Speech by Commissioner Michael V. Dunn before the 55th Annual Beltwide Cotton Production Conference, New Orleans, Louisiana
January 6, 2010
Thank you for the opportunity to address the Belt-Wide Cotton Production Conference. I am very pleased to be with you and to be back in New Orleans-- one of my favorite cities. In the East we recently had a snow fall of well over 18 inches. But the bright side is that my four sons were home for the Holidays and helped to shovel most of it. I am hoping for much better weather in New Orleans.
But, for me the main attraction is to come here and learn all I can about the cotton industry and how you use the commodity futures markets and how actions of the CFTC might impact your businesses and livelihoods.
I have served at the CFTC for over 5 years and have a year and a half left in my term. It looks like there will be plenty of work to keep me busy. The CFTC was created by Congress in 1974 as an independent regulatory agency to replace the Commodity Exchange Authority which was part of the Agriculture Department. The reason for the change was obvious since the futures markets had already begun expanding into non-agricultural products, at that time over 90% of futures activities were agriculture in nature. Future growth of the industry was destined to be in the non-agricultural segment; presently less than 10% are deemed agriculture.
The CFTC like the SEC and FTC are referred to as “independent” regulatory agencies which means that after the five Commissioners are nominated by the President and confirmed by the Senate, they are not beholden to others in the Administration or the Congress for decisions they make. We are to make decisions independent of partisan politics or others holding federal office. No more than 3 of the 5 CFTC Commissioners can be of the same political party—so in establishing the CFTC Congress tried to make the agency as independent as possible.
Fortunately, we currently have a full team on board with five commissioners.
I am currently the Chair of the Agricultural Advisory Committee (ACC). As such, I have appointed an Agriculture Advisory Committee which meets to consider timely issues and offer advice to the Commission on agricultural matters. The cotton industry is well represented on the Agriculture Advisory Committee and the industry sends a number of people to our meetings. In the last two years we have been focusing on the March 2008 markets and the lack of convergence in the Chicago wheat contract.
[BACK TO COTTON CHART]
I know many of you are very interested in the Commission’s investigation of the spike in cotton futures trading during the week of March 3rd 2008. This week the Commission will release that report. The Division of Enforcement conducted an investigation and did not uncover evidence of manipulation.
The Staff Report describes the investigation and describes market events that were likely to cause of the price increases. It also contains three staff recommendations.
Commission staff sought to identify and examine the basic factors of cotton futures and options markets that may have caused or contributed to the increased volatility and the price spike during the week of March 3, 2008.
The study found that large positions were held by index traders and cotton merchants. Generally the index traders did not alter their trading strategy during the week – which is typical of this class of trader. The data also show that the long open interest held by index traders was not much larger that week than in comparable time periods.
Cotton merchants, which generally held short positions, increased those short positions significantly around mid - February and sought to reduce those positions as prices increased during the week of March 3rd. Cotton merchants holding short open interest sometimes exceeding 66% of the short open interest in the May 2008 contract were generally the same level as in comparable periods in most years.
These merchants stated they were uneasy about the situation over the preceding week-end fearing that continued price increases would result in significant margin calls. They wanted to reduce short futures positions to levels where their financing could cover margin calls and/or to increase their lines of credit to finance margin calls.
By the early morning of March 3rd, a substantial number of the merchants attempted to reduce their short positions by buying cotton futures electronically on ICE US once the electronic trading began at 1:30 am. The impact of this rush for cover was a further increase in the price of cotton futures contracts, particularly the May 2008 contract -- this resulted in the limit up price being reached at 4:33 am, and the market locked limit up for the day at 6:48 am. At this point merchants had to wait several hours until the cotton option pit opened at 10:30 am to try to offset losses. ICE Clear U.S., consistent with their rules (and anticipated by some merchants), used the options price (“synthetic futures price”) as the basis for the mark-to-market calculation for open futures positions. As a result, merchants were required to meet significant mid-day and end of day margin calls.
The merchants with short positions had to scramble to cover their exposure and limit losses. ICE Clearing US was calling for higher margins; other traders were holding out for higher bids due to their increased exposure and uncertain access to a locked market. The risk and volatility discouraged new entrants into the market.
Generally, the small number of banks who customarily service cotton merchants tended naturally to become more nervous. This was complicated by the fact that the value of stored cotton, which was a large part of the collateral used by merchants for financing, did not rise proportionally with the futures creating another squeeze on credit availability.
It appears that a number of cotton merchants holding significant short futures positions and concerned about their lines of credit to maintain those positions, desired to offset at least a portions of their positions. In some cases, these merchants established long positions in the options market – i.e. a synthetic futures position – which created an economically offsetting position, essentially protecting against further losses. In other cases, merchants were able to offset futures positions prior to prices hitting the limit. Finally, others held their futures positions and posted additional margin.
While each of these strategies represented a different approach to dealing with a short position that had accumulated large losses, there are significant differences between them. In the cases of merchants who either offset their futures position directly or through synthetic futures positions, they essentially locked in any losses that had accrued on the position. In addition, by closing out or neutralizing their position, they had essentially lifted their hedge against their cash market position. In the case of merchants who posted additional margin, those traders continued to face the risk of rising market prices, but maintained their hedge against falling prices.
It is not clear that hitting the price limit or the combination of hitting the price limit and using the implied futures price to set margins, created additional hardship or losses that otherwise could have been avoided given the state of the market at that time. Had the limit not been in effect, traders seeking to buy futures would have had to pay a higher price than the limit price of March 3rd. Moreover, closing out positions would have locked in losses, which presumably would have reduced a trader’s capital that could have been posted as margin. Therefore, it is not clear that reducing a position would allow a party’s financing to cover additional losses; it would only have the effect of eliminating an exposure to additional futures losses.
Overall, there is no evidence that the existence of price limits, coupled with the use of implied futures prices to calculate mark-to-market, resulted in an improper market price being used to calculate mark-to-market. Certainly from the perspective of traders holding losing short positions, the use of a settlement price above the limit price worked against their immediate financial interest. However, from the perspective of the clearinghouse and financial integrity of the market, there would have been additional risk to default taken on if the limit price, which was obviously not a true market price, was substituted for a clearly identifiable market price that was above the limit price.
In the weeks following the market events of the week of March 3rd, ICE U.S. stopped calculating mark-to-market using synthetic prices. On June 11th, 2008 ICE U.S. made a rule amendment that removes the requirement that synthetic prices be used to calculate mark-to-market when futures prices are locked limit up or limit down. They also developed rule amendments that expand the daily price limits applicable to cotton futures and that apply the same price limit to cotton options. According to ICE U.S. the cotton options rule will become effective “on a business date when the applicable technology systems are able to accommodate options price limits…” To date, ICE U.S. has not implemented the amendment, so options are not yet subject to price limits.
Thank you again for having me here today. I’d like to open it up now to get your thoughts and recommendations on this issue, the report, and where do we go from here! You can obtain a copy of the CFTC staff report on our website: www.cftc.gov. I urge you and the public to send me your comments on this report.
Last Updated: January 24, 2011