The Commodity Futures Trading Commission (CFTC) last Tuesday narrowly voted out a controversial final rule seeking to curb excessive speculation in commodity futures contracts and economically equivalent swaps. While the rule has scaled the regulatory hurdle, it may have a tougher road ahead if it is challenged in court.

With Republican Commissioners Scott O’Malia and Jill Sommers dissenting, the rule cleared the Commission by a vote of 3-2. It establishes limits on speculative positions in 28 core physical commodity contracts, four of which are energy contracts: Nymex Henry Hub Natural Gas, Nymex Light Sweet Crude Oil, Nymex New York Harbor Gasoline Blendstock and Nymex New York Harbor Heating Oil.

CFTC Chairman Gary Gensler and Commissioner Bart Chilton were the rule’s biggest proponents. But they had to drum up a third vote, and it was clear that Gensler had to make several concessions to win over Commissioner Michael Dunn, who had been on the fence. Right up until the final vote, Dunn expressed reservations about the rule.

“My fear is that position limits, at best, is a cure for a disease that does not exist, or a placebo for one that does,” he said. “No one has presented this agency any reliable economic analysis to support either the contention that excessive speculation is affecting the market we regulate or position limits will prevent excessive speculation.”

If anything, “position limits may actually lead to higher prices for commodities,” Dunn said.

“I believe this agency is setting itself up for an enormous failure,” said Sommers. “Over the last four year many have argued for position limits with such fervor and zeal, believing them to be a panacea for everything…I fear that this Commission will be blamed when this final rule does not lower food or energy costs.”

Wall Street investment banks, exchanges and industrial customers also expressed opposition to the final rule.”The speculative limits are so large that they will not have any measurable positive impact reducing excessive speculation,” said Paul N. Cicio, president of the Industrial Energy Consumers of America. “They may as well have done nothing at all because the limits set certainly do not reflect the intent of the Dodd-Frank legislation.”

It’s “too early to tell” whether the speculative limit rule will be challenged in court, he said. “There are those on Wall Street who want no position limits,” and bona fide hedgers believe the limits are far too big, Cicio said. “We’re still reviewing the rule,” said a spokesman for the U.S. Chamber of Commerce, when asked about a possible legal challenge.

“I believe that we are within the four corners of the law” with the final rule, countered Commissioner Bart Chilton. While he admitted that he also had some concerns, Chilton said the rule in the end would prevent excessive speculation.

The final rule sets two types of speculative limits: spot-month position limits and non-spot month limits. The spot-month position limits will take effect 60 days after the term “swap” is further defined under the Dodd- Frank Wall Street Reform and Consumer Protection Act. The limits adopted then will be based on the spot-month position limit levels currently in place at demand contract markets (see NGI, Jan. 17).

Spot-month-position limits for any of the referenced 28 contracts will be set at 25% of estimated deliverable supply, according to the CFTC. These limits would be applied separately for positions in the physical-delivery and all cash-settled referenced contracts combined. The limits have been a rule of thumb at the agency for the past 30-40 years, according to staff.

The cash-settled Nymex Henry Hub natural gas contracts would be subject to a cash-settled spot-month position limit and an aggregate limit (extending across positions in both physical-delivery and cash-settled natural gas contracts) set at five times the limit that applies to the physical delivery Nymex Henry Hub natural gas contract.

The spot-month limits for energy and metal contracts would be reviewed and adjusted annually, while non-spot month position limits would be adjusted biennially.

The non-spot month position limits would apply to positions a trader may have in all contract months combined or in a single contract month. For each reference contract, these limits would be set at 10% of open interest in the first 25,000 contracts and 2.5% thereafter. The limits are reflective of long-standing agency practice since the 1940s, staff said.

The CFTC rule would require quarterly reporting by traders who exceed a non-spot month position level in energy and metal referenced contracts.

With respect to spot-month position limits, the Commission estimates that based on historical patterns on an annual basis, 85 traders in referenced energy contracts “would hold or control positions that could exceed these limits.”

“We…appreciate the Commission’s recognition of the need to establish equivalent position limits in the important spot month for physically settled futures and those cash-settled futures and swaps which are based on the daily and final settlement prices of the primary physically delivered price discovery contracts. With the lone exception of natural gas, the CFTC’s…final rule will appropriately limit opportunities for inter-market manipulation and abuse in the spot month where the risk of misconduct and artificial prices is most acute,” said the CME Group, which owns the Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange and Commodity Exchange.

“The Commission’s decision also rectifies for almost all physical commodities the inherent flaws in its original proposal, which would have allowed a single-market participant to control in the spot month cash-settled positions equal to 125% of the deliverable supply in a covered commodity .” However “we intend to work with the CFTC as soon as possible to ensure that deliverable supply is properly defined and calculated and that existing spot-month position limits are adjusted to reflect current market conditions.

“This is critical given that existing limits in some products are more than 10 years old. We also remain concerned that the Commission has not yet explained its reasons for concluding that its adopted limits especially in non-spot months are necessary or appropriate and that the rules will encourage market participants to seek hedging and risk management alternatives outside of the United States,” CME said.

Several commissioners criticized the final rule on core principles for derivatives clearing organizations (DCO), saying it was too prescriptive. Nevertheless it was voted out by a slim margin (3-2). “This rule is much more prescriptive than I would like to see,” Dunn said. The rule is “needlessly prescriptive,” agreed Sommers, adding that it “[goes] beyond what is require by the statute.”

It appears the rules “are largely colored by the perception that swaps are inherently riskier than futures and options and as a result require a more prescriptive regulatory regime,” Sommers said. She noted that swaps and futures should be treated similarly, “unless there is a compelling reason not to.”

Gensler countered that the rule was intended to be prescriptive to help lower risk to the system.

The final rule would implement 15 core principles for a DCO, which provides clearing and settlement services for financial and commodities derivatives. The principles include financial resources (a DCO must meet a minimum capital requirement of $50 million); participant and product eligibility; risk management; settlement procedures; treatment of funds; default rules and procedures; rule enforcement; system safeguards; reporting; record-keeping; public information; information sharing; antitrust considerations; and legal risk.

The Commission also voted out a proposed order that would further extend the deadline for market participants to comply with certain parts of Title VII of the Dodd-Frank Act. In July the CFTC extended the compliance date to Dec. 31; last week’s order extends the deadline to July 16, 2012 (see NGI, July 18).

The CFTC granted the extension, or so-called exemptive relief, in two parts. First, the extension applies to certain provisions of the Commodity Exchange Act (CEA), which were added or amended by Dodd-Frank, that do not require a rulemaking but reference one or more terms regarding swap entities or instruments that Dodd-Frank requires be “further defined” (such as the terms “swap,” “swap dealer,” “major swap participant,” or “eligible contract participant”).

The second part of the temporary relief, which is based on “Part 35” of the Commission’s regulations, addresses provisions of the CEA that may apply to certain agreements, contracts and transactions in exempt or excluded commodities (generally, financial, energy and metals commodities) as a result of the repeal of various CEA exemptions and exclusions under Dodd-Frank.

Gensler said he anticipated that the Commission would take up the final rule on entity definition in the next few weeks, with the production definition rule to follow “shortly thereafter.”

“I’m disappointed on one hand” that the CFTC has proposed a second extension, but it needs to “put some meat on the bones” of its entity definition rules, Chilton said. “I hope we won’t have to revisit this,” O’Malia noted.

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