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CFTC Limits Speculation on Futures Trading

WASHINGTON (CN) - At its fifth open meeting to consider regulations mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, a divided Commodity Futures Trading Commission adopted two new sets of regulations to limit speculation on futures trading and increase the agency's oversight on derivatives clearing organizations.

In both 3-2 decisions, the majority argued that they were following the mandates of Dodd-Frank, while the dissenters, Commissioners Scott O'Mallia and Jill E. Sommers, said that the agency was being over zealous and had adopted rules that would have a negative economic impact on the commodities futures market.

Dodd-Frank requires that the agency adopt position limits to prevent excessive speculation and manipulation by making it harder for any one trader or entity to corner markets. The rule limits the speculative positions market players can take for 28 physical commodity futures contracts ranging from agricultural products to fossil fuels and precious metals.

The limits are divided in to two types, the spot-month limit and the non-spot month limit. The first applies to positions taken in a specific futures contracts and is applied separately to contracts which require physical delivery and those that are cash settled. The position limit is set at 25 percent of the deliverable supply of the future contract being traded.

The agency placed a separate limit on the cash-settled NYMEX Henry Hub Natural Gas contracts which is equal to five-times the limit on the NYMEX Henry Hub Natural Gas physical-delivery contract.

The non-spot month position limits apply to positions a trader may have in all contract months combined or in a single month and are set at 10 percent of the open interest in the first 25,000 contracts and 2.5 percent after the initial threshold has been sold.

Both dissenters on the position limits rule, Commissioners Scott O'Malia and Jill E. Sommers said that the rules would limit the ability of institutional investors to engage in effective hedging strategies which usually include a futures component.

In an opening statement titled "Does the Commission Always Know Best," Commissioner O'Malia expressed his concern that the cost of compliance will drive investors out of the markets. "If the commercial entities who use futures and swaps markets for hedging commercial risk feel like we are waging war on them, I don't blame them. According to the Commission's cost-benefit analysis, legitimate hedgers will pay close to 1/3 of the total annual $100 million cost of this proposal for reporting alone."

O'Malia also said that while he agreed that Dodd-Frank mandated that the CFTC must create position limits to curb excessive speculation he said the agency should have presented empirical evidence showing excessive speculation for each category of commodities.

"The Commission voted on this multifaceted rule package without the benefit of performing an objective factual analysis based on the necessary data to determine whether these particular limits and limit formulas will effectively prevent or deter excessive speculation."

In her opening statement, Commissioner Sommers said that the agency was "setting itself up for an enormous failure" by succumbing to a campaign for position limits which was based on the false assumption that the limits would reduce the prices of commodities.

"This latest campaign exemplifies my ongoing concern and may result in damaging the credibility of this agency. I do not believe position limits will control prices or market volatility, and I fear that this Commission will be blamed when this final rule does not lower food and energy costs."


Equally contentious was the commissioners vote to set the minimum market capitalization threshold required for financial institutions to become members of derivatives clearing organizations (DCO) at $50 million.

Until now, each DCO set its own capitalization requirements with some requiring members to have as much as $5 billion in assets. With the intention of breaking some of that business away from the large banks Dodd-Frank mandated that the agency lower the cost of access for smaller players.

DCOs substitute their member's credit for the credit of individual counterparties to a contract, ideally reducing the impact on market liquidity if one of the counterparties is unable to meet its obligations because the assets of the clearinghouse cover the risk.

The new rules also will require DCO's to calculate the margin for swap contracts assuming it could take four days for the contracts to clear thus increasing the margin that must be placed in reserve on such contracts on the presumption that they are inherently more risky than futures contracts.

O'Malia objected that there was no evidence for such a presumption and that the agency failed to look at the increased costs to market participants of having to provide a bigger margin compared to the benefit of imposing the higher margin.

Commissioner Sommers agreed with O'Malia in her opening statement, saying "these rules, and many others we have proposed and finalized, are largely colored by the perception that swaps are inherently riskier than futures and options and as a result require a more prescriptive regulatory oversight regime."

This was unfounded, Sommers said, because "futures and options are, and always have, been risky. Swaps that are exchange traded and cleared will likely have a similar risk profile as exchange traded futures and options. We should not be creating a separate regulatory regime for economically equivalent products. I believe this approach will not stand the test of time and will have to be re-thought as the market evolves."

Sommers went on to say that the DCO rules were "needlessly prescriptive" and went beyond what was required by Dodd-Frank while ignoring that the clearinghouses had a "fantastic track record of protecting their own financial safety and soundness and have proven themselves, even during the financial crisis, to be excellent at managing margin and risk."

Where O'Malia and Sommers felt that the agency was over zealous, the majority argued that they were just following the mandates of Dodd-Frank or standard market practices.

In his statement in support of the new regulations, Chairman Gary Gensler said that the new rule on position limits "fulfills the Congressional mandate that we set aggregate position limits that, for the first time, apply to both futures and economically equivalent swaps, as well as linked contracts on foreign boards of trade" and that the increased margin requirements for swap contracts were justified based on the fact that it took five days after the failure of Lehman Brothers in 2008 for the clearinghouse to transfer Lehman's interest rate swaps to other clearing members which could have caused those organizations to collapse had they not had sufficient capital margins to bear the costs.

Gensler defended the new rules and the mandates of Dodd-Frank because they would protect the commodities markets against the disruptions that marked financial crisis.

"There are those who might like to roll the Dodd-Frank Act's reforms back and put us back in the same regulatory environment that preceded the crisis three years ago. But that regulatory system failed to protect the American public. We must not forget about the 8 million lost jobs - the majority of which were lost by people who have never used derivatives. We must not forget what the nation went through three years ago - and what the nation continues to recover from now."

On a less contentious Dodd-Frank issue, the commissioners unanimously approved an order extending the compliance date for swap related requirements of certain provisions of Dodd-Frank from Dec. 21, 2011 to July 16, 2012 to give the agency time to adopt and publish all of the requirements mandated by the Act.

The agency made advanced copies of the DCO rulesand the extension of the effective date for swap regulationavailable after the Oct. 18 meeting but did not publish the final text of the position limits rules.

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