Comment Text:
10-002
COMMENT
CL-02679
UNITED STATES
Commodity Funds, LLC
April22,2010
1320 Harbor Bay Parkway
Suite 145
Alameda, CA 94502
510.522,9600
510.522.9604 fax
VIA E-MA!.L
Mr. David Stawick
Secretary
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, N.W.
Washington, DC 20581
Proposed Federal Speculative Position Limits for
Referenced Energy Contracts and Associated Regulations
Dear Mr. Stawick:
We are submitting this letter on behalf of Unit'ed States Commodity Funds LLC
("USCF"), a commodity pool operator registered with the Commodity Futures Trading
Commission ("CFTC" or "Commission"), that manages several exchange traded commodity
pools, including the United States Oil Fund, LP ("USO") and the United States Natural Gas
Fund, LP ("LING"). USCF wishes to provide a response to your request for comments on the
CFTC's Notice of Proposed Rulemaldng entitled:
Federal Speculative Position Limits for
Referenced Energy Contracts and Associated Regulations
("Proposed Rule"). We believe that
the ability of USCF to prudently meet the investment objectives of the commodity pools that it
manages will likely be significantly hampered by the limits as proposed. We believe the same
may be true for other firms that manage similar publicly traded, Ira-levered, passive commodity
funds. As a result, and more importantly, the value of the exchange traded pools managed by
USCF to the hundreds of thousands of investors in our pools, and the several million investors in
all similar pools currently in operation in the United States, could be adversely affected by
adoption of the Proposed Rule. For the reasons set out below, we believe the Proposed Rule
should not be finalized in its present form.
I. Description of USCF and its Related Funds
As a registered commodity pool operator, USCF is general partner of and manages the
United States Oil Fund, LP, the United States Natural Gas Fund, LP, the United States 12 Month
Oil Fund, LP, the United States 12 Month Oil Fund, LP, the United States Gasoline Fund, LP,
the United States Heating Oil Fund, LP, and the United States Short Oil Fund, LP (each, a10-002
COMMENT
CL-02679
Mr, David Stawick
April 22, 2010
Page 2
"Fund" and collectively, the "Funds"). Each of the Funds is an exchange-traded commodity pool
that principally invests in futures contracts for energy commodities with the investment objective
of having the net asset value ("NAV") of the units of each Fund reflect changes in percentage
terms of the price of a giv.en commodity futures contract. The specific commodity focus and
investment strategy of each Fund varies; however, the structure and method of investing in all of
USCF's Funds is identical. Units of each of the Funds are listed on the NYSE Arca, Inc.
('NYSE Arca"). Publicly listed investment pools such as ours, and those operated by other
passive managers, are frequently referred to as "commodity ETFs," although such a description
is not technically correct. 1
Each of the Funds has thousands of investors (for example, USO and UNG had,
respectively, over 300,000 and 400,000 investors during the course of 2009)
2
and no investor, to
the Funds' knowledge, has ever held more than 5% of the units outstanding of any Fund, other
than a handful of occasions typically during the period when a Fund initially offers its units to
the public and has few investors,
3
Based on discussions with other managers of similar passive
commodity funds, we estimate that the total number of individual "retail" investors in the United
States who hold investments in such exchange traded commodity funds is between 3,000,000
and 4,000,000 based on 2009 totals.
II. Summary of General Comments
The objective of the Funds is generally to allow both retail and institutional investors to
easily gain exposure to the energy markets in a cost-effective manner. Energy prices impact all
investors either directly or indirectly and there has been a growing apprecia.tion by investors that
it may be appropriate to address the escalation and volatility of energy prices through
participation in the financial markets. Investors have several avenues of participation, including
directly buying and selling exchange traded futures contracts. If each of the Funds' investors
individually elected to gain exposure to the energy markets through the purchase and sale of
exchange traded energy futures contracts, the Proposed Rule would be of little consequence
because it is extremely doubtful that any Fund investor would ever hold enough futures contracts
to be impacted by the position limits in the Proposed Rule.
4
Thus, it is solely because such
~ ETFs are considered to be exchange traded vehicles that are registered with the U.S. Securities Exchange
Commission ("SEC") under the Investment Company Act of 1940 ("1940 Act"), ~vhile the "commodity ETFs" are
generally registered under the Securities Exchange Act of 1934 ("1934 Act").
2 According to data compiled in connection with providing Internal Revenue Service Schedule K-1 tax forms.
3 Since each of the Funds are registered under the 1934 Act, investors holding 5% or more of a Fund's units are
required to disclose their holdings and intentions under Section 13 of the 1934 Act.
4 Although it is theoretically possible that the positions of a single investor in one of the Funds could breach the
limits set out in the Proposed Rule, this has not occurred to date and we believe mechanisms could be put in place
that would assure that any investor in the Funds whose positions could breach the limits would be identified.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 3
investors seek to obtain their financial exposure to the energy markets collectively in a simpler,
unleveraged and economically efficient manner through the Funds
that
they will likely suffer
adverse effects from adoption of the Proposed Rule.
The Funds have directly made the case to the Commission that the Funds' collective
investments in futures contracts have not in fact contributed to either the volatility or run ups (or
run downs) in energy prices experienced over the last several years.
5
Perhaps this explains why
in its Proposed Rule the Commission repeatedly makes the point that it is not required to base its
position limits on a finding that the positions of a certain size constitute excessive speculation
that create an actual burden on interstate commerce.
6
Rather, the Commission states that it
"may make and promulgate such rules and regulations that in its judgment are reasonably
necessary to accomplish any of the purposes of the [Commodity Exchange
Act].
''7
Without
belaboring questions regarding the legal authority asserted by the Commission, we believe the
Commission cannot escape the question of whether it is wise or appropriate for it to adopt rules
that will interfere with the ability of ordinary citizens to gain exposure to our energy markets in a
cost effective and efficient manner. The mere fact the Commission might be able to adopt a
particular rule does not mean that such action should be taken.
a. Rationales for Position Limits
We believe that there are essentially four reasons why position limits might be justifiably
imposed on market participants (outside of the limits traditionally put in place during the final
days before expiration of futures contracts when delivery becomes an issue). However, none of
these reasons appears to provide a viable rationale for imposing position limits on publicly
traded, non-leveraged, passive commodity investment funds.
Settlement Risk.
The first reason for imposing position limits on market participants is to
avoid a situation where an unusually large owner of futures contracts becomes a settlement risk
to the futures contract's exchange clearing house. This could occur if a large entity took a
position, long or short, that went against it in such a fashion that it was unable to post additional
margin to cover such position, or the entity in fact went bankrupt. This scenario in turn could
force the entity's futures commission merchant ("FCM") to have to make good on the open
positions of the failed entity. It is possible that this scenario could force the failure of the FCM,
which in turn would place the Cost of the open positions onto the clearing house and its members.
5 See
USCF Comment Letter to the' CFTC's Concept Release on Whether to Eliminate the Bona Fide Hedge
Exemption for Certain Swap Dealers and Create a New Limited Risk Management Exemption From Speculative
Position Limits, 74 FR 12282 (March 24, 2009), filed June 16, 2009; Testimony of John Hyland, Chief Investment
Officer of USCF, before the CFTC on August 5, 2009.
6 See, e.g.,
Proposed Rule, 75 FR 4144, at 4148 (January 26, 2010).
7!d,10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 4
The level of settlement risk presented in this scenario, however, is different depending on the
type of entity holding large positions,
As an example, let us assume there are four types of potential very large holders of
futures contracts. Our entities for this example are the following:
1) A hedge fund or other purely financial investment firm.
Such a firm would often use very
large amounts of leverag'e (10 times or more), take a meaningful price risk in its
investments in futures contracts, and have a highly liquid, but small, capital base.
2) A large bank or investment bank that acts as a dealer in both futures and commodity
related swaps.
Such an entity would also be highly levered (10 times or more), wouId not
always be taking a price risk with its positions in futures contracts since it would
sometimes be acting as an intermediary, and would have a relatively large capital base
that would be a mixture of liquid and illiquid holdings.
3)
A large commodity end-user, producer, or dealer in the physical commodity.
Such a firm
would typically, but not always, be hedging its price exposure, would have lower levels
of leverage, and
might
have a large but very illiquid
capital
base.
4)
An exchange traded commodity fund ("commodity ETF").
Such a fund would typically
be un-levered, would not itself be taking any price risk since it is a passive index-like
vehicle (although its individual investors would be taking price risk), and would have a
very large and very liquid capital base.
laa the above examples, the biggest candidate for settlement risk is #1, the hedge fired, and
the lowest risk is #4, the commodity ETF. However, the position limits in the Proposed Rule
would essentially put both the highest and lowest risk participants (#1 and #4, respectively) in
the same and most restrictive category in terms of limits on holdings. However, the Proposed
Rule would allow the second riskiest category, the dealer (entity #2), to hold twice as many
futures contracts as the least risky category (entity #4) under the current proposal. Finally, the
third riskiest category, the commodity end-user (entity #3), would be essentially allowed
unlimited holdings.
8
Market Manipulation.
The second rationale for the limits is to prevent illegal
manipulation in the markets by a large holder of contracts,
i.e.,
to prevent some sort of"corner"
of the market or other manipulative operation. As major investors on behalf of hundreds of
thousands of shareholders in USCF's commodity ETFs we are certainly in favor of protecting the
markets we invest in against such manipulation. However, we fail to see how such a concern
8 We believe that the common argument that commodity end-users and producers represent the lowest risk category
is refuted by the numerous problems caused in the financial commodity markets by these types of entities, including:
Sumitomo Corporation, Metallgesellschaft Corporation, China Aviation Oil, the Hunt brothers, and the Chinese
State Reserve Bureau, all of whom were physical players in commodities as well as users &futures contracts).10-002
COMMENT
CL-02679
Mr. David Stawiek
April 22, 2010
Page 5
would lead to position limits being placed on publicly traded, passive, un-levered funds such as
ollrs.
The history of the commodity markets suggests that three elements are usually present
when a person or firm sets out to deliberately manipulate the market. First, they need secrecy,
given that if everybody knows what they are doing they will not succeed. Second, they need
leverage, since in any large commodity market an entity's ability to influence prices with
certainty will usually be limited to small amounts and for short periods of time. Finally, they
almost certainly need to be able to participate in BOTH the futures market and the physical
market, because we believe solely using futures contracts does not provide these bad actors with
an adequate tool to create the artificial price necessary to implement their plan.
Based on these three identified elements, and using the same four potential categories of
very large holders that we postulated above, we believe that the category that has the greatest
potential for manipulative abuse is category #3, a large physical player who also uses futures.
9
The second most likely candidate is #2, the bank or investment bank, with #1, the hedge fund, a
distant third.
1°
The least likely candidate is #4, the commodity ETF, since they are typically too
ta'ansparent, too un-levered, and too tied to their benchrnark or index to be a remotely plausible
candidate.
For any observer who raises the suggestion of "unintentional manipulation'' as a possible
basis of concern here, we would have to point out that under the Commodity Exchange Act such
a thing is a legal oxymoron. Manipulation is a crime and requires specific intent. Just because an
investor buys something, and the price goes up, does not mean that manipulation has occurred or
an artificial price has been created. Normally in markets we refer to that as "supply and
demand."
Reduction of Volatility.
The third rationale is that the Commission desires to reduce the
average am,ount of price volatility in various commodity markets. Technically we understand
that the Commission refers to this as taking action to "...diminish, eliminate or prevent excessive
speculation .... "However, it is unclear what the phrase "excessive speculation" really means in this
context. We have not seen a precise definition of what excessive speculation really is or how the
9 As previously noted, we believe that the common argument that commodity end-users and producers represent the
lowest risk category is refuted by the numerous problems caused in the financial commodity markets by these types
of entities, including: Sumitomo Corporation, Metallgesellschaft Corporation, China Aviation Oil, the Hunt
brothers, and the Chinese State Reserve Bureau, all of whom were physical players in commodities as well as users
of futures contracts).
~o In the example given, the hedge fund is not a large risk to manipulate a commodity market because it is not long
or short physical supply and thus it is unlikely to be able to influence spot prices or, on a risk free basis, move the
futures curve. The same line of argument applies to USCF's Funds and other commodity ETFs that operate in a
similar fashion.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 6
Commission measures it. For the purposes of this comment letter we will view the purpose as an
attempt to reduce the average amount of price volatility of a particular commodity over some period
of time. That still leaves the issue of how to determine what is the normal or "correct" level of price
volatility, a problem that we will not attempt to resolve in this letter.
The concern we have with imposing position limits on publicly listed, passive, un-levered
commodity funds is that the empirical evidence suggests that in doing so the Commission will not
obtain a reduction in price volatili~. In fact, the Commission is more likely to create in increase in
price volatility. Viewing the recent price movements in crude oil between 2007 to 2010, for example,
the reports of the CFTC's own staff,
I1
the studies done by recognized energy market academics,
~2
and the data published by firms such as 0urs,
~3
make clear that financial investors in general, and
commodity ETFs in particular, tended to be net sellers of crude oil futures contracts during the mid-
2007 to mid-2008 run up in oil prices, were net buyers of contracts during the fall in oil prices
between mid-2008 and early 2009, and have once again been net sellers in the more recent rise in
crude oil prices between early 2009 and early 2010. If the Commission presumes that large scale
buying and selling of futures contracts can directly influence the price of the spot commodity, which
is itself a highly debated point, then the only conclusion that can be drawn is that the actions of
commodity ETFs over the last three years have been to moderate volatility in crude oil prices, not
increase it.
By comparison, many of the claims made by proponents of position limits in general, and
position limits on passive, non-levered investors in particular, lack any serious analysis to justify
their claims. Typically the "data" that supports these claims consists of saying that on a particular
date a fund did "A", and the markers or prices did "X", thus "proving" that the fund's action caused
the described outcome. However, all the claims we have seen appear to have engaged in selective
data cherry picking. They don't seem to mention that perhaps a month earlier than the above example
the fund also did "A", but the market or prices did "Y", not "X." or that a Week after the fund did
"A" the market or prices did "X" while the fund took no actions at all. Other common claims are
rooted in this logical fallacy of confusing correlation with causality
("cure hoc ergopropter hod').
A common claim of this sort is "Commodity prices rose over the last 5 years while passive
:investments rose over the last 5 years. Ergo, passive investments caused commodity prices to
rise." Leaving aside the statistical issue of "auto-correlation" in the example just cited, the
CFTC's own staff rejected this claim in several of its reports as have studies by the commodity
futures exchanges and many notable economists]
4
~ See, e.g.,
Interagency Task Force on Commodity Markets (July 2008) ("Interagency Commodity Markets Study")
and CFTC Trader Activity and Derivative Pricing (December 4, 2008) ("CFTC Pricing Study").
~2 See, e,g.,
Philip K. Vedeger, Jr., Stephen Craig Pirrong, Dwight R. Sanders and Scott H. Irwin, among others.
~ See infra
pp. 17-19 and accompanying notes.
~4 See supra
notes 11-12.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 7
The foregoing is not to suggest that other types of major market participants have a similar
effect on commodity prices. The data we have seen and cited refers to the impact on markets of
publicly traded, passive, and un-levered commodity funds. We cannot comment on the usefulness of
position limits on other types of market participants in regards to attempting to lower price volatility.
However, we would note that the United Kingdom's financial markets regulator, the Financial
Services Authority ("FSA"), recently cast serious doubts on the usefulness of position limits to
moderate price volatility. In its white paper dated December 2009 and tiffed "Reforming OTC
Derivatives Markets - AUK perspective" ("FSA White Paper"), the FSA stated the following:
In any event, we do not believe a case has been made which demonstrates that
prices of commodities, or other financial derivatives, can be effectively controlled
through the mandatory operation of regulatory tools such as position limits,
whether on exchange or OTC. Analysis of market data where position limits are
already in use suggests that this has not shown a reduction in volatility or
absolute price movements compared to contracts where they are not. Js
We are unaware of any evidence or studies that would lead us to contradict the FSA's
conclusion.
Price Setting.
The fourth and final rationale'is to set prices at some level that the
Commission determines is desirable.' However, the Commission, and the individual
Commissioners, have made clear that they do not view their roll as that of a "price setting"
agency. In addition, if you accept the conclusion of the FSA cited above, it appears that even an
attempt to be a price setting body is destined to fail.
For example, the managers of USCF believe that the prices of crude oil is determined
primarily by the interplay of supply, demand, available inventory, the value of the U.S. dollar
(the currency crude oil is priced in), and amount of spare production capacity that exists at any
point in time. The CFTC's own studies, including the Interagency Commodity Markets Study
and the CFTC Pricing Study, make clear that these fundamentals, not speculation, drove prices
during the 2008 run-up in commodity prices, including not only crude oil and other commodities
for which listed futures contracts exist but also for commodities for which no futures market
exists.
In particular, we would encourage observers to study Figure 10 on page 56 of the CFTC
Pricing Study. It makes very clear that at all times during 2007 and 2008 when oil prices were
high that spare oil production capacity was essentially zero (the chart actually measures all spare
capacity except for Saudi Arabia, however, published reports in early and mid 2008 suggest that
~ FSA White Paper, at chapter 9,10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 8
essentially Saudi Arabia had little or no spare capacity at that time for light, sweet etude oil).
~6
Our own belief is that, regardless of CFTC or FSA actions, market fundamentals will determine
prices. Should global crude oil spare capacity again approach zero in the near future we can
foresee that oil prices will in fact once again rise to record levels. We do not foresee position
limits having any meaningful impact on that possibility.
b. "Look-Through" and Passive Investment Funds
Even if the Commission believes that position limits on energy futures contracts would"
have a positive effect on the financial energy markets, we question why the position limits in the
Commission's Proposed Rule do not provide for a "look-through" to the actual investors in
entities such as the Funds. This would be a more rational approach since it is the Funds'
investors and not the Funds themselves that are in fact making the buy/sell decisions resulting in
the purchase or sale of energy futures contracts. In this context, the Funds are "aggregators but
not actors" from an investment standpoint. Placing limits on the futures contract positions
owned by passive entities like the Funds will not curtail investor interest in the financial energy.
markets. To the contrary, all available evidence points to growing investor interest in gaining
exposure to these markets and that such investment provides a prudent means of balancing an
investor portfolio. As a result, limiting the Funds' ability to meet investor demand for exposure
to financial energy markets may force investors into less transparent mechanisms for hedging
their commodity-related and other investment risks.
As noted above, to our knowledge all publicly traded, passive, and un-levered energy
commodity funds are registered under the 1934 Act. As such, any investor with large holdings of
shares or units, in excess of 5% of a particular fund's outstanding shares, is required to notify the
SEC, through a public filing, oflts ownership interest in the fund]
7
Thus it would be very easy
for the CFTC to monitor individuals or firms that invest indirectly through the funds into the
commodity markets at very large levels. However, we would observe that we have rarely seen
any such filings for any of our large funds. In the ease of USO for example, it has been almost
four years since any investor filed a Form 13G indicating that it owned 5% or more of USO. At
that time, USO was in fact quite small (assets ors10 million). As was pointed out during
testimony by our firm during the August 2009 hearings by the CFTC on these topics, we believe
that investors interested in taking very large positions in the commodity markets wouId typically
not elect to use what is essentially a retail product. To be blunt, they are not willing to "p~y
t6 See
International Energy Agency Monthly Oil Report (May 13, 2008).
t7 See
i934 Act Rule 13-al. In addition, we note that institutional investment managers having investment
discretion over accounts with securities valued at $100,000,000 are required to report each calendar quarter their
equity holdings in such publicly traded funds.
See
1934 Act Rule 13f-1. Finally, we note that the SEC recently
proposed a role to require certain large traders to report aggregate trades above certain trading levels established by
the SEC.
See
SEC Release No. 34-619086 (April 14, 2010).10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 9
retail" in terms of the cost of.using a fund such as ours versus directly buying futures contracts or
over-the-counter ("OTC") swaps.
If the CFTC wished to be able to see investors who hold sizable amounts of indirect
exposure to the commodity futures markets via exchange traded funds, but were still under the
5% limits, we believe that could be accomplished relatively easily with minimal costs to
investors, exchanges, broker-dealers, or fund operators. The broker-dealers who buy and sell
shares of exchange traded commodity funds for clients are already required to report the names
and holdings of clients at the end of each year to those commodity funds that elect limited
partnership tax treatment so that the funds may send out tax reporting statements (many, if not
all, exchange traded commodity funds are partnerships for tax purposes). Thus the mechanism is
already in place for surveillance on a once a year basis. If the CFTC wished to have more
frequent reporting of ownership information, we believe
that
likely would entail a discussion
between the CFTC and the SEC. However, given the SEC's current reporting regime and
the
proposal for large trader reporting noted above, such additional reporting is reasonably possible.
Although broker-dealers are typica!ly required only to submit the holdings data of their clients to
the funds for tax reporting purposes after the close of the calendar year, in fact the major broker-
dealers report the data pretty much on a monthly basis already. As a result we think that creating
a workable "look-through" system in real time would be doable using existing systems in place
at the broker-dealers.
c. "Reasonably Necessary" and Cost to the System
As indicated above, we question the desirability of imposing position limits on previously
regulated entities that are publicly listed, highly transparent, passive, un-levered commodity
funds. We believe there are serious questions about the actual benefit that will be derived by
such an approach. As such we do not see on what basis the Commission could conclude, that such
actions "...in its judgment are reasonably necessary .... "
Art observer might want to conclude that position limits are desirable because even if
there is only a one in a thousand chance that passive, un-levered funds might pose a threat to the
system then the additional regulation would be worthwhile. However, if that low of a threshold
is the basis of the Commission's judgment we must point out that to be consistent
the
Commission would have to impose position limits on every market participant, including
physical participants, since the other categories of market participants all present greater risks
than passive, u_n-levered ftmds. In fact, the UK's FSA specifically commented on this topic in the
FSA White Paper, stating that the FSA did not believe that position limits should be imposed on
one class of market participants but not imposed on other groups:
In relation to controlling or limiting price movement, we have seen no evidence to
suggest that one particular type of market participant has been solely responsible10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 10
for systematically driving derivative market prices. As a result, we do not believe
that limiting one class of market participant by imposing specific limits is a
desirable or warranted response to the changing nature of derivative markets. Is
At the same time, we believe there will be definite harm to the market and market
participants if such a rule is imposed. Should the Proposed Rule be adopted, investors seeking
access to these markets may choose any number of ways in which to avoid or circumvent the
Commission's proposed position limits, including those discussed below. We believe that the
harm to the financial commodity market and the related market participants resulting investor
actions to avoid position limits can come in the following three ways:
First, existing funds can themselves go to OTC and foreign markets to satisfy investor
demand. Additionally, they may modify their investment objectives or benchmarks to avoid
exceeding position limits. In any of these cases, investors will find themselves facing additional
costs and risks. We believe the most prudent and efficient way for commodity ETFs to provide
investors with access to the financial energy markets and to fulfill the funds' investment
objectives is to buy and sell exchange traded energy futures contracts in the U.S. futures markets.
To the extent that adoption of the proposed position limits causes these funds and others to turn
to the OTC markets, investors will necessarily incur both additional costs and risks, including the
following:
First, with respect to the OTC markets there is the not insignificant cost of negotiating
appropriate ISDA master agreements with multiple dealers.
Second, OTC trades introduce counterparty credit risk
(i.e.,
the risk that the dealer could
become insolvent and unable to fulfill its payment obligations) that must be addressed
through supplementary credit support agreements with the respective dealer
counterparties. Such risk is practically nonexistent when dealing directly in the regulated
futures markets where the eounterparty is not a dealer but a regulated clearing entity.
Third, there is the risk of premature termination of trades due to events affecting
particular dealer counterparties.
Fourth, there may be additional costs imposed by the dealer to the extent that the
Commission's position limit rules limit the dealer's ability to hedge the OTC trade in the
futures markets.
Fifth, there will clearly be a cost imposed by the dealer for becoming a party (in effect
another "middleman") to the Funds' investment transactions; absent the regulatory
position limits there would likely be no reason why the Funds would enter into OTC
transactions in order to meet their stated objectives.
m FSA White Paper, at ehapler 9,10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 11
To the extent that a commodity ETF makes use ofnon-U.S, futures contracts and futures
exchanges, then the investors in such entity may face not only greater cost but also certain
settlement, clearing, and currency risks that might be avoided by the use of listed U.S. futures
contracts. Finally, to the extent that a commodity ETF changes its investment objective to
accommodate these proposed regulations, it may be the ease that investors are denied the
opportunity to invest in what they actually want, versus what regulators will permit them to have.
Second, new funds can be created by new sponsors to tap investor demand that cannot be
satisfied by the existing funds that may find themselves "limited out." In either case, the impact,
if any, on participation in the energy futures markets will likely be the same as if the proposed
limits were either abandoned or modified to provide a "look-through" to the existing funds'
actual investors. As was stated before, exchange traded passive commodity funds are
"aggregators, not actors." The actual actors, the hundreds of thousands of investors, will find
another way to achieve their goals. It is indeed ironic that at a time when the Commission and
other financial regulators are pressing to move trading from the OTC markets to the regulated
futures markets in order to promote transparency and reduce systemic risk, the Commission
would itself pursue a new regulation that will encourage migration of trading away from the
regulated futures markets to the OTC and foreign markets.
However, the outcome of a situation where the commodity ETF market goes from a
model of one large, highly liquid commodity ETF in a particular segment along side several
smaller, less liquid commodity ETFs, to a model that instead has several medium sized
commodity ETFs will come with clear costs that will be borne both by the investors and by the
commodity market itself. Empirical evidence shows that total liquidity for investors will drop
and the cost of buying and selling their investments will go up. We believe this in turn will lead
to an overall drop in liquidity seen on listed futures exchanges such as the New York Mercantile
Exchange ('2qYMEX") and the ICE Futures ("ICE").
To see how this might come about, we have included the following examples from the
existing ETF markets that demonstrate how we reached our conclusions,19
One of the largest equity ETFs in the world is the SPDR (ticker: SPY), which tracks the
S&P 500. It has $73 billion in assets and trades approximately 200 million shares a day. Due to
its size and volume, shares of SPY trade during the day at an average spread of 1 cent. However,
there is another S&P 500 based ETF in the marketplace, the iShares S&P 500 Index Fund
(ticker: IVV). IVV has $22 billion in assets at the present time, an amount equal to 28% of
SPY's assets. However, IVV only trades 4 million shares a day, an amount equal to only 2% of
SPY's volume. 1VV also typically trades at a wider bid/ask spread during the market day of 2
Data for the following examples was derived from information publicly available on Bloornberg and NYSE
Euronext.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 12
cents. We would suggest that if for some reason regulatory action forced SPY to get smaller that
other existing S&P 500 ETFs would become larger, and new S&P 500 ETFs would spring up, as
investors moved into ETFs that could still accommodate their investments. However, we also
believe that in that situation, the spread on these medium-sizedETFs would be higher than the
current 1 cent spread of SPY. Assuming that the actual amount of shares trading remained
constant, an extra 1 cent in spread would cost investors an extra $500 million a year in trading
cost to achieve the same exposure they currently obtain from the very large SPY. That cost to
investors would come with no apparent offsetting benefit to either the investors or the equity
market in general.
At the opposite spectrum from the highly liquid SPY we can view the situation in trading
in European ETFs. The counterpart of the S&P 500 in Europe is the STOXX 50. Although the
total market cap of the STOXX 50 is less than that of the S&P 500, the average market cap of its
50 holdings is 3 times that of the average of the S&P 500. Thus one could expect that the cost of
trading an ETF based on the STOXX 50 should be comparable to trading an ETF based on the
S&P 500. However, due primarily to regulatory burdens in place, Europe does not have the same
market structure of one very large and liquid STOXX 50 ETF along side several small STOXX
50 ETFs. Instead, Europe has 4-5 medium sized STOXX 50 ETFs and 6-8 small STOXX 50
ETFs. The result is that investors buying or selling STOXX ETFs face bid/ask spreads that are 6-
8 cents wide, compared to the I cent bid/ask spread of SPY. Once again, multiplied over millions
of shares traded daily the cost of regulatory balkanization amounts to hundreds of million Euros
per year without any offsetting benefit to the investors or the markets themselves.
Finally, in the U.S. energy commodity ETF market, we also have examples of the impact
of size and liquidity on investor costs. Our fund, USO, is the largest crude oil commodity ETF in
the U.S. It has, at present, assets of approximately $1.7 billion and trades an average of 1I
million shares a day. There are in fact three other crude oil vehicles that have reasonable size,
although all are much smaller than USO. The tickers of these other vehicles include DBO,
USL,
and OIL.,
DBO has assets of approximately $350 million and trades around 240,000 shares a day at
a spread of 2-3 cents. USL has assets of approximately $155 million and trades around 75,000
shares a day at a spread of 5-6 cents. OIL has assets of approximately $575 million and trades
around 780,000 shares a day at a spread of 2-3 cents.
It is true that in the case of DBO and USL, there are differences in their investment
objectives and holdings compared to USO that may contribute to their lower volume and higher
bid!ask spreads. However, OIL's investment objective is virtually the same as USO's. Although
it has assets that are 32% of USO's, it trading volume is only 7% of USO's. Thus we believe that
there is a scale effect where liquidity increases as funds grow larger, and it decreases as funds get
smaller.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 13
Looking at the three examples above we think a reasonable observer would conclude that
artificially restricting the size of exchange traded passive commodity pools could not only lead to
a situation where the market will move from a dynamic of one large liquid player and several
small players to a structure of several medium sized players, but that such a transition would be
accompanied by a drop in aggregate liquidity and an increase in investors' costs. Using just USO
and LING as examples, if those assets were redeployed into other exchange traded commodity
vehicles such that we had several medium sized vehicles, and those vehicles traded at 3 cents
instead of the current 1 cent bid!ask of the two large funds, the annual extra cost borne by these
same investors would be $20 million. For this increase in cost there is no apparent benefit to
investors or the market.
However, as indicated above we think it likely that total aggregate volume of al!~ the
medium sized funds is likely to decline compared to the current market structure (remember that
OIL 0nly trades 7% of USO's volume although it has 32% of USO's asset size). As such we
believe that the overall reduction in combined trading in these vehicles will in turn lead to a
reduction in the use of listed eomrnodity futures by equity market makers. Equity market makers
hedge their market making in commodity funds by buying/selling listed futures contracts.
Assuming a 20%-30% drop in aggregate trading volume of crude oil ETFs under the "many
medium sized ETFs, no big
ETF"
scenario, would almost certainly lead to a commensurate drop
in the use of crude oil futures contracts by equity market makers. Thus there is likely to be a very
real and not unnoticeable drop in liquidity in the crude oil futm'es market if the Proposed Rule is
adopted. We are not able to estimate how much impact this will have on futures markets.
However, we would encourage the Commissioners to discuss this scenario with the appropriate
individuals at the listed futures exchanges.
There is currently no reason to believe that adoption of the Proposed Rule will diminish
the role of the Funds' investors in the regulated futures markets. If the Proposed Rule can be
legally circumvented either by moving a portion of the business to the OTC markets (where
dealers will in turn hedge their risk by buying and selling futures contracts), by encouraging the
formation of new fund entities,
2°
or by direct participation in the futures markets by Fund
investors, then there is simply no reason to believe that any possible harm currently posed by
such investors to the regulated energy futures markets will be eliminated or even reduced. If
there are sound economic reasons why the Funds' investors are currently eleeti'ng to participate
in these markets, they will continue to do so even if the proposed position limits are adopted
(albeit at perhaps greater cost and risk).
s0 To the extent that adoption of the proposed rules encourages new entrants into the market, there will likely be
duplication of costs. Although we do not seek protection of the Funds from future competition, we believe
competition should be based on services provided to investors, not simply circumvention of arbitrary regu!atory
position limits.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 14
If the Commission is not attempting to regulate the total amount of futures contracts held
in aggregate by smaller investors or "speculators" (and based on comments by individual
Commissioners we believe that is true), then to a degree we thirA the Commission's concerns
about the particular size of any individual pass-through fund is somewhat misguided. It is a bit
like baseball legend Yogi Berra's response when asked after he ordered a pizza if we wanted it
cut into six slices. He is alleged to have answered, "Better cut it into four pieces, I am not hungry
enough to eat six pieces." We all understand that if you are going to eat the entire pizza, it does
not matter how many slices it is cut into by the person at the counter. Similarly, if individual
investors are going to own 10%, 20%, or 30% percent of a particular commodity futures
contract, it is not clear to us the actual regulatory benefit that is derived by limiting individual
investors' choices when selecting the passive pass-through vehicle by which to achieve this level
of exposure, although we can clearly see the extra costs to the investors and the marketplace.
d. Issues of Aggregation
We would further comment on the notion of aggregation when discussing position limits
and publicly listed, passive, and un-levered commodity funds. If the Commission presumes that
there is a benefit to the market for position limits, although we do not agree with that
presumption, we still think there is no actual regulatory benefit when calculating the position
limits to aggregating the holdings of separate publicly listed ftmds which happento own the
same commodities, if in fact the funds are distinct and designed to track different benchmarks or
investment objectives, merely because they have the same passive manager. We believe this
position is logical because the case of a passive investment manager running two or more funds
with separate investors and investment objectives is not comparable to an active manager with
investment discretion running two or more funds. We think any position limit regulation should
reflect that reality.
As an example, assume that there are two separate listed commodity funds that both own
futures contracts in commodity X. Both funds have different shareholders, different investment
objectives or index benchmarks, and buy and sell independent of each other. However, in this
example we will state they have the same passive manager whose job it is to run the funds
according to their differing investment objectives. So the passive manager is not in the same
situation as a hedge fund manager who runs two different hedge funds. The passive manager is
"an aggregator, but not an actor." As stated before, for investment decision making purposes the
"actors" are the thousands or hundred of thousands ofinvestoks.
Further assume that each of this passive manager's cormnodity funds owas 60% of the
appropriate position limit. If we had a situation where the CFTC indicated, due to aggregation,
that the two funds could no longer own the number of contracts they have, a number of potential
negative outcomes for the shareholders have been created that could lead to higher cost, greater10-002
COMMENT
CL-02679
Mr. David Stawiek
April 22, 2010
Page 15
risks, or less desirable tracking of the investment objective or benchmark. Altematively in this
scenario, the passive sponsor could just sell the management of the second fund to a competitor
who has no exposure to commodity X. In'that situation we would have the same shareholders
invested in the same passive benchmark or index and owning the same number of contracts as
before. The buying and selling of futures contracts for the funds would be unchanged. All that
would have happened is that the first passive sponsor was forced into a sale of a part of its
business for non-economic reasons. But it is not clear how this benefits the market in general, or
the regulators in particular, even if it is presumed that position limits are desirable. The "actors"
and the holdings are unchanged.
It is our belief that any aggregation of position limits as applied to passive investment
pools needs to differentiate between two funds that have different shareholders and different
investment objectives as compared with two funds that are merely identical clones of each other
and were created solely to avoid position limits. In the first case we do not think aggregation is
appropriate since it appears not to serve any useful regulatory purpose (except making the second
passive sponsor happy). In the second example we think aggregation does make sense.
e. Winners and Losers
In recent articles and papers published by noted energy market economist, Prof. Phillip
Verleger, ,he has postulated that the real beneficiary of the proposed position limits will be the
Organization of Petroleum Exporting Countries ("OPEC"), not American end-users or
investors.
21
However, based on our discussions with other market participants we would offer up
another prime beneficiary: foreign exchanges. Although we would only reluctantly move away
from primarily using listed futures on American exchanges, we are aware that many other major
commodity market participants have no such reservations. Based on the comments by the FSA in
the FSA White Paper, we can only surmise that they will not be joining the U.S. on the issue of
position limits. Thus we think places like the U.K., Singapore, and China will look forward to
taking over the U.S. capital markets dominance in energy and commodity trading like they did in
EuroDollars and EuroBonds in the 1970's when the U.S. instituted trading restrictions on banks.
At the same time, we clearly believe the losers should the position limits in the Proposed
Rule be adopted will be the millions of investors in commodity ETFs who will face higher costs
and risks, the U.S. futures exchanges who will face reduced volume, the commodity market in
general which will see greater volatility, and the end-users who ultimately will pay more to the
OPECs of the world.
See, e.g.,
Prof. Verleger's newsletter dated August 24, 2009.10-002
COMMENT
CL-02679
Mr, David Stawick
April 22, 2010
Page 16
III. Responses to CFTC Request for Comments
The discussion below presents our responses to selected questions posed by the CFTC in
the Proposed Rule. We first address Question 15, which is specificaIly directed at the operation
of the Funds, and then respond to various other of the questions in the Proposed Rule.
Question 15.
Concerns have been raised about the impact of large, passive, and
unleveraged long-only positions on the futures markets. Instead of using the futures markets for
risk transference, traders that own such positions treat commodity futures contracts as distinct
assets that can be held for an appreciable duration. This notice of rulemaking does not propose
regulations that would categorize such positions for the purpose of applying different regulatory
standards. Rather, the owners of such positions are treated as other investors that would be
subject to the proposed speculative position limits.22
The series of questions that follow are presumably directed to the activities of entities like
the Funds. We believe that the suggestion that the Funds' investors somehow represent a new
category of market participant overlooks the various reasons why people and institutions invest
in the Funds. Energy prices effect every institution and every individual in our society, thus
increased prices have implications for every business and every individual. We believe that it is
more appropriate to characterize investments in the Funds as a hedge against the economic
effects of higher energy costs rather than as "distinct assets that can be held for an appreciable
duration." Investment in the Funds reduces the adverse impact of higher energy prices on our
investors and, conversely, losses incurred on investments in the Funds when energy prices
decline are generally offset by savings in actual energy costs, It is certainly possible for investors
to purchase shares in the Funds for speculative purposes, but it is highly doubtful that any such
investors would themselves exceed the Commission's proposed speculative position limits and
we would welcome any efforts by the Commission to identify and regulate such individual
investors.
Just as there is a clear rationale for exempting the hedging trangactions of commercial
entities, we believe there is an equally compelling rationale for exempting the hedging
transactions of non-commercial energy consumers. Before the advent of collective investment
vehicles such as those presented by the Funds, there was simply no need to consider this issue
because individual non-commercial energy consumers would never exceed speculative position
limits. Indeed, we believe that if every investor in our Funds were to participate directly in the
22 We note that this question refers to passive investments in "long-only positions" in futures contracts, but not to
short-only positions that are similarly passive and unleveraged. Given the fact that there is both a long and a short
side to each futures contract, we believe that short-only investments should be given the same treatment as long-only
positions in futures contracts. The United States Short Oii Fund, LP, managed by USCF, is an example of an entity
that makes passive, unleveraged short-only investments.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 17
energy products traded on regulated markets there would be no thought given to trying to limit
their aggregate positions. Given the passive nature of the Funds and the fact that Fund
purchases/sales of futures contracts correlate directly to the investment decisions of individual
investors, we do not believe that the investments of the Funds should be aggregated for purposed
of any proposed position limits.
Should the Commission propose regulations to limit the positions of passive
long
traders?
No. The rationale set forth in the Proposed Rule does not apply to the positions in such
contracts held by passive long (or short) traders such as the Funds. In the Proposed Rule, the
Commission states that "[1]arge concentrated positions in the energy futures and option markets
can potentially facilitate abrupt price movements and price distortions.
''23
Given that the
positions of the Funds are generally passive (in that they increase or decrease only in response to
additional investments in or withdrawal of assets from the Funds), it seems self-evident that they
should not facilitate "abrupt price movements and price distortions." FuNaer, USCF has publicly
disclosed data refuting any notion that the activities of its Funds cause sharp movements in or
distortions of their relevant commodity markets. For example, a Form 8-K was filed with the
Securities and Exchange Commission on July 24, 2009, showing that wide swings in the price of
natural gas were not the result of the activities of LrNG.
~4
For example, data shows that during
the run-up in natural gas prices during the time period of September 2007 and $5.50 per Million
BTU ("mbtu"), to July 2008, and roughly $13.50 mbtu, UNG's holdings in natural gas futures
contracts were essentially flat. UNG owned 8,093 contracts on September 7, 2007, and owned
8,587 contracts on July 3, 2008. We do not believe that this data supports the notion that UNG's
investing activities could have been a driving force behind the increase in natural gas prices over
this time period. Indeed the evidence included in the July 24, 2009 Form 8-K suggests from
data available to us that the Funds' activity in the market tends to curb price movements rather
than exacerbate them; investment in the Funds tends to increase when prices are falling and
decrease when prices are rising.
USCF has also publicly disclosed information refuting charges that the large size of USO
will lead to USO's trading activities distorting prices in the oil futures contract market. In a
Form 8-K filed with the Securities and Exchange Commission on February 4, 2010,
~5
USO's
management presented data after reviewing the history of creation and redemption orders since
USO was listed in April of 2006 through the end of January 2010. During that time, USO
processed creation and redemption orders on 705 different days. The average size of daily
Proposed Rule, at 4148.
http://www.sec.gov/Archives/edgar/data/1376227100.01144204090386431vl 55515_8k.htm.
http://www.see.gov/Archives/edgar/datal1327068/O00114420410005 5 50/v
173243_Sk.htm,10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 18
creation or redemption orders received by USO led it to purchase or sell on average
approximately 820 crude oil futures contracts. USO's management noted in its Form 8-K that in
2009, the combined average number of light, sweet crude oil contracts traded
each day
on the
NYMEX and ICE, exceeded 850,000 contracts. As a percentage of daily volume in the light,
sweet crude oil futures market, USO's creation and redemption activity has averaged around
1/10 of 1%.
USO's management further reviewed the history of USO's creations and redemptions to
determine the size of the transactions on the dates where USO had its greiatest amount of creation
activity, and the greatest amount of redemption, activity, since its inception. USO's most active
single day for creation activity occurred on January 28, 2009. That day's creation activities in
turn led to an increase in the total number of USO units outstanding of 10.8%. Those creations
resulted in the purchase of 7,451 light, sweet crude oil futures contracts by USO..However, on
that date, the combined number of light, sweet crude oil futures contracts of the same contract
month as purchased by USO that traded on NYMEX and ICE totaled over 38! ,000, Therefore,
on the day during which USO had its largest amount of creation activity, USO's purchased
futures contracts equal less than 2% of that day's volume in that one contract month. Stated
another way, USO's selling activity that day was roughly equal to the amount of trading on
NYMEX and ICE that occurred every 7 minutes.
As highlighted in the Form 8-K referenced above, USO's redemption activity has a
similarly minimal market impact when viewed both from a daily average and largest single
trading day perspective. Thus objective data supports the notion that merely having large
passive funds active in the financial commodity markets does not cause price distortion, because
these funds represent only a small fraction of the total trading in such markets.
Allegations have also been made to suggest that large passive investment vehicles like
the Funds cause price distortion in the financial commodity markets when they "roll" their
positions in near month futures contracts into next (or other) month contracts on a predetermined
basis in order to meet their investment objectives. USO publicly refuted this charge with data
provided in a Form 8-K filed with the SEC on January 28, 2010, which is described below.
26
As explained in the aforementioned Form 8-K, since the end-of-day settlement prices of
the futures contracts for light, sweet crude oil as well as USO's daily holdings and roll schedule
are all publicly available, USO's management was able to determine what the price spreads were
immediately prior to USO's roll, what they were during the roll and what they were immediately
after the roll was concluded. Since the crude oil futures market was in contango throughout
2009, ifUSO's rolls were affecting the prices of crude oil futures contracts, one would expect
26 http://www, sec.gov/Archives/edgar/data/13270681000114420410004013/v 172435_8k.htm.10-002
COMMENT
CL-02679
Mr. David Stawiek
April 22, 2010
Page 19
that the price spreads would have widened as a result of each monthly roll. However, as shown
below, this was not the case. Instead, the price spreads actually narrowed half the time.
The table below measures the changes in the spread during 2009 in two fashions. The
first compares the price spread between the nearest month to expiration contract and the next
nearest month to expiration contract on the last day before USO's roll began and compares it to
the average price spread during USO's roll. The second measurement compares the average price
spread between the nearest month to expiration contract and the next nearest month to expiration
contract on the four days before USO's roll began and compares it to the aver.age price spread
during USO's roll.
Price, Spread Widened
6
7
,,
Price Spread Narrowed
6
5
In addition, on five 0fthe six occasions where the price spread widened between the last
day prior to the roll and the roll itself, the price spread was still wider even after USO's roll was
over. On five of the seven occasions where the price spread widened between the average of the
four prior days and the roll itself, the price spread was also still wider after USO's roll was
complete. USO's management believes that this suggests that other factors, such as inventory
storage buildups, were at play in determining the price spread both before, during, and after
USO's roll period, and that empirical data supports the fact that USO's activities have not
systematically and predicatively caused changes in the spread between the price of nearest month
to expiration and the next nearest month to expiration crude oil futures contracts as some have
alleged.
Finally, the Commission also stated, as a rationale for the Proposed Rule, that
"[c]oncentratior~ of large positions in one or a few traders' accounts can also create the
unwarranted appearance of appreciable liquidity and market depth. Trading under such
conditions can result in greater volatility than would otherwise prevail if traders' positions were
more evenly distributed among market participants." 27 Again, these concerns do not apply to the
Funds' investments in energy futures. First, the Funds' participation in the markets is fully
transparent, with the trading positions of each Fund publicly accessible on their websites.
Anyone trading in these markets has the opportunity to know about the extent of the Funds'
positions and on what basis they trade. Second, as previously discussed, the Funds are passive
participants and only enter the market to buy or sell futures based on the investment decisions of
the owners of the Funds. Thus, from a volatility perspective, the trading activitie
s
of the Funds
are effectively "distributed among market participants," i.e., the Funds' hundreds of thousands of
investors.
Proposed Rule, at 4149.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 20
If so, what criteria should the Commission employ to identify and define such
traders and positions?
As noted above, we do not believe that the Commission should limit the positions of
passive long (or short) traders, but rather that these traders should be exempted from any position
limits adopted by the Commission. In determining which entities should be provided with
exemptions from position limits, the Commission should employ factors similar to those it
previously used in providing no-action relief to certain index-based funds from position limits on
agricultural products.
28
These factors include the following key elements:
(i)
The futures trading activity passively tracks a widely recognized commodity
benchmark.
(ii)
The futures trading activity is unleveraged.
(iii)
Both the commodity benchmark and the fund are highly transparent.
(iv) .
The futures trading does not result in price exposure for the fund.
Applying these factors would ensure that all exempted entities would be acting in a way that
would not.negatively affect the tinaneial energy markets and also provide appropriate safeguards
to inform and protect potential investors.
Assuming that passive long traders can properly be identified and defined, how
and to what extent should the Commission limit their participation in the futures
markets?
The Commission should not limit the participation of publicly traded and regulated
passive long (or short) traders like the Funds, but rather continue to monitor these market
participants and possibly take additional steps to ensure that investors are not utilizing these
entities to avoid speculative position limits, Such steps might include reporting requirements for
individual investors in the Funds beyond those required by the SEC and the exchange to ensure
that their individual positions do not rise above any position limits that are adopted.
d,
If passive long positions should be limited in the aggregate, would it be feasible
for the Commission to apportion market space amongst various traders that wish
to establish passive long positions?
2~ CFTC Letter 06-09 (April 19, 2006);
CFTC
Letter 06-19 (September 6, 2006).10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 21
ks noted above, we see no reason why these positions should be limited in the aggregate
unless, on a look through basis, an individual investor has positions in excess of the speculative
position limits.
eo
What unintended consequences are likely to result from the Comtnission's
implementation of passive long position limits?
As previously discussed, we have no reason to believe that investor interest in the
financial energy markets is likely to be curtailed by the Commission's Proposed Rule on position
limits. To the contrary, all the evidence points to growin~ investor interest in gaining exposure
to these markets. Moreover, there are any number of ways in which the Commission's proposed
position limits can be avoided or circumvented by investors seeking access to these markets,
including the use of OTC and foreign markets, and the creation of additional funds created by
new sponsors to tap investor demand that cannot be satisfied by the existing funds. In either
case, the impact, if any, on participation in the energy futures markets will likely be the same as
if the proposed limits were either abandoned or modified to provide a "look-through" to the
actual investors of passive funds. As a. result of the foregoing, the Commission's Proposed Rule
may directly cause the migration of trading away from our regulated futures markets to the OTC
and foreign markets. This migration would be in direct opposition to the Commission and other
financial regulators' efforts to move trading from the OTC markets to the regulated futures
markets in,order to promote transparency and reduce systemic risk.
Question 1.
Are Federal speculative position limits for energy contracts traded on
reporting markets necessary to "diminish, eliminate, or prevent" the burdens on interstate
comrnerce that may result from position concentrations in such contracts?
Whatever the case may be for imposing speculative position limits for energy contracts
traded on reporting markets for market participants who are active managers of financial
investments, or who are financial intermediaries such as swap desks, or who are producers/end-
users/physical traders of the underlying commodities, the case has not be made that such limits
should be imposed on passive, un-levered, exchange traded pass-through vehicles such as the
Funds. The Funds are passively managed and employ a "neutral" investment strategy intended
to track changes in the price of a benchmark commodity regardless of whether the price goes up
or down. Thus, the Funds themselves do not engage in speculative activities in the futures
markets. Certain of the Funds' investors may indeed be motivated by the desire to speculate on
the price of the respective commodities; however, other investors no doubt participate in order to
hedge their commodity price risk exposure. Any Commission rule regarding speculative limits
should look through the Funds to their respective investors in determining whether positions
limits should apply. Otherwise, the Commission will potentially penalize hundreds of thousands
of investors who have no speculative intent and are merely seeking to hedge their commodity
exposures in a commercially efficient manner.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 22
.Question 2.
Are there methods other than Federal speculative position limits that should
be utilized.to diminish, eliminate, or prevent the burdens?
Yes. The Funds are "passive" investors in futures contracts and only increase or decrease
their participation in the futures markets based on purchases or sales of Fund units.
9-9
The Funds
do not seek to "profit" from either increases or decreases in commodity prices and thus do not
pose the risks presented by speculators seeking to time market movements. It has been alleged
that the Funds large presence in the futures markets creates inappropriate market disruptions as a
result of the Funds' need to regularly roll their futures investments from the current month's
contract to the following month's contract in order to achieve their investment objectives. This
is accomplished in a transparent manner with the Funds publishing their planned roils on their
website. As rationale for the Proposed Rule, the Commission stated that "[1large concentrated
positions in the energy futures and option markets can potentially facilitate abrupt price
movements and price distortions.
''3°
The data provided in USO's Form 8-K dated January 28,
2010, discussed above, refutes this claim and conforms with the fact that we have seen no
evidence that the Funds' large positions facilitated "abrupt price movements" or "price
distortions." However, we believe that the Commission should continue to examine the impact,
if any, of the Funds' market activity during the roll periods to determine whether any additionaI
steps could be taken to make those activities even more transparent and assure the Commission
that there is indeed no adverse market impact. Additionally, as previously noted, we support any
efforts by the Commission to regulate the positions .of individual investors in entities such as the
Funds in order to ensure that individual investors do not exceed any adopted position limits.
Question 3.
How should the Commission evaluate the potential effect of Federal
speculative position limits on the liquidity, market efficiency and price discovery capabilities of
referenced energy contracts in determining whether to establish position limits for such
con tracts ?
We strongly believe that the Commission should seek to determine on both a qualitative
and quantitative basis how Federal speculative position limits could adversely affect the ability
of investors to participate in our regulated futures markets. From our perspective, this is an
essential question of "market efficiency." As previously noted, we question whether the
29 The Funds only buy or sell futures in response to actions by their investors. In this sense, the Funds' situation is
analogous to that of mutual funds, commodity pool operators and commodity trading advisors that are "eligible
entities" under CFTC Regulation § 151.1(e). The existing regulations exempt the positigns of these entities from
position limits because "the account controllers for these positions are acting independently." Proposed Rule, at
4149-4!50. The exemption is limited by the requirement that "the overall positions held or controlled by each such
independent account controller may not exceed the [specified limits]..." CFTC Regulation § 150.3(a)(4). We
believe the same "independent account controller" "look-through" principles should apply to the Funds.
3o Proposed Rule, at 4148.10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 23
activities of the Funds should properly be covered by "speculative" position limits. The growth
of the Funds in recent years attests to the interest of a very wide spectrum of investors in the cost
efficient mechanism offered by the Funds for gaining exposure to market energy prices. For the
most part, we believe that exposure is intended to hedge the energy price exposure that they face
in meeting their daily business and/or individual investments or energy needs. To characterize
the Funds' investors as speculators is, in our view, a mischaracterization of the primary motive
for investment in the Funds. To the extent that new Federal speculative position limits will
preclude the Funds from accepting new business or cause potential Fund investors to incur
additional costs and expense and thus become less efficient, these investors will be harmed. We
believe it is incumbent upon the Commission to assess this harm to "market efficiency" in
deciding whether they outweigh any supposed benefits to be derived from imposing new Federal
speculative limits.
Question 8.
Proposed regulation 151,3(a)(2) would establish a swap dealer risk
management exemption whereby swap dealers would be granted a position limit exemption for
positions that are hem to offset risks associated with customer initiated swap agreements that
are linked to a referenced energy contract but that do not qualify as bona fide hedge positions.
The swap dealer risk management exemption would be capped at twice the size of any otherwise
applicable all-months-combined or single non-spot-month position limit. The Commission seeks
comment on any alternatives to this proposed approach. The Commission seeks particular
comment on the feasibility of a "look-through" exemption for swap dealers such that dealers
wouM receive exemptions for positions offsetting risks resulting from swap agreements opposite
eounterparties who wouM have been entitled to a hedge exemption if they had hedged their
exposure directly in the futures markets, How viable is such an approach given the Commission's
lack of regulatory authority over the OTC swap markets?
The Funds do not support the Commission's proposal to establish a new swap dealer risk
management exemption. This proposal seems mere window dressing on the more fundamental
decision to preclude swap dealers from relying upon the existing bona fide hedging exemption
and represents a back-door effort to curtail the OTC market for energy transactions. The
proposed prohibition on swap dealers holding any speculative positions while relying on the
swap dealers exemption seems particular onerous, particularly given the Commission's proposed
rules regarding aggregation of positions.
However, to the extent that the Commission is acknowledging that there should be a
"look-through" exemption for entities like the deaIers that are merely holding futures positions to
hedge positions taken with their customers and the decision as to whether to buy or sell such
positions effectively rests with those customers, such an exemption may be appropriate
,Question 13, The
Commission notes that Congress is currently considering legislation
that would revise the Co~nmission's section 4a(a) position limit authority to extend beyond10-002
COMMENT
CL-02679
Mr. David Stawick
April 22, 2010
Page 24
positions in reporting market contracts to reach positions in OTC derivative instruments and
FBOT contracts. Under some of these revisions, the.Commission would be authorized to set
limits for positions he.ld in OTC derivative instruments and FBOT contracts, The Commission
seeks comment On how it should take this pending legislation into accouht in proposing Federal
speculative position limits.
'In light of the pendirig legislation dealing with the Commission's authority to establish
spe~ul.at[ve position limits, we believe it would be in the. public interest to defer action on the
c ,urren¢ Proposed Rule until Congress .enacts new regulatory reform legislation. As'noted
prer~ioUsly, .one 'likely. ~onsequence of adopting the e.urr~nt proposal would be toencourage
market.participants to either move trades fromregulated. U.S. markets..to the OTC markets or
FBOT e0iatr~iet.s. Given. the widely held view that systemic riskis reduced where trading occurs
On regialated exchanges and trades are Clearedby central elearingentitiesl it does not seem
appropriate gt this time to adopt these new rules,
IV. Conclusio~
We appreciate the Commission's efforts lo ensu)e well-regulated, transparent energy
marketS. However, We do not believethat theProposed Rule will further the Commission's
efforts in this area. In fact, the unintended consequences of the Proposed Rule may lead to even
less transparency and more risk for investorsin the.financial energy markets, If the Commission
does eho0setOmove .forward with the Pro'posed Rule, we strongly urge the Commission to add
in provisions that would, exempt passive, unleveraged .investors such as the Funds from any
position.limits ~at are adopted, and instead lake a "look-through" approach in order to regulate
the positions of individual investors in.the.Funds, In this way, the Commission can ensure that
.all investors have safe, transparent, and cost-effective access to the hedging benefits provided by
.the financial energy markets, without forcing such investors into more costly, less-transparent
¯ OTC .or foreign futures markets.
'"
~,
Nicholas D. Gerber
Chief Executive Officer
United States Commodity Funds LLC
