Speculators in futures and options are a much bigger beast than they used to be, but are US regulators right to attack them? Derivative markets depend on this capital, argues Philip McBride Johnson, and if regulators try to classify some participants as less deserving than others, they may just end up tying themselves in knots.

Various governments around the world allow futures and commodity options markets to exist, not as betting parlours, but because they constitute a privately funded insurance pool for people in occupations where some form of price risk arises naturally. If this risk strikes, the markets compensate them for their losses.

A very substantial part of that insurance pool is contributed by speculators willing to wager that the risk, after all, will not occur. As a result, the economic protections offered by derivatives markets could be defeated if speculation is curtailed too much. Yes, it is the bettors who help others reduce their risks.

At the same time, the nature of speculators has changed in recent years. They used to be a disorganised, scattered gaggle of people and modest institutions that could rarely marshal the amount of capital routinely committed to these markets by commercial hedgers.

Indeed, the vast majority of cases brought by the US regulator for market manipulation were aimed at giant grain companies or other large businesses. Today, however, these are often dwarfed by collective investment vehicles which are capable of flooding the market with speculative capital, often in the blink of an eye, only to exit just as rapidly after their influence has been felt.

It would be incorrect to assume that these ‘commodity pools’, hedge funds and the like are driven by nefarious motives. Most have no intention to control market prices. And yet, there they are – the 800lb gorilla on the sofa, a reality that cannot be ignored.

And so they are not ignored. Indeed, they are regularly vilified as pollution in our economic brook. Here are some examples.

Leadership blocked

Late last year, President Obama nominated a brilliant individual to serve as chairman of the Commodity Futures Trading Commission. Meanwhile, an equally talented person with many years in the CFTC’s leadership served as acting chairman. A few senators, citing price spikes in energy and other commodities attributed to evil speculators, both deferred Gary Gensler’s confirmation as chairman for nearly half a year and refused to promote Walt Lukken to full status in the interim. With friends like these…

Then, a valid observation was made that many of the new breed of super-speculators were allowed to operate on unregulated ‘exempt commercial markets’ under the Looney Law (sorry, the Commodity Futures Modernization Act of 2000), and that their activities there were affecting commodity prices on the exchanges regulated by the CFTC. This was called a “significant price discovery function”.

So the Congress amended the laws for these exempt markets to introduce safeguards long taken for granted on the regulated exchanges. The protections included powers for the CFTC to set speculative position limits and transaction reporting duties, conduct market surveillance and invoke market emergencies to force the liquidation of positions or curtail trading.

More recently, the CFTC has conducted public hearings on the subject. It has also begun sharing information with the Financial Services Authority about trading on US and UK markets in very similar commodity instruments, which interacts.

The authority the CFTC had given one UK market to place trading terminals with US participants was modified to include requirements similar to those imposed on domestic exempt commercial markets.

Real or synthetic

But perhaps the most interesting development in the anti-speculation campaign has been the CFTC’s move toward differentiating between “real” businesses (where genuine hedging is welcomed) and “synthetic” (my word) businesses, which engage in the same activity holographically.

In the latter cases, the CFTC may determine that using futures or options to reduce the risks associated with emulating a brick-and-mortar business should not be classified as hedging at all but should be given some different classification and, presumably, stricter limitations on use.

The CFTC even appears willing to turn back the clock for this purpose. Recently, it withdrew two letters issued in 2006 to commodity pools that tracked either an established commodity index or a well-defined proprietary trading programme.

The letters had allowed the funds to exceed the CFTC’s own speculative position limits for certain farm products as part of their effort to replicate the index or programme, although conditions and expanded limits were imposed.

In August this year, both those authorisations were revoked. While the CFTC action contained a cryptic reference to a “change in circumstances or conditions”, no elaboration was provided other than the chairman’s reference to “guarding against concentrated positions”.

The funds had features that are often cited as worrisome. Both were large – $2bn and $4.5bn respectively. Both sought to track a mathematical replication of commodity activity or index. Finally, both funds planned to acquire only contracts to buy the related commodity futures. These long-only index funds are often accused of making commodity prices more volatile, and especially of causing price spikes.

As the CFTC draws conclusions from its recent review of what is and is not excessive speculation, it must reach some resolution about what activity deserves to be hedged with futures or options and what activity is too contrived to warrant such treatment.

One approach would be to distinguish between what risks exist ‘naturally’ in an occupation and what are created artificially through indices or other fabrications. A distinction might be made between an airline, which is virtually obliged to hedge oil costs with futures, and an energy swaps dealer, which offers lookalikes and thus volunteers to take on the related risks.

This approach, of course, suffers from the fact that the airline, like the energy swaps dealer, could have escaped crude oil price risk by becoming a poet or a priest instead. Thus, the test of avoidability could disqualify both.

Or, we could differentiate between a commodity and a replicating financial instrument. This way, a corn farmer may hedge his crop but the vendor of a financial instrument tracking corn prices may not. If so, however, what shall we do with those whose business is confined to buying and selling financial instruments?

Shall we tell a mutual fund or pension plan holding a large portfolio of securities that it may not hedge with S&P 500 futures, or a government securities dealer that it is ineligible to hedge using US Treasury futures?

My philosophy focus in college fails me now.

Philip McBride Johnson is head of the exchange-traded derivatives law practice at Skadden, Arps, Slate, Meagher & Flom in Washington. He was chairman of the Commodity Futures Trading Commission from 1981 to 1983.