The CFTC made two controversial rulings yesterday. One was to impose position limits on traders. The second was to change the capital needed to join a clearinghouse.
Both rulings were incorrect and wrong headed.
First, position limits impose a hard restriction on the amount of contracts one entity can own in any commodity. The logic behind this is false. Fans of position limits assert that if someone holds too many contracts they can influence the price of the contract, or corner the market. They reason that speculators are what drove oil prices significantly higher and made the gasoline pump price more expensive.
The position limit advocates also assert that as commodities have been sold as an asset class, firms that have no physical interest in commodity markets are driving the price, not supply and demand.
Virtually all academic studies I have seen have shown their assertions to be false.
If we are going to have transparent and competitive markets, we don’t need position limits. We ought to be encouraging, not discouraging speculation. More speculation, and more participants interacting in the market place allow for better and more transparent price discovery.
The logic behind the CFTC’s enactment of postion limits essentially says that they think commodity prices haven’t been reflecting the underlying markets. It’s their judgement of “fair”.
You tell me, what’s the “fair” price of a barrel of oil? If it shouldn’t be trading at the price Brent Crude is trading at $ICE, or WTI Crude ($CL_F) at the $CME, then what is it? If you know, you should be able to enter a trade in the market and make a lot of money.
Speculators don’t set prices. They put trades on to profit from where they think prices are going. Other market participants use the market to hedge their risk. Enacting position limits hurts speculators, but it also hurts hedgers because it makes it more expensive to hedge their business risk. Higher costs lead to less production, and less output. These position limits are just another way the Obama administration through regulation is killing our domestic economy. Death by a thousand cuts.
The publicly traded ICE and CME clearinghouses see the customer positions every day, see their cash balances, and also know where the indexes or physical markets are trading. They are so close to the market that they ought to set the position limits, and the margins for the products they clear.
The crisis of 2008 happened and there wasn’t a blip in either clearinghouse. Will that happen under the new rules? Time will tell. Let’s hope we don’t have another melt down until we can get rid of them.
This brings me to the other point, the decrease in the amount of capital a firm needs to join a clearinghouse.
The CFTC lowered it to $50 million. Here is the logic behind their decision. They want to force over the counter derivatives to be cleared in a central clearinghouse. The CFTC also wants the market for clearing those derivatives to be competitive. By lowering the amount of capital you need to join a clearing operation, they think more firms will clear trades.
Fifty million dollars may sound like a lot of money to the average person on the street. However, a clearing operation like the CME moves around billions every day. Fifty million is small potatoes and can be swallowed up with one adverse move in a volatile market.
Sounds reasonable until you think about why a clearinghouse exists.
Clearinghouses exist to remove counter party risk from trading. The clearing mechanism steps in between the two parties, so neither of them are trading with each other, but in effect, are trading with the clearinghouse. The clearinghouse nets the trades, and requires each party to pay a performance bond to hold the position.
That performance bond is generally cash. However, in recent years clearinghouses have begun to accept securities as collateral. With lower amounts of capital needed to join a clearing house, it stands to reason more clearing houses will be started to clear trades of all kinds. Those clearing houses may or may not accept alternative forms of collateral.
My intuition tells me that the newer, smaller, start up clearing operations are going to try and hedge their risk in larger clearing operations-or because they already clear those larger clearinghouses their start up operations become a source of new risk for the existing clearing houses.
MF Global ($MF) and New Edge are starting up OTC clearing houses under the new capital requirements. They will compete. In order to get new business, they may become creative on what type of collateral they accept to hold positions-specifically for over the counter derivatives which the CFTC is trying to get into clearing houses.
What happens when that “creative” collateral is worthless and a clearinghouse is left holding the bag?
Central party clearing (CCP) is desirable when there are standardized products that you can measure risk on. CCP not desirable in customized, highly specialized derivatives where a firm is trying to manage risks that it alone faces in production.
I would encourage you to go through many of the posts at The Streetwise Professor. He is an expert on clearing, and has written extensively, and much more elegantly than I on the impacts of the Dodd-Frank bill and clearing.
Clearing is not a magic bullet. It’s desirable when you can do it, but forcing clearing on a marketplace that isn’t ready for it turns that magic bullet into a weapon of mass destruction.
These guys that have been running the asylum the past few years have made the regulatory environment much, much worse, not better.