The proposed limits outlined yesterday on speculation in the main US crude oil, natural gas, gasoline and heating oil contracts seem to have drawn little outrage so far – apart from Republican appointee to the Commission, Scott O’Malia. More about him later.
Fear of traders shifting to other exchanges was a big factor in the cautious approach, as indicated by Bart Chilton, the commissioner most in favour of setting limits. The UK’s Financial Services Authority, which regulates trade on London-based commodities exchanges, has shown little interest in setting position limits on energy speculators. The fact that fears about regulatory arbitrage of the existing ‘London loophole’ were overblown appears to have been little consolation to the CFTC.
This is how the the rules apply to the two groups eligible for examptions:
There is a clear exemption for bona fide hedgers – that is, companies that use the physical commodities themselves and want to guard against price rises. There’s also a fairly big exemption for swaps dealers that agree to be the counterparty to those hedgers. They don’t get the free pass offered to hedgers themselves, but would be subject to limits double that of ordinary speculative traders.
One of the key complications that have been pointed out here before, is that quite a few big market participants engage in more than one type of trade; swaps dealers and other financial traders sometimes get involved in physical markets so improve their profits; while companies primarily involved with physical oil have certainly been known to run their own proprietary commodity trading desks.
The CFTC’s Q&A document explains its approach to the positions of bona fide hedgers that also trade as either swaps dealers, or speculatively:
The proposed regulations would count bona fide hedging transactions against a trader’s ability to hold speculative positions. For example, a trader holding bona fide hedging positions greater than a proposed Federal speculative position limit would not be able to simultaneously hold a speculative position. Further, a trader’s swap risk management position also would count against a trader’s ability to hold speculative positions.
A trader’s combined bona fide hedging positions and swap risk management positions could be as large as two times a proposed Federal speculative position limit, before the trader’s bona fide hedging positions begin to count against the swap risk management positions.
And, on how one qualifies as for the swap dealer risk management exemption:
To qualify for a swap dealer risk management exemption, the dealer must file an exemption application and update the application annually. The swap dealer also must provide monthly reports of their actual risk management needs and maintain records that demonstrate their net risk management needs. The CFTC would publicly disclose the names of swap dealers that have filed for an exemption after a six-month delay.
Passive speculators and index funds
Passive index investor funds such as the USO have attracted a lot of attention as they’ve become particularly popular during the past year with investors have used them to pile into the energy commodities asset class. Scott O’Malia, who as we mentioned above was critical of the proposed limits, drew attention to this in his statement:
The release states that no more than ten trading entities would be affected and most of those would likely be entitled to a bona fide hedge exemption. This means that few, if any, passive index and speculative investors will be significantly impacted by the proposed position limits. The proposed position limits will not change the investing behavior of passive index investors, so long as they remain under the limits or utilize the over-the-counter markets over which the Commission has limited authority. The Commission would benefit from receiving information on the impact, if any, the proposed position limits might have on the trading strategies of passive index investors going forward.
As Izabella points out on FT Alphaville, the new rules for swaps dealers appears to be good news for oil traders such as Vitol, Trafigura, and Glencore, and not such great news for either hedge funds or index funds.
Update: One of the five commissioners voted against publishing the proposed limits and two were critical of the measures, so once the 90-day comment period is through, it’s far from certain the measures will go ahead anyway.