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CFTC Position Limits: A Bad Idea

So what might the position limits proposed to US regulator the CFTC actually achieve...?

LAST WEEK'S hearing at the Commodity Futures Trading Commission on position-size limits seemed like it would be earth shattering, writes Lara Crigger at Hard Assets Investor.

But in the end, it was mostly just more sound and fury, signifying nothing – for now.

The CFTC, which suggested limiting futures traders' positions to no more than 25% of deliverable supply (among other recommendations), revealed that in fact, it wouldn't have a final plan in place regarding position limits until January next year, at the earliest.

What might such limits on, for instance, the Gold Futures market mean for pricing and liquidity? To help us understand the finer points of the hearing, we turned to John T. Hyland, CEO and portfolio manager of US Commodity Funds. Hyland is no stranger to the debate over increased regulation of commodities futures markets; he has testified before the Commodity Futures Trading Commission about the impact of USCF's controversial United States Oil Fund (NYSEArca: USO) and United States Natural Gas Fund (NYSEArca: UNG), both of which have been accused of distorting their respective energy markets.

Hard Assets Investor: Last Thursday, the CFTC held a hearing and released a report on position limits. But did we really learn anything new about their stance on the matter?

John Hyland: Well, as of last Wednesday, we knew – based on comments by various individual commissioners – that the five commissioners are not on the same page when it came to position limits. You have one true believer, one that's maybe a believer, two who clearly have doubts and one in the middle. There's no consensus on the commission on this topic, and that came through on Thursday in the comments.

We knew the math about calculating position limits would be similar to what was proposed in January, but I think we're still unclear on several points as regards to futures. And we knew they were supposed to bring out position limits on over-the-counter swaps [Ed. where a financial institution agrees to pay a fixed price for a commodity over a period of time, thus taking on the moving-price risk that the other side would have worn – at a cost, of course] but that things had fallen behind schedule. As of Thursday, we still did not know how big the swap/OTC market really is.

So when you add it all up, what did we learn? Not much.

HAI: Can they really devise realistic position limits before you know the size of the swaps market they have to regulate?

John Hyland: Commissioner [Michael] Dunn asked the staff a few times for some commentary on the size of the OTC/swap market. The actual swap trade repository is not supposed to be operational until July 2011, so of course they wouldn't have a full answer, but the staffers basically dodged the question entirely.

Now, they've been working on this position-limits question for over a year now. You'd think they'd have at least some idea, at least for some of the high-profile commodities like crude or natural gas. I don't expect seven-digit accuracy here, but I would imagine the staffers should be able to answer whether the swap market for natural gas is half the size as the listed futures market, or twice as big, or five times as big, or so on.

HAI: What do you think's the hold-up?

John Hyland: Bureaucratic caution. They don't want to put a number out there if it's actually wrong. But I think that by being unwilling to put out a number, they're keeping the market in greater suspense than it needs to be. If they just came out and said, "Here's the order of magnitude," then the market would have some idea of how to gauge how big position limits would be for swaps, and the market could move on. Keeping it an unknown keeps the market stuck there.

Commissioner [Jill] Sommers asked how the math worked on the position limits between the two classes, one being the listed futures and options, the other being swaps. If the position limits for listed futures, are, say, for 5 million contracts' worth – so you can own 120,000 contracts or whatever their math says; and for argument's sake we say the swaps market also totals 5 million – does that mean we really have a 240,000-contract total as our position limit, and [the CFTC] is indifferent on which we elect to use, futures or swaps? Or do we have two sublimits, of 120,000 contracts each?

HAI: Isn't it the former? Reading the report, it seems that the swaps position limits wouldn't be enacted until "Phase Two" later next year.

John Hyland: That is the new plan, I think. Originally Chairman [Gary] Gensler was saying we needed to implement both at the same time, but he's since backed away from that, because it just ain't going to happen.

Nevertheless, it leaves open the question: How will the math work for position limits? Is it going to be one big number – which is basically the CFTC saying that they consider futures and swaps essentially fungible? Or is it two sublimits, in which case they're saying, "We don't believe they're fungible"? And that, in turn, leads to a second question – if you don't believe they're fungible, why are you setting limits on swaps in the first place? But consistency is not always a requirement of regulation.

One of the consistent arguments against enacting position limits on US exchanges is that it would just force investors to take their money overseas. But recently, rumors have swirled that Europe will impose its own position limits. Did the CFTC take this into account when it came up with its own plan?

John Hyland: Commissioner Dunn pressed the staffers for when position limits might be voted on and implemented in Europe, and they responded, "We don't know – maybe never." That's a big problem for Dunn, because I think he's made clear over the past few months that he doesn't want people to just pack up their stuff and go somewhere else. It's a very real risk.

We know from a December 2009 white paper that the UK Financial Services Authority thinks position limits are nonsense. They basically said position limits don't work; they're not useful; and if you thought they were a good idea, we don't see why you'd apply them to futures holders who are investors and not equally apply them to fiscal hedgers. So the UK doesn't believe in position limits – and while maybe France or Germany regulators might still come out in favor of them, the European body that has the most experience in them (the FSA) thinks they're a bad idea.

HAI: Has a cost-benefit analysis been run on the issue of position limits?

John Hyland: Dunn did ask about that, and there's a legal issue here I think he is alluding to. Even if the law says that the CFTC is supposed to put into effect new regulations, there are other laws and administrative procedures that require the commission give consideration to these analyses. So if you don't do them, you run the risk of people objecting, taking the CFTC to court, and having the judges suspending the implementation of the rules until they do.

In 2010, there were a few cases that shaped up just like that for the SEC. So I think we have a concern here that maybe some of the commissioners think, "Well, Congress said 'make it so,' so we just make it so." But the court can just come around afterward and say, "We don't really care."

HAI: Is the CFTC just trying to get this wrapped up as soon as they can, rather than doing it right?

John Hyland: It is a divided commission, I believe. There is no doubt that Dodd-Frank is trying to have the CFTC do far more work than normally would be expected in this period of time we're talking about. In a normal year, how many rule-findings would the CFTC have done? Three or four? And now it's up to 32.

So yeah, they're being asked to do a lot, and I think over the past month it's been quite clear that a number of the commissioners are saying, "Wait a minute, we don't want to rush through this just because." I think you are getting pushback, especially from Commissioners Dunn, [Scott] O'Malia and Sommers, who don't want to race through it. And then there's the political issue too.

The House switches control in January, and you don't want that to color the proceedings. Even though it may very well be that Dodd-Frank remains in place unchanged – although that seems unlikely, as it has some significant legal drafting flaws. There are 23 legally impossible things in it, in that they conflict with an already existing law. So the House that passed the rule is not the same one that will be revising it.

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