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EXCESSIVE SPECULATION AND POSITION LIMITS
IN COMMODITY FUTURES MARKETS
Submitted By: Francisco Vasallo
Regulation of Broker/Dealers and Futures Commission Merchants
Professor Ronald Filler
New York Law School: Spring 2011
April 26, 2011
Francisco Vasallo
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EXCESSIVE SPECULATION AND POSITION LIMITS IN COMMODITY FUTURES MARKETS
Table of Contents
Page #
Introduction………………………………………………………………………………………………………….2
I. An Overview of the Commodity Futures Markets……………………………………………….4
II. The Role of Hedgers and Speculators………………………………………………………………..7
III. The Financialization of Commodity Futures Markets……………………………………….8
IV. The Relationship of Excessive Speculation With Price Volatility in Commodity Markets…………………………………………………………………………10
V. Position Limits as a Regulatory Tool to Prevent Excessive Speculation. ……….…16
Conclusion…………………………………………………………………………………………………………..20
Francisco Vasallo
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EXCESSIVE SPECULATION AND POSITION LIMITS IN COMMODITY FUTURES MARKETS
Introduction
Price risk management and price discovery have traditionally been considered to
be the main societal benefits that commodity futures exchanges provide.1 However, the
financialization of commodity futures trading has made the functioning of commodity
exchanges controversial. Therefore, it has become necessary to consider how the
functioning of these exchanges can be improved so that they will continue to fulfill their
role of providing reliable price signals to producers and consumers of primary
commodities.
Properly functioning commodity markets provide a stable environment for
development and economic growth.2 While it is generally held that commodity exchanges
have historically functioned well, the extreme price volatility that has been taking place
over recent years raises questions about the appropriateness of existing financial
regulations. These questions relate to both the adequacy of information that the
Commodity Futures Trading Commission (CFTC) is mandated to collect, and the extent of
regulatory restrictions imposed on noncommercial financial investors relative to those
imposed on participants with genuine commercial interests.3
1 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets at 54. (2009). 2 17 C.F.R. Part 151 at 18 3 Medlock III, Kenneth B., Jaffe, Amy, James A. Baker III Institute for Public Policy, Who is in the Oil Futures market and How Has it Changed? (August 26, 2009).
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Price volatility in commodity markets between 2002 and mid-‐2008 was the most
pronounced in several decades in magnitude, duration, and breadth.4 Prices increased
and then subsequently declined across all major categories of commodities.5 For example,
from early 2002 to mid-‐2008 the price of oil reached record highs and more than
quadrupled, prompting policymakers to debate proposals to bring relief to their
constituents from the rising price of gasoline. After peaking in July 2008, oil prices
plunged by about 70 percent within six months, which represents the largest percentage
decline ever experienced over such a short period.6
Some attribute the recent commodity price developments to changes in
fundamental supply and demand relationships. Others believe excessive speculation in
futures markets is to blame for the dramatic changes in price and call for added financial
regulation in the form of strict position limits for speculative traders. The debate is
ongoing, and identifying the underlying cause of the recent sharp swings in commodity
prices remains a complex global problem that requires further and deeper study.
Traditionally, speculation relating to commodities has been based on the economic
principles of supply and demand and the behavior of market participants has been based
on their perception of changes in these fundamental factors.7 In recent years, an
increasing number of financial investors have entered commodity futures markets.8
Motivated by portfolio diversification considerations that are largely unrelated to
4 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets at 53. (2009). 5 Id. 6 Id. 7 Id. At 54. 8 Id.
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commodity market fundamentals, they regard commodities as an investment alternative
to asset classes such as equities, bonds or real estate.9 Beyond the specific functioning of
commodity markets, broader macroeconomic and financial factors that operate across a
large number of markets need to be considered to fully understand recent commodity
price developments. This paper aims at enhancing understanding of commodity futures
markets generally and examining whether the speculative activities of financial investors
in commodity futures markets can cause price movements to higher or lower levels than
those dictated by mere market fundamentals.
I. An Overview of the Commodity Futures Markets
A commodity futures market (or exchange) is, in simple terms, a public
marketplace where commodities are contracted for purchase or sale at an agreed price,
for delivery at a specified date in the future. These purchases and sales, which must be
made through a broker who is a member of an organized exchange, are made under the
terms and conditions of a standardized futures contract. The purpose of a commodity
exchange is to provide an organized marketplace in which members can freely buy and
sell various commodities in which they have an interest.10 The exchange itself does not
operate for profit.11 It merely provides the facilities and ground rules for its members to
trade in commodity futures, and also for non-‐members to trade by dealing through a
member broker and paying a brokerage commission.
9 Id. At 54. 10 CME Group, Excessive Speculation and Position Limits in Energy Derivatives Markets. (2010). 11 Comptroller of the Currency, Administrator of Nat’l Banks, Futures Commission Merchant Activities http://www.occ.gov/static/publications/handbook/fcma.pdf (1995).
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The primary distinction between a futures market and a market in which actual
commodities are bought and sold is that a futures market deals in standardized
contractual agreements only. These agreements, called futures contracts, provide for
delivery of a specified amount of a particular commodity during a specified future month,
but involve no immediate transfer of ownership of the commodity involved. In other
words, one can buy and sell commodities in a futures market regardless of whether or not
one has, or owns, the particular commodity involved.
When trading futures on an exchange one need not be concerned about having to
receive delivery of the actual commodity as a buyer, or having to make delivery of the
actual commodity as a seller.12 One may at any time cancel out a previous sale by an equal
offsetting purchase, or a previous purchase by an equal offsetting sale. The contract to
buy and the contract to sell cancel out and thus there is no receipt or delivery of the
commodity. In fact, only a very small percentage, usually less than two percent, of the
total futures contracts that are entered into are ever settled through actual deliveries.13
For the most part they are cancelled out prior to the delivery month.
In a smooth-‐functioning futures market, prices are determined by the healthy
tension between commercial consumers, who want prices to be as low as possible, and
commercial producers, who want them to be as high as possible. Every person who trades
in commodities becomes a party to an enforceable, legal contract providing for delivery of
a commodity. Whether the commodity is finally delivered, or whether the futures
contract is subsequently cancelled by an offsetting purchase or sale, is of no real
12 * providing of course that one does not buy or sell a future during its delivery month. Id. 13 CME Group, Excessive Speculation and Position Limits in Energy Derivatives Markets. (2010).
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consequence. The futures contract is a legitimate contract tied to an actual commodity,
and those who trade in these contracts perform the economic function of establishing a
market price for the commodity.14
Another important component of the commodity futures market is the clearing
house. Each futures exchange has its own clearing house, which acts as a middleman that
guarantees payment between buyers and sellers in the event that one of the parties fails
to perform his contractual obligation. Thus, the clearing house is responsible to all
members for the fulfillment of contracts.15 All members of an exchange are required to
“clear” their trades through the clearinghouse at the end of each trading session, and must
deposit with the clearing house a sum of money, based on clearinghouse margin
requirements, sufficient to cover the member’s debit balance.16 This mechanism greatly
simplifies futures trading by allowing strangers to trade with confidence. Considering the
huge volume of individual transactions that are made, it would be virtually impossible to
do business if each party to a trade were obligated to settle directly with the other in
completing a transaction.
14 Lerner, Robert, The Mechanics of the Commodity Futures Markets. http://www.turtletrader.com/beginners_report.pdf (2000). 15 For example: A enters into a futures contract to buy a barrel of oil from B for $1 in the future. Instead of broker A being responsible to broker B for fulfillment of his end of the contract, the clearing house assumes the responsibility. In like manner, the responsibility of broker B to broker A in connection with this transaction is passed on to the clearing house, with neither A or B having any further obligation to one another. 16 For example, if a member broker reports to the clearing house at the end of the day total purchases of 100,000 bushels of May wheat and total sales of 50,000 bushels of May wheat he would be net long 50,000 bushels of May wheat. Assuming that this is the broker’s only position in futures and that the clearing house margin is six cents per bushel, this would mean that the broker would be required to have $3,000 on deposit with the clearing house.
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The justification for futures trading is that it provides the means for those who
produce or deal in commodities to hedge, or insure, against unpredictable price
changes.17 Because the future is uncertain, there are unavoidable risks when large
amounts of any commodity that is subject to price fluctuation must be owned or stored
for extended periods. Someone must assume the risk of future changes in price. Usually
those in the business of storing, merchandising and processing commodities in large
volume are not in a position to assume such risks.18 They are in a competitive business
dependent upon relatively narrow profit margins that can be wiped out by unpredictable
price changes.19 These risks of price fluctuation cannot be eliminated, but they can be
transferred to others by means of a futures market hedge.
II. The Role of Hedgers and Speculators
Trading participants in commodity markets are categorized into two basic
categories: (1) Commercial traders, known as hedgers, which include both producers and
consumers who trade in futures to offset the risk of price moving unfavorably for their
ongoing business activities, and (2) Non-‐commercial traders, known as speculators, which
include financial institutions and those who seek profit on paper positions from short-‐
term changes in price. Both types are needed for the exchange to function well.20
For example, an oil producer can hedge against declines in oil price by selling oil
futures (taking a short position) on an exchange in light of its physical oil position, which 17 Id. 18 CME Group, Excessive Speculation and Position Limits in Energy Derivatives Markets. (2010). 19 Id. 20 See Senate Staff Permanent Subcomm. on Investigations of the Comm. on Homeland Sec. & Governmental Affairs; Excessive Speculation in the Wheat Market 4 (2009) [staff of senate permanent subcomm. on investigations of the comm. on homeland sec. & governmental affairs, excessive speculation in the natural gas MARKET 51–75 (2007)
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is naturally long. If oil prices fall over time, the producer can offset losses in its physical
business by taking profits on his short financial position in the futures market. If the oil
price rises instead, the profits from the physical sale of the oil are offset by losses from
holding the futures contract. In either case, the producer is neutral to price changes. In
order to facilitate such moves in a more efficient manner, there must be a willing
counterparty in a liquid market.21 Speculators serve this role by acting not only as
potential counterparties, but also as market participants who trade frequently, thus
increasing liquidity.22
Although speculative traders assume the risks that are passed on in the form of
hedges, this does not mean that traders have no choice as to the risks they assume, or that
all of the risks passed on are bad risks. The commodity trader has complete freedom of
choice and at no time is there any reason to assume a risk that he doesn’t think is a good
one. One’s skill in selecting good risks and avoiding poor risks is what determine one’s
success or failure as a commodity trader.
Speculation in commodity futures is sometimes referred to as gambling, but this is
an inaccurate reference. The generally accepted difference between gambling and
speculation is that in gambling new risks are created which in no way contribute to the
general economic good, whereas in speculation there is an assumption of risks that exists
and that is a necessary part of the economy.23 Speculative commodity trading falls into the
latter category because it performs the necessary role of assuming the risks that are
21 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets. (2009). 22 Medlock, Kenneth B, Jaffe, Amy; James Baker Instituter for Public Policy-‐ Who is in the Oil Futures Market and How has it changed? (2009). 23 Id.
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hedged in the futures market. Speculators also bring liquidity that should, in theory, make
the market more efficient.24
III. The Financialization of Commodity Futures Markets
In the aftermath of the 1973 oil crisis, a wide array of financial tools were
employed to allow industry players to manage and diversify price risk and to help raise
capital in innovative ways.25 The widespread adoption of these risk management
products, which were fashioned after similar products that had been used successfully in
foreign exchange and agricultural commodity markets, helped promote market
transparency and greater liquidity in commodity trading. Growth in the use of financial
instruments explicitly linked to commodities such as oil has aided in price discovery by
bringing openly accessible, readily available information about current and expected
future market conditions into the market price. This has in turn, helped establish more
transparency in the global market.
Although modern financial instruments have allowed market participants to hedge,
risk against unexpected price movements with unprecedented precision, the
financialization of commodity markets has not come without its costs. Financial
innovation gave rise to a new class of investment assets that get their reward from the
price performance of futures and derivatives rather than the traditional form of market
reward through capital investment and the resulting increase in productivity.26 Thus,
24 155 Cong. Rec. H14705 (daily ed. Dec. 10, 2009) (statement of Rep. Peterson). 25 Medlock, Kenneth B, Jaffe, Amy; James Baker Instituter for Public Policy-‐ Who is in the Oil Futures Market and How has it changed? (2009). 26 Ahmad R. Jalali-‐Naini, Petroleum Studies Dep’t, OPEC Secretariat, The Impact of Financial Markets on the Price of Oil and Volatility: Developments Since 2007, at 9 (2009).
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financial investments in the commodity markets have substantially moved from capital
raising equity and debt investments for production to betting on price direction.27
Perhaps the most important new element in commodity trading over the past few
years has been the greater presence of on commodity futures exchanges of financial
investors that treat commodities as an asset class. These speculators hold, on average,
very large positions in commodity markets. Moreover, they do not trade solely on the
basis of supply and demand relationships. Their substantial market share places them in
a unique position to potentially exert considerable influence on commodity price levels.
IV. The Relationship of Excessive Speculation With Price Volatility in Commodity
Markets
The devastating impact of the 2008 economic crisis on global financial markets
generated legitimate concerns about how large the market presence of speculators should
be to facilitate the smooth operation of markets. Unlike hedgers, who have an incentive to
trade at a physical commodity’s intrinsic price, speculators have no stake in discovering
the fair price of a commodity. Instead, speculators hope to profit from price-‐directional
movements. They want prices to move as dramatically as possible in the direction of the
bet. As a result, when speculators make up too large a share of the futures market, they
have the potential “to upset the healthy tension between consumers and producers and
resulting adherence of prices to market fundamentals. The resulting volatility makes it
more difficult for commercial consumers and producers to hedge risk, because prices do
27 Greenberger, Michael, the Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility. University of Maryland School of Law: Paper for the International Energy forum (2010).
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not reflect market fundamentals, and so they abandon risk shifting – thereby further
destabilizing the price discovery influence of these markets.”28
The theory that speculators in futures markets cause unwarranted price volatility
and excessively high or low prices is not new; Congress has been repeating that notion
since at least 1950.29 Beginning in the 1990s, however, speculators have dramatically
increased their footprint in the commodity market.30 By adding commodity derivatives as
an asset class to their portfolios, many institutional portfolio managers became
noncommercial traders.31 The CFTC defines a noncommercial trader as any reportable
trader who is not using futures contracts to hedge.32 Speculators, as defined by the CFTC,
have come to account for a significantly greater proportion of activity in the U.S. futures
markets than physical players in the commodities market in recent years.33
Noncommercial players now constitute about 50 percent of those holding outstanding
positions in the U.S. oil futures market, compared to an average of about 20 percent prior
to 2002.34 The change in market composition was driven by the rapid entry of
noncommercial participants and was the principle factor behind the increase in total open
interest.35 It is also highly correlated with the run-‐up in oil prices.36
28 Id. 29 Senate Staff report 109-‐65, Permanent subcommittee on Investigations; The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat (June 27, 2006). 30 17 C.F.R. Parts 1, 20 and 151, Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations. (2011). 31 Id. 32 Id. 33 Greenberger, Michael, the Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility. University of Maryland School of Law: Paper for the International Energy forum (2010). 34 Ahmad R. Jalali-‐Naini, Petroleum Studies Dep’t, OPEC Secretariat, The Impact of Financial Markets on the Price of Oil and Volatility: Developments Since 2007, at 9 (2009). 35 Id. 36 Id.
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A 2006 Senate report on the role of market speculation in rising oil and gas prices
concluded that large speculative buying or selling of futures contracts can distort the
price signals influencing supply and demand in the physical market or lead to excessive
price volatility, either of which can cause a cascade of consequences detrimental to the
supply and price of the commodity and the overall economy.37 “We have seen an
enormous run-‐up in prices across all major categories of commodities, coupled with wide
price swings, despite the fact that there was no major disruption of supplies or spike in
demand. Clearly something other than supply-‐demand fundamentals is at work here…” 38
“Industry fundamentals cannot account for today’s high prices, nor for the enormous
degree of market volatility that we have experienced of late.”39
Generally, economists struggle to quantify the effect of speculators on market
prices.40 Part of the difficulty is due to the absence of specific data about the strategies of
particular traders or classes of traders.41 “Another difficulty is separating cause from
effect: are high prices caused by an increase in speculation, or do more speculators enter
the market when prices become more volatile because that is when the profit
opportunities arise?”42 Several recent analyses have concluded that speculation has
significantly increased energy prices; others have concluded otherwise. In testimony
before the Senate Committee on Foreign Relations, former Federal reserve Chairman Alan 37 Senate Staff report 109-‐65, Permanent subcommittee on Investigations; The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat (June 27, 2006). 38 Greenberger, Michael, the Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility. University of Maryland School of Law: Paper for the International Energy forum (2010). 39 Ali bin Ibrahim Al-‐ Naimi, Minister of Petroleum &Mineral Res., Speech at the 2008 Jeddah Energy Meeting (June 22, 2008), available at http://www.saudi-‐us-‐relations.org/articles/2008/ioi/080627-‐naimi-‐press.html. 40 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets. (2009). 41 Id. 42 Id.
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Greenspan stated that, in the last couple of years, “increasing numbers of hedge funds and
other institutional investors began bidding for oil and accumulated it in substantial net
long positions in crude oil futures.”43 These net long futures contracts, in effect,
constituted a bet that oil prices would rise.”44 The former Chairman observed that
purchases of oil futures have had a cascade of effects on prices, production, inventories,
and consumption.
Within the United States, the view that unchecked excessive speculation in futures
markets has a detrimental impact on commodity prices has been widely accepted by
authorities on the subject, such as the chairman of the United States House Committee on
Agriculture, which has oversight over the CFTC,45 the chairman of the United States
Senate Committee on Banking,46 the United States Senate Subcommittee on Permanent
Investigations,47 and also such well-‐respected economists and market observers as
Nouriel Roubini, George Soros48, and Joseph Stiglitz.49
43 Senate Staff report 109-‐65, Permanent subcommittee on Investigations; The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Beat (June 27, 2006). 44 Id. 45 155 Cong. Rec. H14705 (daily ed. Dec. 10, 2009)(statement of Rep. Peterson). 46 H.R. 4173-‐-‐111th Congress: Dodd-‐Frank Wall Street Reform and Consumer Protection Act. (2009). In GovTrack.us (database of federal legislation). Retrieved April 26, 2011, from http://www.govtrack.us/congress/bill.xpd?bill=h111-‐4173 47 See staff of senate permanent subcomm. on investigations of the comm. on homeland sec. & governmental affairs, Excessive speculation in the wheat market 4 (2009) [hereinafter wheat report]; staff of senate permanent subcomm. on investigations of the comm. On homeland sec. & governmental affairs, excessive speculation in the natural gas Market 51–75 (2007) 48 See Lara Crigger, Nouriel Roubini: The Coming Commodities Correction, HARDASSESTSINVESTOR.COM, Nov. 6, 2009, http://www.hardassetsinvestor.com/features-‐and-‐interviews/1846-‐nouriel-‐roubini-‐the-‐coming-‐commoditiescorrection.html 49 See Edmund Conway, George Soros: Rocketing Oil Price Is a Bubble, DAILY TELEGRAPH (U.K.), May 26, 2008, available at http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2790539/George-‐Sorosrocketingoil-‐price-‐is-‐a-‐bubble.html (quoting Soros, a highly successful speculator, as stating “*s+peculation . . . is increasingly affecting the price” of energy).
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The theory that speculators on futures markets cause unwarranted price volatility
and excessively high or low prices is not new; Congress has been repeating that notion
since at least 1850.50 Farmers and their legislative representatives regularly demand the
elimination of speculators on futures exchanges.51 However, the Commodity Exchange Act
(CEA), which came into existence in the midst of an anti-‐speculation frenzy, does not limit
speculation, but only “excessive speculation.”52 This is an implicit recognition of an
indisputable economic principle — futures markets cannot operate without the
participation of speculators.
CFTC Chairman, Gary Gensler, recognized the difficulty in drawing a precise line
between “speculation” and “excessive speculation” in his recent testimony at the
Commission’s hearings on position limits in the energy markets and exemptions
therefrom (the Hearings).53 The Hearings focused on concerns with “excessive
speculation,” which resurfaced when fuel and food prices spiked to levels that were
shocking to consumers and painful to the economy. Although prices later subsided
significantly, the pressure to control a reoccurrence of price spikes has led to a search for
a simple causal agent that can easily be neutralized.54 The favored cause was speculators.
But, speculators can, and often do, trade based on market fundamentals. That is, they sell
when they think prices are too high and buy when they think prices are too low.55 They
are not always a unified voting block and can be found on both sides of every market.
50 CME Group, Excessive Speculation and Position Limits in Energy Derivatives Markets. (2010). 51 Id. 52 7 U.S.C. § 6a(a) 53 CME Group, Excessive Speculation and Position Limits in Energy Derivatives Markets. (2010). 54 Id. 55 Id.
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Speculative selling and buying send signals to producers and processors that help
keep our economy on an even keel. In the past, high futures prices for corn have induced
farmers to bring new acreage to market.56 High forward energy prices encourage
exploration and new technology to exploit existing untapped reserves. Futures markets
depend on short and long term speculators to make markets and provide liquidity for
hedgers.
Establishing even a minor link between speculation and commodity price volatility
can sometimes be met with skepticism. This skepticism is based partly on the argument
that financial investors only participate in futures and derivative markets, and that they
will affect spot prices only if they take delivery and hold the physical commodities in
inventories.57 This criticism fails to take into account that individual market participants,
who relatively large position changes, even in a derivative market, can impact the price of
the underlying physical commodity.
A more fundamental skepticism with regard to the link between speculation and
commodity price volatility is based on the “efficient market” hypothesis.58 According to
this view, prices perfectly and instantaneously respond to all available information
relevant to a freely operating market.59 Market participants continuously update their
expectations from the inflowing public and private information. This means that prices
will move either when new information becomes publically available, or when private
information is reflected in prices through transactions.
56 Id. 57 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets. (2009). 58 Id. 59 Id.
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The efficient market hypothesis is also problematic in relation to commodity
markets. The theory may fail, at least in the short run. First, changes in market positions
often occur in response to factors other than information about market fundamentals.
60Second, there are many who would argue that the efficient market hypothesis is dead,
especially after the recent financial crisis.
V. Position Limits as a Regulatory Tool to Prevent Excessive Speculation.
A key responsibility of the CFTC is to ensure that prices on the futures market
reflect the laws of supply and demand rather than manipulative practices61 or excessive
speculation.62 The Commodity Exchange Act (CEA) states: “Excessive speculation in any
commodity under contracts of sale of such commodity for future delivery… causing
sudden or unreasonable changes in the price of such commodity, is an undue and
unnecessary burden on interstate commerce in such commodity.63 The CEA directs the
CFTC to establish such trading limits “as the Commission finds are necessary to diminish,
eliminate, or prevent such burden”64
Speculative position limits have been widely used in commodity markets for more
than 50 years.65 These limits are set in order to avoid excessive speculation and market
manipulation. According to CFTC regulations, only positions that are “bona fide hedges”
are exempt from limits.66 The philosophy of exemptions for hedging is grounded in the
60 Id. 61 7 U.S.C. § 5(b) 6262 7 U.S.C. § 6a(a) 63 7 U.S.C. § 6a(a) 64 Id. 65 17 C.F.R. Parts 1, 20 and 151, Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations. (2011). 66 Id.
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notion that a physical market position gives hedgers less incentive to manipulate financial
market prices due to their natural offsetting position in the physical market.67
The CFTC recently proposed the implementation of new speculative position limits
for futures and option contracts in certain energy commodities.68 In addition to
identifying the affected energy contracts and the position limits that would apply to them,
the notice of proposed rulemaking includes provisions relating to exemptions from the
position limits for bona fide hedging transactions and for certain swap dealer risk
management transactions.69 The notice of proposed rulemaking also sets out an
application process that would apply to swap dealers seeking a risk management
exemption from the position limits, as well as related definitions and reporting
requirements.70 In addition, the notice of proposed rulemaking includes provisions
regarding the aggregation of positions under common ownership for the purpose of
applying the limits.71
Position limits further the congressionally endorsed regulatory objective of
preventing unreasonable and abrupt price movements that are attributable to large or
concentrated speculative positions.72 They are a particularly useful regulatory tool given
that the capacity of any reporting market to absorb the establishment and liquidation of
large speculative positions in an orderly manner is related to the relative size of such
67 Id. 68 17 C.F.R. Parts 1, 20 and 151, Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations. (2011). 69 Id. 70 Id. 71 Id. 72 Id.
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positions and is not unlimited.73 Specifically, when large speculative positions are
amassed in a contract, or contract month, the potential exists for unreasonable and abrupt
price movements should the positions be traded out or liquidated in a disorderly
manner.74 Concentration of large positions in one or a few traders’ accounts can also
create the unwarranted appearance of appreciable liquidity and market depth.75 Trading
under such conditions can result in greater volatility than would otherwise prevail if
traders’ positions were more evenly distributed among market participants.76
Although individual commodity exchanges are currently able to impose
speculative position limits on its members, the CFTC has concluded that a national
regulatory framework is still needed. Because individual exchanges have knowledge of
positions only on their own trading facilities, it is difficult for them to assess the full
impact of a trader’s positions on the greater market. As such, monitoring and limiting
positions through exchange-‐specific position limits and through the enforcement of
exchange position accountability rules, though necessary and beneficial, may not
sufficiently guard against potential market disruptions.77
Critics of position limits often claim that such a regulatory approach will not be
successful because market participants will simply take their trading from U.S.-‐ based
exchanges to those located in other countries. “Effective reforms can not be accomplished
73 United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, Chapter II – The Financialization of Commodity Markets. (2009). 74 17 C.F.R. Parts 1, 20 and 151, Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations. (2011). 75 Id. 76 Id. 77 Id.
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by one nation alone. They will require a comprehensive, international response.”78 Given
the global character of commodity futures trading, and the fact that through trading
arbitrage some contracts involve the jurisdiction of regulatory authorities in more than
one country, international collaboration among regulatory agencies is required. Such
collaboration would involve not only the sharing and publishing of information, but also
greater cooperation and harmonization of trading supervision.
Critics have also advanced arguments that establishing position limits is an inexact
science or that there is not enough competent market data upon which such limits can be
based.79 It is true that the establishment of position limits is more properly described as
an art rather than a science. Nevertheless, “U.S. regulatory history has shown that there
are many regulators and commercial users of the markets that are quite experienced in
that art, and with the kind of improved marker data that the proposed regulations call for,
regulators and exchanges will establish limits with greater precision.”80 Moreover,
position limits can be regularly and quickly readjusted if they are shown to cause a lack of
liquidity.81
Futures markets cannot operate effectively without speculators and speculators
will not use futures markets if artificial barriers or tolls impede their access. “Large
speculators are frequently the most efficient bearers of risk. In the old days, large
individual traders played the role of risk bearers. Today, futures funds and hedge funds
78 Medlock, Kenneth B, Jaffe, Amy; James Baker Institute for Public Policy-‐ Who is in the Oil Futures Market and How has it changed? (2009). 79 Greenberger, Michael, the Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility. University of Maryland School of Law: Paper for the International Energy forum (2010). 80 Id. 81 Id.
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that allow investors to diversify can perform this function. Unfortunately, position limits
prevent these traders from bearing as much risk as they would like. Due to these limits,
less risk-‐tolerant traders must absorb additional risk. This leads to an incomplete transfer
of risk. This is costly. Moreover, speculators are frequently well informed about supply
and demand fundamentals. Their trading forces prices towards the level implied by this
information. Since producers, consumers, processors, and storers of commodities rely
upon futures prices to guide their decisions, having more information embedded in these
prices will lead to better decisions. By limiting the ability of informed individuals to trade,
however, position limits reduce the flow of information to the futures market. This
reduces the efficiency of resource allocation.”
Conclusion
Due to the limited transparency of existing data, and the ever-‐increasing
complexity of global financial markets, it is difficult to conduct a detailed empirical
analysis of the link between speculation and commodity price volatility. Nevertheless,
multiple existing studies as well as various official reports persuasively suggest that the
activities of financial investors have accelerated and amplified commodity price
movements. Although there are many factors that have contributed price volatility in
commodity markets, there is room for policy to have a real impact, especially in the longer
term.
To be effective, policy and regulation must be well-‐designed, not an impulsive
reaction to the latest public outcry, and work in a time frame policymakers do not
typically consider -‐-‐ beyond the next four years. Regulation of commodity exchanges has
to find a reasonable compromise between imposing overly restrictive limits on
Francisco Vasallo
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speculative position holdings and having overly lax surveillance and regulation. Being
overly restrictive could impair market liquidity and reduce the hedging and price
discovery functions of commodity exchanges. On the other hand, overly lax surveillance
and regulation would allow prices to move away from levels warranted by fundamental
supply and demand conditions, and would thus equally impair the hedging and price
discovery functions of the exchanges. Better understanding the role of financial players in
commodity futures markets is necessary not only to ameliorate the impact of future
economic shocks, but also to make markets more efficient and beneficial to society.
