The last hurrah for speculative position limits?
Steve Suppan, Senior Policy Analyst, Institute for Agriculture and Trade Policy (IATP)
During the last decade, the growing financialization of agricultural markets, in a context of deregulation was accompanied by a growth in excessive speculation whose amplifying effect on volatility is real and problematic. In this deleterious context, increasingly more experts are recognizing the inherent failure of agricultural markets and the need for greater market regulation.
Position limits are one of the tools used to regulate derivatives markets. They enforce a limit on financial players for the number of contracts on a given raw material at a given time. Their suppression in the 1990s in the United States coincided with the process of hyper-financialization of derivatives markets and caused major price distortions in agricultural markets. They were eventually reintroduced in 2010, when President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act. In November 2013, the CFTC (Commodity Futures Trading Commission) approved a new proposal to limit traders’ positions on 28 commodities.
However, though significant progress has been made regulating derivatives markets, notably through the establishment of position limits, in a recent article (extract here1), Steve Suppan of the IATP called for more guidance and limits on excessive speculation in commodity markets. He recommends in particular the harmonization of US and European regulations for them to be better armed, particularly in the event of further financial crises.
The growth in pure speculative behaviour that is disconnected from economic, physical and strategic market fundamentals is a real danger, in a context of progressive deregulation that is uncontrolled and characterized by price hyper-volatility and the common fight against these excesses is becoming ever more urgent.
momagri Editorial Board
For more than four years, IATP has been submitting comments on proposed U.S. regulations to limit the share of positions controlled by financial speculators in commodity derivatives markets. A position is a financial interest in one or more contracts of a commodity, e.g. Chicago Board of Trade No. 2 Yellow Corn. Commercial hedgers who can show that they have a bona fide commercial need to use the commodity and to manage price risk in a given contract—rather than accumulating contracts without bona fide need, in order to manipulate the commodity’s price—are exempt from position limits placed on financial speculators.
If financial speculators chronically exceed position limits, excessive speculation distorts prices for commercial hedgers, often to a degree where they fail to manage their price risks. For example, food processors will take positions to try to prevent price increases in their raw materials costs. Price risk management failure, if prolonged, can be devastating at every point of a commodity supply chain from producer to consumer.
IATP has submitted what well may be its last comment, for the foreseeable future, on a Commodity Futures Trading Commission rule to establish speculation position limits in 28 of the most frequently traded commodity derivatives contracts, 19 of them agricultural. The “Dodd Frank Wall Street Reform and Consumer Financial Protection Act of 2010” authorized the CFTC to set position limits by 2011 to prevent market manipulation, excessive speculation by financial entities and price distortion.
A successful Wall Street lawsuit against the rule and thousands of comments have delayed the rule’s implementation and enforcement. The CFTC hopes to finalize this, the third proposed rule, by this summer. But the Commissioners may not vote to finalize the rule. IATP does not believe the terms of the rule, as proposed, will be adequate to achieve Dodd-Frank objectives. If the rule is finalized and adequate, the Republican majority in Congress very likely will continue its assault on Dodd Frank by voting again for a budget and terms of CFTC reauthorization inadequate to implement the law.
It was seven years ago that IATP began to research why high price levels and price volatility in agricultural derivatives contracts did not reflect supply, demand and other market fundamentals. We published a compendium of such research in 2011. As we emphasized in our March 30th comment to the CFTC, high and volatile derivatives prices resulted in high and volatile agricultural and energy import prices in 2008 and 2009, which caused food price riots in at least 30 countries, destabilizing governments and contributing to the fall of a few of them, e.g. in Tunisia. The current low price outlook for agriculture and energy commodities could change very quickly, due to climate change and the geo-politics of oil. Excessive speculation usually comes with such changes.
In our comment, we urged the CFTC to take five steps to finalize the rule:
- Set the position limit low enough to enable a return to commercial hedger (commodity producers, processors and/or shippers) dominance of the share of the contracts. Currently financial speculators control an estimated 70 percent of commodity trades. The CFTC proposed 25 percent limit per trader would allow, in theory, just four traders to control a contract.
There is no end to irony in commodity market regulation. Just as the Designated Contract Markets for the position limits rule—including the Chicago Board of Trade and the Intercontinental Exchange—were ramping up their campaign for “position accountability,” (supported by the big banks, who likewise want no effective position limits) on April 1 the CFTC announced its lawsuit against the Kraft Foods Group and its spin-off, Mondelez Global. The CFTC complaint alleges in great and specific detail that Kraft and Mondelez had been engaged in numerous “non-competitive trade practices” in the CBOT wheat contract “beginning in at least 2009 and continuing through January 2014” (p. 1).
- Review position limits every six months, rather than every two years as the CFTC proposes. Position limits for physically deliverable contracts are based on commodity exchange estimated deliverable supply. These estimates can and are subject to error and volatility. In January, IATP responded to CFTC questions about how agricultural estimated deliverable supply should be verified by the CFTC. In our view, exchanges have far too much discretion to decide which and when supplies would be counted as “deliverable.”
- Define each Commodity Index Fund (CIF), e.g. the energy dominant Goldman Sachs-Standard and Poors CIF, as a contract subject to position limits and require each Commodity Index Trader to report their positions. CIFs are massively destabilizing for commercial hedgers because they are almost always traded "long,” i.e. betting that prices will increase. When CIF contracts are sold and new ones bought, the multi-billion dollar CIF investments create price levels and volatility that makes it exceedingly difficult for even the best informed commercial hedgers to manage their price risks. As a recent Growmark Research report dryly noted, “Periodically these Wall Street players change the composition of their investment portfolios to include commodities. When they do, they buy commodities across the board, which explains why most commodity prices move in tandem over time even though they have different fundamentals.”
- Require parity in position limits for physically deliverable contracts and cash-settled only contracts. Parity in the position limit formula will discourage migration of trades to cash-settled only contracts. Migration will occur if the CFTC finalizes the current proposal to allow a position limit to be five times higher for cash-settled only contracts than for physically deliverable contracts. Parity will help put commercial hedgers of physically deliverable contracts on a more level playing field with financial speculators in cash-settled only contracts.
Do not delegate CFTC authority to manage position limits to the exchanges in which the 28 position limited contracts are traded. Exchange managed “position accountability” failed to prevent excessive speculation in the decade prior to Dodd Frank. Exchanges are for-profit entities with a fiduciary duty to maximize returns for shareholders by maximizing trading volume and fees. It would be a violation of this duty for them to limit positions, and thereby limit trading volume, fees and other trade related revenues.
Implementation of the Dodd Frank Act had has varying degrees of success. Despite industry and Republican Party opposition, the reform of retail consumer finance, such as mortgages, student loans, credit cards and predatory payday lending, is arguably well-established in the form of the Consumer Financial Protection Bureau. Progress in regulating institutional finance, such as “Too Big To Fail Banks” and the derivatives market has been more successfully opposed. As Financial Stability Board Chairman Mark Carney wrote in February, despite the political commitments of G20 leaders to reform derivatives markets, there has been “slow and uneven implementation of agreed reforms.” If the big banks and their major corporate clients succeed in imposing a weak CFTC position limit rule, Chairman Carney will have to write of a retreat from reform.
1 The entire article is available from here