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AmericasDecember 1 2011

CFTC commodity rules divide financial world

The US's Commodity Futures Trading Commission's new rules were passed by a slim majority of three to two and met with much chagrin as those opposing the changes threatened legal action. But with its position limit levels set wide, how will the reforms actually affect investment banks?
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CFTC commodity rules divide financial world

When US regulators in late October published new position limits on commodities, it prompted one of the greatest outpourings of sound and fury in US legislative history, with politicians, lawyers and commercial interests lining up to debate what was seen as a fundamental reform of the financial markets.

In a decision split along party lines, the Democrat-dominated Commodity Futures Trading Commission (CFTC) voted three to two in favour of approving sweeping new restraints on speculation in agricultural products, energy and metals. The passing of the rule followed nine months of consultation in which the CFTC received some 15,000 letters of comment, and a final vote described by one observer as “one of the longest, strangest and most rancour-filled meetings in the agency's 37-year history”. 

Party divisions

It was certainly strange. Commissioner Michael Dunn started the meeting with a boisterous rendition of 'Happy Birthday' for chairman Gary Gensler, voted with his Democrat colleagues in favour of the rules and then exited to comment that position limits were a “sideshow” and the “cure for a disease that does not exist".

As CFTC chairman Gary Gensler welcomed the vote, dissenting Republicans railed at the failures of the regulator and threatened legal challenges. Republican commissioner Jill Sommers said the CFTC “is setting itself up for an enormous failure”.

Amid the hubbub, it was barely noticed that one group at the heart of the debate was conspicuous by its absence: the investment banks, at which the legislation was primarily aimed, said nothing.

As the CFTC set out its plans in Washington, DC, many of the industry’s key players were gathering in London for the annual World Commodities Week get-together. As anti-capitalist protesters huddled in nearby St Paul’s Cathedral churchyard, the world’s most powerful commodity investors met in a luxury hotel and quietly digested the implications of the CFTC’s 300-page document. The upshot, whispered quietly over the canapés, was that it could have been a lot worse.

“What we have seen so far is a lot less onerous than we thought it might be,” says a director in the commodities group at a leading European bank. “If you look at the numbers and at today’s level of open interest, there are only a few people who will be affected.”

Reform implications

The CFTC rules increase restrictions on holdings of exchange-traded commodity futures, and introduce limits for over-the-counter derivatives, or swaps. The rules are split into sections relating to the next deliverable month, known as the spot month, and longer-dated contracts. For spot months, traders will be limited to 25% of the deliverable supply of a covered contract. That provision will come into effect in April 2012. Non-spot month limits will not come into force until 2013 or later, and will be set at 10% of the first 25,000 contracts of open interest and 2.5% over 25,000.

The final rules as written would still enable single entities to carry between $15bn and $18bn of derivatives exposure to an index such as the Dow Jones UBS Commodity Index, says one banker. This would cover all but the biggest exposures.

“You may see investors such as Pimco [Pacific Investment Management Company] impacted, and maybe a few of the biggest investment banks would get close, but at today’s levels of open interest most people would be under the limit,” says the commodities group director.

In particular, bankers welcomed what they saw as a softening of proposals published in January, with market participants now not expected to aggregate positions held by entities in which they have a stake, at least until the agency has collected more data.

The final rules also do not include the class limits promised in earlier versions, meaning banks and investors holding both futures and swaps based on the same commodity will be permitted to net positions in the non-spot month.

Little change

“My belief is that the CFTC needed to implement rules under the Dodd-Frank Act, but it has set the position limit levels sufficiently wide that it won’t impact the way we currently operate,” says David Hemming, who helps manage $1.7bn in five commodities funds as part of the Hermes commodities team. "During the information gathering phase of the CFTC study of commodity market participants and concentration levels [which is still ongoing], the results pointed to a market with a high number of diversified participants."

If the CFTC has created a toothless remedy, banks will have reason to be greatly relieved. For many, commodities has become big business. With staffing levels rising to several hundred at the largest operations, it has generated substantial profits from new index and fund-based solutions. According to the US Office of the Currency Comptroller, the top five banks have about $1400bn of commodity derivative exposure, with Goldman Sachs, Barclays, JPMorgan, Morgan Stanley and Deutsche Bank among the leading players.

My belief is that the CFTC needed to implement rules under the Dodd-Frank Act, but it has set the position limit levels sufficiently wide that it won’t impact the way we currently operate

David Hemming

Competition for commodity assets has also intensified; witness the ferocious battle last year between JPMorgan and Deutsche Bank for commodities trader RBS Sempra – eventually won by JPMorgan.

Small help

As larger players keep their counsel, smaller commodity firms welcomed the CFTC ruling, suggesting it may prompt business to move away from the dominant players. “We clearly will benefit because as the big players hit their position limits the money will be forced to flow away from them,” says Sal Gilbertie, president of exchange-traded fund provider Teucrium Trading

Given banks’ patent enthusiasm for the commodities business and the growing excitement among smaller rivals, the industry’s lack of response to new limits is surprising.

“There is no doubt that the rules are restrictive and that the commodity index business is significantly restricted by these rules,” says Kenneth Raisler, former deputy general counsel at the CFTC and head of the commodities, futures and derivatives group at law firm Sullivan & Cromwell. “There is no form of relief for these entities or risk management exemptions and it will be more difficult to grow that business.”

In addition, a Washington, DC-based lawyer says the rules contain heavy burdens for hedges, with increased reporting requirements and qualifications. “I don’t think anybody is too happy about it – limits only used to apply to futures, now they apply to swaps; its going to constrain what people can do,” he says.

Perhaps one reason the banks are reluctant to join the public argument over position limits is that there is a broader and much bigger political argument around the rules that speaks to a wider debate about the role of financial oversight.

To many in the political arena, the whole concept of position limits is anathema, at best analogous to the price controls discredited in the post-war period and at worst a threat to the fundamental American belief in free enterprise.

Food fights

On the other side of the debate are those who argue that if markets are not working, then they must be made to do so. This group points to a decade-long boom in commodity prices which in 2008 pushed global food prices to record highs, sparking food riots across 30 countries and undermining key US industries such as airlines.

Lobby groups such as Stop Oil Speculation Now have powerful allies in Washington, where there is widely held suspicion over the impact of derivatives markets on commodity prices. A 2009 US Senate Permanent Subcommittee on Investigations report argued that the dramatic rise in index investment flows had distorted prices, and that the activities of index traders comprised 'excessive speculation'.

Amid rising political pressure, in 2008 the CFTC launched an investigation into commodity swap and index traders, and the outcome in January of this year was proposals to clamp down on so-called ‘massive passives’ – the index traders, exchange-traded funds, quant funds and other commodity investment strategies that had seen assets under management increase as much as 50-fold over the past 10 years.

CFTC chairman Mr Gensler planted his flag firmly in the anti-speculation camp in June, pointing out that some 90% of wheat futures contracts and derivatives on the Chicago Board of Trade traded long. That suggested they were owned by speculators with no connection to agriculture or food production, according to Mr Gensler.

The CFTC’s monthly index investment data report states that the notional value of long commodity positions on US futures and related markets in August was $322bn, while notional shorts totalled $95bn, leaving an overall long position of $227bn.

On the front line

With the battle enjoined, the front line of the debate centered on one key question: to what extent has the ‘financialisation’ of commodities, which neither side denies, led to rises in prices or increases in volatility? Are commodity prices driven by macro-economic factors such as population growth and land cultivation, or by futures markets betting on price action months or years ahead.

With numerous academic studies produced by both sides, no definitive answer has emerged. The CFTC decided to proceed in any event, while European regulators prepared to introduce their own less restrictive rules under the Markets in Financial Instruments Directive, or MiFID. Banks that contributed to the debate tended to reject the speculation argument, and are now reluctant to acknowledge the legislation’s impact.

“What we found was that there is very little evidence that derivatives have an impact [on price],” says one banker. “About 25% of commodity bankers work in the index business, so about a quarter of the people will be affected by the new rules, but that is levelled by the fact that I don’t think the business will be affected at all.”

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