Comment Text:
10-002
COMMENT
CL-02682
DRW TRADING GROUP
DRW HOLDINGS, LLC
640 W MADISON AVE
CHICAGO, IL 60661
USA
April 26, 20~.0
Mr. David Stawick
Secretary
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Re: Proposed Federal Speculative Position Limits for Referenced Energy Contracts and Associated
Regulations (January 26, 2010)
Dear Mr. Stawick:
DRW Trading Group ("DRW") appreciates the opportunity to respond to the request by the Commodity
Futures Trading Commission (the "CFTC") for comments on its Proposed Rule on Federal Speculative
Position Limits for Referenced Energy Contracts and Associated Regulations (the "Proposal").
DRW is a principal trading organization that trades a wide range of asset classes in the United States and
abroad. DRW is an active liquidity provider in several of the referenced energy products. DRW's energy
trading activity is limited exclusively to centrally cleared products, including Natural Gas and Crude Oil
futures and options markets.
The CFTC asks if "Federal speculative position limits for energy contracts traded on reporting markets
[are] necessary to 'diminish, eliminate, or prevent' the burdens on interstate commerce that may result
from position concentrations in such contracts." The answer to this question is a resounding
"no"
for
the following reasons:
1. Adoption of the proposal would set a dangerous precedent of permitting the government to
intervene in the price discovery process without justification.
2. The Proposal compromises free market principles.
3. The Proposal is anti-competitive in that its open interest formula places smaller exchanges at a
competitive disadvantage to larger, established exchanges.10-002
COMMENT
CL-02682
1. The Proposal Sets a Dangerous Precedent
The debate about position limits has been clouded by the comingling of two very distinct policy
objectives: avoiding "congestion" in certain commodities, and influencing the price of those
commodities by regulating speculation. However, it has not been shown that speculation was the cause
of the 2008 increase in the price of crude oil. Therefore, to adopt the Proposal would be flawed policy
and would set a dangerous precedent of ad hoc, reactive government intervention in free markets
without the requisite demonstration of a link between speculation and a "burden on interstate
commerce".
how exchanges effectively address
Congestion happens when there is large open interest in a deliverable contract near expiration, and
virtually all the participants on one side of the open interest (i.e., long or short) intend to go to delivery,
while virtually all of the participants on the other side of the open interest intend to liquidate their
positions. Congestion can create short term aberrations in the price and volatility of both the front
month futures contract and the spot commodity. Such aberrations would clearly introduce burdens on
interstate commerce.
Currently exchanges manage congestion by imposing position limits near expiration and accountability
in all months. The exchanges are best situated to detect and address excessive concentrations and
irregular positions or patterns. They have systems in place to allow for continuous monitoring of all
participants' positions. Dislocations in the price of front month, physically delivered commodity futures
contracts near expiration is a rare occurrence, which is a sign that the current system of exchange
implemented positions limits works well.
If, in the future, the exchanges demonstrate that they are not effective in setting or enforcing limits or
accountability levels to prevent the effects of congestion due to excessive concentrations, then the CFTC
should intervene. Until then, the exchanges should continue to perform this role.
prices of e~ergy derivatives
Distinct and separate from the issue of congestion is the issue of whether concentrated positions in the
futures markets have impacted overall price levels. This second issue has been the matter of much
debate, but it is important to distinguish it from congestion. Since the exchanges already effectively
deal with congestion, it follows that the primary policy objective of the Proposal is to limit the possible
influence of speculators on prices and the price discovery process of the commodities in question.
The CFTC has failed to establish that speculation reflected in concentrated positions in the futures
markets causes prices to diverge from supply/demand fundamentals, thereby imposing a burden on
interstate commerce. In fact, a report by the CFTC released in September 2008 concluded the10-002
COMMENT
CL-02682
opposite.
I
In particular, it appears that the Proposal is offered in reaction to the rise in the price of
Crude Oil to 5145 per barrel in July of 2008. There is no credible evidence to suggest that anything but
natural market forces drove the price of oil to its highs in 2008, and there is nothing to suggest that the
Proposal would be effective in preventing such a rise in energy prices in the future.
2. The Proposal Compromises Free Market PrincipLes
Market participants should be "free to choose" how to allocate their assets. Currently, many investors
are legitimately concerned about the long term effects of the increased debt burden of the United
States on inflation. A rational response to this concern is to diversify one's portfolio to gain some
exposure to commodities, including energy commodities. Investors have several channels for attaining
that exposure, including taking long positions in regulated futures contracts, entering bilateral OTC
agreements, taking positions in contracts listed on foreign exchanges, purchasing ETFs, or buying
physical energy assets.
The proposed limits on exchange traded futures contracts will force large investors to utilize other
channels to attain their desired exposure. The effect of any of such activity on the supply/demand
balance will be the same regardless of the means through which the exposure is obtained. In the best
case, this will increase the cost and difficulty of portfolio diversification. In the worst case, the Proposal
will be expanded to its logical conclusion and will limit the overall exposure a person can have to a
commodity. This is traditionally known as rationing.
Left behind by the Proposal are small investors. Exchange Traded Funds (ETFs), such as the United
States Oil Fund LP (USO), illustrate this point. Individual investors can buy USO shares in the public
securities markets to gain exposure to crude oil. USO accepts funds from investors and attempts to
replicate the returns of a long position in West Texas Intermediate Crude Oil (WTI). To achieve this, in
part, USO takes long positions in WTI futures contracts. USO is 'comprised of thousands of individual
investors. The Proposal, however, would consider the positions held by USO speculator. The lack of
recognition of the fact that ETFs are an aggregation of numerous market participants is discriminatory
against individual investors.
Treating an ETF as a single speculative position will result in two outcomes. First, many new and smaller
ETFs (each carrying exposure below the position limits) will have to be established to meet the demand
of individual investors. But the costs of managing a smaller ETF are per unit greater than the costs of
managing a larger ETF. These costs are directly passed on to the investors of an ETF. Second, some
energy ETFs (those at position limit) will trade at a premium to their net asset value because of the
~ Commodity Futures Commission, Commodity Swap Dealers & Index Traders with Commission Recommendations
(September 11, 2008)
(http://w~w.cftc'g~v/ste~ent/~r~ups/pub~ic~ne~sr~m/d~cuments/fi~e/cftcstaffrep~rts~n
swapdealersOg,pdf)10-002
COMMENT
CL-02682
inability to create additional shares. In any case, it will be more costly and difficult for smaller investors
to allocate their portfolios to energy commodities.
The Proposal is by title designed to address speculation in energy contracts and, if adopted, would limit
the ability of speculators to participate in the price discovery process. A healthy market requires all
different kinds of market participants, including hedgers (hedging both long and short exposures in the
underlying asset), dedicated liquidity providers, and speculators. Restricting the legitimate risk taking
activities of either liquidity providers or speculators will undermine the benefits of exchange traded
derivatives: transparency, price discovery and risk transfer.
Quite often the term "speculation" is confused with "manipulation". In fact, popular rhetoric often uses
these terms interchangeably. However, speculation is positive and healthy, enabling the flow of capital
from low-return activities to high-return activities. Limits on speculation result in suboptimal capital
allocation. Manipulation is the deliberate effort to interfere with free and fair markets. Manipulation
should be policed and punished. The Futures Industry Association, in its comment letter dated March
18, 2010, also addresses the important role of speculators in markets. I refer to that letter for further
discussion on this topic.
3.
The Proposal's Open Interest Formula is Anti-Competitive
The CFTC's proposed formula for determining the Single Month and All-Months Combined Limits is
based on existing open interest on a per exchange basis, to be revised annually.
2
It serves as a barrier to
entry for new exchanges, and a catalyst to drive more market share to the dominant exchange in cases
of pre-existing competition.
Consider the following example: Financially settled WTI Crude futures contracts are currently listed on
two major US exchanges - NYMEX and ICE. Neither would be considered a "small" or "new reporting
market". On April 23, 2010, NYMEX's open interest in all months combined in the financially settled WTI
Crude futures totaled 1,300,000 contracts, while that of ICE was 500,000. Under the Proposal, the "All-
Months-Combined Limit" would be set to 34,300 for NYMEX, and 14,500 for ICE - less than half. Now
consider a party that has a position of 25,000 in ICE financially settled WTI crude futures contracts. The
Proposal would require that party to reduce its position on ICE to 14,500 contracts. To maintain the
same economic exposure, the party would have to re-establish a position of 10,500 contracts on
NYMEX. This reapportionment of open interest would give the dominant exchange an even a larger
market share. Upon the recomputation of the position limits, the relative numbers would be again
2 Under the Proposal, the All-Months-Combined Limit ('AMC Limit" would be ~.0% of the first 25,000 contracts of
open interest and 2.5% of open interest beyond 25,000 contracts. The Single Month Limit ('SM Limit") would be
set at 2/3 of the All-Months-Combined Limit. For a small reporting market, the AMC Limit would be up to 30% of a
contract's total open interest on that exchange. The SM Limit that would apply to a single exchange would be
equal to 2/3 of that value, or as much as 20% of the total open interest on that exchange. For new reporting
markets, a de minimum AMC Limit would be the greater of 5,000 contracts or 1% of all open interest in a
referenced energy commodity contract.10-002
COMMENT
CL-02682
adjusted in favor of the larger exchange, resulting in further erosion of the smaller exchange's market
share.
4. Conclusion
It is easy to understand why the CFTC has put forth the Proposal. The rise in energy prices in 2008
infuriated many Americans and members of Congress. With that kind of ire, speculators are a
convenient scapegoat. It is much more difficult to accept that market forces drive prices and then
examine the causes behind those forces. To start, there should be meaningful and nonpartisan dialogue
on U.S. energy policy and the effects of government borrowing on the price of commodities.
The foundation of the American economy is free markets. If implemented, the Proposal would be a
direct intrusion on the free market process. For the reasons stated herein, I ask the CFTC to reject the
Proposal and allow the "Invisible Hand" to work. It has served our nation well.
Very truly yours,
Donald R. Wilson, Jr.
Founder and CEO,
DRW Trading Group
Honorable Gary Gensler, Chairman
Honorable Michael Dunn, Commissioner
Honorable Jill E. Sommers, Commissioner
Honorable Bart Chilton, Commissioner
Honorable Scott O'Malia, Commissioner
