January 13, 2011
I believe that releasing this proposed rule for comment in its present form while simultaneously implementing a separate “position points” directive is an attempt to set position limits that is inconsistent with the language and purpose of the Dodd-Frank Act. I believe that the proposed rule and the supplemental directive will create uncertainty regarding the regulatory standards for Commission action and enforcement in a way that does not comply with the requirements of the Administrative Procedure Act (APA). The uncertainty that will result from the publication of both the Commission’s rule proposal and a “position points” directive will stymie the ability of market participants, and specifically large commercial interests, to manage their hedging and investment strategies. Semantics and affirmations of intent will not lessen the real impact of what essentially amounts to an attempt to affect legal rights and obligations. Although the Notice of Proposed Rulemaking is identical to the one presented to the Commission at its December 16, 2010 meeting, the new “position points” directive operates as a Trojan horse by attempting to articulate a requirement of general applicability without providing an opportunity for public notice and comment. Accordingly, I have identified three serious problems with the “position points” directive, and have three recommendations for the Commission.
The Proposed Position Limits Rule and the Trojan Horse
While I believe this proposed rule is significantly improved from the Commission’s pre-Dodd-Frank proposal for imposition of position limits in certain energy contracts,1 it remains flawed by its complexity and unenforceability due to technological hurdles and a lack of reliable data in the near term. These weaknesses will not be resolved by “position points.” This proposal is an improvement because, in response to public comments, it disposes of the “crowding out” provision,2 includes a dealer look-through to the actual trader/customer for aggregation purposes, and extends the availability of the bona fide hedge exemption to swap counterparties when laying off risk relating to certain transactions. I am pleased that the proposed rule will ultimately set aggregate and single-month position limits “on any date” in the future through formulas based on actual trade data. This measure appropriately ensures that no limits will be implemented until the Commission has the ability to monitor and enforce them, and provides further assurance against unsuitable limits by providing that position limits can only be effectuated through Commission order. While this rule proposal is appropriate for public comment, the “position points” directive, which is neither discussed nor referenced anywhere in the proposed rules or preamble, undermines the critical provisions mentioned above and the rulemaking process as a whole.
At this time, two concurring statements and two colloquies accompany the current version of the Notice of Proposed Rulemaking set for vote tomorrow. Neither the statements nor the colloquies create enforceable rights and obligations or serve as reliable guidance to the entities potentially impacted by the proposed rule or directive. Even more unsettling is that a public statement regarding their content has generated support for a “position points” regime, despite the APA concerns and in ignorance of current exchange-set accountability levels and Commission programs implemented to identify large, potentially disruptive positions.
The Chairman’s directive to Commission staff to collect additional information and utilize special call authority will apply to large traders with positions in the futures markets above “position points” set at 10 and 2 ½ percent of futures and options on futures open interest in the 28 contracts for which the Commission is proposing position limits. These “position points” are identical to the position limit formulas set forth in the proposed rule which, in turn, are currently identified in Commission Regulation 150.5(c)(2) as an optional ceiling for the application of exchange-set speculative position limits. While this interim step may be well-intentioned, it is unnecessary and ultimately detrimental to the overall objective of the proposed rule. In practice, the new “position points” directive would set a new, and generally higher federal accountability level alongside the existing exchange set and enforced accountability levels. This will contribute to further uncertainty and possible market disruptions due to vagaries in Commission decision-making and undue influence from constituency pressure—all while jeopardizing the protection of privacy interests.
The Source of the Problem
I see three serious problems with the “position points” directive. First, the directive applies only to the futures markets—the only markets for which we currently have any reliable data. However, when market participants breach the “position points,” the Commission lacks any direct statutory authority, absent an exercise of emergency authority under Section 8a(9) of the Commodity Exchange Act, to order an immediate reduction when a market participant breaches the “position points.” Historically, the Commission has rarely exercised its emergency authority and reserved its use to four rather unique instances in 1976, 1977, 1979, and 1980.3
It has been publicly stated that we could force traders to reduce their positions.4 However, without position limits in place and absent an “emergency,” it is entirely unclear what levels are enforceable against market participants. The “position points” directive does not clarify this uncertainty because the levels do not substitute for federally-set position limits. If the Commission were to take its typical course of action, which includes working with the exchanges and self regulatory organizations to direct a market participant to reduce their position in the futures markets, then the practical result may be that the participant would simply move the position to the OTC markets or overseas exchanges, effectively evading the “position points” entirely. I cannot support a proposal that will encourage regulatory arbitrage and push traders out of the futures market—our most liquid, transparent, and open market.
Second, the “position points” directive fails to consider whether market participants may prospectively qualify for the bona fide hedge exemption that is currently proposed to be included in Rule 150.2. Accordingly, the “position points,” which are effectively set at the proposed position limits levels, would be applied absent consideration of bona fide hedging activities. This is not only contrary to the intent of the Dodd-Frank Act, but could lead to Commission staff engaging in ad hoc analyses to determine whether or not “position point” breaches have occurred in consideration of current Commission Regulation 1.3(z).5 Moreover, due to the lack of investment in technology, even if staff were to attempt to apply hedge exemptions of any sort under the “position points” directive, it would take an enormous amount of staff’s time and effort because the Commission’s data collection system is not automated.
Third, the “position points” directive is not part of a Commission rulemaking for which there will be notice and comment under the APA, and it is not a statement of agency-policy which will operate to guide the Commission’s exercise of discretion. Not only is it inappropriate to suggest that we should set the stage for what will amount to regular special calls and the enforcement of “position points” absent formal rulemaking or Commission adoption of policy,6 but I believe this leaves the Commission vulnerable to justified legal challenges for failure to comply with the APA.
I am opposed to identifying problems without providing solutions. Accordingly, I have three recommendations. My first recommendation is for the Commission to disregard the “position points” directive and wait for implementation of the final rule on Position Reports for Physical Commodity Swaps7 to provide trade data on the futures, options, and swaps markets before considering whether interim measures are necessary.
Second, if the “position points” directive is a preferable course of action, it should not be implemented through a colloquy, concurring statement, or press release, but rather through a formal rulemaking that includes notice and comment under the APA.
Third, I recommend that if the Commission decides to carry out the “position points” directive and exercises authority to direct traders to reduce their positions in the futures markets, the Commission should not take any action that would result in the forcible shift of positions to the OTC swap market or overseas exchanges. In addition, prior to taking any adverse action against a market participant, the Commission should ascertain whether the futures position in question is utilized for offsetting commercial risk, and is therefore eligible for the bona fide hedge exemption under the proposed rulemaking. Regardless of the course of action, the Commission must endeavor to abide by the mandates of the Dodd-Frank Act.
The Proposed Rule—Further Questions
I understand that the Commission will likely vote to approve the release of the Notice of Proposed Rulemaking for Position Limits for Derivatives. To reiterate, I am supportive of the key reforms made in response to public comments received in the prior Commission rulemaking. I still have several concerns on which I hope the public will provide comment. I am interested to understand whether federalizing exchange-established position limits based on estimated deliverable supply for the spot month limits is appropriate, and whether the process for setting such limits is sufficiently transparent and accurate, or whether it should be revised? I am also concerned about the class limits provision imposed in this rulemaking, which appears to prohibit netting across the futures and swaps markets once a trader reaches a certain level. The proposed rule would allow entities to net their swaps and futures positions up to the point where they reach a proposed position limit in either class. For example, once the limit is reached in the futures market, no amount of sales in the swaps market would have the effect of reducing the futures positions. I am interested to know what impact this is likely to have on these markets and the trading strategies of market participants.
I believe this proposed rulemaking, separate from and in contrast to the “position points” directive, is a more realistic approach to the challenges we face in implementing position limits without actual trade data. The data will eventually be collected by the Commission, and it is incumbent on us to make the necessary investment to automate our forms and reporting systems and upgrade our analytical tools. This investment is critical to ensure that (1) we can see across all markets, and (2) legitimate hedging strategies are not negatively impacted by this proposed rule.
I do not believe that the absence of position limits has had any impact on prices in the past, and I do not believe that setting them now will be effective in preventing a barrel of oil from going over $100/barrel. Today, oil prices continue to hover around $90/barrel. As global economic growth increases, prices will continue to rise as long as we continue to rely on foreign countries and cartels to provide more than 60 percent of our national oil demand. Regardless of my position, much of the pressure to immediately implement position limits/“position points” comes from those who advocate the need for price controls. It is not the role of the Commission to control prices, and I do not think that position limits/”position points” will prove effective in doing that. Nevertheless, I would be happy to be shown otherwise. It is my hope that in response to the proposed rules, market participants, academics, and members of the public provide data and research which demonstrates that the imposition of federal position limits will stifle upward price momentum.
When all is said and done, I want to make sure that the rules this Commission implements are clear, coherent, and do not grossly detract from the important goals of price discovery, fair competition, and financial integrity in our markets.
1 Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations, 75 Fed. Reg. 4144 (proposed Jan. 26, 2010) (to be codified at 17 C.F.R. pts. 1, 20, and 151).
2 Id. at 4159-4160.
3 See History of the CFTC, http://www.cftc.gov/About/HistoryoftheCFTC/index.htm.
4 Statement of Commissioner Bart Chilton Regarding Position Limits and Interim Position Points (Jan. 4, 2011), available at http://www.cftc.gov/pressroom/speechestestimony/chiltonstatement010411.html.
5 Commission Regulation 1.3(z), 17 C.F.R. § 1.3(z) (2010) is a provision that defines “bona fide hedging transactions and positions” and applies to positions subject to Regulation 150.2, 17 C.F.R. §150.2 (2010).
6 See 17 C.F.R. § 21 (2010). Even the reach of the Chairman’s authority to direct staff, under Part 21 of the Commission Regulations, to exercise special call authority is tempered. Under Part 21, special call authority remains with either the Commission or with the Director of the Division of Market Oversight until the Commission orders otherwise. Such authority does not currently reside with the Chairman or with any individual Commissioner.
7 Position Reports for Physical Commodity Swaps, 75 Fed. Reg. 67258 (proposed Nov. 2, 2010) (to be codified at 17 C.F.R. pts. 15 and 20).
Last Updated: January 18, 2011