Commodity derivatives regulation

Another spring, another energy price spike and another summer of hearings in Washington about limiting “excessive speculation”. Last July, the Commodity Futures Trading Commission infuriated a group of Senate Democrats, wanting to limit dealers’ ability to hold energy futures contracts. A multi-agency task force, led by the CFTC, echoed numerous academic studies reporting that speculators react to prices rather than drive them. Now the CFTC is re-examining the issue.

Oil prices are half what they were a year ago but much else has changed, too. A new president, a Democratic supermajority in the Senate and a drastic weakening of financial institutions’ political clout. This increases the odds of enacting position limits, but capping the ability of players to make large, mostly market-neutral bets would be a mistake. For one, it could decrease liquidity, making legitimate hedging more difficult and expensive, particularly in long-dated contracts. It might also push hedge funds to offshore dealers and to exchanges in Dubai or Singapore. Alternatively, large, sophisticated dealers could lose share to multiple smaller ones, possibly diluting oversight and increasing the odds of accidents such as rogue trading at PVM.

Such oversight is the true remit of the CFTC, not making artificial distinctions between speculators and legitimate hedgers. One valid question is whether passive long-only commodity investors such as pension funds and endowments, which have raised commodities exposure, distort prices. They probably did, driving much of the tripling of open interest in energy futures from 2004 to 2008. This shifted the slope of some commodities’ forward curve, as more investors piled into front-month contracts.

But markets have adjusted as the bubble deflated and “dumb money” investors realised they were subsidising other players. Naiveté has a way of self-correcting except, apparently, in the US Congress.