Remarks of Commissioner Brian Quintenz before the Commodity Markets Council State of the Industry 2018 Conference
Drawing without an Eraser
January 29, 2018
Thank you for that very kind introduction.
Before I begin, let me quickly say that the views contained in this speech are my own and do not represent the views of the Commission. I’m very pleased to be speaking here with you today at the Commodity Markets Council’s annual State of the Industry conference.
Over the winter holiday, my children and I went on a Disney Cruise. I’m not going to tell you who enjoyed it more, but I did want to share a story from our trip. One of the on-board activities we did together after breaking my children away from the 24 hour self-serve ice cream bar was a Disney animating class. To start the class, everyone was given drawing paper and a pencil, and we followed along step by step as the teacher sketched out Winnie the Poo and Tigger. When my drawing started to look more like a snowman than a Poo bear and I needed to revise it, I suddenly realized my pencil didn’t have an eraser. I quickly looked around to see if I could borrow someone else’s, but none of the other pencils had erasers either. The teacher explained to us that when Walt Disney first organized his animating studio, he removed all the erasers from pencils. His idea was that he wanted his artists to be deliberate in their sketching but to also not be fearful of mistakes – that it was more powerful to see mistakes concretely on paper and use them to “build” the final result or character.
It turns out this philosophy of creation—of being thoughtful and deliberate but also using concrete mistakes as you go to improve the result—is not unique to Disney cartoonists. It was Ernest Hemingway’s practice to first use a pencil and then a typewriter to construct his novels. As he explained in a book he penned for aspiring writers, “If you write with a pencil you get three different sights at it to see if the reader is getting what you want him to. First when you read it over; then when it is typed you get another chance to improve it, and again in the proof. Writing it first in pencil gives you one-third more chance to improve it.”1Stephen King also preferred to write with a fountain pen, noting that the act of writing longhand “slows you down. It makes you think about each word as you write it.”2 Perhaps Michelangelo summed it up best when he stated, “A man paints with his brains and not with his hands.”
You may be wondering what the creative process of these renowned artists can possibly have in common with financial regulation. Well, actually, quite a bit. Good public policy requires thoughtful deliberation, a clear vision of the ultimate objective, and, in some cases, many, many drafts—perhaps even more than Hemingway’s customary three. It is usually only when a policy proposal gets put on paper and disseminated to the public that the far reaching consequences (and perhaps mistakes) of its provisions can be fully understood and, hopefully, improved.
One pending rulemaking before the Commission which certainly warrants rigorous thoughtfulness, a willingness to revise, and has a long history of drafts, is position limits. Indeed, I have heard it described as the “eternal rulemaking”—with the Commission issuing multiple versions of the proposal since 2011. Another way to view the rule’s evolution is to see the Commission’s most recent Reproposal in December 2016 as yet another opportunity to review, refine, and build upon its prior work.3
I would like to take a moment to recognize the number of significant improvements the Reproposal would make to the Commission’s prior position limits proposals. For example, the Reproposal would update the deliverable supply estimates for purposes of establishing spot month speculative limits, permit exchanges to recognize non-enumerated bona fide hedge or spread exemptions, and remove the quantitative test for cross-commodity hedges.
However, market participants have raised a number of practical and logistical, as well as substantive, concerns with the Reproposal. It is also extremely complex—over 280 pages in the Federal Register with approximately 1,730 footnotes. I think the Reproposal can be improved so that any position limits regime adopted by the Commission will be workable and reflect current commercial hedging practices. But before I get into specifics, I think it is helpful to take a step back and remember why Congress included a statutory provision for position limits in the first instance.
Addressing the Burden of Price Volatility
Since 1936, the Commodity Exchange Act (“CEA”) has cited the “burden” posed on the public by sudden or unreasonable fluctuations or unwarranted changes in the price of a commodity, and directed the Commission to establish such limits on trading as it finds necessary to “diminish, eliminate or prevent” any such burden that could be caused by “excessive speculation.”4 When implementing this provision, Congress also directed the Commission in the Dodd-Frank Act, “to the maximum extent practicable” to ensure sufficient market liquidity for bona fide hedgers and ensure that the price discovery function of the underlying market is not disrupted.5
Nowhere, however, did the CEA say position limits were the only tool for addressing the burden of unreasonable or unwarranted price moves tied to excessive speculation. In fact, over the past 80 years, a suite of regulatory tools has been created and implemented at both the Commission and exchange level to address this burden, including the special call powers of the agency, market surveillance capabilities, large trader reporting obligations, and exchange-set accountability levels in various contract months. The exchanges have proved to be strong partners in the CFTC’s efforts to promote and protect vibrant, liquid, well-functioning derivatives and cash commodity markets.6 In addition to their inherent motivation to provide credible, well-functioning markets, both DCMs and SEFs have regulatory obligations to monitor and surveil their markets in real-time and to detect and/or prevent price manipulation, price distortions, disruptions in the delivery or cash settlement process, and position limit violations.7
With that history in mind, I think it is incumbent on the Commission to ensure that any position limits it establishes are appropriately tailored within the construct of the entire regulatory tool kit that is already being used to address price volatility that can be caused by excessive speculation.
In my opinion, an effective position limits regime would be “built” upon two policy platforms. First, the regime must provide commercial market participants and end-users with the reasonable flexibility they need to hedge their risks efficiently – the Commission cannot and should not dictate to commercial firms how they should manage their risk through one-size-fits-all mandates. Second, the final rule should not create the potential for additional price volatility risk in our markets by impairing liquidity and impeding price discovery.
With those complementary objectives in mind, I think several aspects of the 2016 Reproposal should be revisited, such as using accountability levels in lieu of hard limits in non-spot months and the practicality for both end-users and the Commission of imposing position limits for economically equivalent swaps. Given the length and complexity of the rule, there are many issues that I look forward to discussing with staff and market participants.
For purposes of today, however, I have chosen to focus on what is, in my opinion, the lynch pin to an operative positon limits regime: ensuring there are no unnecessary restrictions or burdens placed on market participants’ ability to engage in bona fide hedging activity. That starts with ensuring that the scope of what constitutes a bona fide hedge is broad enough to generally encompass legitimate, risk-reducing activities. Next, it requires ensuring that any “enumerated” bona fide hedges includes common commercial hedging strategies so that market participants have regulatory certainty about their most basic and frequent hedging methods. And lastly, it means providing an efficient, simple process for market participants to receive approval to engage in non-enumerated hedges.
I will discuss each of these points in turn.
Definition of Bona Fide Hedging
The Reproposal would revise the definition of a bona fide hedging position for physical commodities from the prior proposal so that the definition incorporates only those elements required by statute. In doing so, the proposal eliminates two of the general requirements of the existing bona fide hedging definition: the incidental test and the orderly trading requirement test. I support the elimination of both these requirements.
The Commission also received feedback from many commenters expressing concern that this revised definition still remains too narrow. For example, the “economically appropriate test” requires that a position must be “economically appropriate to the reduction of risk in the conduct and management of a commercial enterprise” in order to qualify as a bona fide hedge. In the Reproposal, the Commission interprets the word “risk” in this prior sentence to refer solely to price risk.8 Commenters pointed out that this interpretation excludes a number of risks that may create or impact price risk— operational risk, liquidity risk, credit risk, locational risk, political risk, and seasonal risk—that commercial firms may find appropriate and necessary to hedge.9 I hope the Commission can examine this point further, so that we ensure the Commission’s interpretation of “risk” is broad enough to accommodate the many different types of risks that commercial firms need to hedge in their day-to-day business operations.
Further, the Reproposal also states that in order to meet the “economically appropriate test,” a commercial enterprise generally must take into account all inventory or products that it owns or controls in determining if a derivatives position reduces the overall risk of the enterprise.10 In other words, an entity must generally hedge its cash exposure on a net basis across all entities that aggregate positions—although the Commission did note that gross hedging may be appropriate in certain circumstances where net cash positions do not necessarily measure total risk exposure.11
I am concerned that this interpretation conflicts with how many commercial firms manage the risks of their cash operations. Energy and agricultural firms frequently choose to manage their exposures on a regional or portfolio basis. This makes sense because many of the markets these companies participate in are regional.
For example, an electric utility may have excess physical generation in one region, but be short physical power in another region. Given the geographic dislocation of the two markets, the utility may wish to manage the risks of its power plants independently for any number of reasons—different supply and demand fundamentals, transportation and storage costs, timing issues. I chose electricity as an example, but the same could be true for a grain elevator with fixed price sale commitments in the Midwest and corn inventory in South America. It may not make economic sense for the grain elevator to satisfy its sale commitments in the Midwest with corn from South America. In both cases, I think the firm should be able to choose the level at which it manages its risk. Firms should be able to establish risk management programs that are tailored to the specific facts and circumstances of their businesses and not be forced to adopt a predetermined, one-size-fits all, Washington DC dictated approach to hedging. Going forward, I think there is an opportunity for the Commission to further clarify its views on this point and ensure that commercial firms have the flexibility to manage their exposures in a way that reflects the complexities and realities of their physical businesses.
Enumerated Bona Fide Hedging Positions
In addition to ensuring a sufficiently broad definition of bona fide hedging, I am also concerned that the Reproposal’s list of enumerated bona fide hedge positions is too narrow to allow for many hedging strategies commonly used by market participants.12 The purpose of enumerating certain bona fide hedging positions is to provide regulatory certainty and alleviate administrative burdens for market participants engaging in common, legitimate, risk-reducing activities. If the list is indeed too narrow, then end-users must go through unnecessary, costly hurdles in order for their hedging activity to granted bona fide status.
Generally, in constructing an enumerated hedging list, I do not believe the Commission’s overarching premise should be that all market activity is speculative activity until proven otherwise. Rather, the presumption should be that market participants relying on an enumerated bona fide hedging exemption are engaging in legitimate hedging activity. In fact, the Commission and exchanges have many tools at their disposal to detect, combat, and punish speculative activity masquerading as bona fide hedging, making the risk of a “broad” enumerated list low.
For example, the Reproposal failed to fully include anticipated merchandising activities as an enumerated bona fide hedge, because, depending on the facts and circumstances, the exemption could be utilized in bad faith to engage in speculative activity.13 Accordingly, although the Reproposal recognizes that anticipated merchandising may qualify as a bona fide hedge, it declined to include it among the list of enumerated hedges. As a substitute, the Reproposal provides that exchanges may recognize anticipatory merchandising transactions as non-enumerated bona fide hedges subject to their assessment of the particular facts and circumstances.14
Congress specifically included “merchandising” and “anticipated merchandising” in its statutory bona fide hedging definition.15 Given this statutory language and the prevalence and importance of anticipated merchandising activities in the market, the Commission should consider including such activities among enumerated bona fide hedging positions. Energy and agricultural merchandisers play a critical role in providing economic services and market liquidity for producers and end-users, ensuring that commodities move along the supply chain to the location where they are needed most with minimal price volatility. Through extensive investments in physical storage and transportation capabilities, merchandisers are able to act as the go between producers and end-users, allowing for the management of price risk at both ends of the supply chain.
Let’s take a common example that is frequently cited—unpriced physical purchase or sale commitments when an offsetting sale or purchase is anticipated, but not yet completed. Take a situation where gas oil is trading in Europe at around $130 per barrel, but is trading in New York for around $150 per barrel. Prices show there is a relative excess supply of oil in Europe as compared to New York, where the higher prices reflect a greater demand. Merchandisers respond to these market signals by transporting commodities to meet this heightened demand, ultimately to the benefit of consumers in New York in this particular example. Here, a merchant might purchase the oil in Europe, intending to ship the oil to New York to sell it. But, in order to lock in the price differential between the two locations and avoid assuming unnecessary price risk, the merchant must hedge both its purchase contract and anticipated sale contract with futures contracts.
Although this fact pattern describes a customary hedging practice in the energy or agriculture markets, it would not qualify as an enumerated bona fide hedge under the current definition because at the time the merchant establishes its short futures position, it has not yet executed the sale contract. While I appreciate concerns that a market participant could conceivably take advantage of an exemption for anticipated merchandising to establish a speculative position without ever having the intent to incur price risk in the physical markets,16 I think such concerns must be balanced against the harms caused by burdening and potentially restricting the use of legitimate risk management practices. Merchandising performs a critical role in the functioning of our commodity markets by connecting the two ends of the value chain: production and consumption. That activity needs to be risk managed effectively and efficiently. The Commission has other reporting and surveillance tools at its disposal to address speculative activity masquerading as a bona fide hedge.17
Going forward, I am eager to hear from market participants about how the list of enumerated bona fide hedging exemptions can be broadened to recognize legitimate commercial hedging activity.
Process for Exchange-Granted Non-Enumerated Hedge Exemptions
Of course, the list of enumerated bona fide hedges under CFTC regulations cannot, and should not, be expected to account for all forms of legitimate commercial hedging. Accordingly, market participants need an expeditious, efficient process for seeking non-enumerated hedge exemptions. In this regard, I think the Reproposal represents a significant improvement over the 2013 proposal, which required market participants to either request an interpretive letter from Commission staff or seek exemptive relief from the Commission itself in order to engage in non-enumerated bona fide hedging.18 Limiting end-users to only those two avenues for engaging in non-enumerated hedges is not commercially workable.
Under the Reproposal, eligible exchanges have the authority to administer exemptions for non-enumerated bona fide hedges, certain anticipatory bona fide hedges, and certain spread positions. This makes sense because exchanges have a deep familiarity with their contracts, customers, and prudent risk management strategies. As such, they are well-positioned to determine if a particular hedging activity should be recognized as a bona fide hedge.
However, I am concerned that even under the much improved Reproposal, the process for seeking a non-enumerated bona fide hedge exemption remains too burdensome for market participants and exchanges. From the perspective of the market participant, the proposed process provides little regulatory certainty. As proposed, the CFTC may review and overturn an exchange’s determination at any time, even years after the initial decision was made. This is problematic because market participants rely in good faith on exchange-granted exemptions to manage the risks of entire lines of business.
The exemption process also entails frequent reporting and extensive recordkeeping requirements, which I understand are designed to provide transparency and enable a fulsome, robust review by the Commission.19However, I would like to consider whether the exchange exemption process, and the CFTC’s oversight of it, can fit within the existing supervisory framework. For example, one good suggestion from commenters is for the Commission, as part its periodic Rule Enforcement Review process, to incorporate an exchange’s approval practices of hedging exemptions.20 If, during the course of those reviews, the Commission determines an exemption has been granted that is inconsistent with the bona fide hedging definition, then the Commission can revoke the exchange’s determination, provided the participant is given a reasonable amount of time to liquidate the position. On the other hand, if the Commission finds no discrepancies with the exchange’s determinations, this provides market participants with some certainty that the Commission’s and exchange’s views are generally aligned.
It should not be a significant regulatory burden for end-users to seek approval to engage in non-enumerated bona fide hedge activities. With that principle in mind, I am eager to explore how the application process for non-enumerated hedges could be improved.
In conclusion, I would like to reiterate my appreciation for all of the hard work staff has devoted over the past several years to improving and refining prior position limits proposals. I would also like to thank the members of the Commodity Markets Council and your leadership for submitting many letters and thoughtful comments throughout this process that will allow the Commission to create a workable position limits regime. Good public policy, while needing to start with a sound a reasonable premise, is usually “built” upon many drafts and revisions. I recognize that getting this rulemaking right is a much harder, and more frustrating task than completing a Winnie the Poo sketch without an eraser. But I am confident we can get there. I look forward to engaging with staff and market participants to work together to develop a position limits regime that enhances market integrity, liquidity, and efficiency. Thank you very much for having me.
1 Ernest Hemingway, By-Line: Ernest Hemingway: Selected Articles and Dispatches of Four Decades (William White ed., 1967).
2 Michael Bywater, Everything Starts with the Pen, The Independent, Oct. 17, 2010, http://www.independent.co.uk/arts-entertainment/books/features/everything-starts-with-the-pen-2109252.html.See also Interview by Bryant Gumbel with Stephen King, The Early Show (2001), https://youtu.be/w0lofwQTWKk.
3 Position Limits for Derivatives, 81 Fed. Reg. 96704 (Dec. 30, 2016) (“Reproposal”).
4 Commodity Exchange Act of 1936, P.L. 74-675, 49 Stat. 1491, §5 (adding section 4a), available at https://fraser.stlouisfed.org/scribd/?title_id=1096&filepath=/files/docs/historical/congressional/commodity-exchange-act.pdf.
5 CEA section 4a(a)(3). CEA section 4a(a)(3) also provides that the Commission should, to the maximum extent practicable in its discretion, diminish, eliminate, or prevent excessive speculation and deter and prevent market manipulation, squeezes, and corners.
6 Since 2015, NYMEX, COMEX, CME, CBOT, and ICE Futures U.S. have brought over 50 exchange enforcement actions for violations of position limits or position accountability levels. See CME Group, Market Regulation Enforcement, http://www.cmegroup.com/market-regulation/enforcement.html; ICE Futures U.S., Disciplinary Notices, https://www.theice.com/futures-us/notices. This is in addition to the exchanges’ regular market surveillance activity that enables them to detect and investigate potential trade practice violations. See also NYMEX-COMEX Market Surveillance Rule Enforcement Review, Division of Market Oversight 6-10 (Oct. 11, 2016), http://www.cftc.gov/idc/groups/public/@iodcms/documents/file/rernymex_comex101116.pdf; Ice Futures U.S. Market Surveillance Rule Enforcement Review, Division of Market Oversight 10-11 (July 22, 2014), http://www.cftc.gov/idc/groups/public/@iodcms/documents/file/rericefutures072214.pdf.
7 See, e.g., 17 C.F.R. §37.300 and §38.200 (respectively requiring SEFs and DCMs to only permit trading in contracts that are not readily susceptible to manipulation); 17 C.F.R. §§37.400-01 and §§38.250-38.253 (respectively requiring SEFs and DCMs to monitor trading to prevent manipulation, price distortion, and disruptions of the delivery or cash settlement process and monitor and evaluate market data in order to detect and prevent manipulative activity that would result in the failure of the market price to reflect the normal forces of supply and demand); 17 C.F.R. §37.404 (requiring a SEF to “demonstrate that it has access to sufficient information to assess whether trading in swaps listed on its market, in the index or instrument used as a reference price, or in the underlying commodity for its listed swaps is being used to affect prices on its market”); 17 C.F.R. §§37.500-504 and §38.254 (respectively requiring SEFs and DCMs to establish rules regarding the collection of information from market participants); 17 C.F.R. §37.600 (requiring a SEF to (i) adopt position limits or position accountability levels as are necessary and appropriate to reduce the potential threat of manipulation or congestion), and (ii) monitor compliance on the SEF with any Commission-set limit); and 17 C.F.R. §§38.300-301 (requiring DCMs to adopt, as necessary and appropriate, position limits or position accountability levels). It should be noted that currently position limits for swaps have not been established. In addition, the Reproposal contains guidance for DCMs and SEFs stating that they do not need to demonstrate compliance with Core Principles 5 and 6, respectively, until such time as they have sufficient swap position information. Reproposal; 81 Fed. Reg. at 96963.
8 Reproposal, 81 Fed. Reg. at 96746-47; Position Limits for Derivatives: Certain Exemptions and Guidance; Proposed Rule, 81 Fed. Reg. 38458, 38463 (June 13, 2016).
9 See letter from Edison Electric Institute dated February 28, 2017; letter from CME Group dated February 28, 2017 (arguing for inclusion of risks arising from conduct of a commercial enterprise); letter from Archer Daniels Midland Company dated February 28, 2017 (“managing price risk often entails assessing the various factors that influence price…it is ‘economically appropriate’ to manage the potential price risk of an exogenous event”); letter from Futures Industry Association dated February 28, 2017; letter from National Green and Feed Association dated February 28, 2017 (arguing for inclusion of basis risk, quality risk, locational risk and timing risk, among others).
10 Reproposal, 81 Fed. Reg. at 96746-48; Position Limits for Derivatives; Proposed Rule, 78 Fed. Reg. 75680, 75709 (Dec. 12, 2013) (“2013 Proposal”).
11 Reproposal, 81 Fed. Reg. at 96747.
12 Proposed 17 C.F.R. §§ 150.1(3), (4), or (5).
13 Energy and Environmental Markets Advisory Committee Meeting Transcript 168-169 (Feb. 26, 2015) (explaining that it was appropriate to defer to exchanges to evaluate a particular example of anticipatory hedging because, based on the generic fact pattern, the Commission could not be certain market participants would not use the exemption as a pretext for speculation); available at http://www.cftc.gov/idc/groups/public/@aboutcftc/documents/file/emactranscript022615.pdf; Reproposal, 81 Fed. Reg. at 96749.
14 Reproposal, 81 Fed. Reg. at 96749.
15 CEA section 4a(c)(2)(A). Specifically, the CEA states that a bona fide hedge includes hedges against the “potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing or merchandising.”
16 2013 Proposal, 78 Fed. Reg. at 75718-19 (explaining why the Commission withdrew the exemption for anticipated merchandizing).
17 For example, if anticipated merchandising is recognized as an enumerated bona fide hedging position, market participants would be required to file forms with the Commission containing information about the firm’s activities in the cash market that justify its reliance on the exemption. The CFTC can ensure that these forms provide the information necessary for the Commission to confirm that the market participant’s business and activities in the cash market are consistent with the claimed exemption. These filings, along with the Commission’s ability to subsequently request additional information from the market participant, are powerful tools at the Commission’s disposal that should deter and prevent speculators from misusing hedging exemptions. Proposed Rule 150.3(h); 17 C.F.R. §18.05 (special call authority).
18 Reproposal, 81 Fed. Reg. at 96775-76.
19 For example, exchanges must provide weekly reports to the Commission describing all hedge exemptions granted, revoked, or modified; publish at least quarterly summaries of the types of positions recognized by the exchange; keep records of all oral and written communications between the exchange and the applicant; and, submit to the CFTC on a monthly basis any required reports provided by the applicant to the exchange.
20 See, e.g., 17 C.F.R. part 37 (SEFs); 17 C.F.R. part 38 (DCMs); and 17 C.F.R. part 40 (provisions common to registered entities). DMO conducts regular reviews of a DCM’s ongoing compliance with core principles, including rules requiring exchanges to prevent market manipulation, monitor trading, and monitor for compliance with position limits. DMO intends to conduct similar rule enforcement reviews for SEFs.
Last Updated: January 31, 2018