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04/26/2010

The CFTC Should Sit on Their Hands


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There are several things that the Commodity Futures Trading Commission (CFTC) will be considering as they convene hearings. Hopefully they will hear well-researched, and well-thought-out opinions, unlike that of Michael Masters—whose testimony was slammed equally by the left and the right, by the likes of Nobel Laureate Paul Krugman and commodity trader Jim Rogers. Among the issues that the CFTC is looking at are transparency in the markets and the position reporting limits where there are not currently any Federal guidelines. A third issue is the stratification of the COT—the commitment of traders—which characterizes how the market participants are biased in the marketplace. Ultimately, these make for good talking points, but regulation in these areas will not stamp out speculation nor insure Americans against high commodity prices.

Position Limits

That commodity futures contracts should have position limits is not a new concept. The various exchanges set position limits, except for agriculture futures which are set (Federally) by the CFTC. Each commodity has its own position limit, and they tend to be very specific. NYMEX crude oil, for example, has the position limit of 10,000 net futures in any one month and 20,000 net futures contracts for all months combined. You are limited to “only” 3,000 contracts in the last three days of the spot month, including any concurrent call or put option positions on the same commodity. The question before the CFTC is how to account for the over the counter (OTC) market in aggregating position sizes. Also, the Intercontinental Exchange (the ICE), has evolved substantially since trading has become much more electronic. The ICE offers “look-alike” futures which are cash-settled, and no physical commodity is ever involved by definition. The position limits for the ICE Crude Oil Futures are exactly the same as those set by the NYMEX on its crude oil contract. These are two different contracts on two different exchanges and their limits should be separate.

If Victor decides to sell 5,000 NYMEX crude oil contracts, and Mike is buying 5,000 NYMEX crude oil contracts at the same time, there is no effect on crude oil itself. Neither is creating nor producing the physical oil; they are trading against one another. They are not impacting the consumer, unless the consumer happens to be a speculator and is taking part of the position. What they are doing, however, is providing valuable information to the marketplace on the outlook for crude oil. They  already abide by the reporting levels. Further transparency will not annul volatility in commodity futures trading. Uncertainty causes volatility. Hedgers, real hedgers, are hedged oftentimes to the back of the board and they use several techniques beyond futures contracts.

Commodity investors, also called indexers, invest in commodities for the long-term to assuage the effect of inflation on their traditional investments and “paper assets,” such as stocks and bonds. Through passive investments such as the US Oil Fund (ticker: USO) discussed below, or through the asset class known as managed futures, they seek diversification along their investment frontier to enhance their returns while reducing risk. These indexers, which have billions and billions under management, are the large pensions (and in some cases endowments) that have defined benefit plans that they are legally bound to pay out of to plan beneficiaries—retirees—in the future. It has been alleged that such indexers, due to their sheer size, are driving up the price of commodities. So far, there has been no evidence of fact to this regard. Regulating pensions and endowments out of the market or to the point where their participation would be meaningless, would be a great disservice to them and, frankly, discriminatory because of their size. Such regulatory banishment would likely come back to haunt lawmakers and tax payers, because if there was a shortfall in corpus that is due to be paid out, it would have to be made up. This would be a drama known as Social Security, Part II.

High prices are the best cure for high prices. Sound like a riddle? It could be. When prices rise to extremes, such as they did during Peak Oil, producers will run at full capacity to sell as much as they can into these high prices. The costs to produce oil is relatively static, so there is great profit potential. At the same time, consumers will consume less and less as prices rise. The confluence of the demand backing away and eventual supply glut drives prices down. There is no speculator or commodity indexer on the planet who can compete with the perfect production knowledge of Saudi Aramco or the National Iranian Oil Company (NIOC), the two largest oil producers in OPEC.

Read the entire article at The Big Picture.

Michael Martin has been a successful trader for 20 years. He’s been teaching for the last 11 of those years, mostly through UCLA Extension and the CFA Institute. You can follow him on Twitter.

As an impartial, nonprofit forum for the finance and banking industries NYSSA encourages discussion and debate among its member and other professionals. Commentaries, however, should be taken as the sole opinion of the author(s) and not of NYSSA. If you would like to submit a commentary to the Finance Professional's Post, send your article to the editor.

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Comments

I would dismiss this op-ed as a belated justification of failed policies of the Bush Administration by one of the Chicago School literalists. Yet, there are some
fallacies, which are shared by agitprop and some scholarly textbooks.

The author of the above comment uses a standard "straw man" fallacy when
the imagined opponent is ascribed subtly different and erroneous argument,
which then is refuted. Extreme market volatility would not be dangerous, if, as in neo-classical theory it were totally decoupled from the credit risk. But it is not--enter margin requirements.

Bad policies of the past decade had the same outcome as the pre-Depression
era lack of regulation: namely, the possibility of creating unsustainable leverage. Moreover, modern derivative instruments facilitate hiding this leverage
in places where one cannot see it.

This problem is especially acute for the commodity derivatives. Unlike purely
monetary instruments commodity market is ostensibly driven by supply and
demand of a physical product. With the massive avoidance of credit discipline
by the market participants, it is relatively easy and cheap: (1) to create
positions far in excess of any thinkable supply of the commodity, sometimes
in excess of the presence of this commodity in the Earth's crust, (2) to sell a portfolio containing shredded parts of these positions to the unsuspecting investors and (3) to bet against this portfolio using credit derivatives. Unlike the pre-Depression strategies of cornering the market, where the capital for cornering had to be found by operator himself, now this capital is raised from the multiple investors and counterparties against their direct financial interest. This is, in essence, what GS was doing on the housing market.

While more nuanced distinction is required between commodity derivatives, which allow only financial settlement, the others, which allow alternative delivery
of financial or physical assets and the physical delivery-only derivatives, the
market needs to be regulated. Not for the sake of reducing volatility but for
the sake of weeding out operators, who have credit risk exposures inconsistent
with their working capital.

Peter Lerner, MBA, PhD is semi-retired, teaches one business course on Manhattan and also is an author of "Price volatility in the context of market microstructure" published in "Stock Market Volatility" (G. Gregoriou, ed.)

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