Several leading Wall Street firms have written to the Commodity Futures Trading Commission, urging it not to go ahead with plans to set position limits for speculative energy futures trading.
The letters follow a similar objection by the CME Group, a long time opponent of the plan, all of which have been received just days before the watchdog closes its door to any more comment. The 90 day comment period runs out at the end of April.
In January the CFTC, led by chairman Gary Gensler, set out plans to impose position limits for trading futures on light sweet crude oil, Henry Hub natural gas, New York Harbor No 2 heating oil and New York Harbor gasoline blendstock.
The proposal contains exemptions for “bona fide hedging” and for “certain swap dealer risk management transactions”. Limits would relate to the size of the market and would be “administratively reset” annually.
Leading the charge by futures commission merchants were Morgan Stanley, Bank of America Merill Lynch, Deutsche Bank, and Barclays Capital.
Each of the letters from leading FCMs, sent on Monday April 26 and published yesterday (April 28) on the CFTC’s website, outlined two central reasons why each believes the position limit plan would cause significant disruptions to their business.
Fears of aggregation
When working out adherence to the limits, the CFTC plans to aggregate all positions for accounts in which any person has an ownership or equity interest of 10% or more at both the account owner and control level.
This decision is particularly unpopular with FCMs.
Kelly Funderburk, general counsel at Merill Lynch Commodities, urged the CFTC to reconsider. She said the provision would oblige Merrill to aggregate its holdings in energy commodities with the holdings of various independent business units trading for all the bank’s proprietary and customer servicing accounts.
She also said Merrill Lynch would have to aggregate positions with any equity investment above the 10% threshold made by any of the bank’s business units in a third party business that held positions in any of the referenced energy commodities.
Funderburk said that although Merill Lynch Commodities is the bank’s primary commodities trading unit, other parts of the bank may also invest in third party entities that trade in commodities.
Merrill said that if the proposal was introduced, it would allocate limited position volume across “separate and unrelated entities that previously have had separate position limits”, which it said would need real time coordination between independent entities, which it concluded would “be difficult, if not impossible”.
The firm also said this would put too big a burden on its back office.
Morgan Stanley and Barclays Capital also said the CFTC proposal for aggregating limits would prove unworkable as each had several entities active in US energy markets.
Crowding out seen as threat
Perhaps the biggest source of frustration for FCMs, however, is the so-called “crowding out provision”.
Under the CFTC proposals, the proposed swap dealer exemption would be limited to twice an applicable all-months-combined or single non-spot month speculative position limit. Further, traders would be required to aggregate positions held as swap dealer risk management transactions with net speculative positions for the purpose of determining compliance with the proposed Federal speculative position limits.
However, critically, as with bona fide hedgers that hold positions in excess of the proposed limits, swap dealers holding large positions pursuant to the proposed swap dealer exemption would be unable to also take on positions as speculators. In effect, the CFTC said, “this proposed “crowding out” provision would restrict a trader controlling a large position used for swap risk management from also entering into large speculative positions.”
Colin Bryce and Simon Greenshields, global co-heads of commodities at Morgan Stanley, described the CFTC’s crowding out provision as “impractical” because a perfectly hedged transaction portfolio, without a single speculative futures contract position, is “very difficult, if not impossible, to maintain”.
They said that because positions are not static, futures trades initially executed as hedges may not remain hedges for the entire duration of the underlying contract. If the hedged position expires, or is “booked out”, cancelled or terminated as a result of a default, they argued, the corresponding futures position is arguably no longer a hedge, at least not for the original transaction. Yet, the company’s overall transaction portfolio may still be flat.
Joseph Gold, head of commodities for the Americas at Barclays Capital, also called the crowding out provision “unworkable”.
“Depending on how narrowly ‘speculative’ is defined, it is extraordinarily difficult, if not impossible, for any active hedger to avoid holding a single speculative contract,” Gold wrote. “Even the most careful hedger will find that the exposure being hedged is often closed out before the related hedge is taken off. For that moment in time, the hedger inadvertently holds a ‘speculative’ position. Any portfolio with an options position will move regularly, creating ‘speculative’ positions which require delta-hedging.”
Greenshields and Bryce said that if the CFTC implemented the proposed rule, it would need to provide guidance to market participants on whether exceeding the position limits under these types of circumstances would be considered a violation of its rules.
Claims of risk to hedging
In closing their letters, the FCMs painted a dire picture of the consequences of introducing the position limit plan.
Each said that it would make it harder for market participants to engage in necessary hedging as liquidity and open interest would be diminished.
Barclays Capital held up an even more alarming prospect. “By forcing more illiquid, long dated and complex products into clearing houses and reducing the ability of intermediaries of scale to take on large portfolios, we introduce the very significant risk that clearing will not work in the next financial crisis,” Gold wrote.
Defence of speculation
The letters make clear the breadth of the divide between the two sides in the US energy debate.
On one side there is the wider world, led by US politicians, who argue that position limits are the only way to prevent the kind of excessive speculation that they believe caused 2008’s unprecedented highs in energy prices.
On the other side are many energy market participants, who continue to argue that the market is working fine, and that there was no excessive speculation in 2008.
Troy Martin, chief operating officer of Deutsche Bank Global Commodities, wrote to the CFTC: “No party has offered any empirical evidence to support these assertions [that excessive speculation caused the price spike]. Further, a number of studies were undertaken by domestic and international regulators adhering to sound and commonly accepted economic principles in response to these assertions, yet none have produced any empirical evidence that supports the conclusion that speculation during the relevant time periods was ‘excessive’ or that speculation (excessive or otherwise) was responsible for the price conditions that prevailed.”
An alternative approach
Morgan Stanley, one of Wall Street’s largest commodity market players, said the CFTC could prevent excessive speculation more effectively and with less disruption by using and enhancing its existing authority.
“The Commission can increase the frequency of its current special call on swap dealers and commodity index traders from a monthly to a weekly basis,” Greenshields and Bryce said. “In addition, the CFTC can implement and administer accountability rules that apply across multiple trading platforms. These enhancements would ensure that the CFTC has the tools that it needs to address market congestion or possible excessive speculation, but also would allow energy market participants to have continued access to critically important risk management contracts.”
This plan was echoed by Deutsche Bank, which also said the CFTC could in this way achieve “greater transparency”.
The bank said this alternative approach would give CFTC staff more flexibility to react to potentially disruptive events as they arose, based on specific circumstances, rather than “constraining them to a rigid, hard-limits approach that may diminish the liquidity and price discovery function of the US futures markets, without providing any benefit in terms of market stability”.
Colin Packham, Sydney cpackham@fow.com