CFTC to Revise Commodity Index Fund Policies

The New York Times reported that the CFTC is set to announce new policies on Monday, June 2. There are no details available, except that the Commission is not expected to enact sweeping changes recommended by me and others. Read the Times article here: 

This announcement does have market-moving potential if it is perceived as restricting the buying activity of commodity index traders. I cover the CFTC’s current and historical policies regarding CITs on pages 9 through 13 of my book, The Commitments of Traders Bible. To recap, the Commission has been most accommodating to these long-only commodity “investors” represented by the largest swap dealers. They have granted wholesale exemptions from speculative trading limits imposed on traditional commodity and hedge funds. Last fall they announced their intention to drop limits altogether for long-only commodity indexers. (This idea has since been put on hold.)

And the CFTC has refused to go on record to explain how these exemptions meet the requirements of the Commodity Exchange Act, which requires the CFTC to establish speculative position limits, allowing exemptions only for “bona fide hedges” by firms involved in the respective commodity’s cash business (supply chain). It is pretty clear that the CFTC has exceeded it authority in concessions to swap dealers.

Here is the danger. If the CFTC were to announce new, genuine restrictions on swap dealers—who are the largest players on the long side of commodity futures—the resulting loss of buying power, or resulting selling pressure could impact commodity prices. There may be a lot of longs trying to exit the markets at once in anticipation of lower prices.

Many commodity markets employ daily price limits. In recent months, hitting a trading limit has become a common event. It may be difficult or impossible to exit a trade in a market that has moved the daily limit against your position. The potential risk on Monday is to long positions. If the market interprets the CFTC’s announcement as bearish, you may want to have your stop-loss within the daily range and in the market. This still does not guarantee a fill, which are executed on a first come-first served basis.

Daily limits are generally increased following a lock limit day. But markets can stay locked even at expanded limits. Losses can mount quickly under these conditions. So quickly that counter-party payment risk could become a concern. But isn’t this risk removed through central clearing in the futures markets? In theory, yes, but the CFTC’s exemptions have concentrated something on the order of $200 billion (contract value) with the majority held by just 4 large swap dealers. These are the same firms that have already written off 10s of billions of dollars in subprime loan losses, and have had to go looking for new capital in the Middle East and elsewhere to stay solvent. These swap dealers will need cash to meet margin calls if positions move against them. We have already witnessed an old-line investment bank go under because of a cash shortage. The futures clearing houses have not been tested under conditions where such a large player could not meet a margin call.

I really don’t like being alarmist, but I am not confident in the CFTC’s willingness or ability to resolve the problems their ill-advised (and likely illegal) actions have created.