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From Securities Regulation Daily, December 9, 2014

Agricultural producers should be excluded from commodity position limits, says CFTC Commissioner Giancarlo

By Lene Powell, J.D.

In a meeting of the CFTC Agricultural Advisory Committee, staff economists explained how deliverable supply of physical commodities is used to set position limits for core commodities and contracts that reference them. They noted that the amount of deliverable supply plays an important part in driving price convergence between the cash and physical markets, and that a proposed formula for position limits of 25 percent of deliverable supply is a traditional one that has worked well over the decades.

Commissioner J. Christopher Giancarlo stressed the need for a strong bona fide hedging exemption, saying, “If we replace farmers’ commercial risk management decisions with Washington’s risk management decisions, we are all in a lot of trouble. Stock up on corn flakes.”

The meeting included many representatives from the agricultural industry, and was part of the agency’s efforts in considering thousands of public comments regarding the proposed expansion of position limits to additional commodities. The CFTC initially issued final position limit rules, as required by the Dodd-Frank Act, in 2011. Subsequently, the rules were challenged in court and vacated. The CFTC re-proposed the rules at the end of 2013.  On December 1, 2014, the agency reopened the comment period for the re-proposed rules to allow for input from the Agricultural Advisory Committee. The deadline for the reopened comment period is January 22, 2015.

Reducing burdens on end users. Chairman Timothy Massad said the CFTC’s goal, in addition to promoting market integrity and transparency, is to avoid creating unnecessary burdens on commercial end users and to build a reliable, orderly framework for oversight in which vibrant markets can thrive. Some of the agency’s recent actions have been especially important to the agricultural industry, such as a proposal on residual interest and changes to certain recordkeeping requirements. The CFTC has also proposed changes to accommodate contracts with volumetric optionality to make sure publicly owned utilities can access the energy swaps markets, and to allow end users to use their treasury affiliates for swap transactions and still benefit from the Congressional end user exemptions.

Commissioner Giancarlo echoed the need to reduce burdens on end users. Futures and swaps markets play a critical role in feeding the world’s population by providing reliable and fair benchmarks for prices, thus resolving imbalances. They also reduce price volatility in a resource-constrained world by removing the economic incentive to hoard physical supplies. Federal regulation raises the cost of farming and ranching, and the CFTC must ensure that the regulations it promulgates are smart and efficient.

Giancarlo welcomed the CFTC proposal to prevent an automatic shift in how futures commission merchants (FCMs) collect residual interest, which would have caused farmers and ranchers to pre-fund their margin accounts. However, he said that farmers, ranchers, and other agricultural participants should be wholly excluded from any new CFTC position limits regime, and should not be second-guessed on whether their agricultural hedges satisfy the agency’s concept of bona fide hedges. “What do we know about hedging farm production?” he asked.

Deliverable supply. According to Christa Lachenmayr, an economist with the CFTC Division of Market Oversight, deliverable supply for futures contracts is referenced in a Federal Register notice from 1997, which specifies that “for all delivery months on the contract, deliverable supply should be sufficiently large and available to market participants that futures deliveries, or the credible threat thereof, can assure an appropriate convergence of cash and futures prices.” Most short futures positions do not result in physical delivery of the commodity, but the credible threat of delivery drives convergence between cash and futures prices.

The definition of deliverable supply is provided in Appendix C to Part 38 as “the quantity of the commodity that potentially could be made available for sale on a spot basis at current prices at the contract's delivery points.” There are a number of qualifiers, including that the supply meets the contract’s delivery specifications during the delivery period. Excluded from deliverable supply are (1) quantities of the commodity that would not be economically obtainable or deliverable at prevailing price levels (i.e., supplies that are “out of position”); and (2) an amount of commodity committed for long-term agreements. Exchanges must take the amount of deliverable supply when submitting new contracts for approval; there should be enough to ensure that the contract is not susceptible to price manipulation or distortion.

Proposed rules. Senior Economist Stephen Sherrod explained that the proposed position limits rule would set initial spot month position limits for 19 agricultural commodities at the current exchange-set or CFTC legacy limit levels for the core referenced futures contracts (and associated referenced contracts and swaps) for two years after the rule becomes effective. Position limit levels would be reset at least every two years, and exchanges that list core referenced contracts would need to submit deliverable supply estimates accompanied by a methodology description and supporting data.

Sherrod described three approaches to setting position limits:

  • Set initial spot month limits based on 25 percent of estimated deliverable supplies submitted by CME Group as of July 1, 2013;

  • If the CFTC could not verify that an exchange’s estimated deliverable supply was “reasonable” in a particular commodity, apply the current limits, or a higher level based on a Commission estimate of deliverable supply for such commodity, but not greater than would result from the exchange’s estimated deliverable supply;

  • Allow the CFTC, in its discretion, to set an initial spot month limit and subsequent levels at (1) an exchange-recommended level; (2) a level not more than 25 percent of estimated deliverable supply; or (3) the current levels.

A number of committee members stressed that convergence of the cash and physical markets is critical, and that exchanges understand that convergence is necessary for a contract to be successful. They asked that the CFTC allow exchanges to set limits less than deliverable supply. Sherrod responded that yes, the proposed rule only sets a cap or upper limit on what the exchanges can set. Where the CFTC has set a limit, the exchanges would have to follow that at a level no greater than the federal level. Asked whether the CFTC would provide for notice and comment before resetting limits, he said it is contemplated that the reset would be automatic.

Quizzed by Commissioner Giancarlo as to the reasoning behind the formula of 25 percent of deliverable supply, Sherrod said as with most things relating to position limits, it goes back to the 1930s. The 25 percent formula is a rule of thumb, but the Commission has long articulated that spot month limits are not an exact science; there is a reasonable range. If four traders each had 25 percent of deliverable supply, and acting independently they each decided to take physical delivery, then together they would take all the supply. In response to Giancarlo’s question whether there was any proof that 25 percent was still a good level, Sherrod noted that the exchanges have levels that are set much lower than 25 percent in some cases.

MainStory: TopStory CommodityFutures CFTCNews Derivatives

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