Commodity Trading Cap Coming: 6 Things Investors Need to Know

Commodities markets are a lot like the Wild West: they’re either unregulated or have poorly defined regulations, offer enormous possibilities for investors and are prone to boom and bust cycles.

One of the top criticisms investors (as well as consumers and politicians) often make with these markets is "price volatility," and now the governing body of these markets, the Commodity Futures Trading Commission (CFTC), is weighing in with a new rule designed to prevent commodity price swings caused by rampant speculation.

The new rule plans to implement mandatory position limits in the futures market, including metals, energy and agriculture.

It’s important to note first of all that this rule has not yet gone into effect. It was originally passed by the CFTC in October 2011, but was then blocked by a federal court. That court ruling is now on appeal and, in the meantime, the CFTC is planning to vote in as little as two weeks on a new version of the rule which it hopes will overcome these legal objections.

However, diligent investors should anticipate this rule will eventually be implemented and probably in the near term, as the CFTC considers it a mandate under the Dodd-Frank Act.

Since this could be the most significant change to the futures market in years, it’s important for investors to understand six key implications of the rule and how it will affect future trading:

1. What is the CFTC proposing exactly? - Mandatory position limits on options, futures contracts and swaps (including ‘swaptions’) for 28 metal, energy and agricultural commodities. These limits would ultimately be 25 percent of what is determined to be the “deliverable supply” of the commodity (including both physical-delivery contracts and cash-settled contracts, with some exceptions).

2. What are likely to be the long-term implications on commodity prices as a result? This is highly debatable. The CFTC is engineering these limits to prevent future price spikes in commodities, but even the CFTC’s own members disagree on the effect this will have.

Personally, I do not expect to see much change in overall price volatility because there are so many over-the-counter transactions that are still allowed by this new rule. However, if the position limits are truly universal and without exception, it could succeed at mitigating some of the extreme price swings that sometimes afflict this market. Also, if the CFTC’s regulations are perceived as too restrictive by some participants, these players will simply take their business to other jurisdictions. So, the overall effect could be to diminish the total number of trades in the commodities specified under the new regulations.

3. Will it raise the price or reduce the availability of these contracts for smaller investors? It’s unlikely to hurt the price or availability of contracts for smaller investors. If anything, this should be a net positive for the average investor by limiting how much of the market large banks and trading firms can control, it’s an attempt to level the playing field a bit for the average investor, increase transparency and prevent artificial price manipulation which benefits a small group of inside players.

4. How will it affect swaps? Swaps are a big part of this new rule. This will provide a new regulatory framework for swaps and security-based swaps, including swap dealers and major swap participants.

The same 28 commodities that will be under mandatory position limits for futures and options, will also be under limits for physical commodity swaps. It will include clearing and trade execution requirements on these products. Will these new regulations on swaps really prevent the big banks from being able to circumvent these new limits on the commodities market? That remains to be seen.

5. Who are the winners and losers? Small speculators and trading funds will be the main beneficiaries as this new regulatory framework will increase transparency and prevent bigger players from having too much influence on the market. Large banks and trading firms will be the biggest losers.

6. What does the average investor need to know? Regardless of this new CFTC rule, price volatility will always be a factor in the futures game. This volatility can be extremely risky, day-trading futures is best left to the professional commodities traders, not average investors. If you buy commodities, plan to hold onto them for a longer term, for better potential price appreciation.

David Morgan, publisher of The Morgan Report, is a commodities expert who consults for hedge funds, high net worth investors, depositories, bullion dealers and mining companies.