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CFTC Environmental Markets Advisory Committee Meets on Position Limits

Commodity Futures Trading Commission

Environmental Markets Advisory Committee

Thursday, February 26, 2015 

Key Topics & Takeaways

  • Need for Liquidity: Commissioner Giancarlo hoped that the EEMAC discussions would augment the Commission’s “assessment of the need for and efficacy of position limits” and examine how the rules can be set in a way that maintains liquidity for hedgers.
  • Bona Fide Hedging: Witnesses expressed concern regarding the narrow definition of “bona fide hedge” in the Commission’s proposed position limits rule, noting that it would impede current hedging and risk management practices  resulting in increased risk premiums, and that costs will be passed along to end consumers.
  • Position Accountability: CME’s LaSala noted that exchanges manage their exemptive process and position accountability program in a way that has promoted liquidity and stressed that speculators provide a valuable source of this liquidity

Meeting Participants

Opening Statements

Commissioner Giancarlo

J. Christopher Giancarlo, Commissioner at the Commodity Futures Trading Commission (CFTC) and sponsor of the Environmental Markets Advisory Committee (EEMAC), noted in his opening remarks that this meeting is the first for the EEMAC since it had been reconstituted and explained that there have been no EEMAC since the passage of the Dodd-Frank Act. 

Giancarlo noted that the energy and environmental markers are “undergoing the most sweeping technological and structural changes in a generation” and that further sessions exploration of the unique concerns of energy market participants regarding the position limits rulemaking will ensure that the CFTC has a “complete picture of the consequences of these proposals on all aspects” of these markets. 

He hoped that the EEMAC discussions would augment the Commission’s “assessment of the need for and efficacy of position limits” and examine how the rules can be set in a way that maintains liquidity for hedgers. 

Giancarlo noted there is concern among the Commissioners that the bona fide hedging exemption definition may be too narrow noting that the CFTC proposed a “significant reorganization” of its bona fide hedging policy, which “eliminates the possibility of any un-enumerated hedges.” He then expressed concern that bona fide hedging rules structured in this way impose federal regulatory edicts in place of business judgment in everyday commercial risk management. 

Chair Massad

CFTC Chairman Tim Massad stated that advisory meetings such as these are an important way for the Commission to get input on their rulemakings and said it was “good governance” for the CFTC to re-open their comment period on the position limits rulemaking. He said he does not believe that the re-opening of the comment period will affect the timing of the CFTC’s rulemaking process. 

Commissioner Wetjen

Commissioner Mark Wetjen called the position limits rulemaking “the rulemaking that keeps on giving” noting that he has lost count of the number of roundtables and meetings the Commission has held to discuss issues on the topic. He then commended Commissioner Giancarlo for this contributions to the CFTC since joining the Commission. 

Commissioner Bowen

Commissioner Sharron Bowen noted that is has been five years since the CFTC was tasked with writing a rule for position limits and said that leaving the rule unfinished harms consumers who are looking for protections and deprives the industry of regulatory certainty. 

Presentation – Current Conditions in U.S. Energy Markets

Adam Sieminski, Administrator, U.S. Energy Information Administration, gave a presentation in which he explained that futures and options prices are used to derive a range of expected volatility in the market for crude oil and noted that the market is predicting a wide range for the expected future price of $30 to $70 a barrel. He noted that for every $10 drop in the price of oil, gross domestic product (GDP) growth is expected to increase by 0.2 percent and thus current decreases in oil prices could add almost one percent to U.S. GDP this year. 

Panel 1 – What Does the Data Show?

Craig Pirrong

Craig Pirrong, Professor of Finance and Energy Markets, Director of Global Energy Management Institute, Bauer College of Business, University of Houston, stated in his presentation that there is an academic research problem when trying to detect excessive speculation in the markets due to problems with identifying the cause of price movements. He noted that it is even difficult to determine causes when looking back at price movements historically. 

Pirrong said that econometric evidence in a “non-manipulation context” is limited by the fact that relevant data on supply and demand cannot be observed and said the best approach to determining supply and demand levels is to rely on quantity data or inventories, noting that inventories should increase is prices are excessively high. 

He said that empirical studies fail to find evidence of distortion or that speculators are causing distortion. He added that contrary empirical and theoretical evidence papers “have serious flaws.” He also noted that a study from the Bank of International Settlements (BIS) “mightily” tries to blame “financialization” of the marketplace for price movements but said “its conclusions are unsupported and implausible,” noting that “fundamentals are clearly at work” in the market. 

Pirrong said that position limits would be ineffective against broad-based “speculation waves” where a number of market players are involved and stated that position limits may constrain efficient risk-taking by “unduly restricting hedging or limiting risk bearing capacity.” 

Question and Answer

An EEMAC member asked how likely it is that regulators and academics would fail to spot excessive speculation in the market, if it occurred. Pirrong replied that the “power” of market testing abilities can be measured on a continuum and that distortions which affect consumers are the ones that are most likely to be spotted. 

Tyson T. Slocum, Energy Program Director at Public Citizen, asked if requiring more detailed data on trades and speculation would make it easier to observe causes of price movements. Pirrong replied that the big gap in data is in areas of fundamental supply and demand information, noting that information on demand levels in China, for instance, is lacking. 

Commissioner Wetjen asked why “financialization” of the markets did not have the impact that the BIS said it did. Pirrong said that the BIS study did not measure the proper things and explained that “financialization” is generally affects risk premiums and not the supply and demand of commodities. 

Slocum then asked if the traders themselves are using inadequate data. Pirrong said that this is where the “genius of the markets” comes into play because traders effectively aggregate price information to bring about price discovery. 

Presentation – CFTC’s Sherrod

Steve Sherrod, Senior Economist, Division of Market Oversight, stated in his presentation that the CFTC collects data on the futures market through its large trader reporting system, where marker participants submit information daily on reportable positions. He also noted that the CFTC is in the process of implementing rules for ownership control reports, which will enable the Commission to receive automated reports on the identity of traders that are in trade capture reports. 

Sherrod also explained that the CFTC asks traders to indicate the business purpose of their derivatives trades get an indication of their general hedging use, but noted that this “indication is general” and does not specify if each trade was hedging or speculation. He highlighted that the CFTC used to require regular data collection on whether each trade was done to hedge or speculate, but that this rule was eliminated in 1981 to reduce burdens on commercial entities. 

Presentation – ICE’s Haas

Erik Haas, Director of Market Regulation at ICE Futures U.S., stated in his presentation that that ICE lists 175 futures and options contracts for natural gas, 281 for power, and 119 environmental. He said that the data from ICE and the “make of the markets” alleviates concerns that one category of market participant is having undue influence on the markets. 

Haas said that anything that makes it harder for an energy company to hedge “is going to directly impact the price people pay to heat their homes” and because costs of hedging eventually get pass on to end consumers.  He said that any regulations aimed at excessive speculation are “a solution to a non-existent problem in these contracts.” 

Presentation – CME’s LaSala

Tom LaSala, Tom LaSala, Chief Regulatory Officer, CME, in his presentation, showed market data and noted that there is no clear correlation with index investment and pricing in the market, and “no discernable influence” of money manager positions on price movements, noting that “other fundamental forces” are dictating prices. 

Question and Answer

Lael E. Campbell, Director of Government Affairs at Exelon, referenced one of Haas’s slides saying that the number of hedgers in the marketplace in his charts seemed “shockingly high.” He asked if speculators are becoming less active in the markets and if this has an impact on bid-ask spreads. Haas said that there are definitely less speculators in the market than there used to be, especially “out the curve” and said bid-ask spreads has widened as a result. 

Slocum then asked if this chart is really representative of hedging activity or just notes the category of market participant as being a hedging entity. Massad also wondered if the percentages listed in the chart on hedging referenced open interest of hedging or referred to CFTC categories. Haas explained that the hedge category on his chart is taken from CFTC large trader reporting information where entities classify themselves as commercial or speculative, and that the figures are not reflective of how anyone is trading. 

When asked what trends he is seeing in the market, Haas said that a lot of market participants have exited the market because it has become more expensive to operate. He noted that this decline in market participation has led to decreases in liquidity. 

Panel 2 – Designated Contract Market Experience with Position Limits and Trading Liquidity

Presentations

Haas gave a second presentation on how ICE operates and its regulatory regime. He noted that any “undue influence” on the market from regulations or market activity “directly impacts commercial companies and end-users” and said a “one-size fits all approach to futures does not work.” 

Haas noted that ICE takes a “bottom up approach” to market regulation that includes audit trails, position data, social media, and news sources to understand how participants are using the markets, so that ICE can offer better guidance on complying with its rules. He said the rules are “aimed at gauging a position concentration impact” that may be present in the market but said the position level itself is rarely the sole factor in having an impact on the market. Haas said the rules allow give the exchanges to ability to force participants not to increase positions or reduce their positions in an orderly manner. 

Haas stressed that spot month limits must be set based on updated deliverable supply information, which focuses on the specific needs of the energy market. He also said that ICE “strongly believes” that cross-commodity, anticipatory, and unfixed hedging must be recognized by the Commission and that exchanges should be given the flexibility to review and grant exemptions based on exposure “where appropriate.” 

LaSala, in his presentation, explained that the CME has access to market information that enables then to quickly run an analysis on market participant activity is there is a price aberration. He noted that the CME uses position accountability levels to evaluate what a market can handle and prevent concentrations and also noted the exchange can grant exemptions to certain limits. 

LaSala noted that the CME can modify or terminate these exemptions but noted that the current CFTC proposal would not allow for certain exemptions. He said that taking away these exemptions would be detrimental to the marketplace, by reducing liquidity and widening bi-ask spreads, and said the CME should be able to rely on discretion on a case-by-case basis. 

He concluded that CME has managed its exemptive process and position accountability program in a way that has promoted liquidity and stresses that speculators provide a valuable source of this liquidity. 

Bill McCoy, Futures Industry Association (FIA), said that position accountability in the spot month has been an effective tool and questions the need for a federal regime. He suggested that the Commission could conserve resources by not imposing limits on non-spot month contracts and delegating responsibility to exchanges for position accountability. He said the CFTC has the authority to put forth a less restrictive regime that considers the impact on the markets. 

Question and Answer

Rob Creamer, FIA Principal Trader Group, said the firms in his association are not affected very much by the position limits rule, but shared concerns with the rules potential impact on end-users. He asked how the exchanges determine the impacts on the markets and prices. Haas said that impact is assessed by looking at liquidity levels and levels of price convergence. LaSala added that looking at bid-ask spreads is important to determining regulatory impact. 

Wetjen asked Creamer why his group is not impacted by the proposed rules. Creamer said that the firms in his group solved many of the issues that were presented and that these firms net their position across terms while acting as market makers and hedging all of their activity. 

In response to a question, Sherrod said that if the CFTC added a federal limit at the exchange level it would not prevent the exchanges from engaging in dialogue with market participants around position accountability. LaSala agree said that a federal structure would not trump th exchange’s obligations. 

Panel 3 – Bona Fide Hedging

Presentations

Steve Sherrod briefly highlighted some of the Commission’s proposed changes to the definition of “bona fide hedging”, which would include “incidental” and “economically appropriate” tests. 

Ron Oppenheimerpresented next on behalf of the Commercial Energy Working Group.  Oppenheimer first raised concern that the Commission’s proposed Position Limits rulemaking would have the unintended consequence of introducing risk to the pricing of commodities and raising the cost of such commodities to consumers.  He then expressed concern with the Commission’s proposed “economically appropriate test,”  stating that it “substitutes a governmentally imposed one size fits all risk management paradigm” on companies that already seek to prudently manage risk “in light of [their] own facts and circumstances,” and would require commercial entities to build a system to manage risk in this specific way.   Additionally, Oppenheimer argued that it would be problematic for the Commission to only allow those transactions enumerated in its proposal as “bona fide hedges,” as “no one can be expected to understand or anticipate every type of hedge that can be done that could fit all markets or fit all market participants.”

Oppenheimer then went on to illustrate two examples where current hedging practices in the energy space would not be granted “bona fide hedging” treatment under the Commission’s proposal (found here).  A question was raised as to why these examples would not be considered a “bona fide hedge” by the Commission, to which Sherrod responded that staff, at least when fact patterns were initially raised via previous petitions, required more information to make such determinations, and encouraged further comments. 

Joe Nicosia, on behalf of the Commodity Markets Council, spoke noted that Commission rules were intended to curb excessive speculation, not to curb hedging.  Under the proposed Position Limits rule, he said, the “practice of hedging would be curbed” and that “there is no public benefit to the curbing of bona fide hedging.” Nicosia further stated that “merchants accept and manage several different types of risks in the supply chain,” and stressed that their ability to hedge these risks impacts consumer prices.  By narrowly construing what risk is considered a “bona fide hedge,” he argued “risk premiums will be growing wider throughout the business channel, which will be passed along to end consumers. Bid offer spreads will widen, credit risk widen and liquidity will be reduced.”

Question and Answer

Following the witness presentations, members of the EEMAC provided additional comments.  Russ Wasson, National Rural Electric Cooperative Association, expressed concern that it would be impossible for the Commission to create a “bona fide hedge definition” that would cover the “thousands upon thousands of ways that electric utilities have to hedge their operational risk”, noting that he would prefer to see an entity-based exemption (or a transaction exemption, in the alternative). 

Dena Wiggins, Natural Gas Supply Association, expressed the view that the list of bona fide hedges should be expanded, and “at a very minimum” there should be some fairly fast process for determining whether a transaction is deemed a “bona fide hedge,” to prevent uncertainty and allow market participants to hedge risks appropriately. 

Benjamin Jackson, ICE Futures U.S., noted that many of the concerns expressed by energy market participants are applicable to agricultural market participants as well, and went on to discuss issues related to open interest. 

Arushi Sharma Frank, American Gas Association, noted the difficulties of fitting “non-generic” transactions in the proposed definition of “bona fide hedge” and asked the CFTC whether market participants should be presenting a series of specific examples or alternative procedural mechanisms to the Commission.  Sherrod noted that market participants are already taking such action, and welcomed further feedback. 

Sue Kelly, American Public Power Association, reiterated that entity-based exemptions would be preferable, noting that it was not clear to her why not-for-profit city and state owned utilities, “special entities,” are being subjected to the same regime as other market participants. 

Paul Hughes, Southern Company, expressed concern that the current Position Limits rule includes trade options.  Given the significant difficulties in attempting to include trade options in calculations, he said it is imperative these not be included in the final rule.  He went on to discuss the lack of liquidity in markets currently facing hedgers, largely due to the overall impact of Dodd Frank, and expressed that the Commission should take this into account. 

Chairman Massad concluded by saying that “no one is trying to attack bona fide hedgers” or drive speculators out of the market, but that the CFTC must carry out their statutory responsibility. He said that he does not think anyone “wants to go back to 1981” where CFTC reporting rules required information on when a position was speculation or a head, adding that he is not sure how that worked apart from “Boy Scouts’ honor.” He stressed that the CFTC is “very committed to make sure these markets still work for participants.” 

For more information, including presentation materials, please click here.