A divided CFTC pitches federal position limits, large role for exchanges

Washington — The US Commodity Futures Trading Commission voted 3-2 propose new federal position limits 25 physical commodity derivatives, even as it remained split over a key legal finding and its decision to hand private commodity exchanges a leading role in granting exemptions for hedging of commercial risk.

Nearly a decade in the making, the proposal has implications for the level of participation in energy derivatives markets as well as energy-sector hedging strategies.

Aiming to preserve commercial entities' ability to hedge their risk, the proposal expands the list of hedges expressly exempted from limits. Further, it seeks to create a streamlined process for major exchanges to grant more hedge exemptions, provided the full CFTC does not object within 10 days of a request. A two-day review is set out for sudden hedging needs.

TARBERT'S TAKE

CFTC Chairman Heath Tarbert said the proposal would help protect against "some of the most nefarious schemes" in derivatives markets, and help prevent cornering and squeezing. It could also "cut down on chaotic price swings caused by speculative gamesmanship," he said.

But the vote broke down along party lines, with Democrats raising questions about how high the levels were set, how much of the CFTC's role was ceded to exchanges, and CFTC's position on the long-standing legal fight about whether it had to make a "necessity finding" before setting limits.

"Today, we're back in Bizarro World where the Dodd-Frank Act is being interpreted to make it more difficult to put limits on speculative activity," said Democratic Commissioner Dan Berkovitz. The logic of the proposal would require the CFTC to make a necessity finding for core contracts while exchanges would not need to for other contracts, he noted.

LIMITS IN 25 CONTRACTS

The proposal would set limits in 25 core futures contracts, including the NYMEX Henry Hub natural gas contract and three petroleum contracts, as well as futures and options related to those contracts and "economically equivalent" swaps.

The limits on energy contracts are focused on the spot month, leaving open the possibility exchanges could set position limits or more flexible accountability limits for other months. The spot month limits are set at or below 25% of the deliverable supply of the commodity.

For natural gas, the limit is set at 2,000 physically settled contracts, double the existing exchange-set limit. The 2,000 contract limit could be exceeded, provided the market participant's position in cash-settled gas contracts does not exceed 10,000 NYMEX Henry Hub equivalent contracts per exchange — if a market participant exits its spot-month position in the NYMEX physically settled contract. For that market participant, an additional 10,000 contracts would be allowed in economically equivalent swaps that are cash-settled.

HEDGE EXEMPTIONS

Energy interests had previously feared that CFTC exemptions would exclude commonly used commercial hedging strategies. The expanded list gets at some of those concerns: it adds anticipatory hedging strategies such as anticipatory merchandising, eliminates restrictions on holding positions during the last five days of the spot month, creates an exemption for spreads, and includes cross-commodity hedging.

The proposal marks the CFTC's fifth attempt at the regulation since it was called for in the Dodd Frank Act following the financial collapse. A first attempt, approved by a split vote in 2011, was struck down in court September 2012 in a case centering on whether the CFTC needed to first make a threshold finding that the limits were needed.

NECESSITY FINDING

That question continued to divide commissioners Thursday. In the proposal, the commission included such a showing for the core contracts covered. Berkovitz worried legal vulnerabilities were created by taking the view that a showing was needed, opening the CFTC to challenges about whether the showing was adequate.

Commissioner Rostin Benham, who voted against the proposal, said it pushes the bounds of reasonable interpretations of the statute by deferring to the exchanges in an area where Congress opted for the commission's experience and expertise. He questioned whether the CFTC, by increasing the list of exemptions and establishing a self-perpetuating system, runs the risk of "not being able to monitor the market as we should."

"I'm a little bit puzzled," he said, over how the CFTC would step in as a primary regulator within 10 days and take a full commission action on matters of significant importance.

Commission Dawn Stump backed the proposal but nonetheless hoped for refinements. She sought further hedging exemptions on the enumerated list, seeking comment from energy and metals interests on that question. She also found the 10-day/2-day exemption review unworkable—both too long for market participants who may need take a position quickly and too short for the commission to meaningfully make a determination.

Berkovitz was concerned about the "significant jump" in the limits being proposed and said he would like the ability to phase it in if necessary. He also objected to having the CFTC members involved in the 10-day review process as envisioned. "It's not a political process. It's a substantive process," he said.