The U.S. futures regulator on Thursday set out its most aggressive steps yet to prevent speculators from distorting commodity markets, but it relented on several provisions that were fiercely opposed by Wall Street banks and large commodity traders.
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The Commodity Futures Trading Commission's proposal to set position limits showed the agency had taken heed of objections raised since January, when it first put forward a plan to cap the influx of investor capital that some blamed for driving oil and grain prices to record highs in 2008.
But the core principle was unchanged: restricting the number of swaps and futures contracts that speculators can hold in energy, metals and agricultural derivative markets, a rule it estimated could affect nearly 80 agricultural traders and dozens of metals and energy players.
"This is going to help us ensure these markets are efficient and effective and devoid of fraud abuse and manipulation," CFTC Commissioner Bart Chilton, a proponent of the news rules, told Reuters Television.
The proposal is part of broader efforts to boost oversight of the $600 trillion global over-the-counter derivatives market required under the Dodd-Frank bill passed by the U.S. Congress in July, which has expanded the CFTC's mandate but also complicated its work.
It has already been forced to slow down the timeline. As expected, the proposal set out general formulas for calculating the limits and applying those to the spot month contract, but it suggested waiting until the agency has more data on the opaque swaps market before expanding that to all months.
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The plan, which commissioners must vote to release for 60 days of public comment, likely offers some relief for companies such as Goldman Sachs and Royal Dutch Shell that argued overly strict rules could reduce market liquidity, elevate volatility and make the markets more risky.
"This is the CFTC trying to stick to the letter of the law ... but at the same time ease their way into the rulemaking process with the market, recognizing that the markets are kind of jittery about whatever comes down the line," said Chad Hart, an agricultural economist at Iowa State University.
Compared to the previous proposal offered in January, which applied only to energy markets, the new rules attempted to draw a clearer line between financial players who have flooded commodity markets with over $350 billion over the past decade, and the traditional traders who often take large positions to hedge their own -- or customers' -- physical trading.
Under the rules, the big banks can now claim an "unlimited bona fide hedge exemption" -- allowing them to engage in hedging on behalf of big producers or raw material customers without counting against their own limits.
This replaced a more limited risk management exemption that had been proposed in January.
But trades to offset swap deals with speculators or investors would still be subject to the limits, and the CFTC narrowed the bona fide hedger definition, seeking to limit it only to those who have a legitimate physical business.
The biggest change was the removal of a "crowding out" provision that would've made it hard for any company to run both speculative and hedging books. This had drawn widespread criticism and was generally expected to be removed.
"We looked at the comment letters we received, and staff did not propose that provision," an agency official said in a background briefing.
CFTC also appeared to relax a provision around aggregation, which requires companies to combine positions across any firms in which they own more than 10%. It said a firm may be allowed to exclude those positions if the investment is passive and the stakeholder does not participate in management.
Some commissioners remained concerned about the pace.
"While the proposal meets the mandates of the Dodd Frank Act, this proposal still suffers from significant flaws in its complexity, and the likelihood of achieving an end-state of controlling excessive speculation remains in question," CFTC Commissioner Scott O'Malia said in a statement.
The rules are a response to the dramatic change in commodity markets, which until recently were mostly dominated by companies that produced, consumed or traded the physical product, with some smaller speculators adding liquidity.
Supporters say large, passive investors like California pension fund Calpers -- which has $2.5 billion in commodities -- are distorting the market and should be limited; critics say these speculators don't affect prices over the longer term and capping their involvement would curtail liquidity.
The CFTC intensified its focus on trading activity of banks and funds in commodity markets since 2008, when the price spike prompted demands from consumers and lawmakers to crack down.
The agency proposed limits for oil and gas futures markets in January. They were withdrawn after Congress required it to set position limits for all physical commodities including metals and agricultural goods, in addition to energy, and to both futures and swaps markets.
Efforts by the CFTC to clampdown on speculation comes amid similar efforts by regulators overseas. Last week, a European Commission issued a plan that would open the door to position limits on Europe's large commodities exchanges, despite opposition from the UK Financial Services Authority.
Regulators contend a crack-down in Europe could help prevent traders from fleeing stricter U.S. regulations in search of laxer venues.
There was no surprise in the actual formula the CFTC will use to determine position limits, which mirrored the January plan. Spot-month position limit levels will be set at 25% of the deliverable supply for each commodity, which is now used by exchanges to set their accountability limits .
The CFTC currently has position limits for agricultural markets, but not for energy and metals. For those commodities, exchanges have their own accountability limits, which act as guideposts for holding levels but are rarely enforced.
The limit for holdings covering all months would be calculated based on 10% of open interest below the first 25,000 contracts, and 2.5% after exceeding that level. CFTC said the all-months limit would be determined after collecting the necessary data to gauge the scope of the swaps market.
CFTC said a large number of traders could be affected by the all-months position limits, including 80 agricultural, 25 base metals, 20 precious metals, and 10 energy traders.
The measured approach by the CFTC comes as commissioners worry position limit deadlines -- energy and metals by mid-January and agricultural markets in April -- put the agency in the awkward position of having to set limits before it knows the size of the swaps market it's charged with regulating.
Gary Gensler, the chairman of the CFTC, admitted for the first time on Wednesday the agency would not meet the January deadline for issuing a final rule.