Speculation crackdown: Is regulatory arbitrage a threat?

Speculators irritate a lot of people in times of volatile markets. They certainly made Lenin and Lincoln mad:

‘‘For as long as we fail to treat speculators the way they deserve—with a bullet in the
head—we will not get anywhere at all.’’ – Vladimir Lenin

‘For my part, I wish every one of them [speculators] had his devilish head shot off.’’
Abraham Lincoln

As quoted in a paper by David S. Sacks on the role, and perception, of speculators in futures markets. And there’s more. Speculators have always been regarded with open suspicion “at best”, writes Sacks – but more generally, he says, with open hostility.

Today the chief investment officer for the big ETFs, United States Oil and United States Natural Gas, John Hyland is appearing at the CFTC’s hearings on commodities speculation, while in London, UK Financial Services Authority and Treasury officials are meeting representatives from oil companies and traders.

The CFTC’s chairman Gary Gensler has been fairly forthright in his views that tougher limits on speculators in energy commodities markets. So some new measures in the US seem likely (although John Kemp believes that will only represent minor changes). Those involved in the UK meetings seem to anticipate an even milder outcome.  But a fear of future tightening of limits can be enough to change minds. So will a change in the US commodities markets mean speculators move elsewhere?

From the FT:

An unsigned paper opposing trading limits circulating in Houston’s natural gas hedge fund community warns that “domestic liquidity will suffer terribly” as CFTC rules grow more onerous. “While the US natural gas market could very well die, the other commodities, like oil and copper, would certainly find homes in foreign markets,” the paper says.

As for the latter part of that statement – commodities other than gas moving elsewhere – the story reports that quite a few people agree. Gregory Mocek, a partner at lawyers McDermott Will & Emery in Washington and former head of enforcement at the CFTC is among them.

Rather than regulatory arbitrage between the US and the UK, some worry that the real danger is that any crackdown by the CFTC and the FSA will trigger a flight to smaller, but rapidly growing, commodities hubs, such as Dubai, Shanghai or São Paulo.

But we wonder how much the US and UK really stand to lose. As Izabella has written over on FT Alphaville, ICE’s Jeffrey Sprecher’s statement to the CFTC last week includes the suggestion that greater limits on energy futures only apply to non-commercial traders – ie those who are not involved in physical goods.

The distinction between the ‘real’ traders of goods and those who merely speculate on them taps into the morally-charged history of speculation. Sacks’ paper quotes a passage from the US Committee on Agriculture in 1892, amid concerns about the volume of futures trades exceeding the value of physical wheat:

All the investment of this capital, all this infinite labor, all the employment of these
people throughout the United States. . .we employ all these people, and all we can
offer, after a year, on the markets of the world is 10,000 bushels of wheat, and
any young fellow in Chicago who can raise $250 can order his broker to sell as many
bushels of wheat as we have grown at the cost of this infinite labor and investment of
capital, and yet, so long as the $250 and the broker’s lung power is good, they can
continue to offer 10,000 bushels every minute in competition with the 10,000 bushels
of wheat which we produce. . .The men who grow cotton or wheat suffer from such
competition. It is a destructive competition. These people extend nothing for their
product, they have no capital employed, neither do they labor. (Committee on Agriculture,
1892, pp. 14–15).

So, commercial traders = good and non-commercial/speculative traders = bad in the public perception (never mind that physical traders need speculators to take positions against). But the line between commercial traders and non-commercial traders has long been blurred.  As Chris Cook, former director at the International Petroleum Exchange, has pointed out, big investment banks have been heavily involved in physical oil for some time, while companies whose core business is oil are not averse to profiting from their knowledge in speculation. And a recent move by large hedge fund GLG into physical oil suggests the benefits of getting into ‘commercial’ trade is not lost on anyone.

So will this regulatory arbitrage occur between regulatory regimes, or within them?

Related links:

Presenting, the ‘physical loophole’ (FT Alphaville, 29/07/09)
Oil: the market is the manipulation (The Oil Drum)

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