Keynote Address of CFTC Commissioner J. Christopher Giancarlo before the EnergyRisk Summit USA: Houston, TX
“The CFTC’s Proposed Position Limits Regime: Are U.S. Energy Markets at Risk?”
May 13, 2015
Good morning ladies and gentlemen. Thank you for your warm welcome.
Before I begin, let me say that my remarks reflect my own views and do not necessarily constitute the views of the Commodity Futures Trading Commission (CFTC), my fellow CFTC Commissioners or of the CFTC staff.
Thank you to EnergyRisk for inviting me to speak today. It is a pleasure to attend this conference that brings together so many important participants in the North American energy markets. I have read EnergyRisk for many years now. It is a consistently well-informed and insightful perspective on the constant evolution of the energy trading markets.
As you all know, the financial crisis of 2008 brought about the greatest legal and regulatory changes to the U.S. financial system since the Great Depression. Among those changes was a new regulatory focus on American energy markets, particularly the use of derivatives to manage risk and hedge against swings in the prices of energy commodities. Unfortunately, end-users of derivatives have been caught up in that new regulatory focus, despite assurances that they would remain exempt. As I have said many times before, but will repeat again, end-users, particularly in the energy markets, were not the source of the financial crisis and new Dodd-Frank rules should not treat them like they were.
Today, I would like to focus on the CFTC’s proposed rule on position limits that was discussed at the February meeting of the CFTC’s Energy and Environmental Markets Advisory Committee (EEMAC or Committee) that I sponsor.
Recent EEMAC Meeting – Position Limits
When I joined the Commission eleven months ago, EEMAC hadn’t met since 2009. EEMAC is the only CFTC advisory committee that was created in the Dodd-Frank Act. Congress obviously felt that it was important to make it a permanent fixture at the Commission as a forum to examine energy issues.
As you all know, since the passage of Dodd-Frank, we have had a sea-change in the CFTC’s influence on U.S. energy markets, while at the same time the markets themselves are undergoing the largest technological and structural change in at least a generation. That fact makes EEMAC a critical forum for examining how CFTC regulations impact energy producers, refiners, merchants, utilities and everyday American consumers.
The CFTC’s position limits proposals are so complex and concerns about them so widespread, that I devoted the entire first EEMAC meeting in five years to explore them. The meeting focused on three topics: (1) the data supporting position limits; (2) the impact this rulemaking likely will have on liquidity; and (3) the proposed redefinition of bona fide hedging.
Data Raises Serious Questions
Compelling evidence presented at the meeting supports the contention that additional federal position limits are not currently necessary in energy markets. The Committee heard evidence that the run up in oil prices before the financial crisis did not bear any of the signs of excessive speculation.1 This discussion aligns with the same findings made by the CFTC’s chief economist in 2008.2 Similarly, the Committee heard powerful evidence that speculators are not responsible for the significant declines in oil prices over the last nine months.3
In fact, Energy Information Administration Administrator Adam Sieminski aptly pointed out that “something had to happen” when the supply of oil in the markets became out of balance with global demand and that “something” was a price decline.4 Both he and University of Houston Professor Craig Pirrong indicated that non-fundamental market factors, such as speculation, have played only a negligible, if any, role in the recent sharp decline in domestic and global energy prices.5 Similarly, another well-informed presenter’s analysis asserted that index investors, managed money and swap dealers all had “no discernible impact [or] influence” on oil prices from approximately January 2011 through January 2015.6
I find particularly apt the analogy used by EEMAC member, Michael Cosgrove, who wrote: “If we thought that elephants are playing in the back yard last night, then we would expect to see their footprints. The excessive speculation, if it is taking place [in U.S. energy markets], is leaving no data footprints. Instead of being obvious, it is undetectable.”7
In fact, EEMAC heard evidence that energy derivatives markets are generally functioning well, especially in the spot months, with no evidence that excessive speculation is causing any price movements, much less sudden and unreasonable ones. Energy markets are well-functioning, with “model convergence,” which ensures that they are venues for accurate price discovery and successful risk management.8 For the time being, major energy markets also exhibit reasonable liquidity, such that some market participants can trade an “entire years’ worth of exposure [to gas or power] in one transaction.”9 Based on the health of these markets, a witness pointedly observed that “any regulations aimed at excessive speculation is a solution to a nonexistent problem” in the major energy markets.10
Yet, despite the lack of speculators (or even their footprints), the CFTC casts its proposed rules as necessary to curb excessive speculation.
As I’ve previously noted, the CFTC primarily relies on two, decades-old “black swan” episodes of market manipulation in two commodities (silver and natural gas) to find that position limits are necessary in 28 commodity contracts. It is critical to note, however, that market manipulation is generally distinct from excessive speculation. Respected economists highlighted the simple fact that these concepts are “very different.”11 The CFTC has ample tools not only to detect manipulation, but also to punish it.12
More essentially, these two historic examples do not serve to evidence any contemporary presence of excessive speculation. They provide no evidentiary justification for the current necessity of the sweeping federal limits that the CFTC has proposed.
Potential Liquidity Challenges
At the EEMAC hearing, CME and ICE each explained that, although markets are currently working well, liquidity is starting to become shallower, particularly along points farther out the curve and outside of the spot month. Where liquidity is available, wide bid-ask spreads make it increasingly costly and harder to hedge.13 EEMAC members reported that liquidity is often scarcest in some of the smaller markets, such as regional power and gas markets, where liquidity has started to dry up completely.14 This reduction of liquidity has resulted from the withdrawal of speculators from the markets.15 Another EEMAC member observed that: “I wish there were a lot more speculators in the market . . . it sounds like we may have an excessive hedging problem.”16
The EEMAC meeting suggests that the current problem is not one of excessive speculation; rather, it appears to be a problem of inadequate speculation.17
And that’s just one of the problems. It is important to note that the CFTC has not considered data on any over-the-counter (OTC) swap, either reported to a swap data repository or to the Commission, in determining whether position limits are necessary or appropriate. Similarly, no OTC swaps were considered in setting proposed non-spot month position limits levels, despite, for example an OTC swap open interest of over 1 million futures equivalents in natural gas.18 The CFTC candidly admitted in the proposal – as it has elsewhere – that the reason for this omission is that there are significant problems with the swaps data we have.
Quite simply, the data we have is not reliable and is riddled with errors.19 As I have said for months, the data reporting goals of Title VII of the Dodd-Frank Act were laudable, but much work remains to be done to optimize the value of the data collected. Former Commissioner Scott O’Malia noted the CFTC’s lack of swaps data analysis and data issues in his dissent to the position limits proposals, saying “… the Commission should have taken the time to analyze the new data, especially from the swaps market, that has been collected under the Dodd-Frank Act. It is especially troubling that the large trader data being reported under Part 20 … is still unreliable and unsuitable for setting position limit levels, almost two full years after entities began reporting data…”.20
As a result, it is hard to believe that the CFTC has set necessary and appropriate limits if it doesn’t even understand the true scope of the market. Without that understanding, it is difficult to believe the CFTC can confidently predict the impact position limits would have on the marketplace when the amount of open interest in swaps is not considered.
In order to prevent further erosion of liquidity at the most critical points, the EEMAC discussed two potential changes to address the negative impact the CFTC’s proposal would have on liquidity: accountability and updated deliverable supply.
Accountability. The first of these changes would call on the CFTC to utilize a system of position accountability. Position accountability is a process long utilized by futures exchanges – and approved not only by the CFTC but also Congress21 – to obtain more detailed information from futures market participants upon the reaching of specified position thresholds. Based on that and other information, the exchange may order the market participant to cap, reduce or even liquidate a position.22 This tool is essential because, as it was explained at the meeting, “as you get further out the curve, there’s naturally less liquidity, less players,” while adequate liquidity at those points in the market remains quite important to hedgers.23
To guard against concentration risk, futures exchanges currently monitor market participants – and the market as a whole – when they reach certain position levels.24 Under this supervision, market participants may be allowed to exceed the position limit levels the Commission has proposed. As an added safeguard to the use of position accountability, the CFTC periodically evaluates the adequacy of exchanges monitoring the positions of traders in the marketplace.25 The exchanges and the CFTC have collaborated for years to ensure that positions across markets are monitored and policed under a position accountability regime.26
The CFTC’s position limits proposal would ignore the exchanges’ years-long experience and expertise in assessing whether a market participant’s positions are appropriate, especially with respect to conditions in the market as a whole, including the depth and shallowness of available liquidity. Indeed, it appears that dismantling this system and replacing it with the CFTC’s proposed hard limit levels would undoubtedly harm liquidity in the spot month and beyond, without commensurate enhancement of market integrity.27
Updated Deliverable Supply. Second, the Committee discussed the necessity for the CFTC to review and update its deliverable supply estimates. The CFTC’s proposed deliverable supply estimates appear deficient in several respects. They must be improved to have any hope of creating a viable position limits regime. EEMAC heard compelling evidence that deliverable supply calculations, like so many other aspects of position limits, cannot be done on a “one-size-fits all” basis. Energy markets have unique characteristics that must be specially considered in calculating deliverable supply.28
The CFTC’s proposed method of calculating deliverable supply is particularly deficient as to natural gas and electricity because it ignores – and does not permit the exchanges to consider – “supply that is in a different location but can still serve demand in a certain area through transportation of that commodity.”29 This deficiency underscores the need for the CFTC to exercise great care when imposing concepts that may work for agricultural markets, for example, but do not work for energy markets, which function quite differently.30
As I recently reported to the House Ag Subcommittee on Commodity Exchanges, Energy, and Credit,31 the deliverable supply estimates the Commission proposes to use are terribly out of date. The Commission proposes to use 1983-vintage deliverable supply estimates in setting silver and gold spot-month position limits, and the comparatively recent 1996-era deliverable supply estimates for natural gas.32
News Flash (to the CFTC): we have had a revolution in natural gas exploration and production since the mid-nineties. It is critical that the CFTC adopt current deliverable supply estimates, not estimates that are 20 or 30 years out of date.
Bona Fide Hedging: Risk Management at Risk
Importantly, the EEMAC meeting also focused closely on the CFTC’s sweeping proposals to circumscribe the bona fide hedging exemption to position limits. Congress intended that position limits target those who engage in “excessive speculation,” while leaving hedgers to their task of reducing risk in their businesses. Unfortunately, the Committee heard evidence that the CFTC’s proposal unduly focuses on “limiting the activity of commercials in hedging in the markets,” which in turn increases the risk of pricing commodities, the cost of which “is ultimately borne by consumers.”33
Most alarmingly, in a break from decades of precedent, the CFTC has proposed to limit the entire universe of transactions that can receive bona fide hedging treatment. The CFTC has proposed a number of “enumerated” hedges, and if a transaction does not fall into one of these categories, it is not entitled to the bona fide hedging exception to position limits, even if the a particular position is risk reducing and is a common, “bread and butter” transaction widely used in the market.34 To make matters worse, the CFTC has proposed to repeal its current system in which market participants can submit proposed risk reducing transactions and the CFTC reviews those on a timely basis to determine whether they can be considered bona fide hedging transactions.35
Let me briefly summarize a few elements of the CFTC’s significant reduction of the bona fide hedging exemption:
- Storage transactions. In a reversal from its 2011 proposal, the CFTC no longer recognizes as bona fide transactions used to hedge risk from storage, transmission or generation of commodities. The Committee learned that these transactions form the “bread and butter” of energy industry efforts to hedge risks – and therefore pass along the best possible prices to consumers.36 Although the CFTC once recognized the legitimacy of this sort of hedge, the new proposal denies bona fide hedge treatment, apparently because of the fear of abuse in the agricultural sector where a storage bin could be used for multiple commodities37 – soybeans and corn, for example. At the EEMAC meeting, CFTC staff could not explain why this transaction is unavailable in the energy space where storage, transmission and generation are obviously not fungible in the same way.38 I recently toured the Valero refinery here in Houston, and it was a fascinating and educational experience. But I didn’t need to have a chemical engineering degree to understand that liquefied natural gas or generated electricity cannot be stored in a gasoline storage tank. The CFTC ought to understand that as well.
- Merchandising and anticipatory hedging. EEMAC members expressed considerable frustration that the CFTC’s proposal does not recognize the importance of merchandising and its role in connecting the two ends of the value chain: production and consumption.39 Moreover, merchandising promotes market convergence, an important component of price discovery and market health.40 EEMAC members explained that unfixed price contracts are frequently used in merchandising transactions, and argued forcefully that the CFTC re-evaluate its approach to basis contracts.
- Cross-commodity hedges. EEMAC members also raised significant concerns with the CFTC’s application of the hedge exemption to cross-commodity hedges. Cross-commodity hedging, such as hedging jet fuel with ultra-low sulfur diesel futures contracts, is currently permitted in the spot month and is critical to the price discovery process, but would not be permitted under the position limits proposal.41 Similarly, Committee members stated that the proposed quantitative restriction on cross-commodity hedges was deeply problematic.42 This proposed quantitative restriction would kill long used, tried-and-true cross-commodity hedges, including hedging electricity with natural gas and fuel oil with crude oil.43 The question is why?
- Gross versus net hedging. Finally, EEMAC members raised concerns regarding the CFTC’s proposed approach of permitting hedging only on an enterprise-wide level. The Committee heard evidence that this approach substitutes regulatory edict for the common-sense business judgments that underlie existing risk management procedures and hedging programs.44 The risk management systems and procedures on which so many hedgers rely were built in reliance on long-standing CFTC interpretations, which this proposal changes suddenly and with questionable justification.45 In some cases, the CFTC’s proposed approach is in tension with other state and/or federal regulatory requirements with regard to hedging and/or reliability.46 Again, the question is why?
I am very concerned that the overall effect of the CFTC’s bona fide hedging framework is to impose a federal regulatory edict in place of business judgment in the course of risk hedging activity by commercial enterprises. I believe that the CFTC must allow greater flexibility. It must encourage – not discourage – commercial enterprises to adapt to developments and advances in hedging practices.
The CFTC is primarily a markets regulator, not a prudential regulator. The CFTC has neither the authority nor the capability to substitute its regulatory dictates for the commercial judgment of business owners and hedgers when it comes to basic risk management.
I can’t think of anything riskier than having Washington dictate commercial risk management practices for America’s Main Street businesses. That is the LAST thing our struggling economy needs.
The position limits rulemaking is a significant undertaking and both the CFTC and its staff are struggling to get it right. I continue to keep an open mind on how many of the difficult questions raised before the EEMAC should be resolved. I am guided in this endeavor by two major principles. First, we need to follow the data. Considering the data and research in the record, significant questions remain as to whether additional federal position limits are necessary or appropriate. The only way to make this determination is to draw upon current and accurate data and confirm that any final rule will facilitate price discovery, maintain liquidity and not unduly disrupt markets that by all accounts are functioning fairly well. We should all agree that basing such important rulemaking on twenty or thirty-year-old data is simply unacceptable in a modern, well-regulated economy.
Some people love to cite data when it supports their arguments. When it doesn’t, they conveniently ignore it. In the case of position limits, there is an entire absence of any data-based, quantitative foundation for the proposed regulations. This absence cannot be ignored. It draws into the question the entire efficacy and validity of the CFTC’s proposed position limits regulations.
Second, the CFTC must be attentive to the costs and benefits of its rulemaking. There is no doubt that the position limits rule will impose very expensive compliance costs, and that hedgers will bear a significant share of those costs. Moreover, as an EEMAC member observed, this rule is likely to result in higher costs for consumers of energy, and will be felt most heavily by low-income Americans.47
And we must also be attentive to the additional costs to the taxpayer: administering a position limits regime like the one proposed will take a considerable amount of taxpayer dollars – dollars that the CFTC does not have and that the United States should not go further into debt to acquire.
Let’s pause for a moment and consider the current economic landscape: U.S. Gross Domestic Product (GDP) grew at only .02 percent between January and March of this year48 and has averaged less than three percent annual growth for the past half-dozen years – the slowest rate of growth since the U.S. began compiling reliable economic statistics a century ago.49 The job participation rate, at 62.5 percent,50 has not been this low in over 35 years;51 one in three Americans between the age of 18 and 31 are living with their parents52 and in one out of five American families, no one has a job.53
Over-regulation is not making things any easier, as regulations now cost the U.S. more than 12 percent of GDP, or $2 trillion annually. The average manufacturing firm spends almost $20,000 per employee per year on complying with federal regulations. For manufacturers with fewer than 50 employees, the per-employee cost rises to almost $35,000.54 With that amount of cost per employee, is it any wonder that the rate of hiring is so abysmal?
We must ask ourselves, in a weak economy with many out of work facing limited employment opportunities do we really want to saddle American consumers with higher prices for energy and other commodities? Do we really want to do this on the basis of a political narrative that has hardly any hard evidence to back it up?
Before making a dubious necessity finding, construing an ambiguous statute or even putting in place individual aspects of its proposal, the CFTC needs to undertake a clear-eyed assessment of the costs and benefits associated with expanding the position limits regime. That assessment has not been done.
Before I close, let me turn for a moment to an issue that I first addressed publicly in January of this year. I remain very concerned about the CFTC’s special call process. My concerns have only heightened since it has become known that the CFTC issued several hundred special call letters in error last fall. Some of my concerns are whether the special call process is subject to proper control, oversight, supervision and transparency. I am also concerned whether ongoing decisions to issue special calls are made upon consistent, reasonable and objective criteria. I am further concerned that the full Commission has little input into the ongoing oversight and management of the special call process. Nevertheless, I intend to continue to monitor this issue and will publicly address it further in the future as appropriate.
Returning to U.S. energy markets, let me close by noting how extraordinary the past few years have been. We have witnessed something that, frankly, I thought I would never see. Through American ingenuity and free enterprise, the United States is on the verge of energy independence that will allow American consumers to reduce purchasing petroleum overseas. It will also allow American manufacturing to lower its costs of production and compete fairly in global markets. There are simply amazing strategic opportunities ahead. They must not be squandered.
We in the federal government must do everything we can to support U.S. energy markets to function efficiently and effectively. At a minimum, that means not deploying artificial position or trading limits in the absence of current, reliable and dispositive data justifying the necessity for such limits in a time of energy abundance. If we are ever going to get out of the current economic malaise, breakthroughs in U.S. energy production and markets must be allowed to lead the way without unnecessary restraint. Let’s stop holding ourselves and our markets back. With healthy U.S. energy markets, we can help revive American prosperity.
Thank you very much for your time, I look forward to taking a few questions.
1 EEMAC Transcript, 29-34 (Feb. 26, 2015) (hereafter “EEMAC Tr.”).
2 Dr. Jeffrey Harris, the CFTC’s then-Chief Economist, testified before Congress that there was “little evidence that changes in speculative positions are systematically driving up crude oil prices.” Tom Doggett, “Congress Told Speculators Not Driving Up Oil Price,” Reuters, Apr. 3, 2008, available at http://uk.reuters.com/article/2008/04/03/us-cftc-oil-speculators-idUKN0337748220080403.
3 EEMAC Tr. at 36-38.
4 Id. at 21.
5 Id. at 15-40.
6 See Thomas LaSala, “February 26, 2015 EEMAC Panel I,” 4-7 (Feb. 26, 2015), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/generic/eemac022615_lasala1.pdf; see also EEMAC Tr. at 73-78.
7 Vectra Capital LLC Comment Letter, 1 (Mar. 24, 2015), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1562.
8 EEMAC Tr. at 68-70.
10 Id. at 70.
11 Id. at 16; see also id. at 30.
12 See, e.g., id. at 30; see also Position Limits for Derivatives, 78 Fed. Reg. 75680, 75691 & n.101 (Dec. 13, 2013) (hereafter “Proposal”) (noting complaint against and eventual settlement with Amaranth and Brian Hunter); Kurt Eichenwald, “2 Hunts Fined and Banned from Trades,” New York Times, Dec. 21, 1989, available at http://www.nytimes.com/1989/12/21/business/2-hunts-fined-and-banned-from-trades.html.
13 E.g. EEMAC Tr. at 81-82, 91-92, 95-96, 103-04, 174-76.
14 Id. at 220-22.
15 Id. at 81-83.
16 Id. at 82-83.
17 See id.
19 Id.; see also Proposal, 78 FR at 75734 n. 428.
20 Proposal, 78 FR at 75841.
21 See 7 U.S.C. 7(d)(5).
22 E.g. EEMAC Tr. at 106.
23 Id. at 107.
24 Id. at 107-08.
25 E.g. Rule Enforcement Review of the Chicago Mercantile Exchange and the Chicago Board of Trade, 39-50 (Jul. 26, 2013), available at http://www.cftc.gov/idc/groups/public/@iodcms/documents/file/rercmecbot072613.pdf.
26 EEMAC Tr. at 139-40.
27 See id. at 108-12; Proposal, 78 FR at 75839-40 (proposed App. D); Proposal, 78 FR at 75766.
28 EEMAC Tr. at 99-100, 112.
29 Id. at 100, 131-33.
30 See, e.g., id. at 130-33.
31 Testimony Before the U.S. House Committee on Agriculture, Subcommittee on Commodity Exchanges, Energy, and Credit (Apr. 14, 2015) (statement of Commissioner J. Christopher Giancarlo).
32 CME Comment Letter, 3 (Feb. 20, 2014).
33 EEMAC Tr. at 157-58, 183.
34 Id. at 160-61.
35 Id. at 177-78.
36 Id. at 170-76.
37 Id. at 174-75.
38 E.g. id. at 178-79.
39 E.g. id. at 161-62, 190-91, 209.
40 E.g. id. at 191.
41 Id. at 115-16.
42 E.g. id. at 191, 200-03; see also Proposal, 78 Fed. Reg. at 75717-18 (describing quantitative factor and suggesting it should not apply to electricity-natural gas cross commodity hedging).
43 EEMAC Tr. at 200-03.
44 E.g. id. at 158-60, 186-87, 216-18.
45 See id.
46 Id. at 216-18.
47 Id. at 196-99.
48 U.S. Department of Commerce, Bureau of Economic Analysis, Apr. 29, 2015, available at http://bea.gov/newsreleases/national/GDP/GDPnewsrelease.htm.
49 See, e.g. Rove, Karl, “The Messes Obama Will Leave Behind, Wall Street Journal,” Apr. 30, 2015, available at http://www.rove.com/articles/583 (hereafter “Rove”).
50 U.S. Department of Labor, Bureau of Labor Statistics, Apr. 3, 2015, available at http://www.bls.gov/news.release/empsit.t01.htm.
53 U.S. Department of Labor, Bureau of Labor Statistics, News Release: “Employment Characteristics of Families – 2014,” Apr. 23, 2015, available at http://www.bls.gov/news.release/pdf/famee.pdf.
54 National Association of Manufacturers, “The Cost of Federal Regulation to the US Economy, Manufacturing and Small Business,” available at http://www.nam.org/Data-and-Reports/Cost-of-Federal-Regulations/Federal-Regulation-Full-Study.pdf.
Last Updated: May 13, 2015