Thursday, April 07, 2011

Hedge Fund Industry Troubled by CFTC Proposed Position Limits on Derivatives Regulations under Dodd-Frank

In a letter to the CFTC, the hedge fund industry said that the Commission’s proposed position limits under Section of Dodd-Frank do not strike the right balance among the statutory goals of diminishing excessive speculation, deterring market manipulation, and ensuring sufficient market liquidity for bona fide hedgers and the price discovery function of the underlying market. Research and experience demonstrate that position limits have not reduced price volatility or prevented market manipulation, noted the Managed Funds Association. Rather, research shows that such limits may negatively impact

The MFA believes that the proposed position limits will place a greater burden on interstate commerce by hindering the ability of futures markets to perform their fundamental price discovery, risk transfer, and risk management functions, which depend on the existence of liquid, fair, and competitive markets. Moreover, absent coordination with foreign regulators and boards of trade, the imposition of position limits on U.S. markets may shift liquidity to foreign markets.

In addition, the proposed limits are a flawed cure for a problem that the Commission has not found to exist. Even if the Commission were to find excessive speculation in the commodity markets, there are several defects in the proposed rules. For example, the annual recalculation methodology for CFTC determination of non-spot month position limits results in a bias towards lower annual limits.

Further, the CFTC’s proposed changes to the disaggregation rules will result in unnecessary aggregation of independently controlled accounts, burden investors and investment managers, and potentially reduce liquidity in U.S. futures markets. Disaggregation based upon independence of control has been a longstanding policy of the Commission and U.S. futures exchanges. This policy was adopted gradually and refined over time in a carefully considered and open process. Because the current policy is effective, the MFA reasoned that the Commission’s proposed changes are unnecessary and may have severe unintended consequences.

The proposed spot-month limits on cash-settled contracts are not supported by any data that establishing such limits by reference to 25 percent of deliverable supply is appropriate or that further limiting the reference to a specific delivery point is justified. Alternative approaches should be considered to ensure that liquidity is not diminished in these widely-used risk management contracts.

The legislative history of the Dodd-Frank Act indicates that the Commission’s setting of position limits is intended to be an authorized, rather than a required, action. Dodd-Frank specifies that, if the CFTC does set position limits, they must diminish, eliminate, or prevent excessive speculation, deter and prevent market manipulation, squeezes, and corners; ensure sufficient market liquidity for bona fide hedgers; and ensure that the price discovery function of the underlying market is not disrupted. While Frank Act requires the Commission to maximize to the extent practicable each of the four factors when setting limits, it does not specify the weight to be given to each factor.

The MFA believes that the Commission has not struck the appropriate balance among these four criteria, but instead has focused on addressing the fear of excessive speculation and market manipulation at the expense of ensuring sufficient market liquidity and price discovery. Further, the association said that the Commission has not adequately considered whether the proposed rules will cause price discovery in the referenced commodities to shift to trading on foreign boards of trade. The referenced contracts are global commodities that are traded worldwide, noted the MFA, and thus the CFTC should not implement rulemaking until there is global cooperation on position limits, otherwise U.S. markets will be disadvantaged.

Dodd-Frank granted the CFTC broad, essentially unlimited, discretion to exempt traders and contracts from the position limit requirements. In the MFA’s view, to the extent the application of position limits to a particular class of trader or contract would not further all of the four factors above, the Commission should use its exemptive authority to reach the appropriate balance among the four criteria.

The MFA also urged the CFTC, when adopting regulations, to be cognizant of the effect of the proposed federal limits on the ability of futures markets to perform their fundamental price discovery, risk transfer, and risk management functions, which depend on the existence of liquid, fair, and competitive markets. Under this rubric, any proposal that would tend to adversely affect the liquidity, fairness or competitiveness of the futures markets must be carefully scrutinized. Throughout the letter, the MFA suggests revisions to the proposed rules intended to better balance the statutory policy objectives and to permit the Commission to fulfill its statutory mandate to protect the integrity of the market, but in a manner that is less disruptive to the liquidity of the market and to the operations of market participants.

The association of hedge funds urged the CFTC to exempt inter-commodity spread and arbitrage transactions. Exchange rules currently contemplate the availability of an exemption for inter-commodity spread and arbitrage transactions, noted the MFA, but no analogous exemption has been included in the position limits proposal. The Commission should provide for an exemption for intercommodity spreads, said the MFA, which reflect a relationship between two commodities rather than an outright directional position in the spread components.

The proposal would provide a limited exception for positions in futures or options contracts on a derivatives contract market that are in excess of the position limits at the time they are implemented. Traders would not be permitted to enter into new contracts in the same direction, but could enter into offsetting positions.

The MFA has concerns about the implementation of this exemption. For example, an index fund manager who has established and carries a pre-existing position in excess of the proposed new limits and desires to roll its positions into a subsequent month will have to trade naked out of that portion of its position that exceeds the new limits. Since the index fund positions generally are known to the market, other traders may take undue advantage of the index fund when it rolls its positions, and the liquidation of the excess position could be disruptive to the market. If the Commission moves forward with the proposed limits, the MFA suggested a six-month phase-out period for pre-existing positions and allow managers to roll pre-existing positions into the next month, despite the fact that they may exceed the new position limits.