CFTC Approves Position Limits Proposal
Commentary by Bob Zwirb and Steven Lofchie
The CFTC approved by a 3-1 vote a revised proposed rulemaking to establish a federal position limit regime for exchange-traded commodity futures contracts on 28 physical commodities and economically equivalent swaps. The vote came a little more than a year following a federal district court's vacation of a nearly identical rulemaking on the ground that, prior to imposing them, the CFTC had failed to make a finding that position limits were in the public interest. ISDA v. CFTC, 887 F. Supp. 2d 259 (D.D.C. Sep. 28, 2012) (ruling that CFTC had no "clear and unambiguous mandate" to set position limits under the Dodd-Frank Act). At the same time, the CFTC approved issuing a second proposed rulemaking for aggregation of accounts under its Part 150 rules. In connection with the proposed rulemaking, the CFTC announced that it will withdraw its appeal of the adverse federal court ruling.
Position Limit Proposal
The proposed limits would apply to 19 agricultural futures contracts, including ten not covered by the CFTC's current position limits for certain agricultural commodities, as well as to four energy contracts traded on the NYMEX exchange and five metals contracts that trade on either NYMEX or COMEX. As with the previous rulemaking, the proposed rules set forth two types of limits: spot-months and non-spot-months position limits, with spot-month limits set at 25% of estimated deliverable supply and applied separately for positions in the physical-delivery referenced contracts and cash-settled contracts combined. The proposal also incorporates a "conditional" spot-month limit for cash-settled contracts, under which a market participant can hold speculative positions up to five times the spot-month limit for cash-settled contracts, provided that it does not hold positions in the physical delivery contract. To rely on the proposed conditional limit, a market participant must make a daily filing of its cash-market positions with the CFTC.
Non-spot-month limits would be set at 10% of open interest in the first 25,000 contracts and 2.5% thereafter based on open interest data in futures and swaps that are significant price discovery contracts. Subsequent levels would be reset at least every two years based on open interest data in futures, cleared swaps and uncleared swaps.
The proposed rulemaking includes enumerated bona fide hedging transactions eligible for the bona fide hedge exemption request, and allows market participants to seek non-enumerated hedge exemptions by filing of a petition under CEA Section 4a(a)(7). At the same time, the proposal would eliminate CFTC Rules 1.3(z) and 1.47, which currently define bona fide hedge transactions and allow participants to seek exemptions for non-enumerated hedges.
Commissioner Scott O'Malia dissented from the proposed rule, arguing that the Commission had failed (1) to perform a perform a rigorous and objective fact-based analysis in order to determine whether position limits will effectively prevent or deter excessive speculation, (2) to provide enough flexibility for commercial end-users to engage in necessary hedging activities, and (3) to establish a useful process for end-users to seek hedging exemptions. He criticized the Commission for "rel[ying] on a new legal strategy - but not new data - in order to circumvent the spirit of the district court's decision."
Aggregation Proposal
The aggregation proposal would amend current rules that require a person to aggregate all contract positions in accounts in which such person directly or indirectly holds positions or controls trading or which are held by one or more other persons acting pursuant to an expressed or implied agreement or understanding. Under the new proposal, a market participant with a 10% or greater ownership interest in an entity could disaggregate the contract positions of the owned entity, provided there is independence of trading between the entities and the ownership interest is not greater than 50 percent. In the event that a market participant's ownership interest is greater than 50 percent, the CFTC proposed an exemption if the entities are not consolidated and the owned entity either: (1) only holds bona fide hedge positions; or (2) does not hold positions in excess of 20 percent of the speculative limit.
Click here for a summary of the meeting and proposal by Delta Strategy Group.
See: CFTC Press Release; CFTC Proposed Regulations on Position Limits for Derivatives Fact Sheet. See also: Cadwalader Memo on Proposed Position Limits and Aggregation Rules; Chairman Gensler's Opening Statement; Chairman Gensler's Statement of Support; Chairman Gensler's Statemeng of Support: Aggregation Provisions; Commissioner Chilton's Statement; Commissioner O'Malia's Statement of Dissent; Commissioner Wetjen's Statement; CME Group's Statement on Position Limits Proposal. Related news: CFTC Votes to Dismiss Appeal of 2011 Position Limits Rule (October 29, 2013); CFTC to Court: Position Limits Appeal Will Be Dropped if New Rule Reached on Nov. 5 (with Lofchie Comment) (October 28, 2013); Blog Post Quotes Commissioner Wetjen on Position Limits (October 23, 2013); CFTC Commissioner O'Malia Blasts Cross-Border Guidance and Potential Position Limits Rule (with Lofchie Comment) (September 26, 2013); ISDA and SIFMA v. CFTC Court Date Set for Oral Arguments on Position Limits (August 23, 2013); CFTC's Appeal Brief on Position Limits Litigation (with Zwirb Comment) (July 24, 2013); Interested Parties Submit Opposing Amicus Brief in ISDA v. CFTC Position Limits Case (with Zwirb Comment) (June 25, 2013).
Commentary
As in previous iterations of this rule proposal, the CFTC argues that it need not analyze the empirical economic evidence on speculation and the effectiveness of position limits, insisting that Congress mandated the issuance of these rules and that it has longstanding authority of a "prophylactic" nature to do so in any case. Those who were hoping for a more robust demonstration of administrative agency "experience and expertise," as called for by the federal district court in this matter, came away disappointed, notwithstanding Chairman Gensler's insistence that the revised rules will survive any renewed judicial challenges. First, during the Commission meeting, the Chairman called on the agency's General Counsel to substantiate the view that the CFTC had no choice. The General Counsel obliged by repeating the agency line that Congress directed the CFTC to adopt position limits with "tight" deadlines, and that requiring the CFTC to find that such limits were "necessary" or "appropriate" (as called for in the statute) "makes little sense."
Then in an effort to show that the agency had considered the economic evidence in any case (apparently in an effort to hedge its bets with a future court challenge), the Chairman called upon a representative from the Division of Economic Analysis, who stated that, based upon the Division's analysis of 130 studies on the subject, there was no consensus on whether speculation affected the market or position limits were efficacious. The Chairman then seized upon this finding as evidence to support his view that the proposed rules were necessary, arguing that it was equivalent to a "jump ball" in basketball and that in such circumstances the Commission should "err on the side of caution" and rely upon the studies (representing about a third of the 130 considered) that found that speculation harmed the markets.
There are several disturbing aspects regarding this showing. First, at its public meeting, the CFTC relied upon a staff member from its economic division who does not have an advanced degree in economics to present the findings of 130 or so empirical studies. Second, of those studies, only one-third support the CFTC's thesis. Third, the CFTC's analysis of these studies appears to take into account only the quantity of studies and not their quality. One economist who has probed into a similar group of studies relied upon by Commissioner Chilton to support position limits, Professor Craig Pirrong, has found them wanting from a methodological view. See, e.g., Craig Pirrong, "Still No Theory. Still No Evidence." Streetwise Professor (Apr. 10, 2011) (characterizing studies cited by CFTC Commissioner Chilton which associate speculation with price distortions, as "superficial quasi-academic studies, and quotations from various figures, including some well-known economists, who have done absolutely no serious research on the subject"). Fourth, Chairman Gensler's rationale for going ahead - as "erring on the side of caution" - could just as easily provide grounds for not issuing the rule, especially if this is a "jump-ball" situation as the chairman has characterized it. Finally, in what seems a rather remarkable if unsurprising omission, there was no mention by the CFTC of the study conducted by the CFTC's own expert economists in 2008 that found an inverse relationship between speculation and the price of oil - which would mean that that the agency's own study would show that the CFTC is actively damaging price stability by its action.
All of this is to say that, notwithstanding the passage of time, it appears that the CFTC is still relying upon what seems to be an overly flawed rationale for seeking to impose an aggressive, complicated and costly rule. One of the points emphasized by dissenting Commissioner O'Malia is that the Commission's reliance on a new legal strategy instead of evidence-based standards "does little to affirm the Commission's self-proclaimed 'expertise.'" In other words, in order for an agency to be treated as an expert, it must first act like one. See Elliott v. CFTC, 202 F.3d. 926, 942 (7th Cir. 2000) (Easterbrook J., dissenting) ("Our recent opinion in Chicago Board of Trade v. SEC, 187 F.3d 713 (7th Cir. 1999), and the D.C. Circuit's thoughtful opinion in Bechtel v. FCC, 10 F.3d 875 (D.C. Cir. 1993), stress that an agency must act like an expert if it wants the judiciary to treat it as one.").
Commentary
The comment by the Chairman of the CFTC that a "jump ball" provides an argument for more regulation is indicative of a regulatory "philosophy" that is exactly backwards; if the CFTC cannot make a solid case as to why regulation is beneficial, then it should not regulate. The notion that the government adopts a rule (particularly a complicated and expensive one) because there is a 50% chance that the rule will do less harm than good is so strange as to be eccentric. That the Chairman who has been recently quoting Adam Smith's ("invisible hand") philosophy in defense of Dodd-Frank can believe that a tie argues in favor of more regulation perhaps adds to the irony.
Even this assumes that the intellectual case in favor of position limits is 50-50. As to whether that is the case, see the discussion below.