Analysis: Crunch time for U.S. commodity speculation crack-down

Banks, exchanges and traders have only days left to convince regulators to take a lighter touch on tough curbs on commodity market speculation, after a four-year fight against proposals to limit their role in the markets.

Having almost certainly lost the battle to forestall position limits in some form, traders see victory or defeat depending on the details of the proposed regulations.

With billions of dollars at stake, opponents are still hoping to gain ground on issues including separate "class limits" for futures and swaps, a heavy compliance burden, and whether wheat and corn markets need special protections.

After months of behind-the-scenes lobbying, the industry's biggest players will publicly show their hand in the final hours before the March 28 deadline for feedback on the Commodity Futures Trading Commission's proposal, which was released for 60 days of public comment in January.

Their arguments are well-rehearsed: the plan will make it harder for companies to hedge risk, more costly for consumers to protect themselves from higher prices and, ultimately, markets more volatile by driving away liquidity.

And they come at a time when soaring oil prices has revived debate about the role of speculators in driving up costs.

"The proposed rule actively shifts investors' incentives away from regulated U.S. exchanges and toward darker areas of the financial markets, outside of the purview of the CFTC," Mark Fisher, a famed trader in the New York futures pits, wrote in a letter to the agency.

The plan to limit the number of speculative positions that any one trader can hold mainly targets the big financial players who have plowed hundreds of billions of dollars into commodities via index swaps or exchange-traded funds. They will not be eligible for any exemptions under the proposal and have little hope of winning any significant reprieve.

But firms like Goldman Sachs, Vitol and Royal Dutch Shell that trade both on their own account and on behalf of customers are expected to say they're being unfairly caught in the crossfire.

The CFTC already had abandoned what traders considered to be the most draconian elements of a year-ago proposal to limit energy speculators. But there's still much to fight for.

Consumers Seek Crack-down

Many in the industry will continue to encourage the CFTC to abandon the plan altogether, which is unlikely to happen given that it is part of the Dodd-Frank financial reform law.

The law mandated the CFTC to set limits across futures and over-the-counter markets "as appropriate," but three of the five commissioners who ultimately must vote on whether to finalize the plan have expressed reservations. No date has been set yet for a final vote.

Commissioners have been careful to separate speculation from the issue of soaring fuel and food prices.

But the CFTC has so far received more than 3,700 comments from consumers, fuel retailers and retail silver investors urging tight limits. Many link speculation to higher prices.

Large consumers like Delta Air Lines are expected to join the comment fray by the March 28 deadline, pushing for limits they see as essential to controlling their fuel costs.

Class Limits a Target

The CFTC's plan applies to 28 energy, metals and agricultural markets, with a formula applied to each of exchange-traded futures, related over-the-counter swaps, and across both combined.

Traders exceeding the futures "class limit" won't be able to use opposing positions that fall underneath the swaps "class limit" to reduce the futures speculative position.

Getting rid of the "class limits" will be a common theme in comment letters from traders, who want to be allowed to "net" their OTC and futures positions.

"Legacy" Agricultural Limits

The CFTC also proposed to keep in place existing limits for agricultural markets. Yet, it can be argued that these long-standing controls have not kept up with the times.

Many industry players are likely to echo an argument made by Gresham Investment Management to raise "legacy" limits, which are based on open interest data from 2004. If they were adjusted to reflect the surge in market investment since then, wheat limits would rise by 144 percent and corn by 108 percent, according to Gresham.

"Gresham takes strong exception to the Commission's inexplicable proposal that would insulate the agricultural contracts from the realities of the current market," said the fund, which manages more than $12 billion for pension funds, endowments, and other clients.

"Compliance Mess"

Trades that are "bona fide hedges" will be exempt from the limits, but companies and dealers making those trades will have to provide evidence they are not speculative.

"It's going to be a compliance mess," said Andrea Kramer, a Chicago-based partner with law firm McDermott Will & Emery.

Compliance will be particularly difficult for companies with large books where hedging is done on a portfolio basis, rather than transaction by transaction, said an industry source involved in swaps dealing who is hoping the final rule is less of a burden.

"Never before has anyone ever had to give their entire book to a regulator every night and justify why you've hedged certain things they way you have," the source said.

Aggregation a Sore Point

It's unlikely funds would be granted any kind of hedge exemption under the plan, and grandfathering provisions will offer only short-term protection for short-term positions that need to be rolled forward.

Forcing funds to get out of some of their positions ahead of the compliance deadline could make markets volatile.

"How will that happen without disrupting the market?" a senior derivatives lawyer said.

Industry will push for some types of funds to be exempt from new aggregation requirements, arguing that the regulator should look at individual investors' speculative positions rather than the funds' position on the whole.

"Plenty of Room"-fund

CFTC Chairman Gary Gensler has said he hopes the position limit rule will be finalized this summer. But the bulk of the regulation will not be phased in until the CFTC is able to police it with new data on the swaps market through a system that also is still in the rule-making phase.

The data will reveal that the OTC market is "staggeringly large" compared to futures, leaving "plenty of room" underneath the position caps for the vast majority of traders, said Sal Gilbertie, president of Teucrium Trading, which operates a series of single-commodity ETFs.

While position limits may harm portions of the market, the impact will be muted because the formula proposed creates a very high threshold, and could take years to get in place, said Gilbertie, who ran an OTC desk for Newedge before helping start the ETFs.

"We don't view the new position limits as proposed as a threat, and we are convinced the proposal isn't going to be tightened -- it's going to be loosened, if anything," he said.

[Source: By Roberta Rampton, Reuters, Washington, 23Mar11]

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