October 18, 2011
I respectfully dissent from the action taken today by the Commission to issue final rules relating to position limits for futures and swaps. While I have a number of serious concerns with this final rule, my principal disagreement is with the Commission’s restrictive interpretation of the statutory mandate under Section 4a of the Commodity Exchange Act (“CEA” or “Act”) to establish position limits without making a determination that such limits are necessary and effective in relation to the identifiable burdens of excessive speculation on interstate commerce.
While I agree that the Commission has been directed to establish position limits applicable to futures, options, and swaps that are economically equivalent to such futures and options (for exempt and agricultural commodities as defined by the Act), I disagree that our mandate provides for so little discretion in the manner of its execution. Throughout the preamble, the Commission uses, “Congress did not give the Commission a choice”1 as a rationale in adopting burdensome and unmanageable rules of questionable effectiveness. This statement, in all of its iterations in this rule, is nothing more than hyperbole used tactfully to support a politically-driven overstatement as to the threat of “excessive speculation” in our commodity markets. In aggrandizing a market condition that it has never defined through quantitative or qualitative criteria in order to justify draconian rules, the Commission not only fails to comply with Congressional intent, but misses an opportunity to determine and define the type and extent of speculation that is likely to cause sudden, unreasonable and/or unwarranted commodity price movements so that it can respond with rules that are reasonable and appropriate.
In relevant part, section 4a(a)(1) of the Act states: “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery . . . or swaps . . . causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.” Section 4a(a)(1) further defines the Commission’s duties with regard to preventing such price fluctuations through position limits, clearly stating: “For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits . . . as the Commission finds are necessary to diminish, eliminate, or prevent such burden.” Congress could not be more clear in its directive to the Commission to utilize not only its expertise, but the public rulemaking process, each and every time it determines to establish position limits to ensure that such limits are essential and suitable to combat the actual or potential threats to commodity prices due to excessive speculation.
An Ambiguously Worded Mandate Does Not Relieve the Commission of Its Duties Under the Act
Historically, the Commission has taken a much more disciplined and fact-based approach in considering the question of positions limits; a process that is lacking from the current proposal. The general authority for the Commission to establish “limits on the amounts of trading which may be done or positions which may be held . . . as the Commission finds are necessary to diminish, eliminate, or prevent” the “undue burdens” associated with excessive speculation found in section 4a of the Act has remained unchanged since its original enactment in 1936 and through subsequent amendments, including the Dodd-Frank Act.2 Over thirty years ago, on December 2, 1980, the Commission, pursuant in part to its authority under section 4a (1) of the Act, issued a proposal to implement rules requiring exchanges to impose position limits on contracts that were not currently subject to Commission imposed limits.3
In support of its proposal, the Commission relied on a June 1977 report on speculative limits prepared by the Office of the Chief Economist (the “Staff Report”). The Staff Report addressed three major policy questions: (1) whether there should be limits and for what groups of commodities; (2) what guidelines are appropriate in setting the level of limits; and (3) whether the Commission or the exchange should set the limits.4, 5 In considering these questions, the Staff Report noted, “Although the Commission is authorized to establish speculative limits, it is not required to do so.”6 In its Interpretation of the above language in section 4a, the Staff Report at the outset provided the legal context for its study as follows:
[T]he Commission need not establish speculative limits if it does not find that excessive speculation exists in the trading of a particular commodity. Furthermore, apparently, the Commission does not have to establish limits if it finds that such limits will not effectively curb excessive speculation.7
While not directly linked to the statutory language of section 4a or an interpretation of such language, the Staff Report utilized its findings to formulate a policy for the Commission to move forward, which, based on comments to the Commission’s January 2011 proposal,8 is clearly embodied in the purpose and spirit of the Act:
Perhaps the most important feature brought out in the study is that, prior to the adoption of speculative position limits for any commodity in which limits are not now imposed by CFTC, the Commission should carefully consider the need for and effectiveness of such limits for that commodity and the resources necessary to enforce such limits.9
In its final rule, published in the Federal Register on October 16, 1981—almost exactly thirty years ago today—the Commission chose to base its determination on Congressional findings embodied in section 4a(1) of the Act that excessive speculation is harmful to the market, and a finding that speculative limits are an effective prophylactic measure. The Commission did not do so because it found that more specific determinations regarding the necessity and effectiveness of position limits were not required. Rather, the Commission was fashioning a rule “to assure that the exchanges would have an opportunity to employ their knowledge of their individual contract markets to propose the position limits they believe most appropriate.”10 Moreover, none of the commenters opposing the adoption of limits for all markets demonstrated to the Commission that its findings as to the prophylactic nature of the proposal before them were unsubstantiated.11 Therefore, the Commission did not eschew a requirement to demonstrate whether position limits were necessary and would be effective—it delegated these determinations to the exchanges.
Today, the Commission reaffirms its proposed interpretation of amended section 4a that in setting position limits pursuant to directives in sections 4a(a)(2)(A), 4a(a)(3) and 4a(a)(5), it need not first determine that position limits are necessary before imposing them or that it may set limits only after conducting a complete study of the swaps market.12 Relying on the various directives following “shall,” the Commission has bluntly stated that “Congress did not give the Commission a choice.”13 This interpretation ignores the plain language in the statute that the “shalls” in sections 4a(a)(2)(A), 4a(a)(3) and 4a(a)(5) are connected to the modifying phrase, “as appropriate.” Although the Commission correctly construes the “as appropriate” language in the context of the provisions as a whole to direct the Commission to exercise its discretion in determining the extent of the limits that Congress “required” it to impose, the Commission ignores the fact that in the context of the Act, such discretion is broad enough to permit the Commission to not impose limits if they are not appropriate. Though a permissible interpretation, the Commission’s narrow view of its authority permeates the final rules today and provides a convenient rationale for many otherwise unsustainable conclusions, especially with regard to the cost-benefit analysis of the rule.
Section 4a(a)(2)(A), in relevant part, states that the Commission “shall by rule, regulation, or order establish limits on the amount of positions, as appropriate” that may be held by any person in physical commodity futures and options contracts traded on a designated contract market (DCM). In section 4a(a)(5), Congress directed that the Commission “shall establish limits on the amount of positions, including aggregate position limits, as appropriate” that may be held by any person with respect to swaps. Section 4a(a)(3) qualifies the Commission’s authority by directing it so set such limits “required” by section 4a(a)(2), “as appropriate . . . [and] to the maximum extent practicable, in its discretion” (1) to diminish, eliminate, or prevent excessive speculation as described under this section (section 4a of the Act), (2) to deter and prevent market manipulation, squeezes, and corners, (3) to ensure sufficient market liquidity for bona fide hedgers, and (4) to ensure that the price discovery function of the underlying market is not disrupted.14
Congress, in repeatedly qualifying its mandates with the phrase “as appropriate” and by specifically referring back to the Commission’s authority to set position limits as proscribed in section 4a(a)(1), clearly did not relieve the Commission of any requirement to exercise its expertise and set position limits only to the extent that it can provide factual support that such limits will diminish, eliminate or prevent excessive speculation.15 Instead, by directing the Commission to establish limits “as appropriate,”16 Congress intended to provide the Commission with the discretion necessary to establish a position limit regime in a manner that will not only protect the markets from undue burdens due to excessive speculation and manipulation, but that will also provide for market liquidity and price discovery in a level playing field while preventing regulatory arbitrage.17
I agree with commenters who argued that the Commission is directed under its new authority to set position limits “as appropriate,” or in other words meaning that whatever limits the Commission sets are supported by empirical evidence demonstrating that those would diminish, eliminate, or prevent excessive speculation.18 In the absence of such evidence, I also agree with commenters that we are unable, at this time, to fulfill the mandate and assure Congress and market participants that any such limits we do establish will comply with the statutory objectives of section 4a(a)(3). And, to be clear, without empirical data, we cannot assure Congress that the limits we set will not adversely affect the liquidity and price discovery functions of affected markets. The Commission will have significant additional data about the over-the-counter (OTC) swaps markets in the next year, and at a minimum, I believe it would be appropriate for the Commission to defer any decisions about the nature and extent of position limits for months outside of the spot-month, including any determinations as to appropriate formulas, until such time as we have had a meaningful opportunity to review and assess the new data and its relevance to any determinations regarding excessive speculation. At a future date, when the Commission applies the second phase of the position limits regime and sets the non-spot-month limits (single and all-months combined limits), I will work to ensure that the position formulas and applicable limits are validated by Commission data to be both appropriate and effective so that those limits truly “diminish, eliminate, or prevent excessive speculation.”
An Absence of Justification
Today the Commission voted to move forward on a rule that (1) establishes hard federal position limits and position limit formulas for 28 physical commodity futures and options contracts and physical commodity swaps that are economically equivalent to such contracts in the spot-month, for single months, and for all-months combined; (2) establishes aggregate position limits that apply across different trading venues to contracts based on the same underlying commodity; (3) implements a new, more limited statutory definition of bona fide hedging transactions; (4) revises account aggregation standards; (5) establishes federal position visibility reporting requirements; and (6) establishes standards for position limits and position accountability rules for registered entities. The Commission voted on this multifaceted rule package without the benefit of performing an objective factual analysis based on the necessary data to determine whether these particular limits and limit formulas will effectively prevent or deter excessive speculation. The Commission did not even provide for public comment a determination as to what criteria it utilized to determine whether or not excessive speculation is present or will potentially threaten prices in any of the commodity markets affected by the new position limits.
Moreover, while it engaged in a public rulemaking, the Commission’s Notice of Proposed Rulemaking,19 in its complexity and lack of empirical data and legal rationale for several new mandates and changes to existing policies—in spite of the fact that we largely rely on our historical experiences in setting such limits—tainted the entire process. By failing to put forward data evidencing that commodity prices are threatened by the negative influence of a defined level of speculation that we can define as “excessive speculation,” and that today’s measures are appropriate (i.e. necessary and effective) in light of such findings, I believe that we have failed under the Administrative Procedure Act to provide a meaningful and informed opportunity for public comment.20
Substantive comment letters, of which there were approximately 100,21 devoted at times substantial text to expressions of confusion and requests for clarification of vague descriptions and processes. In more than one instance, preamble text did not reflect proposed rule text and vice versa.22 Indeed, the entire rulemaking process has been plagued by internal and public debates as to what the Commission’s motives are and to what extent they are based on empirical evidence, in policy, or are simply without reason.
Implementing An Appropriate Program for Position Management
This rule, like several proposed before it, fails to make a compelling argument that the proposed position limits, which only target large concentrated positions,23 will dampen price distortions or curb excessive speculation—especially when those position limits are identified by the overall participation of speculators as an increased percentage of the market. What the rule argues is that there is a Congressional mandate to set position limits, and therefore, there is no duty on the Commission to determine that excessive speculation exists (and is causing price distortions), or to “prove that position limits are an effective regulatory tool.”24 This argument is incredibly convenient given that the proposed position limits are modeled on the agricultural commodities position limits, and despite those federal position limits, contracts such as wheat, corn, soybeans, and cotton contracts were not spared record-setting price increases in 2007 and 2008. Indeed, the cotton No. 2 futures contract has hit sixteen “record-setting” prices since December 1, 2010. The most recent high was set on March 4, 2011 when the March 2011 future traded at a price of $215.15.
To be clear, I am not opposed to position or other trading limits in all circumstances. I remain convinced that position limits, whether enforced at the exchange level or by the Commission, are effective only to the extent that they mitigate potential congestion during delivery periods and trigger reporting obligations that provide regulators with the complete picture of an entity’s trading. I therefore believe that accountability levels and visibility levels provide a more refined regulatory tool to identify, deter, and respond in advance to threats of manipulation and other non-legitimate price movements and distortions. I would have supported a rule that would impose position limits in the spot-month for physical commodities, i.e. the referenced contracts,25 and would establish an accountability level. The Commission’s ability to monitor such accountability levels would rely on a technology based, real-time surveillance program that the Commission must be committed to deploying if it is to take its market oversight mission seriously.
And to be absolutely clear, “speculation” in the world of commodities is a technical term ascribed to any trading that does not qualify as “bona fide hedging.” Congress has not outlawed speculation, even when that speculation reaches some unspecified tipping point where it becomes “excessive.” What Congress has stated, for over seventy years until the passage of the Dodd-Frank Act, is that excessive speculation that causes sudden or unreasonable fluctuations or unwarranted changes in the price of a commodity is a burden on interstate commerce, and the Commission has authority to utilize its expertise to establish limits on trading or positions that will be effective in diminishing, eliminating, or preventing such burden.26 The Commission, however, is not, and has never been, without other tools to detect and deter those who engage in abusive practices.27 What the Dodd-Frank Act did do is direct the Commission to exercise its authority at a time when there is simply a lack of empirical data to support doing so, in a universe of legal uncertainty. However, the Dodd-Frank Act did not leave us without a choice, as contended by today’s rule. Rather, against the current backdrop of market uncertainty, and Congress’s longstanding deference to the expertise of the Commission, the most reasonable interpretation of Dodd-Frank’s mandate is that while we must take action and establish position limits, we must only do so to the extent they are appropriate.
Today I write to not only reiterate my concerns with regard to the effectiveness of position limits generally, but to highlight some of the regulatory provisions that I believe pose the greatest fundamental problems and/or challenges to the implementation of the rule passed today. In addition to disagreeing with the Commission’s interpretation of its statutory mandate, I believe the Commission has so severely restricted the permitted activities allowed under the bona fide hedging rules that the pursuit by industry of legitimate and appropriate risk management is now made unduly onerous. These limitations, including a veritable ban on anticipatory hedging for merchandisers, are inconsistent with the statutory directive and the very purpose of the markets to, among other things, provide for a means for managing and assuming price risks. I also believe that the rules put into place overly broad aggregation standards, fail to substantiate claims that they adequately protect against international regulatory arbitrage, and do not include an adequate cost-benefit analysis.
Bona Fide Hedging: Guilty Until Proven Innocent
The Commission’s regulatory definition of bona fide hedging transactions in §151.5 of the rules, as directed by new section 4a(c)(1) of the Act, generally restricts bona fide hedge exemptions from the application of federally-set position limits to those transactions or positions which represent a substitute for an actual cash market transaction taken or to be taken later, or those trading as the counterparty to an entity that it engaged in such transaction. This definition is narrower than current Commission regulation 1.3(z)(1), which allows for an exemption for transactions or positions that normally represent a substitute for a physical market transaction.
When combined with the remaining provisions of §151.5, which provide for a closed universe of enumerated hedges and ultimately re-characterize longstanding acceptable bona fide hedging practices as speculative, it is evident that the Commission has used its authority to further narrow the availability of bona fide hedging transactions in a manner that will negatively impact the cash commodity markets and the physical commodity marketplace by eliminating certain legitimate derivatives risk management strategies, most notably anticipatory hedging. Among other things, I believe the Commission should have defined bona fide hedging transactions and positions more broadly so that they encompass long-standing risk management practices and should have preserved a process by which bona fide hedgers could expeditiously seek exemptions for non-enumerated hedging transactions.
In this instance, Congress was particularly clear in its mandate under section 4a(c)(2) that the Commission must limit the definition of bona fide hedging transactions/positions to those that represent actual substitutes for cash market transactions, but Congress did not so limit the Commission in any other manner with regard to the new regulatory provisions addressing anticipatory hedging and the availability of non-enumerated hedges.28 Moreover, inasmuch as the bona fide hedging definition is restrictive, section 4a(a)(7) provides the Commission broad exemptive authority which it could have utilized to create a process for expeditious adjudication of petitions from entities relying on a broader set of legitimate trading strategies that those that fit the confines of section 4a(c)(1). In addition, given the complex, multi-faceted nature of hedging for commodity-related risks, the Commission could have, as suggested by one commenter, engaged in a separate and distinct informal rulemaking process to develop a workable, commercially practicable definition of bona fide hedging.29 Given the commercial interests at stake, this would have been a welcome approach. Instead, the Commission chose form over function so that it could “check the box” on its mandate.
In order to qualify as a bona fide hedging transaction or position, a transaction must meet both the requirements under §151.5(a)(1) and qualify as one of eight specific and enumerated hedging transactions described in §151.5(a)(2). While the list of enumerated hedging transactions is an improvement from the proposed rules, and responds to several comments, especially with regard to the addition of an Appendix B to the final rule describing examples of bona fide hedging transactions, it remains inflexible. In response to commenters, the Commission has decided – at the last minute – to permit entities engaging in practices that reduce risk but that may not qualify as one of the enumerated hedging transactions under §151.5(a)(2) to seek relief from Commission staff under § 140.99 or the Commission under section 4a(a)(7) of the CEA. Whereas this change to the preamble and the rule text is helpful, neither of these alternatives provides for an expeditious determination, nor do they provide for a predictable or certain outcome. In its refusal to accommodate traders seeking legitimate bona fide hedging exemptions in compliance with the Act with an expeditious and straightforward process, the Commission is being short-sighted in light of the dynamic (and in the case of the OTC markets, uncertain) nature of the commodity markets and with respect to the appropriate use of Commission resources.
One particularly glaring example of the Commission’s decision to pursue form over function is found in the enumerated exemption for anticipated merchandising found at §151.5(2)(v). The new statutory provision in section 4a(c)(d)(A)(ii) is included to assuage unsubstantiated concerns about unintended consequences such as creating a potential loophole for clearly speculative activity.30 The Commission has so narrowly defined the anticipated merchandising that only the most elementary operations will be able to utilize it.
For example, in order to qualify an anticipatory merchandising transaction as a bona fide hedge, a hedger must (i) own or lease storage capacity and demonstrate that the hedge is no greater than the amount of current or anticipated unfilled storage capacity owned or leased by the same person during the period of anticipated merchandising activity, which may not exceed one year, (ii) execute the hedge in the form of a calendar spread that meets the “appropriateness” test found in §151.5(a)(1), and (iii) exit the position prior to the last five days of trading if the Core Referenced Futures Contract is for agricultural or metal contracts or the spot month for other physical-delivery commodities. In addition, (iv) an anticipatory merchandiser must meet specific filing requirements under §151.5(d), which among other things, (v) requires that the person who intends on exceeding position limits complete the filing at least ten days prior to the date of expected overage.
Putting the burdens associated with the §151.5(d) filings aside, the anticipatory merchandising exemption and its limitations on capacity, the requirement to “own or lease” such capacity, and one-year limitation for agricultural commodities does not comport with the economic realities of commercial operations. In recent testimony, Todd Thul, Risk Manager for Cargill AgHorizons, commented on its understanding of this provision. He said that by limiting the exemption to unfilled storage capacities through calendar spread positions for one year, the CFTC will reduce the industry’s ability to continue offering the same suite of marketing tools to farmers that they are accustomed to using.31 Mr. Thul offered a more reasonable and appropriate limitation on anticipatory hedging based on annual throughput actually handled on a historic basis by the company in question. It is unclear from today’s rule as to whether the Commission considered such an alternative, but according to Mr. Thul, by going forward with the exemption as-is, we will “severely limit the ability of grain handlers to participate in the market and impede the ability to offer competitive bids to farmers, manage risk, provide liquidity and move agriculture products from origin to destination.”32, 33 Limiting commercial participation, Mr. Thul points out, increases volatility—and that is clearly not what Congress intended. I agree. I cannot help but think that the Commission is waging war on commercial hedging by employing a “government knows best” mandate to direct companies to employ only those hedging strategies that we give our blessing to and can conceive of at this point in time. Imagine the absurdity that we could prevent a company such as a cotton merchandiser from hedging forward a portion of his expected cotton purchase. Or, if they meet the complicated prerequisites, the commercial firm must get approval from the Commission before deploying a legitimate commercial strategy that exchanges have allowed for years.
In another attack on commercial hedging the Commission has developed a flawed aggregation rule that singles out owned-non financial firms for unique and unfair treatment under the rule. These commercial firms, which, among others, could be energy producers or merchandisers, are not provided the same protections under the independent controller rules as financial entities such as hedge funds or index funds. I believe that the aggregation provisions of the final rule would have benefited from a more thorough consideration of additional options and possible re-proposal of at least two provisions: the general aggregation provision found in §151.7(b) and the proposed aggregation for exemption found in §151.7(f) of the proposed rule,34 now commonly referred to at the Commission as the owned non-financial exemption or “ONF.”
Under §151.7(b), absent the applicability of a specific exemption found elsewhere in §151.7, a direct or indirect ownership interest of ten percent or greater by any entity in another entity triggers a 100% aggregation of the “owned” entity’s positions with that of the owner. While commenters agreed that an ownership interest of ten percent or greater has been the historical basis for requiring aggregation of positions under Commission regulation §150.5(b), absent applicable exemptions, historically, aggregation has not been required in the absence of indicia of control over the “owned” entity’s trading activities, consistent with the independent account controller exemption (the “IAC”) under Commission regulation §150.3(a)(4). While the final rule preserves the IAC exemption, it only does so in response to overwhelming comments arguing against its proposed elimination, which was without any legal rationale.35 And, to be clear, the IAC is only available to “eligible entities” defined in §151.1, namely financial entities, and only with respect to client positions.
The practical effect of this requirement is that non-eligible entities, such as holding companies who do not meet any of the other limited specified exemptions will be forced to aggregate on a 100% basis the positions of any operating company in which it holds a ten percent or greater equity interest in order to determine compliance with position limits. While the Commission concedes that the holding company could conceivably enter into bona fide hedging transactions relating to the operating company’s cash market activities, provided that the operating company itself has not entered into such hedges,36 this is an inadequate, operationally-impracticable solution to the problem of imparting ownership absent control. Moreover, by requiring 100% aggregation based on a ten percent ownership interest, the Commission has determined that it would prefer to risk double-counting of positions over a rational disaggregation provision based on a concept of ownership that does not clearly attach to actual control of trading of the positions in question.
Exemptions like those found in §§151.7(g) and (i) that provide for disaggregation when ownership above the ten percent threshold is specifically associated with the underwriting of securities or where aggregation across commonly-owned affiliates would require information sharing that would result in a violation of federal law, are useful and no doubt appreciated. However, the Commission has failed to apply a consistent standard supporting the principles of ownership and control across all entities in this rulemaking.
Tiered Aggregation – A Viable and Fair Solution
Also, the Commission did not address in the final rules a proposal put forth by Barclays Capital for the Commission to clarify that when aggregation is triggered, and no exemption is available, only an entity’s pro rata share of the position that is actually controlled by it, or in which it has an ownership interest will be aggregated. This proposal included a suggestion that the Commission consider positions in tiers of ownership, attributing a percentage of the positions to each tier. While Barclays acknowledged that the monitoring would still be imperfect, the measures would be more accurate than an attribution of a full 100% ownership and would decrease the percentage of duplicative counting of positions.37
I believe that a tiered approach to aggregation should have been considered in these rules, and not be entirely removed from consideration as we move forward with these final rules. Barclays (and perhaps others) has made a compelling case and staff has not persuaded me that there is any legal rationale for not further exploring this option. While I understand that it may be more administratively burdensome for the Commission to monitor tiered aggregation, I would presume that we could engage in a cost-benefit analysis to more fully explore such burdens in light of the potential costs to industry associated with the implementation of 100% aggregation.
Owned Non-Financial – No Justification
The best example of the Commission’s imbalanced treatment of market participants is manifest in the aggregation rules applied to owned non-financial firms. The Commission has shifted its aggregation proposal from the draft proposal to this final version. The final rule does not ultimately adopt the proposed owned-non-financial entity exemption which was proposed in lieu of the IAC to allow disaggregation primarily in the case of a conglomerate or holding company that “merely has a passive ownership interest in one or more non-financial companies.”38 The rationale was that, in such cases, operating companies would likely have complete trading and management independence and operate at such a distance that is would simply be inappropriate to aggregate positions.39 While several commenters argued that the ONF was too narrow and discriminated against financial entities without a proper basis, the Commission provided no substantive rationale for its decision to fully drop the ONF exemption from consideration. Instead, the Commission relied upon its determination to retain the IAC exemption and add the additional exemptions under §§151.7(g) and (i) described above to find that it “may not be appropriate, at this time, to expand further the scope of disaggregation exemptions to owned-non financial entities.”
In failing to articulate a basis for its decision to drop outright from consideration the ONF exemption, the Commission places itself in the same improvident position it was in when it proposed eliminating the IAC exemption, and now has given no reasoned explanation for discriminating against non-financial entities. This is especially disconcerting since at least one commenter has pointed out that baseless decision-making of this kind creates a risk that a court will strike down our action as arbitrary and capricious.40
Since I first learned of the Commission’s change of course, I have requested that the Commission re-propose the ONF exemption in a manner that establishes an appropriate legal basis and provides for additional public comment pursuant to the Administrative Procedure Act. The Commission has outright refused to entertain my request to even include in the preamble of the final rules a commitment to further consider a version of the ONF exemption that would be more appropriate in terms of its breadth. The Commission’s decision puts the rule at risk of being overturned by the courts and exemplifies the pains at which this rule has been drafted to put form over function.
The Great Unknown: International Regulatory Arbitrage
In addressing concerns relating to the opportunities for regulatory arbitrage that may arise as a result of the Commission imposing these position limits, the Commission points out that is has worked to achieve the goal of avoiding such regulatory arbitrage through participation in the International Organization of Securities Commissions (“IOSCO”) and summarily rejects commenters who believe it is a foregone conclusion that the existence of international differences in position limit policies will result in such arbitrage in reliance on prior experience. While I don’t disagree that the Commission’s work within IOSCO is beneficial in that it increases the likelihood that we will reach international consensus with regard to the use of position limits, the Commission ought to be more forthcoming as to principles as a whole.
In particular, while the IOSCO Final Report on Principles for the Regulation and Supervision of Commodity Derivatives Markets41 does, for the first time, call on market authorities to make use of intervention powers, including the power to set ex-ante position limits, this is only one of many such recommendations that international market authorities are not required to implement. The IOSCO Report includes the power to set position limits, including less restrictive measures under the more general term “position management.” Position Management encompasses the retention of various discretionary powers to respond to identified large concentrations. It would have been preferable for the Commission to have explored some of these other discretionary powers as options in this rulemaking, thereby putting us in the right place to put our findings into more of a practice.
As to the Commission’s stance that today’s rules will not, by their very passage, drive trading abroad, I am concerned that the Commission’s prior experience in determining the competitive effects of regulatory policies is inadequate. Today’s rules by far represent the most expansive exercise of the Commission’s authority both with regard to the setting of position limits and with regard to its jurisdiction in the OTC markets. The Commission’s past studies regarding the effects of having a different regulatory regime than our international counterparts, conducted in 1994 and 1999, cannot possibly provide even a baseline comparison. Since 2000, the volume of actively traded futures and option contracts on U.S. exchanges alone has increased almost tenfold. Electronic trading now represents 83% of that volume, and it is not too difficult to imagine how easy it would be to take that volume global.
I recognize that we cannot dictate how our fellow market authorities choose to structure their rules and that in any action we take, we must do so with the knowledge that as with any rules, we risk triggering a regulatory race to the bottom. However, I believe that we ought not to deliver to Congress, or the public, an unsubstantiated sense of security in these rules.
Cost-Benefit Analysis: Hedgers Bear the Brunt of an Undue and Unknown Burden
With every final rule, the Commission has attempted to conduct a more rigorous cost-benefit analysis. There is most certainly an uncertainty as to what the Commission must do in order to justify proposals aimed at regulating the heretofore unregulated. These analyses demonstrate that the Commission is taking great pains to provide quantifiable justifications for its actions, but only when reasonably feasible. The baseline for reasonability was especially low in this case because, in spite of the availability of enough data to determine that this rule will have an annual effect on the economy of more than $100 million, and the citation of at least fifty-two empirical studies in the official comment record debating all sides of the excessive speculation debate, the Commission is not convinced that it must “determine that excessive speculation exists or prove that position limits are an effective regulatory tool.”42 I suppose this also means that the Commission did not have to consider the costs of alternative means by which it could have complied with the statutory mandates. It is utterly astounding that the Commission has designed a rule to combat the unknown threat of “excessive speculation” that will likely cost market participants $100 million dollars annually and yet, “[T]he Commission need not prove that such limits will in fact prevent such burdens.”43 A flip remark such as this undermines the entire rule, and invites legal challenge.
I respect that the Commission has been forthcoming in that the overall costs of this final rule will be widespread throughout the markets and that swap dealers and traditional hedgers alike will be forced to change their trading strategies in order to comply with the position limits. However, I am unimpressed by the Commission’s glib rationale for not fully quantifying them. The Commission does not believe it is reasonably feasible to quantify or even estimate the costs from changes in trading strategies because doing so would necessitate having access to and an understanding of entities’ business models, operating models, hedging strategies, and evaluations of potential alternative hedging or business strategies that would be adopted in light of such position limits.44 The Commission believed it impractical to develop a generic or representative calculation of the economic consequences of a firm altering its trading strategies.45 It seems that the numerous swap dealers and commercial entities who provided comments as to what kind of choices they would be forced to make if they were to find themselves faced with hard position limits, the loss of exchange-granted bona fide hedge exemptions for risk management and anticipatory hedging, and forced aggregation of trading accounts over which they may not even have current access to trading strategies or position information, more likely than not thought they were being pretty clear as to the economic costs.
In choosing to make hardline judgments with regard to setting position limits, limiting bona fide hedging, and picking clear winners and losers with regard to account aggregation, the Commission was perhaps attempting to limit the universe of trading strategies. Indeed, as one runs through the examples in the preamble and the new Appendix B to the final rules, one cannot help but conclude that how you choose to get your exposure will affect the application of position limits. And the Commission will help you make that choice even if you aren’t asking for it.
I have numerous lingering questions and concerns with the cost-benefit analysis, but I will focus on the impact of these rules on the costs of claiming a bona fide hedge exemption.
In addition to incorporating the new, narrower statutory definition of bona fide hedging for futures contracts into the final rules, the Commission also extended the definition of bona fide hedging transactions to swaps and established a reporting and recordkeeping regime for bona fide hedging exemptions. In the section of the cost-benefit analysis dedicated to a discussion of the bona fide hedging exemptions, the Commission “estimates that there may be significant costs (or foregone benefits)” and that firms “may need to adjust their trading and hedging strategies” (emphasis added)46 Based on the comments of record and public contention over these rules, that may be the understatement of the year. To be clear, however, there is no quantification or even qualification of this potentially tectonic shift in how commercial firms and liquidity providers conduct their business because the Commission is unable to estimate these kinds of costs, and the commenters did not provide any quantitative data for them to work with.47 I think this part of the cost-benefit analysis may be susceptible to legal challenge.
The Commission does attempt a strong comeback in estimating the costs of bona fide hedging-related reporting requirements. The Commission estimates that these requirements, even after all of the commenter-friendly changes to the final rule, will affect approximately 200 entities annually and result in a total burden of approximately $29.8 million. These costs, it argues, are necessary in that they provide the benefit of ensuring that the Commission has access to information to determine whether positions in excess of a position limit relate to bona fide hedging or speculative activity.48 This $29.8 million represents almost thirty percent of the overall estimated costs at this time, and it only covers reporting for entities seeking to hedge their legitimate commercial risk. I find it difficult to believe that the Commission cannot come up with a more cost-effective and less burdensome alternative, especially in light of the current reporting regimes and development of universal entity, commodity, and transaction identifiers. I was not presented with any other options. I will, however, continue to encourage the rulemaking teams to communicate with one another in regard to progress in these areas and ensure that the Commission’s new Office of Data and Technology is tasked with the permanent objective of exploring better, less burdensome, and more cost-efficient ways of ensuring that the Commission receives the data it needs.
We Have Done What Congress Asked—But, What Have We Actually Done?
The consequence is that in its final iteration, the position limits rule represents the Commission’s desire to “check the box” as to position limits. Unfortunately, in its exuberance and attempt to justify doing so, the Commission has overreached in interpreting its statutory mandate to set position limits. While I do not disagree that the Commission has been directed to impose position limits, as appropriate, this rule fails to provide a legally sound, comprehensible rationale based on empirical evidence. I cannot support passing our responsibilities on to the judicial system to pick apart this rule in a multitude of legal challenges, especially when our action could negatively affect the liquidity and price discovery function of our markets, or cause them to shift to foreign markets. I also have serious reservations regarding the excessive regulatory burden imposed on commercial firms seeking completely legitimate and historically provided relief under the bone fide hedge exemption. These firms will spend excessive amounts to remain within the strict limitations set by this rule. Congress clearly conceived of a much more workable and flexible solution that this Commission has ignored.
In its comment letter of March 25, 2011, the Futures Industry Association (FIA) stated, “The price discovery and risk-shifting functions of the U.S. derivatives markets are too important to U.S. and international commerce to be the subject of a position limits experiment based on unsupported claims about price volatility caused by excessive speculative positions.”49 Their summation of our proposal as an experiment is apt. Today’s final rule is based on a hypothesis that historical practice and approach, which has not been proven effective in recognized markets, will be appropriate for this new integrated futures and swaps market that is facing uncertainty from all directions largely due to the other rules we are in the process of promulgating. I do not believe the Commission has done its research and assessed the impacts of testing this hypothesis, and that is why I cannot support the rule. As the Commission begins to analyze the results of its experiment, it remains my sincerest hope that our miscalculations ultimately do not lead to more harm than good. I will take no comfort if being proven correct means that the agency has failed in its mission.
1 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
2 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
3 Speculative Position Limits, 45 FR 79831 (proposed Dec. 2, 1980) (to be codified at 17 CFR pt. 1).
4 Id. at 79832; Speculative Limits: a staff paper prepared for Commission discussion by the Office of the Chief Economist at 1, June 24, 1977.
5 The Staff Report ultimately made four general recommendations. First, the Commission ought to adopt a policy of establishing speculative limits only in those markets where the characteristics of the commodity, its marketing system, and the contract lend themselves to undue influence from large scale speculative positions. Second, that in markets where limits are deemed to be necessary, such limits should only be established to curtail extraordinary speculative positions which are not offset by comparable commercial positions. Third, there ought to be no limits on daily trading except to the extent that the limits would prevent the accumulation of large intraday positions. Fourth, in markets where limits are deemed necessary, the exchange should set and review the limits subject to Commission approval. Office of Chief Economist, supra note 4, at 5-6.
6 Office of Chief Economist, supra note 4, at 7.
7 Id. at 7-8.
8 See, e.g., Comment letter from Futures Industry Association on Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 6-7 (Mar. 25, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=34054&SearchText=futures%20industry%20association; Comment letter from CME Group on Position Limits for Derivatives at 1-7 (Mar. 28, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=33920&SearchText=cme; and Comment Letter of International Swaps and Derivatives Association, Inc. and Securities Industry and Financial Markets Association on Notice of Proposed Rulemaking – Position Limits for Derivatives (RIN 3038-AD15 and 3038-AD16) at 3-6 (Mar. 28, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=33568&SearchText=isda.
9 Office of Chief Economist, supra note 7, at 5.
10 46 FR at 50938, 50940.
12 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
14 See section 4a(a)(3)(B) of the CEA.
15 See, e.g., Comment letter from BG Americas & Global LNG on Proposed Rule Regarding Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 4 (Mar. 28, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=965 (“Notwithstanding the Commission’s argument that it has authority to use position limits absent a specific finding that an undue burden on interstate commerce had actually resulted, the language and intent of CEA Section 4a(a)(1) remains unchanged by the Dodd-Frank Act. As a consequence, the Commission has not been relieved of the obligation under Section 4a(a)(1) to show that the proposed position limits for the Referenced Contracts are necessary to prevent excessive speculation.”)..
16 See La Union Del Pueblo Entero v. FEMA, No. B-08-487, slip op., 2009 WL 1346030 at *4 (S.D. Tex. May 13, 2009) (“[W]hen ‘shall’ is modified by a discretionary phrase such as ‘as may be necessary’ or ‘as appropriate’ an agency has some discretion when complying with the mandate.” (citing Consumer Fed’n of America v. U.S. Dep’t of Health and Human Servs., 83 F.3d 1497, 1503 (D.C. Cir. 1996) (indicating that where Congress in mandating administrative action modifies the word “shall” with the phrase “as appropriate” an agency has discretion to evaluate the circumstances and determine when and how to act))).
17 Section 4a(a)(6) mandates through an unqualified “shall,” that the Commission set aggregate limits across trading venues including foreign boards of trade.
18 See, e.g., Comment letter from Futures Industry Association on Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 6-8; Comment Letter of International Swaps and Derivatives Association, Inc. and Securities Industry and Financial Markets Association on Notice of Proposed Rulemaking – Position Limits for Derivatives (RIN 3038-AD15 and 3038-AD16) at 3-4.
19 Position Limits for Derivatives, 76 FR 4752 (proposed Jan. 26, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
20 See Am. Med. Ass’n v. Reno, 57 F.3d 1129, 1132-3 (D.C. Cir. 1995) (“Notice of a proposed rule must include sufficient detail on its content and basis in law and evidence to allow for meaningful and informed comment: ‘the Administrative Procedure Act requires the agency to make available to the public in a form that allows for meaningful comment, the data the agency used to develop the proposed rule.’”) (quoting Engine Mfrs. Ass’n v. EPA, 20 F.3d 1177, 1181 (D.C. Cir. 1994)).
21 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
22 See, e.g., 76 FR at 4752, 4763 and 4775 (In its discussion of registered entity position limits, the preamble makes no mention of proposed §151.11(a)(2) which would remove a registered entity’s discretion under CEA §5(d)(5)(A) for designated contract markets (DCMs) and under CEA §5h(f)(6)(A) for swap execution facilities (SEFs) that are trading facilities to set position accountability in lieu of position limits for physical commodity contracts for which the Commission has not set Federal limits.).
23 Today’s final rule does not hide the fact that the position limits regime is aimed at “prevent[ing] a large trader from acquiring excessively large positions and thereby would help prevent excessive speculation and deter and prevent market manipulations, squeezes, and corners.” See Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151). See also Comment letter from Better Markets on Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 62 (Mar. 28, 2011) available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=34010&SearchText=better%20markets (“[T]here are critical differences between a commodities market position limit regime focused just on manipulation, and one focusing on a very different concept of excessive speculation.”).
24 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151) (“In light of the congressional mandate to impose position limits, the Commission disagrees with comments asserting that the Commission must first determine that excessive speculation exists or prove that position limits are an effective tool.”).
25 As defined in new §151.1.
26 See section 4a(a)(1) of the CEA.
27 See Establishment of Speculative Position Limits, 46 FR 50938, 50939 (Oct. 16, 1981) (to be codified at 17 CFR pt. 1) (“The Commission wishes to emphasize, that while Congress gave the Commission discretionary authority to impose federal speculative limits in section 4a(1), the development of an alternate procedure was not foreclosed, and section 4a(1) should not be read in a vacuum.”).
28 To the contrary, Congress specifically indicated that in defining bona fide hedging transactions or positions, the Commission may do so in such a manner as “to permit producers, sellers, middlemen, and users of a commodity or a product derived therefrom to hedge their legitimate anticipated business needs for that period of time into the future for which an appropriate futures contract is open and available on an exchange.” See section 4a(c)(1) of the CEA.
29 See, e.g., Comment letter from BG Americas & Global LNG on Proposed Rule Regarding Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 13.
30 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
31 Testimony of Todd Thul, Risk Manager, Cargill AgHorizons before the House Committee on Agriculture, Oct. 12, 2011, available at http://agriculture.house.gov/pdf/hearings/Thul111012.pdf.
33 Though I rely upon the example of agricultural operations to illustrate my point, the limitations on the anticipated merchandising hedge are equally harmful to other industries that operate in relatively volatile environments that are subject to unpredictable supply and demand swings due to economic factors, most notably energy. See, e.g., Comment letter from ISDA on Notice of Proposed Rulemaking – Position Limits for Derivatives at 3-5 (Oct. 3, 2011).
34 See 76 FR at 4752, 4762 and 4774.
35 See 76 FR at 4752, 4762.
36 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
37 Comment letter from Barclays Capital on Position Limits for Derivatives (RIN 3038-AD15 and 3038-AD16) at 3 (Mar. 28, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=965.
38 76 FR at 4752, 4762.
40 See Comment letter from CME Group on Position Limits for Derivatives at 16 (Mar. 28, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=33920&SearchText=CME (“Where agencies do not articulate a basis for treating similarly situated entities differently, as the Commission fails to do here, courts will strike down their actions as arbitrary and capricious. See, e.g., Indep. Petroleum Ass’n of America v. Babbitt, 92 F.3d 1248 (D.D. Cir. 1996) (“An Agency must treat similar cases in a similar manner unless it can provide a legitimate reason for failing to do so.” (citing Nat’l Ass’n of Broadcasters v. FCC, 740 F.2d 1190, 1201 (D.C. Cir. 1984))).
41 Principles for Regulation and Supervision of Commodity Derivatives Markets, IOSCO Technical Committee (Sept. 2011), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD358.pdf.
42 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
46 Position Limits for Futures and Swaps, 76 FR _____, ______ (____ __, 2011) (to be codified at 17 CFR pts. 1, 150 and 151).
49 Comment letter from Futures Industry Association on Position Limits for Derivatives (RIN 2028-AD15 and 3038-AD16) at 3 (Mar. 25, 2011), available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=34054&SearchText=futures%20industry%20association.
Last Updated: October 19, 2011