CFTC Position Limits for Gold and Silver?

US regulators are considering "position limits" in silver and Gold Futures...

ON THURSDAY 14 JAN., the Commodities Futures Trading Commission (CFTC) held a rare public meeting to discuss a new proposal, aimed at imposing Federal position limits in four energy futures contracts, writes Gene Arensberg in his Got Gold Report for the Gold Newsletter.

Position limits on Gold Futures and silver contracts were also mentioned, with a CFTC hearing now scheduled for March. What might that mean for precious metal prices and investors?

The CFTC's energy "hearing" was videotaped and is available for anyone to view, and a comprehensive discussion of the proposed new rules on energy markets is also available. The public is invited to comment on these proposals for 90 days. The CFTC will post a link on its website for those who wish to put their comments into the public record.

The energy rule proposes Federal limits on the number of futures contracts a single entity may hold in all CFTC-regulated exchanges (such as the Nymex, CBOT, CBOE and ICE) but of course does not impose limits on exchanges outside the CFTC's jurisdiction. And instead of fixed size limits, the new rule proposes that limits be set annually by a formula based on the total number of contracts open in those markets.

One of the concerns expressed by Commissioners Michael Dunn and Jill Sommers was that these new position limits, if adopted without the Commission having similar authority over the Over-the-Counter market (OTC) – where dealing takes place trade-to-trader, without being routed through a formal, recognized exchange – would have the perverse effect of forcing a higher portion of the trading away from CFTC regulated markets to more opaque, less regulated markets such as the OTC or overseas markets.

The CFTC now says it intends to look into a similar proposal for precious metals in March, according to comments by Commission Chairman Gary Gensler and Commissioner Bart Chilton. We'll leave it to other commentators give their blow-by-blow descriptions, hopes and disappointments and focus our commentary on just two main issues which seem important to precious metals investors.

1. The Commission seems hell bent to preserve the same or very similar exemptions to the new futures position limits afforded "bona fide hedgers"; and
2. The limits being proposed for energy are so large as to be only minimally restrictive on speculators, but designed to be lethal to aggregators of long-only investors and commodity futures-backed ETFs and ETNs (exchange-traded funds and notes).

The proposed formula for setting position limits allows a single trader up to 10% of the first 25,000 contracts and up to 2.5% of the open interest beyond 25,000 contracts across all CFTC regulated markets, including the Nymex and ICE for energy.

According to a Q & A primer released by the Commission, the new proposed limits allow the largest energy traders to accumulate as much as 30% of the "all months combined" (AMC) action in any one exchange in CFTC regulated markets and up to two-thirds of that amount, or 20% of the market, in any one month.

While some commentators were hopeful that the new speculative limits would be applied equally to both sides of the trading battlefield (i.e. both speculators and hedgers), it is crystal clear, both from the documents and from comments by the Commissioners, that the CFTC intends to maintain exemptions to the limits for the largest hedgers and short sellers of energy futures (as was our suspicion here at Got Gold in previous commentary on the subject last year).

If this same formula were adopted by the CFTC for the Gold Futures and silver metals complex later this year, it would have minimal – if any – effect on the very concentrated positioning of a few large, dominant players on the short side of the market. Instead, the effect would be to limit most traders on the long side of the precious metals battlefield somewhat, but continue to favor those very large traders who claim "bona fide hedging" with no real effective limits.

For example, Swap Dealers would be limited to no more than twice the speculative limit even with an exemption, but bona fide hedgers would not be limited as such.

When the CFTC meets to discuss gold and silver in March, they may still be under the mistaken impression that investors are worried about the "excesses caused by excessive speculation", which was the driving force behind their energy market initiative. Instead, what the Commission should be focused on in March should be the overwhelming and commanding position which is currently held by one or two US banks.

The banks are able to amass very large positions in excess of the exchange-set position (and accountability) limits, because they take advantage of exemptions from those limits as bona fide hedgers. One key part of the exemption rules allow a "person" to claim an exemption not because of anticipated production, but because of ownership of the physical commodity. Bona fide hedging exemptions currently include exemptions for "traders with inventory or anticipatory purchase or sale transactions in the physical commodity." And we see nothing in the current proposed change to Federal position limits which alters that.

Hedging can be utilized to offset merely financial risk, as opposed to hedging for future production, for example. In fact, for precious metals, a majority of bona fide hedging has nothing whatsoever to do with future production of metal. That's why it is not a good argument to compare the amount of hedging in precious metals futures markets to future production of the commodity. Future production is a miniscule amount of metal compared to existing metal already above ground. That is especially true for Gold Bullion, less so for silver.

A bullion bank, for example, which holds (or manages for clients) large amounts of the metal in its vaults, would be able to claim an exemption from Gold Futures position limits, presumably so it can hedge the risk of the value of the metal held from falling. Some savvy market watchers point out that, perversely, the trading-size-limit exemptions allow those bullion banks to take such large hedging and short positions that over time they are able to ensure that the price will fall from the weight of their own short selling in that commodity.

Speculative position limits on the long side of the market, in contrast, will not affect the hedger's positioning as long as the exemptions afforded hedgers are kept as they are. And when the rules favor one side of the market and only the largest actors in that market, it creates short-term distortions in the price discovery mechanism of that market – for a time.

Allowing one or two traders the ability to amass overly large positioning on one side of the market, long or short, could lead to disorderly liquidation in that market or even contract default in times of severe market stress.

We can look at the silver market as an example. According to the CFTC Participation of Banks in Futures and Options Markets Report, as of January 5, 2010 fewer than four (probably two) US banks held 579 contracts long in silver and 37,871 contracts short for a net position of 37,292 contracts net short when the entire Comex open interest for silver was 125,391 contracts and silver closed on the cash market at $17.77.

So, as of January 5, probably two US banks held a net short position in silver equal to 29.7% of all the contracts open on the COMEX. The positioning relative to the total open interest of the US banks in silver futures is shown in the monthly graph just below.


Please Note: For most of 2008 and all of 2009 the CFTC said there were two reporting US banks, but in December the Commission quit reporting the number of banks when the number is less than four.

Thus, the actual number of reporting US banks is not currently known, but was constant at two for the 19 months prior to December 2009. We believe that perhaps 80% to as much as 90% of the US bank positioning in futures markets is through one of the banks, J.P. Morgan Chase.

As of Jan. 5th, the less than four (and probably two) US banks held 38,450 silver contracts on both sides of the Comex market, or just over 30% of all the action on that CFTC-regulated exchange. So even if the Commission were to impose the same speculative position limits on metals it just announced for the four energy contracts, and even if they were to also apply those same limits to the hedgers (which is very highly improbable), it would have little or no impact to the status quo in the CFTC regulated exchanges.

The dominance of the two US banks in the Comex silver and Gold Futures market cannot be well understood if we just view their position-size relative to all contracts open in the market. Rather, we need to understand their positioning in proportion to all commercial hedgers and short sellers. It is there we begin to see just how concentrated the bank's positioning really is.

The graph below charts the positioning of the US banks net short positioning in silver relative to all traders classed by the CFTC as commercial since 2006. At times during the last year and a half, these two large, well-funded and dominant bullion banks held as much as 98.7% (not a misprint) of all the commercial net short positioning on the Comex. As of January 5, 2010 the US banks still held 65% of all the commercial net short positioning.

Again, some analysts were hopeful that the Commission intended to level the playing field between the long and short sides of the market. Some high-profile commentators even seemed pleased that Commissioner Bart Chilton and Chairman Gary Gensler both mentioned the silver market in their remarks, as expected.

But this new proposed rule for the energy markets, if applied by the Commission in the future to precious metals, will not deal with the very real issue of over-concentration of one or two very large players on the short side of the market. Because those major actors have been and will be able to avail themselves of liberal exemptions to the position limits based on the bona fide hedger provisions.

Anyone can see why the large banks might welcome the new speculative position limits so long as they are not the ones being limited. And at the same time, the CFTC has now proposed position limits for aggregators of long-only funds, such as the United States Oil Fund, treating them as though they are a single trader and, in effect, removing their ability to use the same exemptions for size as the hedgers use. That means that funds will not be able to claim an exemption to size in the market even if they represent hundreds of thousands of like-minded clients. It also probably means that, wherever possible, those aggregators will now seek out less restrictive markets outside the US to do business for their clients.

Anyone commenting on the proposed new position limits should mention that position-limits which only restrict the long side (and aggregators of investors on the long side) are unfair and anti-competitive if similar limits are not enforced equally on the short side of the market (thanks to exemptions). If you're going to send the CFTC your comments, be professional, direct and specific. The issue is NOT a problem of "excessive speculation" in gold and silver futures. The issue is that one or two very large traders could, if they wanted to or felt compelled to, overwhelm the Comex market with the weight of their own short selling – by virtue of the exemptions the CFTC and the exchanges grant to "bona fide hedgers".

New speculative limits, unless applied to both sides of the trading battlefield equally, are unnecessary, unfair and anti-competitive. But thankfully, the price of silver and Gold Bullion are set globally, and not just on the US Comex futures market. Even more thankfully, most precious metals trust funds (ETFs) do not use futures at all, but instead stockpile the actual physical metal to back their shares.

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