Comment Text:
April 6, 2010
Mr. David Stawick
Secretary
Commodity Futures Trading Commission
1155 21
~t
Street, NW
Washington, DC 20581
Re:
Comments on Proposed Federal Speculative Position Limits on
Referenced
Energy Contracts
Dear Mr. Stawick:
lntercontinentalExehange, Inc. (ICE) welcomes the opportunity to comment on
the Commission's proposed rulemaking on federal speculative position limits for
referenced energy contracts. As background, ICE was established in 2000 as an over-the-
counter (OTC) marketplace with the goal of providing transparency and a level playing
field for the previously opaque, fragmented energy market. Since that time, ICE has
grown significantly through organic growth fostered by product, technology and clearing
innovation, and by acquisition of futures exchanges that have broadened its product
offerings and risk management services. Today, ICE operates a leading global
marketplace for futures and OTC derivatives across a variety of product classes,
including agricultural and energy commodities, foreign exchange and equity indexes.
Commercial market participants rely on our products to hedge and manage risk and
investors in these markets provide necessary liquidity.
Introduction
ICE believes proper regulation is essential for ensuring that market participants--
as well as the broader public -- have confidence in the price formation process that takes
place in our markets. This assurance of integrity lies at the heart of the futures exchange
model, The U.S. energy futures markets, governed by the Commission's comprehensive-
but-flexible regulatory structure, have permitted commercial and professional market
users to hedge future price risk in an efficient and cost-effective manner, In particular,
energy futures market participants have benefited from intense competition between
multiple exchanges, clearing houses and brokers to a degree unmatched in other markets.
It is often tempting for policy makers to take steps to address what they perceive
to be structural problems in markets during times when markets are sending unpopular
price signals. While well intentioned, these measures often fail te achieve their desired
objectives or, worse, lead to unintended consequences such as
increased price volatility
and
distortion of important price signals
that would otherwise have been conveyed by a
10-002
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freely operating market. If policy changes are not carefully tailored to address actual
problems in the market, such changes could ultimately leave our country, its businesses,
and American consumers in a
worse position in the long run,
unable to
prepare today
for what everyone - policy makers, businesses and consumers alike - agree will be a
difficult energy future.
In this regard, ICE notes that no investigation or quantitative study has
demonstrated that speculation was the cause of increased energy commodity prices in
2008. Indeed, it is telling that commodities for which there was no active futures market
experienced
similar or even larger price increases
as those for which there are active
futures markets. Subsequent enhancements to position reporting, including disaggregated
historical and current large-trader reports, have also demonstrated that the U.S. energy
markets offer a healthy balance of commercial and speculative interest, while failing to
tie price increases with speculative buying. In the course of setting policy, it is also
critically important to recognize that deep, liquid markets, with broad speculative
participation, are better at price discovery and are less susceptible to manipulation.
Further, with reasonable and effective reporting structures in place, the Commission and
other agencies will have a clear, comprehensive picture of market activity.
Against this backdrop, the Commission has proposed significant changes to the
position limit regime for energy commodities. Protecting the integrity of the energy
derivatives markets from excessive speculation is a laudable goal, but it is important to
note that the Commission has neither demonstrated nor determined that excessive
speculation occurred in the energy markets. In addition, the Commission's position limit
proposal comes at a time of significant flux in derivatives regulation. Congress is
currently considering legislation that would modify the derivatives markets structure by
mandating that standardized transactions be conducted on an exchange and be centrally
cleared. By implementing its proposed position limit regime, the Commission may
inadvertently restrict the ability of market participants to put positions into clearing
houses at the same time that Congress is requiring more, or all, positions be cleared. In
addition, while Congress has proposed that the Commission have greater authority over
the OTC markets, such authority has not yet been granted, and the implementation of the
Commission's new position limit rules could result in a migration of business off of
futures markets and transparent electronic platforms and out of the reach of regulators.
Given these factors, the Commission should carefully consider the tinting of the proposal
given the limited powers of the Commission at this time.
In addition, tying position limits to excessive speculation, especially without a
finding of excessive speculation, could lead the Commission to play the role of price
authority, Every unpopular price may lead to allegations of excess speculation and calls10-002
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for the position limits to be adjusted.
~
Instead, position limits should be set according to
market size to prevent manipulation and delivery disruptions, and not to influence
commodity price levels, In determining position limits or accountability levels, the
Commission should consider the entire size of the relevant energy market- both
exchange-traded and OTC and both domestic and domestically-linked. While the
feasibility or necessity of OTC position limits is not the subject of this rulemaking, it is
clear that the Commission has the authority to collect data on the OTC markets. In fact,
the Commission is currently doing so in publishing certain data in the large trader reports
and has already deemed the largest OTC U.S. natural gas contract an SPDC with
attendant position limits and large trader reporting. Thus, the Commission should set
position limits not based upon current activity alone, but to permit growing participation
in the energy markets. Failing to accurately assess market size and thus, liquidity needs,
in setting position limits, accountability levels and appropriate exemptions will likely
result in artificially low limits and create barriers to a well-functioning, centrally cleared,
regulated and competitive derivatives market in the U.S.
Should the Commission decide that the modification of the existing position
limits is nevertheless appropriate in the energy markets, ICE respectfully offers the
following comments regarding the framework outlined in the Commission's proposed
rule making.
Framework for Commission's Proposal
The Commission's proposed position limit regime for energy markets adopts the
position limit regime that the Commission currently uses for agricultural commodities, It
is important to note at the outset that certain of the key U.S. agricultural markets guided
by these limits are plagued by long-standing price convergence issues at settlement,
Conversely, the market structure in energy futures does not face these issues and hedging
physical exposure is very reliable as a result.
The agricultural position limit regime was first established in 1938, during the
height of the Great Depression and amid concerns about low commodity prices, The
regime places federal position limits on agricultural commodities both in the spot month,
in single months, and in all months. Exchanges, as the self-regulatory organizations,
administer the position limits pursuant to Commission oversight. However, the
Commission has not demonstrated how the agricultural regime prevents "excessive
speculation." On the contrary, as Commissioner Scott O'Malia noted in the
Commission's January 14, 2010 hearing on position limits the Commission's agricultural
limits did not cause agricultural market prices to behave differently from energy
~ Note that historically, speculators have been blamed fbr
high
prices in energy,
low
prices in agricultural
commodities, and
high
prices in gold.10-002
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markets.
2
To the extent the Commission is arguing that its proposed limits would prevent
energy price distortions, the apparent absence of any historical impact that position limits
have had on agricultural market prices is relevant.
Moreover, the agricultural position limit regime was designed for domestic
agricultural markets, which are very different markets than the global energy markets that
the Commission seeks to address. These differences raise a number of important
questions. For example, agricultural markets are primarily seasonal markets, and one can
understand why an "all month" position limit regime could be important in such a market
given the potential impact of positions held in all months on less liquid, seasonal markets.
By comparison, energy markets such as crude oil are not seasonal markets per se and
present different time horizons for hedging price risk. For example, farmers may be
primarily interested in hedging price risk for the following season's crops. In
comparison, energy companies generally hedge price risk far into the future given the
long lead times for energy exploration and extraction. Imposition of "all month" position
limits for these markets could sap vital speculative liquidity from long dated portions of
the pricing curve, making future price signals less accurate and potentially inhibiting
commercial market participants from being able to hedge long-dated price risk. This is
not simply a theoretical concern - if markets are inhibited from sending accurate future
price signals that reflect rising demand, important energy infrastructure may not be built
today that will be needed to meet tomorrows energy needs.
In considering comtnents and proposed changes to this rulemaking, the
Commission should not be constrained by the existing agricultural commodity
framework, and should consider whether more liberal position limits are appropriate for
energy markets given fundamental differences between the agricultural and energy
markets.
ICE Supports Aggregate Position Limits Administered by the Commission
ICE has stated previously that the current position limit regime is outdated and
does not take into account the existence of competing markets where economically
equivalent contracts are traded across markets. In connection with its existing proposal,
ICE supports the Commission's proposal to set aggregate position limits across trading
venues for similar products.
Unlike other markets, liquidity is not concentrated at a single exchange or trading
venue for energy commodities. Economically equivalent contracts may vary only where
they are listed for trading or in how they are settled, and have repeatedly been shown to
trade as
a single market
up until the final days o,f trading. For example, the June 2007
report published by the U.S. Senate Permanent Subcommittee on Investigations entitled,
Commodity Futures Trading Commission, Open Meeting Regarding Position Limits Rule (January 14,
2010) http://www.cftc.gov/PressRoom/Events/oeaevent011410.html10-002
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"Excessive Speculation in the Natural Gas Market," focused on natural gas trading by the
hedge fund, Amaranth Advisors, in both the NYMEX physical futures market and the
ICE swaps market. The report is replete with analysis supporting the conclusion that
these two markets, one physically settled and the other cash settled, were and are
"functionally equivalent"
and
"provide economically identical hedging and risk
management functions. ,,3
Given competitive markets and the fact that a number of exchanges can trade the
same energy contract, ICE believes that the Commission, rather than an exchange, is the
appropriate, neutral authority to set and administer aggregate position limits and hedge
exemptions for U.S. energy futures or significant price discovery contracts. Only the
Commission is in a position to view a market participant's positions across all venues,
and to administer aggregate position limits in an objective manner that promotes, rather
than impedes, market competition.
Having a dominant exchange set or administer position limits for a competing
exchange is rife with potential for conflicts of interest. Further, the current process for
determining position limits and hedge exemptions is completely opaque to ICE, to market
participants and to the public in general, creating uncertainty about market integrity. If
the Commission sets position limits and hedge exemptions, appropriate transparency and
neutrality will be brought to the process. Because the Commission is charged by the
Commodity Exchange Act to promote fair competition among markets, the Commission
is the appropriate and transparent body to set and administer a position limit regimes.
Size of the Limits and Application to All Months
In determining the appropriate levels for position limits, the Commission should
consider the entire size of the energy market in question -across futures and OTC
markets. While the feasibility or necessity of OTC position limits is not the subject of
this rulemaking, it is clear that the Commission has the authority to collect data regarding
the broader OTC markets. If the Commissions view is that position limits should cover
3 "The data analyzed by the Subcommittee, together with trader interviews, show that NYMEXand ICE are
/hnctionally equivalent tnarkets. Natural gas traders use both markets; employing coordinated trading
strategies...The data show that prices on one exchange affect the prices on the other. "
("Excessive
Speculalion in the Natural Gas Markel", U.S. Senate Permanent Subcommittee on Investigations,
Committee on Homeland Security and Governmental Affairs, Sen. Carl Levin, Chairman, June 25, 2007, p.
3.)
"The ICE natural gas swap and the NYMEX natural gas fittures contraet per/brm the same economic
fimetions. "
(Ibid, p. 29).
"In stun, the structure of the ICE swaps and NYMEXJittures contracts, the virtually identical prices of
these two contracts, and the testhnoto~ of traders provide compelling evidence that the NYMEX natural gas
fittures contract and the corresponding ICE natural gas Henry Hub swap are econotnically
indistinguishable finaneial h~struments /br risk-management purposes."
(Ibid, p. 3 6).10-002
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all segments of the market, including segments of the OTC market not presently covered,
the size of the additional portion of the market should be considered in establishing the
size of the limits being proposed. Failing to accurately assess market size in setting
position limits and appropriate exemptions will likely result in artificially low limits and
create barriers to a well-functioning, centrally cleared derivatives market.
In addition, the Commission should consider whether "all month" position limits
are necessary or appropriate in energy markets for the long-dated portions of the trading
curve. While hard limits in the expiration month and months surrounding the expiration
month are appropriate, blanketing such limits across all contract months may have
unintended effects on the proper operation of markets, such as draining speculative
liquidity from the longer dated portions of the trading curve where it is most needed. It is
axiomatic that the farther into the future an expression of price is made by a speculative
market participant, the less connected or relevant such an expression is likely to be to the
current spot market price. In order to promote greater liquidity in longer dated portions
of the price curve - which would benefit commercial users attempting to hedge long
dated risk -- the Commission should consider implementing its "all month" limit only on
the front portion of the trading curve - for example, the first eighteen contract months -
and maintain a position accountability regime for longer dated portions of the trading
curve beyond that period.
It is important to consider that, in addition to commercial users, large speculative
traders are often the only market participants willing to assume price risk in long dated
portions of the trading curve where commercial are attempting to layoff price risk. As
such, one potential impact of an "all month" regime is that such parties could choose to
exit the longer dated portion of the market, sapping valuable liquidity from commercial
market users and their ability to hedge long dated risk. Hard position limits in the first
eighteen months of a contract and position accountability levels in the remainder of the
contract would encourage speculative participants to assume risk in out months and give
commercial participants the ability to hedge exposure farther in the l'uture.
ICE Supports Spot Month Position Limits D~fferentiating Between Cash and Physical
Markets Subject W Refinement
The Commission also proposes to adopt the agricultural position limit regime for
spot month energy position limits. The spot month position limit would be set to 25% of
deliverable capacity for the physically delivered energy contact, tIistorically, a 25% spot
month limit is necessary to prevent corners and squeezes in a physical contract. In
agricultural contracts, this is appropriate as the markets are physical and no meaningful
cash-settled contracts presently exist. However, in the energy markets there is robust
participation and liquidity in financially settled energy contracts that do not make claims
on physical supply. In fact, today the vast majority of energy contracts are cash settled.10-002
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As the Commission's proposal notes, a physically settled contract may have several
financially settled equivalents. These products serve an important function in the market,
providing market participants with the ability to hedge exposure to the final contract
settlement price without basis risk and allow them to avoid the risk of physical delivery
that is attendant to a physically delivered contract. Therefore, it is important that the
Commission treats physically settled contracts and financially settled contracts differently
in its proposal.
Limiting positions based on deliverable capacity could have negative
consequences for firms requiring hedging and/or exposure to energy prices, For example,
certain energy contracts, such as Henry Hub natural gas or West Texas Intermediate
crude oil represent the national or international price of a commodity, and are used by
firms to approximate the national price of that commodity in their hedging strategies.
These firms are not participants in the physical delivery process and the location of the
physical hub is of no importance. What is important, however, is their ability to hedge
their exposure to an established benchmark, For example, the market created an OTC
financially settled WTI swap contract specifically to allow hedgers, who reference
CME's WTI futures settlement price in their physical crude oil purchase and sale
contracts, to hedge the expiration price used in such contracts. Without such a
mechanism, it is impossible to hedge the final futures settlement price, as a party would
be forced to trade out of its position before final settlement or take delivery of physical
crude oil at expiration.
Further, setting the spot month limit based upon deliverable supply may operate
as unrealistic restraint on energy markets, resulting in unintended consequences. For
example, faced with impractical limits, firms may be forced off-exchange into the
bilateral OTC swaps market in order to hedge their exposure. The Commission should
note that hard limits on financially settled energy contracts are new, The first hard limit
was imposed on the February 2010 contract expiration for the CME and ICE cash settled
Henry Hub contracts. The Commission should monitor the effect of these limits,
including whether the limits inhibit orderly markets or other adverse impacts on market
participants before adopting the proposed rule on spot month limits.
The Commission should be commended for recognizing the distinction between
financially settled and physically settled contracts in proposing that a trader in a
financially settled contracted be permitted to take a speculative position five times the
spot month position limit for the physical contract if the trader exits the physically settled
market in the spot month. However, this provision should be refined to better fit the
market as it currently operates based upon the needs of market participants, In this
regard, the Commission should consider (i) whether forcing these participants to leave
the physically settled contract a full three days in advance of expiration is appropriate
given the differences between physically and financially settled contracts, and (ii)10-002
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whether having speculative traders exit the physical contract in this manner will impair
price discovery by reducing liquidity and concentrating pricing power among a smaller
group or market participants. Previous Congressional and Commission reviews of the
energy markets have found that financially and physically settled contracts behave
differently at expiration. As the Senate PSI Subcommittee states in its Report on
Excessive Speculation in the Natural Gas Market:
"[B]ecause the final settlement price for the ICE swap is
defined to be the final settlement price of the NYMEX futures
contract for the same month, the most significant divergence in price
between the two contracts often
occurs during the final 30 minutes
of trading for the NYMEX contract,
which is used to compute the
final NYMEX contract prtce. (The NYMEX final settlement price
is computed by taking the volume-weighted average price of all
trades during the final 30-minute period.) Most of the trading
during these final 30 minutes will occur on NYMEX rather than
ICE, and hence the NYMEX price often will "lead" the ICE price
during this period. Based on the ICE and NYMEX data reviewed by
the Subcommittee, as well as trader interviews, this final settlement
period is the only period in which it can be categorically stated that
one exchange "leads" the other in price.
''4
(emphasis supplied)
Given compelling findings by the Commission and Congress that physically and
financially settled contracts trade differently on the last day of expiration, the
Commission should remove the three day prohibition from the conditional limit or
limiting the "no trade" period for the physically delivered contract to the narrower
window of trading.
Concentration Limits for Single Exchanges Should Be Eliminated
In addition to the aggregate position limits across exchanges and the spot month
position limits, the Commission has proposed a concentration limit for single exchanges.
The concentration limit would be set at 30% of the given exchange's open interest for all
months and 20% of open interest in any single month, in each case based offthe previous
year open interest for that exchange, The Commission's rationale for the concentration
limit is to prevent concentrated positions from causing abrupt price movements and
distortions in the energy futures and options markets. Further, the Commission contends
that a concentration limit will "fragment" the market and allow multiple traders to step in
where a single trader was previously. The theory rests upon the assumption that large
traders are crowding out smaller participants. ICE disagrees with setting an exchange
4
Id, p, 34.10-002
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concentration limit as such a limit ignores the premise that economically equivalent
contracts operate as a single aggregate market, and such a limit may operate in an
anticompetitive fashion,
Exhaustive hearings by Congress and the Commission over the last several years
have concluded that economically equivalent contracts traded on two separate exchanges
operate as a
single aggregate market.
For example, testifying before the House
Agriculture Committee, Subcommittee on General Farm Commodities and Risk
Management, in September 2007, Dr. James Newsome, former Commission Chairman
and then President of NYMEX, stated "the two competing trading venues [ICE and
NYMEX] are now tightly linked and highly interactive and in essence are simply two
components of a broader derivatives market.
''s
Further, as outlined in the Commission's
Report on Exempt Commercial Markets, one of the Commission's underpinnings of new
regulations for exempt commercial markets (ECMs) was that financially settled contracts
could be arbitraged (and therefore affect) a physically settled contract.
6
Against this
backdrop, the idea of imposing a concentration limit on an "individual exchange" basis is
logically flawed, and poses the risk of being anti-competitive for smaller or new
exchanges attempting to compete with an incumbent exchange.
Importantly, the Commodity Exchange Act mandates that the Commission
"regulate the futures markets by the least anticompetitive means available." By design, a
concentration position limit will impose smaller, or stricter, concentration limits in
smaller markets. Applying a concentration limit for each individual exchange will inhibit
competition by impeding liquidity in a competing market and effectively locking in the
market share of existing exchanges. Large market participants will be effectively
prohibited from leaving one market for a market that offers a competitive advantage,
therefore limiting innovation and the choice that exists in today's markets. Slowly, over
time, the dominant market will continue to gain market share, as liquidity attracts
liquidity. In the end, the Commission may create the opposite of its intention to foster a
diverse, highly competitive market.
One of the Commission's rationales for imposing the concentration limit is to
create a market with a larger number of smaller participants. The Commission's proposal
does not mention any study of the derivatives markets where the Commission has
determined that crowding out is occurring, or that a concentration limit creates an influx
of smaller market participants, nor what benefit a larger number of smaller participants
s Testimony of Dr. James Newsome, Chief Executive Officer, New York Mercantile Exchange, before
the
Subcommittee on General Falan Commodities and Risk Management, United States House of
Representatives (September 26, 2007).
Commodity Futures Trading Commission Report on Exempt Commercial Markets (October 2007).
http://www.cft~.g~v/ste~ent/gr~ups/pub~ic/@newsr~m/d~cuments/~e/pr54~3-~7~ecmrep~rt.pdf
910-002
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would bring to the market. Before implementing new policies and regulations, the
Commission should consider whether it is likely that new, smaller market participants
will in fact enter the market and whether the creation of these smaller participants is
necessarily a good or meaningful objective. Large, better capitalized market participants
are generally able to manage risk more effectively than smaller market participants,
especially in outlying months where less liquidity can result in higher volatility and price
risk. Smaller, less well-capitalized market participants may default more frequently,
leading to an increased risk to clearinghouses and clearing firms.
Finally, the Commission should understand that the concentration limit is
duplicative of the aggregate limit and entirely unnecessary. The Commission's proposed
aggregate limits are set, like the concentration limit, using open interest and would be
designed to prevent corners, squeezes, and congestion in a market--all stated goals of the
concentration limit. Another exchange set concentration limit, also based upon open
interest, is unnecessary and would only create confusion for market participants,
potentially biasing business to dominant exchanges with higher limits. If the
Commission's concern is that a forced liquidation of a concentrated position could cause
unwarranted price volatility in a market, then this issue would presumably be addressed
by the aggregate limit across all markets. Having a separate exchange specific
concentration limit would have no impact if the "one market" hypothesis is correct.
Given that the "one market" concept is the cornerstone upon which the proposed rules are
built, an exchange set concentration limit is logically flawed, redundant, and unnecessary.
A position accountability regime rather than an exchange specific concentration
limit would serve the Commission's purpose. Accountability level regulation, by design,
is intended to serve as an early warning system that triggers heightened surveillance by
and contact fi'om the exchange and puts the trader "on notice." Position accountability
levels are set low for this very reason] Such a regime would achieve the Commissions
stated goals of preventing abrupt price movements and distortions in the derivatives
markets through active position management far better than an exchange specific
concentration limit, while avoiding the unintended and anticompetitive consequences
outlined above. Therefore, instead of an exchange set position limit regime that
duplicates and complicates the Commission set aggregate position limits and is
anticompetitive, it is our view that the Commission should adopt a position accountability
regime for concentration.
Further, from a risk and market integrity standpoint, unusually large or
concentrated positions have been and continue to be a core area of focus for exchange
and Commission market surveillance. Significant resources are deployed today toward
the market surveillance and compliance missions of exchanges, with concentration being
7 The current position accountability levels for ICE OTC's Henry Hub contract are approximately 1% of
open interest, fro" lower than the proposed concentration limits.
1010-002
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a paramount consideration, alongside other key aspects of price formation. Highly
leveraged participants present risks to the clearinghouse, to their clearing members and
potentially to the market. An effective risk surveillance program should identify these
market participants and insure that they are not presenting undue risk,
Finally, if the Commission does adopt a concentration position limit, it should
note that the limit creates opportunities for regulatory arbitrage or regulation-driven
commercial opportunities. There exist many loopholes under the proposed rulemaking in
this regard. For example, in the proposed rulemaking, the Commission divided physically
delivered and cash settled contracts into separate classes. Within each of these classes,
the Commission included options on futures ("options") that settle into an underlying
futures contract. Options and futures open interest is then calculated separately, but
thereafter aggregated in determining a "futures equivalent" open interest number for the
purpose of establishing the exchange specific concentration limit. This number could be
misleading. For example, when a trader holds open positions in both options and futures,
the open interest is calculated regardless of the directional strategy that the trading may
be employing. A trader could be holding 1,000 call options with a delta of 50 while also
being short 500 contracts in the underlying contract. The trader would be considered
delta neutral and - for position limit purposes - be considered flat. However, for open
interest purposes, an exchange would receive the benefit of having 1,000 futures
equivalent positions open for calculating position limits. In setting the concentration
limit in this manner, the rules would provide an exchange with relatively more open
options positions an outsized commercial advantage, while potentially permitting more
speculative activity in that exchange's markets, counter to the aims of the Commission.
The Commission's Proposal fo~' Hedge Exemptions Should Be Mod~[ied
As stated in the proposed rulemaking, the Commission would adopt the
agricultural position limit regime for energy contracts. However, for hedge exemptions,
the Commission is proposing a radical and unsupported departure from the current
agricultural position limit regime and past Commission practice. The proposed hedge
exemption provision ~vould exempt
bona~de
hedging transactions from position limits,
but unlike the agricultural position limit regime and current Commission practice, the
new hedge exemption regime would prohibit a trader with a
bonafide
hedge exemption
from holding a speculative position unless the speculative position is in the spot month.
Likewise, a new risk management exemption would exempt swaps dealer risk
management transactions fi'om position limits, but again would prohibit traders from
holding speculative positions. The Commission proposes this new regime to prevent
"crowding out" of positions, though the Commission has not set forth any evidence of
"crowding out" in energy derivatives markets
The Commission should note that the CEA states that, "[n]o,
rule, regulation, or
1110-002
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order issued under subsection (a) of this section shall apply to transactions or
positions which are shown to be bona fide hedging transactions or positions
.... "
The Commission's proposal would invalidate a
bona fide
hedge exemption if a trader
takes just one position that might be counted as speculative. This is contrary to a plain
reading of Section 4a(c). The ultimate effect of the Commission's proposal would be to
create legal uncertainty for commercial participants
and force participants to take these
transactions off-exchange or overseas.
8
Similarly, the proposed risk management exemption is equally troublesome. The
Commission should be commended for recognizing that swaps dealers perform a
valuable service to the derivatives markets by allowing market participants to create
customized hedging solutions for commercial firms, which are then offset by the swaps
dealer on derivatives exchanges. However, the Commission again, forces traders seeking
exemptions to choose whether to offset risk in the derivatives markets, or whether to
engage in proprietary or speculative trading. This could have the impact of diminishing
liquidity in the derivatives markets or concentrating risk in swaps dealers,
It is important to note that swaps dealers
are oJfsetting risk and transferring @
exchange positions
to transparent and centrally cleared markets. This is a stated goal of
financial reform in every proposed bill under consideration by Congress, The
Commission's proposal is at odds with these goals and would greatly impair the ability of
swaps dealers to drive positions to exchange traded and centrally cleared markets,
Finally, ICE reiterates its view that the Commission should administer hedge
exemptions and risk management exemptions in a transparent, market neutral manner. In
any final rulemaking, it is our view that the Commission should keep the current hedge
exemption and risk management regime, but should undertake the hedge exemption and
risk management process at the Commission level,
The Commission Should Consider Granting Passive Investors an Exemption
Passive investors such as index funds and exchange traded funds (ETFs) have
come under much scrutiny in the past few years as they are blamed for high commodity
prices, often based on a lack of or flawed analysis.
9
However, quantitative studies have
8 For example, with an energy speculative position limit of 500 contracts, unintended scenarios could
result: if a bona fide hedger holds 501 contracts pursuant to a hedge exemption and the nature of the hedge
changes such that only 499 contracts are required, pursuant to the proposed rulemaking, the trader is (i)
crowding out the market; (ii) has invalidated the bona fide hedge and (iii) has violated federal law. Keep in
mind that this might not be the intent of the trader as a hedged transaction might turn into a speculative
ta'ansaction given a change in business strategy. Thus, the trader, through no fault of her own, has just
violated federal law.
See,
Michael Masters and Adam K. White,
The Accidental Hunt Brothers, Act II,
(2008)
1210-002
COMMENT
CL-02688
demonstrated that, contrary to conventional wisdom, passive investors may have
beneficial effects on the market, dampening volatility and improving liquidity outside of
the spot months.
~°
In addition, passive investment vehicles are beneficial to retail
customers, including pension fund managers and equity investors, as these investments
allow customers access to the futures markets -- and the attendant hedge against inflation
-- without the cost and complexity of directly accessing futures markets.
Limiting ETF or index fund participation in the exchange traded derivatives
markets will have three consequences: (i) it will expose retail passive investor customers
to bilateral credit risks; (ii) it will increase price volatility and reduce liquidity; and (iii) it
will force more retail customers to access the futures markets directly. Further, limiting
the size of passive investors will lead to less efficiency, as the cost of operating the fund
(which is passed to customers) can be spread out across more customers in a larger fund.
Given the passive investment strategy, 10 smaller funds should have the same market
impact as one larger fund. In light of these facts, the Commission should consider
allowing passive investors, such as ETFs or index funds, to have a separate position
exemption to speculative limits.
The Commission's Proposal for Account Aggregation Should Be Eliminated
In another departure from the agricultural position limit regime, the Commission
has proposed to eliminate the "independent account controller" exemption from position
limit aggregation rules. Currently, pursuant to the Commission's position limit rules, an
account is aggregated for position limit purposes where a person controls 10% or greater
of a common entity. However, if an account is independently controlled, then the
position is not aggregated. This makes sense, for example, in the case of two
independent operating companies of a corporate parent who independently trade under
the same corporate entity, because they are not viewed as trading for the same account.
The Commission offers no explanation for its decision to depart from previous
practice, other than stating that the independent controller exemption "would allow
traders to establish a series of positions each near a proposed outer bound position limit
without aggregation, may not be appropriate." Beyond this assertion, the Commission
never explains why the independent account controller exemption would ever be
inappropriate.
The proposal's departure from the Commission's Part 150 standards also may be
unworkable and surely will drive up the cost of compliance without offering associated
market benefits. Firms with decentralized and international trading operations through
1o See.
Scott h'~vin, Dwight Sanders, Robert Merrin,
Devil or Angel? The Role of Speculation in the Recent
Commodity Price Boom (and BusO,
JOURNAL OF AGRICULTURAL AND APPL1ED
ECONOMICS, Vol. 41, No.
02, August2009. ~t :/ url..mn.edu/
. See also . Philip K. Verleger, Notes at the Margin,
January 11, 2010. http://www.pkverlegerllc.com!nam100111 .pdf
1310-002
COMMENT
CL-02688
multiple independent account controllers would find it extremely difficult, and very
costly, to track position limit levels for each of these disparate trading operations in the
over 100 unique contracts affected by the proposal.
Conclusion
ICE commends the Commission for undertaking a comprehensive review of the
energy market position limit regime and we appreciate the opportunity to comment, We
ask that thc Commission be prudent in enacting a position limit regime and remain
mindful of the consequences of miscalculation, Should the Commission determine that it
should move forward in implementing a revised position limit regime for energy, in
summary ICE recommends that:
the Commission should set aggregate position limits across markets, but should
consider whether the "all month" limit should apply across all contract months;
the Commission should set spot month limits by differentiating between
financially settled and physically settled markets;
the Commission eliminate the anticompetitive exchange concentration limits;
the Commission should not adopt the hedge exemption or risk management
regime that ban firms with hedge or risk management exemptions fi'om holding a
speculative position;
the Commission consider an exemption for passive investors; and
the Commission should not eliminate the independent account controller
exemption,
ICE thanks the Commission fbr the opportunity to comment on the proposed role
making,
Sincerely,
R. Trabue Bland
Director of Regulatory Affairs
and Assistant General Counsel
14Addendum
ICE
Responses to Questions Posed by the Commission's Notice of Proposed Rulemaking
10-002
COMMENT
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t
be utilized to diminish, eliminate, or prevent such burdens?
¯
In general, speculation is an amorphous concept.
transaction in a market is speculative in nature.
1.
Are Federal speculative position limits for energy contracts traded on
reporting markets necessary to "diminish, eliminate, or prevent" the burdens on interstate
commerce that may result from position concentrations in such contracts?
¯
No. Position limits are meant to prevent corners, squeezes, and congestion. If the
Commission revises its position limit scheme for energy contracts, it should do it
for two reasons: (i) to strive for consistency across commodity products; and (ii)
to insure that position limits are applied equally and fairly across exchanges.
Are there methods other than Federal speculative position limits that should
Defined broadly, every
For example, a hedger is
speculating on future prices when placing a hedge. As such, excessive speculation
is even harder to define. That is why ICE believes that the Commission should
not tie position limit rulemaking to excessive speculation, but should instead
focus on consistency across its jurisdictional markets and the prevention and
detection of market manipulation, which differs significantly from excessive
speculation. Tying position limits to excessive speculation may place the
Commission in role of price arbiter, as any unpopular price will lead to the
conclusion of "excess" speculation.10-002
COMMENT
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¯
If the Commission believes that a price is unwarranted and the result of
manipulation, it has the mandate and capabilities to investigate and punish any
misconduct by any market participants, whether the participant is a speculator or a
hedger.
3.
How should the Commission evaluate the potential effect of Federal
speculative position limits on the liquidity, market efficiency and price dlscovery
capabilities of referenced energy contracts in determining whether to establish position
limits for such contracts?
¯
Besides examining the effect on the number of participants, volume, and open
interest in the market, the Commission should examine whether the speculative
position limits, which by definition apply to speculators, are impacting price
discovery and volatility by curtailing the valuable information that speculators
bring to the market.
4.
Under the class approach to grouping contracts as discussed herein, how
should contracts that do not cash settle to the price of a single contract, but settle to the
average price of a subgroup of contracts within a class be treated during the spot month for
the purposes of enforcing the proposed speculative position limits?
°
In grouping contracts together for position limits, the Commission should strive to
treat economically equivalent contracts similarly. In addition, as with significant
price discovery contracts, the Commission should examine the average price
contract to see if it has a material effect on the underlying contracts.
5.
Under proposed regulation 151.2(b)(1)(i), the Commission would establish an
all-months-combined aggregate position limit equal to 10% of the average combined
futures and option contract open interest aggregated across all reporting markets for the
most recent calendar year up to 25,000 contracts, with a marginal increase of 2.5% of open
interest thereafter. As an alternative to this approach to an all-months-combined
aggregate position limit, the Commission requests comment on whether an additional10-002
COMMENT
CL-02688
increment with a marginal increase larger than 2.5% would be adequate to prevent
excessive speculation in the referenced energy contracts. An additional increment would
permit traders to hold larger positions relative to total open positions in the referenced
energy contracts, in comparison to the proposed formula. For example, the Commission
could fix the all-months-combined aggregate position limit
at 10%
of the prior year's
average open interest up to 25,000 contracts, with a marginal increase of 5% up to 300,000
contracts and a marginal increase of 2.5% thereafter. Assuming the prior year's average
open interest equaled 300,000 contracts, an all-months-combined aggregate position limit
would be fixed at 9,400 contracts under the proposed rule and 16,300 contracts under the
alternative.
¯
As stated in its comment letter, ICE believes that the Commission should set
aggregate position limits across markets; however, ICE disagrees with the
reasoning. The Commission should strive for consistency across jurisdiction and
tying the position limit rulemaking to excessive speculation, without a finding that
position limits have an effect on excessive speculation, couId lead the
Commission into the role of price arbiter.
°
A higher limit is warranted if the limit achieves its intended purpose- to prevent
squeezes and corners of a contract.
6.
Should customary position sizes held by speculative traders be a factor in
moderating the limit levels proposed by the Commission? In this connection, the
Commission notes that current regulation 150.5(c) states contract markets may adjust their
speculative limit levels "based on position sizes customarily held by speculative traders on
the contract market, which shall not be extraordinarily large relative to total open positions
in the contract
* *
* *"
Today position limits apply to the spot month because of concerns relating to the
potential for congestion and pricing abnormalities in the delivery month, as
suggested by the statutory provisions applicable to contract markets. CFTC
Regulation 150,5(c) allows contract markets to take into account customary10-002
COMMENT
CL-02688
positions for speculators as a factor in administering existing limits.
That seems
to be an appropriate regulatory interest for the delivery month.
7.
Reporting markets that list referenced energy contracts, as defined by the
proposed regulations, would continue to be responsible for maintaining their own position
limits (so long as they are not higher than the limits fixed by the Commission) or position
accountability rules. The Commission seeks comment on whether it should issue
acceptable practices that adopt formal guidelines and procedures for implementing
position accountability rules.
¯
ICE does not see a need for acceptable practices for exchange set position limits.
in addition, as referenced in previous Commission rulemakings, acceptable
practices are just one way to comply with a core principle. Formal guidelines or
prescriptive roles are not compatible with acceptable practices.
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 held 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 would receive exemptions for
positions offsetting risks resulting from swap agreements opposite counterparties who
would 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 Commission should seek authority from Congress to regulate the OTC swaps
markets in order to ensure the most effective oversight regime.
°
A swaps dealer is not a flow though entity; transactions may be offset indirectly in
the futures markets. Therefore, a "look tlu'ough" approach may be impractical or
impossible to implement.10-002
COMMENT
CL-02688
¯
In addition, the Commission should keep in mind that in making a risk
management exemption request, a swaps dealer is looking to offset risk.
Artificially limiting this activity could end up concentrating risk elsewhere and
could lead to less efficient hedging and risk management by major U.S.
commercial entities.
9.
Proposed regulation 20.02 would require swap dealers to file with the
Commission certain information in connection with their risk management exemptions to
ensure that the Commission can adequately assess their need for an exemption. The
Commission invites comment on whether these requirements are sufficient. In the
alternative, should the Commission limit these filing requirements, and instead rely upon
its regulation 18.05 special call authority to assess the merit of swap dealer risk
management exemption requests?
¯
The Commission's special call authority should not be used to obtain information
about exemption requests; instead, the Commission should promulgate a rule
detailing the information it requests and analyzing the burden on market
participants.
10. The Commission's proposed part 151 regulations for referenced energy
contracts would set forth a comprehensive regime of position limit, exemption and
aggregation requirements that would operate separately from the current position limit,
exemption and aggregation requirements for agricultural contracts set forth in part 150 of
the Commission's regulations. While proposed part 151 borrows many features of part
150, there are notable distinctions between the two, including their methods of position
limit calculation and treatment of positions held by swap dealers. The Commission seeks
comment on what, if any, of the distinctive features of the position limit framework
proposed herein, such as aggregate position limits and the swap dealer limited risk
management exemption, should be applied to the agricultural commodities listed in part
150 of the Commission's regulations.
¯
As a general matter, the Commission should strive for consistency across all
products. As ICE states in its comment letter, the Commission should follow its10-002
COMMENT
CL-02688
agricultural position limit rules and not adopt hedge exemption or account
controller provisions of the rulemaking,
11. The Commission is considering establishing speculative position limits for
contracts based on other physical commodities with finite supply such as precious metal
and soft agricultural commodity contracts. The Commission invites comment on which
aspects of the current speculative position limit framework for the agricultural commodity
contracts and the framework proposed herein for the major energy commodity contracts
(such as proposed position limits based on a percentage of open interest and the proposed
exemptions from the speculative position limits) are most relevant to contracts based on
other physical commodities with finite supply such as precious metal and soft agricultural
commodity contracts.
o
Again, ICE believes that the Commission should strive for consistency in
implementing its regulations. Treating products or classes of products
inconsistently leads to confusion and to charges of creating a loophole. For
example, in addition to examining energy, agricultural and metals markets, the
Commission should examine whether aggregate position limits should be placed
upon financial contracts such as Treasury futures or Eurodollars, as those
contracts are also commodities with a finite supply.
12. As discussed previously, the Commission has followed a policy since 2008 of
conditioning FBOT no-action relief on the requirement that FBOTs with contracts that
link to CFTC-regulated contracts have position limits that are comparable to the position
limits applicable to CFTC-regulated contracts. If the Commission adopts the proposed
rulemaking, should it continue, or modify in any way, this policy to address FBOT
contracts that would be linked to any referenced energy contract as defined by the
proposed regulations?
¯
ICE's European subsidiary, ICE Futures Europe, has worked closely with the
Commission and the FSA over the past decade on continuing to evolve its No
Action Letter to respond to changing market conditions, ICE believes that it is
clearly appropriate for exchanges that offer linked-contracts to operate under the10-002
COMMENT
CL-02688
13.
rules that apply to US exchanges, though this is currently only applied to ICE
Futures Europe, ICE Futures Europe has submitted more detailed comments on
this topic.
The Commission notes that Congress is currently considering legislation that
would revise the Commission's section 4a (a) position limit authority to extend beyond
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 held in OTC derivative instruments and FBOT contractsJ
~
The
Commission seeks comment on how it should take this pending legislation into account in
proposing Federal Speculative position limits.
¯
ICE believes that the Commission should take OTC derivatives into account when
setting position limits, OTC and futures markets are often used in tandem by
market participants to hedge risk, A position limit set too low in regards to the
OTC market could thwart the policy goal of moving OTC derivatives onto
exchanges,
¯
Separately, the Commission should be aware that setting position limits for
bilateral OTC transactions could be problematic, as forcing a participant to exit a
position in a bilateral contract could be punitive to an innocent counterparty,
¯
in regards to contracts listed on a foreign board of trade, as stated above, ICE
believes that aggregate position limits on contracts linked to a U.S, exchange
contract are warranted, However, the Commission cannot regulate the entire
global financial system, It must defer to other regulators, Setting position limits
on foreign contracts, such as Asian interest rates or EU emission credits, will
L I See, e.g,
Over-the-Counter Derivatives Markets Act of 2009 (OTCDMA), H.R. 4173, I 1 lth Congress, 1 st
Sess. (2009).10-002
COMMENT
CL-02688
invite retaliation by foreign regulators and hamper the ability of the CFTC to
work cooperatively with other regulators,
14. Under proposed regulation 151.2, the Commission would set spot-month and
all-months-combined position limits annually.
a.
Should spot-month position limits be set on a more frequent basis
given the potential for disruptions in deliverable supplies for referenced energy contracts?
¯
No. In the event of a disruption, a change to the Commission set spot-month and
all-months combined position limit would be too late, given the required notice
and comment period, In addition, firms need time to implement the back-office
systems needed for new position limits. Finally, the Commission should be aware
that sudden and!or overly frequent position limit changes could introduce
unnecessary uncertainty into markets and exacerbate the effects of these
disruptions.
b.
Should the Commission establish, by using a rolling-average of open
interest instead of a simple average for example, all months-combined position limits on a
more frequent basis? If so, what reasons would support such action?
°
No, More frequent adjustments would destabilize the markets by injecting
uncertainty and would increase administrative costs for market participants'
compliance activities,
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.10-002
COMMENT
CL-02688
a.
Should the Commission propose regulations to limit the positions of
passive long traders?
¯
The Commission should be aware that limiting ETF or index fund participation in
the exchange traded derivatives markets will have two consequences: (1) it will
expose retail passive investor customers to bilateral credit risks; and (2) it will
force more retail customers to access the futures markets directly.
¯
Passive investors looking for access to commodity markets will undoubtedly seek
other avenues, such as equity investments in commodity-intensive or commodity-
producing businesses, if not allowed to invest directly.
b.
If so, what criteria should the Commission employ to identify and
define such traders and positions?
c.
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?
¯
Passive investors, such as exchange traded funds, are an important way for retail
customers to access derivatives markets. This is key as these participants use
commodities to hedge against inflation and attendant rising commodity prices.
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?
¯
No. Apportioning space in commodity markets would put the government in the
place of picking winners in the passive investor space.
e.
What unintended consequences are likely to result from the
Commission's implementation of passive long position limits?
¯
Index funds or ETFs could buy the physical product or take transactions over the
counter (which has happened previously). Their customers would be subject to10-002
COMMENT
CL-02688
counterparty risk. In addition, studies have shown that passive investors may
have a dampening effect on commodity prices as they sell as prices rise and buy
as prices decrease.
~2
Eliminating passive investors could have adverse effects on
markets, including increasing volatility.
16. The proposed definition of referenced energy contract, diversified
commodity index, and contracts of the same class are intended to be simple definitions that
readily identify the affected contracts through an objective and administerial process
without relying on the Commission's exercise of discretion.
a.
Is the proposed definition of contracts of the same class for spot and
non-spot months sufficiently inclusive?
Yes.
b.
Is it appropriate to define contracts of the same class during spot
months to only include contracts that expire on the same day?
¯
No, the appropriate class should include contracts that are economically
equivalent, including penultimate (LD2) and LD3 contracts.
c.
Should diversified commodity indexes be defined with greater
particularity?
o
Yes.
17. Under the proposed regulations, a swap dealer seeking a risk management
exemption would apply directly to the Commission for the exemption. Should such
exemptions be processed by the reporting markets as would be the case with
bona fide
hedge exemptions under the proposed regulations?
¯
ICE believes that the Commission should handle hedge and risk management
exemptions.
See, e.g.,
Philip K. Verleger,
Notes at the Margin,
January 11,2010,
hllp://www.pkverlegerllc.com/nam100111.pdf10-002
COMMENT
CL-02688
In
implementing initial spot-month speculative position limits, if the notice of
proposed rulemaking is finalized, should the Commission:
a.
Issue special calls for information to the reporting markets to assess
the size of a contract's deliverable supply;
b.
Use the levels that are currently used by the exchanges; or
c.
Undertake an independent calculation of
deliverable supply without
substantial reliance
on exchange
estimates?
¯
The Commission should rely on reporting markets for deliverable supply
information. Again, the Commission should not use the special call provisions to
undertake a regular, routine reporting scheme. It should propose, for notice and
comment, a rulemaking to request such information.
