Commissioner Jill Sommers Announces her Resignation

01/24/2013 03:02 PM EST

Appointed by President Bush in 2007, Sommers previous job was chief lobbyist for the International Swaps and Derivatives Association, and is the poster child for “First, Do Nothing” in regulatory reform in the financial industry. As Commissioner, she opposed implementation of any regulation that might impact the ability of the four large swap dealers who account for 94% of swap contracts: JP Morgan/Chase, Bank of America, Citigroup, Goldman Sachs.

Watch the news. Best guess is she will land on her feet–in a plush office with a major bank.

But the same cannot be said about commodity index traders who, on average, hold eight times the position size of large speculators. Commodity indexers would have you believe that theirs are benign passively-managed positions, which are simply roll forward as futures contracts expire, without affecting prices. The truth, as the chart below illustrates, is that commodity index traders show the same momentum trading pattern as speculators, adding buying pressure to rising prices and selling pressure  to declines. Despite the fact that commodity indexers are long-only traders, their trading shows high volatility than speculators. Any commodity price movement or volatility caused by speculators is magnified two-and-a-half-fold by commodity index traders.

Commodity Index Traders outpaced CTA’s since 2009 commodity bottom

Who are these outsized traders? And how do they circumvent position limits designed to prevent market manipulation. According to International Swaps and Derivatives Association, 70% of commodity index long futures contracts are held by just four large banks (Bank of America, JP Morgan, Goldman Sachs, and Citibank). In 1991 the futures market regulator, The Commodity Futures Trading Commission (CFTC) was convinced to grant these swap dealers trading limit exemptions previously reserved for actual commodity producers and processors who had real inventory to hedge. The four big banks use futures markets hedge commodity index swap agreements made with commodity index, pension, sovereign, and other funds who wish to add a commodity exposure to their portfolios.

Commodity index traders are the largest long player in commodities, currently holding 35% of reported long positions.

With swap dealer regulation a primary goal Frank-Dodd reforms you would think that these cozy relationships between regulators and swap dealers would be old news. But it is business as usual at the Commodity Futures Trading Commission. And this means continuing loopholes for large swap dealers.  The commodity indexers have become the largest long players in future markets – at least in those reported in the CFTC’s Commitments of Traders reports. And this is not about to change as the CFTC created a new loophole for swap dealers–post Frank-Dodd–on page 170 of “the Final Rules for Position Limits for Futures and Swaps:”

“the Commission understands that swap dealers, who constitute a large percentage of those anticipated to be near or above the position limits set forth in § 151.4, generally use futures contracts to offset the residual portfolio market risk of their uncleared swaps positions. Under these final rules, market participants can net their physical delivery and cash-settled futures contracts with their swaps transactions for purposes of complying with the non-spot-month limit.  In this regard, the netting of  futures and swaps positions for such swap dealers would reduce their exposure to an applicable position limit.

“Taking these considerations into account, the Commission anticipates that for the majority of  participants, the non-spot month levels are estimated to impose limits that are sufficiently high so as to not affect their hedging or speculative activity as these participants could either rely on a bona fide hedge exemption [pass-through from a bona fide hedger] or hold a net position that is under the limit. Thus, the Commission projects that relatively few market participants [that is, swap dealers] will have to adjust their activities to ensure that their positions are not in excess of  the limits.”

These big banks use netting offsets to effectively reduce their derivative risk by more than 90%, increasing their trading capacity. This practice ignores counter-party payment risk, but if the Treasury’s bank regulators allow this practice for to meet reserve requirements, that is a separate issue. But applying this accounting stratagem to offset futures positions is Bizarro logic the defies reason—and unequivocal Congressional direction to the contrary—while granting swap dealers what amounts to unlimited futures trading capacity and gutting Frank-Dodd in the bargain. Business as usual.

The shame of this is that it is so unnecessary. In my book, “The Commitments of Traders Bible” (Wiley 2008), I list hundreds of company stocks and mutual funds whose price movements are highly correlated with various commodity markets. I point out that the S&P GSCI—the most-tracked commodity index—has a near-perfect .98 correlation to crude oil prices. There are hundreds of oil sector stocks that move in virtual tandem with crude oil prices that would substitute nicely for a futures position.

Avoiding the moral difference between investing in a producer of a strategic commodity and the buying and hoarding of same, we need to be realistic about investor demand versus market capacity. Commodity investing’s popularity continues to grow. The total open interest for major US commodity futures markets is currently about $600 billion (notional value). This is a pittance compared to equities. The five SuperMajor oil company stocks alone have a float-adjusted market capitalization of twice this amount. Stock markets are made for investors. If you want a commodity exposure, you won’t start a food riot by investing in an oil stock.

Mr. President, if you are looking for a silver bullet for gasoline (and food) prices, you will find it in your shirt pocket. Take out your pen and sign an executive order directing the CFTC to finally disgorge swap dealers of their oversized commodity positions. This may be the simplest fix of your Presidency. Will creating a level playing field in commodity markets cause a market disruption? A bit, but it will be in favor of American consumers.

While you are at it, you might insist that the CFTC complete its “Commodity Index Trader” report by including the remaining core commodity markets. While they have added a number of reports of questionable usefulness in the past five years, they have neglected this illuminating report, which was suppose to be a two-year pilot program. (It may not be coincidental that the International Swaps and Derivatives Association is on record opposing the creation of this report.)

FT reporter Gregory Meyer may have revealed a bit of bias and frustration, commenting that, “the data are maddeningly vague [without errors].” It is a natural human reaction to disparage what you do not understand. But the evidence Mr. Meyer offers up to support his premise is entirely unconnected:

“In a sign that even CFTC officials acknowledge how hard it will be to generate accurate data, they created what they call a “safe harbour for less than fully compliant reporting” until late March [2012].”

Mr. Meyer fails to note that the safe harbour only applies to the CFTCs new swap reporting regime, which is just being implemented in response to Dodd-Frank. This is hardly detrimental to our purposes since we refer only to standard futures and options contract figures.

Mr. Meyer’s case (and the reader) would have been better served by disclosing the full extent of the Newedge reporting problems. The FT article failed to mention that the CFTC noted in their order that Newedge’s “inability to file accurate and timely large trader reports” extended from at least 2009.

Correct or not, these kind of news articles generate doubts about the usability of COT data. I have never suffered from the illusion that government reports were without error. Error-free data would be an unexpected gift in any statistical endeavor.

In spite of whatever shortcomings may affect the COT reports, we have found the data quite valuable. Recent evidence of this is included in our year-end report (BR874, Dec. 26, 2011).

We do build in safeguards in our data collection and analysis procedures (which have allowed us to notify the CFTC of potential errors on numerous occasions). For instance–and this is only one example–although I typically display actual trader net positions in Bullish Review, I also examine percent net positions when preparing the newsletter. This tends to mitigate open interest reporting errors.

I am beginning my 25^th year of writing Bullish Review and over this time have come to appreciate unflattering articles concerning the COT data. You will not see me sending a letter to the FT editor defending the CFTC or disputing the “maddeningly vague” appraisal. The more widely-held this perception, the greater our trading edge.

Comments:

Quoted By GENE EPSTEIN in Barron’s

The rebound in commodity prices is not setting any records, and in fact remains well short of normal rebound targets such as a minimum Fibonacci .382 retracement of the year-long down move. And commodity index traders are not setting any record either. They are still the largest players on long side of commodity futures markets, but they have not seen the bottom of this bear market yet. I still expect that most of these “investors” will either swear off commodities by the time they hit bottom and/or be barred by Congress from investing in commodities. If the latter, commodity prices could collapse well below fundamental value levels.

In summary, there is scant evidence that a new commodity bull market is underway. Last year’s bull market has not been fully retraced yet, as every other commodity bull market has since 1983. If the dollar breaks down to new lows on the year and gold breaks out above $1000, we will take another look. But both are low probabilities.

Of course if oil producers are buying oil futures through swap dealers it amounts to shilling–running up prices with leveraged purchases of paper oil.

read the article here…

There are definitive, obvious answers to both questions. First, the blame must be laid at the feet of speculators who have been allowed to run amuck by the Commodity Futures Trading Commission (CFTC), the very agency charged by Congress with preventing excess speculation. Why am I convinced that speculators are to blame? The answer will be obvious to fans of tv’s Dr. House. We can eliminate causes for which there is no ready cure; including supply shortages, Chinese and Indian demand, and the weak dollar. Ignoring the distraction of causes with no quick fix, we can focus on the one factor that has a prescription: excess speculation.

The source of commodity speculation is two-fold: traditional commodity pools and hedge funds who provide necessary liquidity to the futures markets, and the commodity indexers who buy and hold long futures contracts for appreciation (as they would stocks or bonds). Those who down-play speculative excesses point out that the “Commitments of Traders” report shows that the percentage of long contracts held by speculators has been declining. What they miss is that the CFTC commingles speculative long positions held by commodity index traders with those of traditional commodity hedgers—the actual end-users of commodities. This subterfuge effectively hid the accumulation of upwards of 40% of outstanding commodity contracts, making commodity index “investors,” the largest long players in US commodity markets.

How do we ascertain the commodity indexer numbers? Under pressure for more transparency, in 2007 the CFTC began publishing the positions of commodity index traders separately in the “COT-Supplemental” report. This development uncovered the fact that the four largest US investment banks dominate this business, issuing swaps to institutional funds wishing to invest in commodities, then locking in a profit by buying long futures contracts. At the behest of these swap dealers, who pleaded for continuing anonymity, the commission included only twelve agricultural markets in this weekly report. But since these swap dealers invest according to known commodity index benchmarks, we can deduce their gross positions fairly closely: currently about $230 billion in US markets alone.

The CFTC has, in direct violation of its mandate, orchestrated a free-for-all speculative environment, giving funds of all types virtual free reign to run-up prices. This has been accomplished through a covert two-front assault on federal laws: (1) Systematically raising or eliminating speculative trading limits, and (2) granting wholesale speculative exemptions to swap dealers.

The CFTC operates under the authority of the Commodity Exchange Act (CEA) of 1922. Section 6a of the CEA requires that the Commission “shall” set position limits to prevent excess speculation. In direct contravention of Congress, the CFTC has interpreted “shall” to mean “may, if I please” and instead of establishing speculative caps, has eliminated federal trading limits in all but a handful of agricultural markets.

This is why you did not hear a squeal from swap dealers and other large speculators when the CFTC announced plans to close the “London loophole,” and hold oil traders there to the same limits imposed on the New York Mercantile Exchange (NYMEX). News flash: The CFTC imposes no trading limits whatever on NYMEX oil futures trading (or gasoline, natural gas, and heating oil). The exchange itself limits trading, but only in the last three days before contract expiration, when indexers have long since rolled their massive positions forward to deferred contracts.

The lack of speculative limits would make exemptions to the limits moot, except that indexers wish to gain equivalent weightings in relatively small grain and livestock markets where limits still exist. Section 6c of the CEA states that the only exemptions permitted are for “bona fide hedging.” Here the CFTC’s own rules are in agreement with the CEA; they have simply chosen to ignore them. US Code Title 17 defines who is a bona fide hedger in such intricate detail that no one of reasonable intelligence could mistake swap dealers JP Morgan Chase, Citigroup, Bank of America, Wachovia, or HSBC North America as legitimate “bona fide hedgers” such as farmers, grain merchants, and other cash market participants.

What should Congress do? The question of whether commodity investment is good public policy should be debated in Congress, and not decided by a handful of political appointees drawn from the very industry they oversee. But please, first investigate current law enforcement before adding unneeded regulation. Congress anticipated the current mess, which might have been largely averted but for regulator subversion.

• Before rubber-stamping current CFTC requests for more funding, ask the right questions of the acting Chairman Lukken. The big one: “Under what authority are you granting swap dealers exemptions to, or just plain eliminating, mandated speculative trading limits?” Number 2 might be to provide a rational explanation of how a small group of traders could accumulate 30% to 60% of a commodity’s long contracts and—as the agency claims—not inflate prices.

• US futures markets are easily the most transparent markets in the world. But they and the public would benefit by requiring the CFTC to make permanent the 2-year pilot program under which it publishes the weekly “Commodity Index Trader” report and expanding it to include all futures markets. The CFTC should also require and publish the same trader report for foreign boards of trade and regulated swap platforms as a requisite for US distribution.

• In your deliberations, be mindful that commodity bull markets are cyclical and responsive to laws of supply and demand. High prices discourage buying and stimulate new production, eventually retracing. Though the current run-up is arguably more speculative than usual, there is no reason to believe this time is different. This bubble will likely take care of itself long before Congressional action (or a Presidential magic wand) could be effective.

• The direct and most efficient course would be to compel the CFTC to implement real speculative trading limits in accordance with current law, and to comply with their own regulations, which clearly disqualify swap dealers and other index traders for exemption from speculative trading limits. A logical first step might be to cap swap dealers positions at current levels.

• A caveat: There is no evidence that the CFTC is capable of correcting the speculative excesses that they continue to deny. Even the most deft and delicate attempt to deflate the current bubble is likely to cause reverse market distortions even more painful than the bubble itself.

ECONOMIC BEAT  
A Simple Old Reg That Needs Dusting Off
By GENE EPSTEIN
Fixing the inflation problem.

IN ITS STATEMENT ACCOMPANYING ITS DECISION last week to leave the short-term interest rate unchanged, the Federal Open Market Committee expressed concern about "the upside risks to inflation," specifically mentioning the "continued increases in the prices of energy and other commodities."

Meanwhile, the Homeland Security and Governmental Affairs Committee held Capitol Hill hearings on "Curbing Excessive Speculation in the Commodity Markets."

The connection between the two events was little noticed but is direct: Something can be done about the higher prices of food and fuel — the source of the inflation that concerns the Federal Open Market Committee. Much as I hate to agree with any politician who blames the speculator whenever goods get too dear, which usually amounts to shooting the messenger, Homeland Security Committee Chair Joe Lieberman unfortunately had a point when he accused speculators of "artificially inflating the prices of food and fuel futures."

The remedy for restoring stability, however, is far simpler than Senator Lieberman seems to realize. Instead of acting on his resolve to "introduce comprehensive bipartisan legislation to address excessive speculation," his committee should simply demand that the Commodity Futures Trading Commission enforce rules that have been on the regulatory books since 1936.

The rules the CFTC should enforce are position limits that specify the maximum number of contracts in a given market that any single speculative entity can hold. These limits, which generally amount to about 2% of all contracts outstanding, are set for a good reason: The commodity markets are too small to absorb an excess of speculative dollars. Even at current inflated prices and a near-record level of trading interest, the total contract value on all domestic commodity exchanges comes to only $960 billion. By way of comparison, even at current depressed prices, the total market capitalization of all domestically traded stocks tops $13 trillion.

But as though commodity markets were as large as stock markets, a new breed of commodity index "investor" has taken speculative buying way beyond anything domestic commodity markets have ever seen. These commodity indexers ignore individual market fundamentals, instead flooding liquidity into markets based solely on the weightings dictated by one or another commodity index benchmark. The flood has become a torrent. For example, based on commodity trader Steve Briese’s calculations, "long" bets by the indexers in wheat account for nearly 60% of the 2007 domestic wheat crop.

Some analysts still insist that, despite the huge volume of speculative bets, prices are merely reflecting supply-demand fundamentals. (For an alternative view, see "Oil Bubble" in last week’s Barron’s.) But even if the bulls are right, they should have nothing to fear. To avoid all possible dislocations, let position limits imposed on the indexers be phased in — say, over a period of six to nine months. Then, if the fundamentals really do justify these lofty price levels, the absence of this speculative liquidity will hardly make a difference.

The indexers circumvent position limits by trading through dealers that belong to the International Swaps and Derivatives Association. These "swaps dealers" serve as market-makers for the index funds, while laying off their speculative risk on the organized commodity markets. Back-of-the-envelope calculations I did with Briese show a huge retrenchment if speculative position limits currently on the books were imposed on the swaps dealers. For example, in corn and soybeans, they would have to rid themselves of at least half the value of their current long positions in these two commodities.

Swaps dealers’ positions in crude oil are not available. But based on the standard commodity indexes, it is possible to make rough estimates. Briese estimates that their long bets on the New York Mercantile crude oil contract could account for more than a third of all long contracts, or the equivalent of nearly 90 days of U.S. consumption. Apply proportionately similar position limits in force for soybeans and corn, and there, too, at least half these long bets would have to be covered.

The CFTC currently exempts swaps dealers from position limits on the basis of an argument that would bring the commissioners a flunking grade in Econ 101. Contrary to the CFTC, the swaps dealers are not "hedgers," since hedgers are clearly defined as those who take offsetting positions in the physical commodity. In their role as market-makers for the index funds, the swaps dealers are taking offsetting positions, but they are obviously not dealing in the physical commodity.

History teaches that regulatory commissions often become hostage to the very industry they’re supposed to regulate. In that regard, it’s worth noting that CFTC Commissioner Jill Sommers is a former Head of Government Affairs at the International Swaps and Derivatives Association.

Say that legislators do ride herd over the CFTC by requiring that it enforce position limits. Even if, as proposed, the rules were phased in slowly, Briese fears an anticipatory collapse in prices that could drive the swaps dealers into bankruptcy. While that would hardly be welcome, the decline in food and energy prices would provide welcome relief to consumers.

E-mail: gene.epstein@barrons.com
      URL for this article:
http://online.barrons.com/article/SB121460970889212409.html

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved

Of course, the laws of unintended consequences pertain. Some commodities have daily trading limits. If a bearish shock were to hit these markets, bulls have to potential to be locked in adverse positions as prices fall day after day without any significant trades taking place. I have been there. It ain’t fun.

If the CFTC simply wants to panic the market, this is a good start. Read the advisory at: http://www.cftc.gov/stellent/groups/public/@newsroom/documents/file/cftcemergencyauthoritybackgrou.pdf