During the more than three years since Congress passed the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act, financial regulators have struggled to draft, approve and implement the rules authorized by Dodd-Frank. No agency has met greater Congressional, Wall Street and corporate resistance to Dodd-Frank rulemaking than the Commodity Futures Trading Commission (CFTC), which has authority over more than 90 percent of the $300 trillion U.S. derivatives market. Derivatives are financial contracts, whose value is derived from the value of an underlying asset, such as wheat, oil or a mortgage interest rate. No single CFTC proposed rule has generated more comments—more than 23,000 and counting—than a rule that would limit financial firm market share of agricultural, energy and metals derivatives.
On November 5, the CFTC approved a nearly 400-page revised position limits rule and consequently withdrew an appeal to defend its original rule at the Washington D.C. Court of Appeals. (For an explanation of the October 2012 district court ruling that gave rise to the appeal, see IATP’s blog.) Position limits attempt to prevent excessive speculation and market manipulation by regulating the market share percentage that any one trader and its affiliates can control of a designated commodity contract. The CFTC also approved a rule on the data aggregation of positions across borders, to prevent regulatory evasion by trading through foreign affiliates. And so begins Round 2 of the position limits fight.
A large share of the price increases and volatility in agricultural, energy and metals contracts in U.S. markets have been attributed to the regulatory exemptions, waivers and exclusions that allowed financial firms to control market share. For example, a 2011 Better Markets study shows that 70 percent of the Chicago Board of Trade’s wheat contracts from 2006 to 2010 were controlled by financial speculators, not by traders or processors of wheat. Commodity index fund speculators, with the long-term investment horizons of their pension fund and endowment investors, bet on prices to increase and induced extreme price volatility as they bought and sold contracts according to the fund formula.
Derivatives prices, historically reliable benchmarks for setting the prices at which farmers sell in advance of harvest to grain elevators, were too volatile to be reliable. Food import–dependent developing countries were unable to forward contract enough basic grains at affordable and predictable prices. This loss of price risk–management capacity contributed to food price riots in more than 30 countries, particularly in 2008-09. Foreign exchange and energy contract price increases and volatility further destabilized these countries, since these contracts are often U.S. dollar denominated. What the U.N. Conference on Trade Development has called the “financialization of commodity markets” has driven price trends even in defiance of supply and demand fundamentals.
The CFTC has applied position limits to agricultural contracts without legal challenge from its inception in 1975. As CFTC Chairman Gary Gensler noted in an opening statement to the November 5 meeting, the Commodity Exchange Act authorized the CFTC’s predecessor to set position limits in 1936. The Dodd-Frank legislation authorized the CFTC to set position limits on all commodity contracts, including contracts traded in the unregulated over-the-counter (OTC) markets, which during the previous decade had become at least eight times as large in value as the regulated futures and options contract market.
The litigation and lobbying campaign to prevent implementation and enforcement of position limits and an associated rule on the aggregation of position data, also approved on November 5, cannot be fully understood apart from the Wall Street campaign to carve out regulatory exemptions to allow as many contracts as possible to remain in the OTC market, “dark” to regulators and the public. OTC contract opacity is key to the huge profits to be made not just in OTC commodities trading but in OTC trading of foreign currency exchange and interest rate contracts, by far the largest share of the OTC universe. For example, according CFTC Chair Gary Gensler, cited in a recent New York Times article, the price fixing of a benchmark interest rate by many of the worlds’ largest banks affected the pricing of $10 trillion in loans.
Why have the banks, and many of their largest corporate clients, as members of the International Swaps and Derivatives Association, challenged the authority of the CFTC to set position limits under Dodd Frank? The reason cannot be simply fear of a loss to the overall bottom line of ISDA members. According to the Office of the Comptroller of Currency, bank trading revenues from commodities trading in U.S. markets for the second quarter of 2013 were reported at $282 million, large enough, but small when compared to the $2.8 billion in interest rate contract trading or $3.1 billion in foreign exchange trading revenues for the same quarter.
In his statement on the revised position limit rule, Chairman Gensler noted that the CFTC was holding its ninth public meeting on position limits, more than for any other CFTC rule, out of a total of 31 Dodd-Frank related meetings. The intense public interest registered by more than 23,000 comments on the position limit rule concerns not just a debate over whether the interests of commodity users and consumers will prevail over those of OTC dealer brokers.
Of course, comments from commodity users and consumers concern their commercial self-interest, and many NGO comments concerned the effect of unregulated markets on prices that affect public policy objectives in food and energy security. But more broadly, the position limit debate is about whether governments will regulate markets or whether the position management, i.e., self-regulation by trading venues, of the past decade will continue. The ferocity of Wall Street opposition to position limits is token of its ferocious resistance, both ideological and commercial, to regulation under Dodd-Frank.
Once the revised position limit rule is posted in the Federal Register, it will be open for 60 days for comments. IATP will be among the many who will comment on revised rule. According to a CFTC fact sheet, the revised rule and the related aggregation standards rule contain new exemptions that will certainly merit comment.
The numerical formulations of the limits and when those limits apply are certainly crucial to the effectiveness of the limits in preventing excessive speculation and market disruption, public policy objectives of the Commodity Exchange Act. But equally important are the standards for aggregating position data, particularly as they apply to transactions executed by foreign affiliates of U.S. parent firms. In other words, if data aggregation standard exemptions enable big financial players’ positions to appear smaller than their influence on price formation and price discovery, then the effectiveness of the position limit rule is diminished, if not negated.
The fact sheet states there will be an exemption from position data aggregation when “sharing information [on positions] would violate or create reasonable risk of violating Federal, state or foreign law or regulation.” As I noted in July, foreign governments have complained that CFTC requirements for regulator access to foreign trade data repositories to verify compliance with CFTC’s cross-border guidance would violate data privacy laws in Group of 20 countries. This exemption, as summarized in the fact sheet, appears to be a concession to that complaint.
Nevertheless, it appears that the CFTC’s justification for the exemption indicates that this will be a narrow exemption subject to a high standard of proof. In the proposed aggregation standards rule the CFTC considers IATP comments on aggregation (footnotes 25, 26, 31 and 32), in the context of reviewing comments on how claims that aggregation would violate local, as well as federal and foreign law, might serve the purpose of regulatory evasion. The CFTC agreed with the comments of IATP and others that local laws would not serve to justify an exemption from aggregation and with IATP’s argument that international law, such as trade treaties, do not contain data sharing prohibitions that would justify an exemption (pp. 19–20).
By framing consideration of the use of the exemption in the context of potential for regulatory evasion, the CFTC shows that contrary to earlier regulatory practice, exemptions will be granted only when they cannot be used to serve the purpose of regulatory evasion.
It is likely, as Better Markets stated in a press release welcoming the CFTC decision to propose a revised position limits rule, that ISDA will again sue the CFTC to prevent implementation and enforcement of the rule. The seemingly endless resources of Wall Street for litigation and for paying billions of dollars of fines, part of which are tax deductible, and without criminal sanctions, are understandable causes for despair.
However, when as redoubtable a defender of Wall Street as William Dudley, chair of the Federal Reserve Bank of New York, chastises his member banks for lack of respect for the law, it is one of several signs that the more than decade-long reign of regulatory evasion and impunity for violations of the law may be coming to a reckoning. If ISDA and other industry groups challenge the position limit rule again in court, it will be with the backdrop of its members paying billions of dollars of fines for trillions of dollars of price fixing. Even the notoriously conservative Washington D.C. circuit may not find in favor of such plaintiffs.
Furthermore, the announcement by the European Commission that it will permit no further delay in trade data–reporting rules by European Union member state regulators, takes away another Wall Street argument for the death by a thousand cuts to CFTC regulation. European banks will have to report their OTC trades to trade data repositories and the CFTC and other foreign regulators will have access to those repositories to verify compliance with position limit and other rules. No more Wall Street excuses that CFTC rules will put them at a competitive disadvantage with their European counterparts!
Round 2 of the position limits fight begins in an environment more favorable to both transatlantic regulatory cooperation and reduced opportunities for regulatory evasion by OTC traders.