps under CFTC oversight. The CFTC is the futures market regulator.

CDS instruments were censured for amplifying last year’s credit turmoil. The steep decline in financial markets prompted proposals for tougher federal regulation. Some of the proposals in the climate bill, such as mandatory clearing of OTC derivatives, are part of the Obama administration proposal for financial regulatory reform. A bill pending in the House allows suspension of trading in "naked" CDS, but would not ban them outright.

Looks like some politicians snuck something into the climate-change bill that doesn't belong (we will discuss the the climate-change bill and cardbon trading later.) Not clear what is meant here by banning "naked" credit default swaps. Certainly writing protection without posting margin is a problem. But buying protection on a name that one doesn't actually own shouldn't be an issue.

People get annoyed hearing this because it feels like buying insurance on a house you don't own. But this is no different than buying a put option on IBM without owning any IBM shares. Except CDS is a put on credit rather than equity. Are we so far gone that we will allow the government to potentially prohibit us from buying put options? Pathetic.