Excessive Speculation and Position

Limits in Energy Derivatives Markets
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EXECUTIVE SUMMARY

During the period from 2002 to 2006, energy prices, like other

commodity prices, trended consistently higher and then increased

dramatically from 2007 to mid-2008, in many cases to historical highs.

Although the prices of most commodity products have since decreased

significantly from those highs, the prices experienced in 2008 triggered

a number of investigations and analyses of the causative factors underlying these price changes. For example, numerous hearings on the issue

have been held in both the Senate and the House of Representatives,

and a review was conducted by the U.S. Government Accountability

Office at the request of the House Agricultural Committee. Reports

have been issued by academics and research groups addressing the

topic. Nearly all economists that have carefully studied these markets

have concluded that supply and demand fundamentals and other

macroeconomic factors were the cause of these price movements.1

However, a small but vocal group has argued that “excessive speculation” was, and remains, the cause of prices deemed to be “too high”

and they often point to the risk management activities of swap

dealers and index funds as the primary “speculative” force driving

high prices. These claims are unsupported by any empirical evidence

or legitimate economic analysis, including the Commodity Futures

Trading Commission’s (CFTC) own data and analysis.2 To the contrary,

the activity of speculators, as well as swap dealers and index funds,

are essential to creating the liquidity necessary for the efficient functioning of the market and make it possible for traditional commercial

participants to manage their risk.

CME Group strongly opposes regulatory policies that unfairly

discriminate against index funds and swap dealers in their ability

to access energy and commodity futures markets. There is already

significant evidence that CFTC actions to repeal no-action letters

that granted exemptions from position limits to two index funds

and the rhetoric regarding the possible imposition of position limits

on swap dealers and index funds without allowance for exemptions

is pushing these participants to exempt-over-the-counter (OTC)

swap markets, foreign exchanges with less restrictive or non-existent

position limits requirements, and even domestic securities markets.

Market participants are also developing other product substitutes that

will allow investors to bypass the regulated exchange markets in the

United States.

CME Group supports the CFTC’s mission to ensure that energy markets

effectively serve their important economic functions for the benefit of

all market participants. Although the evidence is clear that speculative

position limits in the energy markets, beyond those already in place,

are not warranted, we also recognize that confidence in the futures

markets may be undermined by perceptions. Therefore, CME Group

is proposing the following recommendations:

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months combined, single months and the delivery period based

on traditional considerations, focusing on its open interest and,

at or near the delivery period, the deliverable supply.

 <XZ_\oZ_Xe^\j_XccY\i\jgfej`Yc\]fiX[d`e`jk\i`e^`kj

hedge exemption program for its markets subject to its existing

exemption standards until such time as common exemption

standards are established by the CFTC. Swap dealers and index

funds will remain eligible for risk management exemptions to

hedge bona fide exposure but be subject to position limits for

their speculative proprietary trading.

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positions and, after gaining authority to impose aggregate limits

that include OTC positions, be responsible for ensuring an enduser’s combined on-exchange and OTC speculative positions

do not exceed the aggregate total market position limit.

We are prepared to lead, but any steps taken to impose hard position

limits must support the national policy of enhancing transparent

markets and central counterparty clearing and prevent market

participants from moving away from the best regulated, most

transparent, safest marketplace to less regulated or even completely

1 See e.g. Philip C. Abbott, Christopher Hurt, Wallace E. Tyner, “What’s Driving Food Prices,” Farm Foundation, Issue Report ( March 2009 Update); Ronald Trostle , “Global Agricultural Supply and Demand: Factors

Contributing to the Recent Increase in Food Commodity Prices,” A Report from the Economic Research Service of the USDA (July 2008); and Ennis Knupp & Associates, “The Role of Institutional Investors in Rising

Commodity Prices” (June 2008).

See also, U.S. Government Accountability Office, Issues Involving the Use of the Futures Markets to Invest in Commodity Indexes, (Jan. 30, 2009), available at http://www.gao.gov/new.items/d09285r.pdf , which analyzed

the available data respecting any causal relationship between speculation and commodity prices and concluded that the eight empirical studies reviewed “generally found limited statistical evidence of a causal relationship

between speculation in the futures markets and changes in commodity prices – regardless of whether the studies focused on index traders, specifically, or speculators, generally.” Id at 5.
Excessive Speculation and Position Limits in Energy Derivatives Markets

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unregulated markets that are and will continue to be beyond the

control of the Commission and Congress. Consequently, in conjunction

with our adopting a hard limits regime, exempt commercial markets

(ECMs) and foreign boards of trade (FBOT) must do so as well for all

similar contracts.

Our proposed hard limits regime is intended to be administered in

a way that fosters competition among trading venues in all markets

based solely on liquidity, technology, price, clearing capability and

quality and customer service, not regulatory arbitrage.3

 We caution,

however, that efforts to increase confidence in the futures markets

by imposing hard limits on energy products must be balanced with

ensuring that such limits do not have a detrimental effect on the price

discovery and hedging functions of futures markets or drive trading

to unregulated markets. We believe that our carefully designed hard

limits regime accomplishes these goals and represents an immediate

improvement for those seeking to impose hard limits, while avoiding

any unintended harm to the U.S. markets and their users.

AN HISTORICAL PERSPECTIVE

In developing a method for imposing position limits on specific

energy products, it is also important to consider the history of

speculative trading and speculators in futures markets. In fact,

the theory that speculators on futures markets cause unwarranted

price volatility and excessively high or low prices is not new;

Congress has been repeating that notion since at least 1850.

Farmers and their legislative representatives regularly demand

the elimination of speculators on futures exchanges. However,

the Commodity Exchange Act (CEA), which came into existence

in the midst of an anti-speculation frenzy, does not limit speculation,

but only “excessive speculation.” This is an implicit recognition of

an indisputable economic principle — futures markets cannot

operate without the participation of speculators. CFTC Chairman,

Gary Gensler, recognized this principle in his recent testimony

at the Commission’s hearings on position limits in the energy

markets and exemptions therefrom (the Hearings).

The Hearings focused on concerns with “excessive speculation,” which

resurfaced when fuel and food prices spiked to levels that were shocking

to consumers and painful to the economy. Although prices later subsided

significantly, the pressure to control a reoccurrence of price spikes has

led to a search for a simple causal agent that can easily be neutralized.

The favored cause was speculators. But, speculators sell when they

think prices are too high and buy when they think prices are too low.

They are not a unified voting block and are on both sides of every

market. Speculative selling and buying send signals to producers and

processors that help keep our economy on an even keel. High futures

prices for corn induced farmers to bring new acreage to market. High

forward energy prices encourage exploration and new technology to

exploit existing untapped reserves.

Futures markets perform two essential functions — they create a venue

for price discovery and they permit low cost hedging of risk. Futures

markets depend on short and long term speculators to make markets and

provide liquidity for hedgers. Futures markets cannot operate effectively

without speculators and speculators will not use futures markets if artificial barriers or tolls impede their access. As one noted scholar explains:

“Large speculators are frequently the most efficient bearers of

risk. In the old days, large individual traders played the role of

risk bearers. Today, futures funds and hedge funds that allow

investors to diversify can perform this function. Unfortunately,

position limits prevent these traders from bearing as much risk

as they would like. Due to these limits, less risk-tolerant traders

must absorb additional risk. This leads to an incomplete transfer

of risk. This is costly.

Moreover, speculators are frequently well informed about supply

and demand fundamentals. Their trading forces prices towards

the level implied by this information. Since producers, consumers, processors, and storers of commodities rely upon futures

prices to guide their decisions, having more information embedded in these prices will lead to better decisions. By limiting the

ability of informed individuals to trade, however, position limits

reduce the flow of information to the futures market.

This reduces the efficiency of resource allocation.” 4 

2

 See Commodity Futures Trading Commission, Commodity Swap Dealers & Index Traders with Commission Recommendations, (Sept. 11, 2008), available at http://www.cftc.gov/stellent/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf

3 Should concerns that “excessive speculation” is driving commodity prices in the metals derivative markets or adversely impacting liquidity in such markets arise in the future, we are prepared to consider a similar hard

limits regime for metals contracts as well.
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Thus, position limits that are too broad indeed impede speculators’

access to the futures markets, undermining “the ability of the futures

markets to perform their essential functions.”5

THE ROLE OF SWAP

DEALERS AND INDEX FUNDS

The targets of the latest “excessive speculation” claims are index

funds and swap dealers. Neither, however, is engaged in traditional

speculative activity — namely, trying to beat the market. Rather,

both are engaged in legitimate risk management activity and contribute

positively to the overall functioning of the futures market. Moreover,

as discussed in more detail later in this paper, there is no reliable

economic evidence to support the contention that either market

participant drives commodity prices, including energy prices.

Swap Dealers

Swap dealers use futures markets to facilitate the hedging of more

complex and specific risks accepted in connection with swap transactions with commercial customers and others, including institutional

investors who seek broad exposure to commodity prices as an inflation

hedge through commodity index swaps. Increased restrictions on swap

dealers’ ability to obtain exemptions from position limits will likely

cause two unintended yet foreseeable consequences. First, limiting

the hedge exemption for swap dealers could make it more costly for

commercial enterprises and institutional investors to execute strategies

in the OTC market to meet their hedging needs. Second, swap

dealers may well widen spreads in order to internalize risks or attempt

to hedge their risk through increased use of OTC instruments rather

than exchange-traded futures. Both strategies undercut current

regulatory and legislative efforts to reduce systemic risk by driving

OTC-generated risk into a central counterparty clearing context.

Finally, the assertion that swap dealers were regularly and widely being

used as intermediaries by speculators and others who would not have

been entitled to a hedge exemption as a device to circumvent exchange

position limits has been contradicted by the information so far released

by the Commission of data obtained from swap dealers by use of its

special call authority.

Index Funds

Index funds aggregate the buying and selling decisions of many

thousands of investors, most of whom are diversifying their investment

portfolios and hedging inflation risks to their investment returns in

order to maximize their retirement savings and their individual wealth.

Moreover, index funds supply a pool of stable, passive, unleveraged

capital to bear commodity price risk.6

 Thus, “by allowing commodity

producers to transfer their inherent commodity price risk exposure

to long-term investors who are better-suited to bear it, the participation

of the index investors in the commodity futures markets lowers the cost

of capital to commodity producers, and by lowering costs helps to lower

commodity prices over the long run.”7

Moreover, index funds, like those swap dealers hedging commodity

index swaps, cannot make or receive delivery and consequently

they must sell their long positions in the nearby contract month

and establish long positions in a more distant month prior to the

termination of trading in the nearby contract. Therefore, index investors clearly do not create artificial demand for the physical commodity.

Denying index funds a risk based exemption from position limits will

preclude thousands of small investors from a cost effective means of

investing in commodities. More importantly, the absence of such an

exemption will reduce market liquidity and thereby increase the costs

of hedging for producers, which costs will ultimately be passed on to

consumers. Thus, some of the most vocal proponents of eliminating

these risk-based exemptions will, contrary to their stated expectations,

see commodity prices increase as a result of the very action they are

encouraging.

4Craig Pirrong, Squeezes, Corpses, and the Anti-Manipulation Provisions of the Commodity Exchange Act, available at http://www.cato.org/pubs/regulation/regv17n4/reg17n4c.html 5 Id.

6

 Testimony of Steven H. Strongin, Managing Director, Goldman, Sachs & Co. Before the Permanent Subcommittee on Investigations Committee on Homeland Security and Governmental Affairs, U.S. Senate (July 21, 2009)

at 4, available at www.hsgac.senate.gov. (“Strongin Testimony”). 7 Id.
Excessive Speculation and Position Limits in Energy Derivatives Markets

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The Evidence

The assertion that commodity prices are being driven by swap dealers

and index funds, directly and indirectly trading OTC with swap dealers,

rather than by the expected forces of supply and demand, does not have

a factual basis. Most every competent economist who has looked at real

data, rather than anecdotes, and who has applied legitimate economic

analysis concludes that neither speculators, swap dealers nor index

funds are distorting commodity prices.8

 Contrary to the assertion that

these industry participants speculators are uniformly on the buy side

and are pushing prices up on that basis, the publicly available data has

been relatively consistent over time in demonstrating that speculators

in crude oil futures contracts have been relatively balanced as between

buy and sell positions in the market. In fact, The Wall Street Journal

surveyed a significant cross section of economists who agreed that:

“The global surge in food and energy prices is being driven primarily

by fundamental market conditions, rather than an investment bubble . .

. .”9

 The weight of the evidence and informed opinion confirms that the

high prices are a consequence of supply and demand factors external

to speculative trading and the hedging of swap dealers and index funds

on futures exchanges.

Expert economists, however, are being ignored and important

legislation and regulation is in danger of being shaped by spurious

economics that is profoundly flawed in its methodology and logic.

Well-regarded economists who have reviewed the work of the

“experts,” who have been lobbying for restrictive positions limits

and the exclusion of swap dealers and index funds from futures

markets, have found, among other flaws, that the proponents

of the restrictions demonstrated:

(1) unfamiliarity with industry fundamentals resulting in

misinterpretation of petroleum statistics; (2) confusion of the

consequence of demand for physical product and demand for

derivatives; (3) use of overly simplistic models; (4) arbitrary and

meaningless characterization and measurement of “excessive

speculation”; (5) misstatement of volatility trends; and (6) conflation

of speculation and market manipulation.

The debate regarding controlling excessive speculation in the energy

markets by means of position limits should be informed by two facts:

first, it is rare for a single speculator, index trader or swap dealer to

have control of a large share of the open interest in any futures contract,

and second, efforts to control price or volatility by position limits

has been a failed strategy. As an experienced futures trader in energy

products explains:

“The U.S. natural gas market is very robust. The NYMEX NG

physically settled futures contract is very well designed with

dozens of companies able to both make and take delivery of

the product. . . . The NYMEX NG contract is managed through

expiration without giving anyone the ability to manipulate

the market for the physical product. A significant amount of

gas can be made available and delivered at contract specifications with minimal cost, and many users can actually make

use of that product. At expiry, among many players available, a

willing and knowledgeable buyer and seller, both having other

options, must agree to exchange Henry Hub natural gas at the

settlement price. The NG contract simply cannot deviate from

fair value at expiration. The fact that so little actually goes to

delivery is a testament to the efficiency of this market.”

Proponents of hard limits on speculative trading and the elimination

of risk management exemptions believe that such limits will bring

commodity prices to some favored level — in the case of energy

commodities - down; in the case of cattle - up. Not only is there

a complete disconnect between the implied promise to drive

prices down or up (whichever the most vocal constituency desires)

and the ability of position limits to deliver on that promise, but

improperly calibrated and administered position limits can easily

distort markets and increase costs to hedgers, which in turn

increases costs to consumers.

8David S. Jacks, Populists versus theorists: Futures markets and the volatility of prices, (June 2006), available at http://www.isda.org/speeches/pdf/Onion-futures-Annex.pdf. 9Phil Izzo, Bubble Isn’t Big Factor in Inflation, WALL ST. J., May 9, 2008, at A2.
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THE SCOPE OF THE CFTC’S AUTHORITY

RESPECTING POSITION LIMITS

The CFTC has adequate authority to set hard limits on energy contracts

trading on registered exchanges and, in limited circumstances, trading

ECMs, which have been essentially exempt from CFTC oversight.

Section 4a(a) of the CEA directs the Commission to fix position limits

for a commodity traded on a “designated contract market” (DCM),

i.e., regulated futures exchange, or a “derivatives transaction execution

facility” (DTEF) if it first finds that such action is “necessary to

diminish, eliminate, or prevent” “sudden or unreasonable fluctuations

or unwarranted changes in the price of such commodity.” However,

the Commission’s direct use of the authority conferred in Section 4a(a)

is neither required nor justified if the relevant designated contract

market has acted effectively to avoid “excessive speculation.” Indeed,

as the Commission has previously noted, the exchanges have the

expertise and are in the best position to fix position limits for their

contracts.10 In fact, this determination led the Commission to delegate

to the exchanges authority to set position limits in non-enumerated

commodities, in the first instances, almost 30 years ago.11

Since that time, the regulatory structure for speculative position

limits has been administered under a two-pronged framework; with

enforcement of speculative position limits being shared by both the

Commission and the DCMs.12 Under the first prong, the Commission

establishes and enforces speculative position limits for futures contracts

on a limited group of agricultural commodities.13 Under the second

prong, for all other commodities, individual DCMs, in fulfillment

of their obligations under the CEA’s Core Principles, establish and

enforce their own speculative position limits or position accountability

provisions (including exemption and aggregation rules), subject to

Commission oversight. The Commission has authority to enforce

exchange-set speculative position limits, which it has approved, as

violations of the Act.14 We do not believe that there is any reason to

deviate from this effective framework.

The CFTC’s authority respecting position limits is confined to futures

contracts traded on U.S. DCMs, DTEFs and price discovery contracts

(SPDC) traded on ECMs. The statutory definition of an SPDC is very

limiting of the CFTC’s authority and, so far the only SPDC is natural

gas. As Chairman Gensler acknowledged in his recent Congressional

testimony before the Senate Permanent Subcommittee on Investigations,

in view of the various exclusions and exemptions from CFTC authority

available for transactions executed in OTC market, the CFTC does not

currently have authority to impose federally mandated position limits

that would extend to the traditional bilateral OTC market.

Because the Commission has limited authority respecting the

imposition of position limits across all markets in which positions in

the same underlying commodity may be assumed, we believe that new

self-imposed or CFTC-imposed restrictions on fully regulated DCMs

likely will have the predictable and inevitable effect of simply shifting

trading from regulated and transparent derivatives markets to less

regulated markets such as ECMs, or unregulated, opaque markets,

including, offshore Exchanges, ffshore OTC Markets, U.S. physical

markets and offshore physical markets, all of which are beyond the

Commission’s control respecting position limits. This result runs

counter to the public interest and current efforts by the Administration

and Congress to limit systemic risk in the financial system.15

10 46 Fed. Reg. 50938, 50940

11 Id.

12The Commission has consistently endorsed this framework when addressing issues related to speculative limits. See, e.g., 74 Fed. Reg. 12282; 72 Fed. Reg. 66097; 70 Fed. Reg. 12621; 69 Fed. Reg. 33874.

13 These “Federal limits” are enumerated in Commission regulation 150.2, and apply to the following futures and option markets: CBOT corn, oats, soybeans, wheat, soybean oil, and soybean meal; Minneapolis Grain

Exchange (MGX) hard red spring wheat and white wheat; ICE Futures U.S. (formerly the New York Board of Trade) cotton No. 2; and Kansas City Board of Trade (KCBT) hard winter wheat. The exchanges, under their

own rules, have adopted the Federal limits and enforce violations of these limits.

14Violations of exchange-set speculative limits are subject to exchange disciplinary action; violations of exchange speculative limit rules approved by the Commission are subject to enforcement action by the Commission,

in addition to any action that the exchanges may take.

15 This result also would seem contrary to the legislative intent underlying last year’s legislation imposing new CFTC oversight on certain contracts traded on the essentially unregulated exempt commercial markets.

Congress undertook this action after witnessing the results of the Amaranth experience. Using the market surveillance tool of position accountability levels, NYMEX staff members determined to direct Amaranth in

August 2006 to reduce its open positions in the first two nearby contract months based upon what they believed to be a significant concentration in NYMEX markets in Natural Gas futures. However, this prudent regulatory

action by the regulated futures exchange simply resulted in a shift of positions by Amaranth from NYMEX to the Intercontinental Exchange (“ICE”), which was undetectable at that time both by NYMEX and the CFTC.

o
Excessive Speculation and Position Limits in Energy Derivatives Markets

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Nonetheless, there are steps that the Commission and Congress may

take to provide the CFTC with adequate authority to cure the problem

it perceives. Specifically, Congress can expand the CFTC’s power

to cover certain U.S.-based behavior by amending the provisions of

Section 2 of the CEA dealing with “excluded” commodities, as the

term is defined in the CEA, to grant the CFTC authority to impose

and enforce position limits on positions taken in excluded OTC

transactions.

Moreover, the ECM category should be eliminated in order to subject

these exchanges to the full panoply of the CFTC’s authority respecting position limits. Indeed, any trading facility that is now successfully

operating as an ECM can easily convert to a DTEF or DCM. A DTEF

has an affirmative obligation to deter market abuses and to implement

systems and procedures to comply with that obligation.16 DTEFs,

however, are not explicitly obligated to comply with Core Principle

5. Thus, to ensure DTEFs take appropriate action respecting position

limits the CFTC should make Core Principle 517 applicable to DTEFs

trading enumerated or excluded commodities. The Commission has

oversight powers to insure that these obligations are met. Once Core

Principle 5 is applicable to DTEFs, this regulatory scheme would appear

to provide an effective remedy to the problems identified with ECMs

without the need to revise the current structure.

We caution, however, that any regulatory or legislative action aimed

at constricting market activity without closing these regulatory gaps

is likely to drive business to a more amenable jurisdiction or to

unregulated markets; there is not likely to be a significant impact on

the overall size of speculative and risk management positions. There

will, however, likely be damage to the liquidity of the regulated markets

with the attendant increases in costs to their users and, ultimately,

U.S. consumers.

The United States has been the center of world trading because of its

first mover advantage and its rational regulatory regime. If speculators

and accumulators like swap dealers and index funds are restricted from

trading world commodities such as oil and metals on U.S. exchanges

and on the U.S. OTC market, their alternative is clear. They will turn

to their foreign affiliates and the market will move offshore. Although

Natural Gas delivered at Henry Hub is a natural U.S. product and it

is not likely that that specific contract will move offshore, natural

gas is a global product and it is certain that a new global benchmark

contract will emerge on a foreign exchange if trading on U.S. markets

is constricted by inappropriate limits. The likely chain of effects is

predictable and unacceptable; liquidity of U.S. markets will be impaired

causing damage to the domestic natural gas industry.18

Even if Congress or the Commission could find a legitimate basis to

restrict or impede U.S. firms from participating in offshore markets,

the only consequence will be to disadvantage U.S. firms and U.S.

markets. World prices will be set without U.S. participation. Thus,

the importance of precisely calibrated and properly administered

position limits on energy contracts, along with a carefully managed

exemption process, cannot be understated.

16 CEA Section 5a (c)(2) provides as follows: Deterrence of abuses — The board of trade shall establish and enforce trading and participation rules that will deter abuses and has the capacity to detect, investigate, and

enforce those rules, including means to-- (A) obtain information necessary to perform the functions required under this section; or (B) use technological means to — (i) provide market participants with impartial access

to the market; and (ii) capture information that may be used in establishing whether rule violations have occurred.

17Core Principle 5 of section 5(d) of the Act: POSITION LIMITATIONS OR ACCOUNTABILITY — To reduce the potential threat of market manipulation or congestion, especially during trading in the delivery month, the

board of trade shall adopt position limitations or position accountability for speculators, where necessary and appropriate. (b) Acceptable practices. (1) In order to diminish potential problems arising from excessively large

speculative positions, and to facilitate orderly liquidation of expiring futures contracts, markets may need to set limits

on traders’ positions for certain commodities.

18Before the successful introduction of futures trading in 1983, the oil market had migrated through a series of non-competitive and non-transparent mechanisms for price determination. Before World War II, the

Texas Railroad Commission oversaw production and price determination within the State of Texas. After the war, a corporate oligarchy — “the seven sisters”— organized a system for pricing based largely on netbacks to

geographic points. In the early 1970s, OPEC, which was established in 1960, successfully asserted itself to take control of price determination. Though these three mechanisms were independent of each other, they shared

two significant characteristics: prices were determined non-competitively and each process lacked transparency.
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CME GROUP/NYMEX RESPONSE

We recognize that confidence in the markets may be undermined by

the perception that speculators may be driving commodity prices.

We also support the CFTC’s mission to ensure that the energy markets

subject to its regulation can operate efficiently to carry out their

core missions. The vocal public criticism respecting the impact of

“speculative” trading on energy commodities strongly suggests that

the imposition of hard limits in such markets may increase confidence

in the futures markets, and in the U.S. markets overall. The effort to

increase confidence in the futures markets by imposing hard limits

on energy products, however, must be delicately balanced with the

need to ensure that such limits do not have a detrimental effect on the

price discovery and hedging functions of futures markets. We believe

that a carefully designed hard limits regime can accomplish these goals.

Accordingly, we make the following recommendations, which are

described in more detail below.

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months combined, single months and the delivery period based

on traditional considerations, focusing on its open interest and,

at or near the delivery period, the deliverable supply. The CFTC

may alter or amend the limits set by an exchange or adopt a

formula to be applied separately by each exchange based on

factors pertinent to its market if it finds that the exchange’s

rules are inadequate to prevent the effects of “excessive

speculation.”

 <XZ_\oZ_Xe^\j_XccY\i\jgfej`Yc\]fiX[d`e`jk\i`e^`kj

hedge exemption program for its markets subject to its existing

exemption standards until such time as common exemption

standards are established by the CFTC. Each exchange will

continue to funds will remain eligible for risk management

exemptions to hedge bona fide exposure but be subject to

position limits for their speculative proprietary trading.

 K_\:=K:n`cc\jkXYc`j_Xjpjk\d]fii\gfik`e^f]\e[$

user OTC positions and, after gaining authority to impose

aggregate limits that include OTC positions, be responsible

for ensuring an end-user’s combined on-exchange and OTC

speculative positions do not exceed the aggregate total market

position limit. The CFTC may grant exemptions for OTC

positions that represent hedging rather than speculative activity.

We are prepared to lead, but any steps taken to impose hard position

limits must support the national policy of enhancing transparent

markets and central counterparty clearing — which was reaffirmed

 by Congress in its amendments to the CEA just last year — and prevent

market participants from moving away from the best regulated, most

transparent, safest marketplace to less regulated or even completely

unregulated markets that are and will continue to be beyond the

control of the Commission and Congress. Therefore, in conjunction

with our adopting a hard limits regime, ECMs and FBOTs must do so

as well for all similar contracts. As previously noted, if these entities

are not subject to a hard limit regime for all similar products, not just

SPDC, hard limits at NYMEX will simply bleed business into unregulated

or less regulated venues. Additionally, placing DCMs, ECMs and FBOTs

on equal footing with respect to position limits will ensure that market

competition among these trading platforms is based on liquidity,

technology, clearing quality, price and customer service, and not

regulatory arbitrage.

Moreover, it is essential that the exchanges be permitted to continue

to administer exemptions from the speculative limits for risk mitigating

trades. The imposition of hard position limits, absent a hedge exemption

for swap dealers and index funds, on a U.S. futures exchange

with respect to a commodity that trades on a global basis, that is

readily stored, that has numerous dedicated exchanges and a number

of well-established OTC trading venues is unlikely to have any

significant commercial impact other than driving the prohibited

positions off-exchange or to venues outside the United States with

predictable harm to the U.S. regulated markets and their users

(e.g., commercials, producers, consumers). Thus, it is essential that

swap dealers and index funds be allowed a risk offset exemption.
Excessive Speculation and Position Limits in Energy Derivatives Markets

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Position Limits – Calibrated

To Existing CFTC Authority

NYMEX currently employs hard position limits during the last

three days of trading before the delivery period begins and position

accountability levels at other times to avoid congestion and other

market disrupting events that may flow from excessive concentrations

of positions. NYMEX’s administration of its accountability regime has

been discredited in the press simply by listing the number of traders

who, and time periods during which, such traders held positions in

excess of the accountability levels. Of course, current accountability

levels are set as an early warning alert well below the level at which

position concentrations present a market integrity concern.

Consequently, traders frequently hold positions in excess of those

levels for extended periods. For example, NYMEX’s accountability

limits are set as a small percentage of the front month’s open interest:

It is well-understood in the industry and among CFTC staff that

traders can and do hold positions in excess of the accountability

levels without adversely impacting prices or volatility. The CFTC has

repeatedly found that the NYMEX’s administration of its accountability

levels is in compliance with its obligations under the CEA to prevent

excessive speculation, as interpreted by the CFTC in its “Acceptable

Practices” for Core Principle 5. Notwithstanding the success of

NYMEX’s accountability regime, as previously noted, we recognize

that concerns have been raised about accountability regimes for the

energy products and such concerns may be impacting confidence in

our markets. We are committed to working with the Commission and

other market participants to address these issues in a way that ensures

continued market integrity and competition among the markets.

To this end, if those ECMs and FBOT that trade energy products

agree to adopt comparable programs, we will adopt hard limits for

energy contracts, in addition to the current limits that apply during

the last three trading days of the expiration month, which will include

single-month and all-months combined limits as well as concentration

ratio thresholds. This modified regime will include the administration

of tailored hedge exemptions for swap dealers and index funds, that

reflect the individual circumstances of the participants and are limited

in duration and quantity, and as whole, should alleviate external

concerns that positions held by these investors and hedgers will

increase price volatility or artificially inflate or deflate prices.

Each exchange and ECM, which is obligated to control excessive

speculation, has an obligation under the CEA to set its own limits

in proportion to liquidity, volume, open interest and other factors

respecting trading for which it is directly responsible. It is contrary

to the purposes of the CEA’s prohibition on excessive speculation for

an exchange with limited liquidity, volume and/or open interest to

simply mimic the position limits set by the exchange on which it is

attempting to free ride. For example, if NYMEX with substantial

volume, open interest and liquidity, sets its single-month position

limit at 20,000 and an exchange with one-fourth of NYMEX’s liquidity,

volume and open interest, simply expropriates that number, traders

would be able to exploit a position limit of 40,000 when the correct

level should have been 25,000 with no more than 20,000 on NYMEX

and 5,000 on the less liquid exchange.

Crude Oil 10,000 3%

Natural Gas 6,000 4%

RBOB Blendstock Gasoline 5,000 6%

Heating Oil 5,000 7%

Single-Month

Accountability

Level

Percentage of Front

Month FuturesEquivalentOpen

NYMEX Contract Interest
cmegroup.com

10

Proposed Principles For Single Exchange

Position Limits For Energy Contracts

Spot Limit: During a short period beginning near the termination

of trading in a contract (last three days in energy) setting the position

limit at 25 percent of deliverable supply for a physically delivered

contract is well-established and appropriate for the purposes of

minimizing the potential for manipulation and allowing for effective

convergence of futures and cash. Financially-settled contracts

referencing the physically-settled contract should have an equivalent,

but separate, spot limit.

Single-Month and All-Months Combined Limits: Single-month

limits should be a function of liquidity as the objective is to limit

the potential for the initiation or liquidation of a large position to

cause price distortions. Our experience suggests that futures-equivalent

open interest in the lead month is an appropriate proxy for liquidity

on each exchange. We suggest that the single-month limit be

established as 10 percent of the first 25,000 contracts of open interest

with a 5 percent marginal increase for open interest in excess of 25,000

at each exchange – DCM, ECM or FBOT; the all-months-combined

limit would be 150 percent of the single-month limit and the all-months

limit would also be applicable to spread positions within the same

contract. Additionally, for physical and financially settled contracts

based on the same underlying commodity and traded on the same exchange, the open interest (adjusted for contract size) will be calculated

across the products and a single aggregate limit will be established for

the full complement of such contracts.

This methodology allows for natural limitations of concentration in

excess of levels that a market can appropriately handle without risk

to the integrity of the market. This methodology also produces a

natural aggregate limit across exchanges that is fairly applied and

which fosters competition. It also produces a self-correcting limit

level based on periodic, sustained changes in open interest, and is

accomplished without requiring CFTC resources and intervention

in administering exchange limits.

Concentration: Concern that position limits calculated according to

this formula will permit excessive concentration in some thinly traded

contract months will be addressed by including, on top of the position

limits, a flexible concentration ratio threshold, which will be calculated

on the basis of open interest in a single month. These concentration

thresholds will protect against the potentially disruptive effects of

excessive concentration by a single trader and allow the exchange

to direct a trader not to increase his position or to reduce his position.

The concentration ratio threshold will be flexible enough to accommodate the development of liquidity in deferred month contracts and also

to ensure that participants can manage their positions appropriately.

Our proposed concentration threshold is 25 percent of open interest

in a single month that has developed liquidity.
Excessive Speculation and Position Limits in Energy Derivatives Markets

11

Proposed Principles For Position

Limits – Cross-Market Aggregation

If the CFTC gains authority over OTC trading, and if it finds a means

to minimize the impact of transfers of trading to foreign jurisdictions

or to some variation of the cash/physical market, then the CFTC

should adopt an aggregate limit for the total positions held in all of

the markets and apply the aggregate position limit at the level of the

actual position owner/controller in accordance with the provisions of

CFTC Regulation 150.4 respecting aggregation. The CFTC-set aggregate

limits would be set in terms of equivalents of the largest most liquid

futures contract. For example, the light sweet crude oil limit would be

set in terms of equivalents to the NYMEX contract WTI specification,

or 1,000 barrels per contract. In addition to the aggregate limit, each

regulated exchange would continue to be responsible for enforcing its

exchange-specific limits.

In order to properly enforce aggregate limits, each of the ultimate

customers would need to be identified and its total derivatives position,

including U.S. futures, FBOT futures, SPDC, ETFs and OTC contracts

would be aggregated. The CFTC would identify traders whose aggregate

speculative on-exchange and related OTC positions exceeded the CFTC

aggregate limit and would be responsible for enforcing compliance with

the aggregate limit. The CFTC would also grant exemptions for OTC

positions that qualified for hedge treatment.

Assume that the one month aggregate limit for WTI was set by the

CFTC at 40,000 contract equivalents. A trader would be entitled to

accumulate and hold derivative contracts covering 40,000,000 barrels.

That trader would also be constrained by position limits set by DCMs

and ECMs. For example, based on open interest, the trader might be

entitled to hold 20,000 contracts at NYMEX and 5,000 at ICE. The

remaining 15,000 contract equivalents could be held in some combination of ETF shares, OTC swaps and FBOT contracts. Traders will be

responsible for reporting their OTC positions directly to the CFTC.

The CFTC would be responsible for requiring the trader to reduce its

positions, but would not take an action that favors a particular venue.

CONCLUSION

Regulated futures markets have played an integral role in the economic

life of this country for almost 100 years and, increasingly, are playing

a critical role in the world economy. Futures markets permit those

who seek to minimize risk to quickly and efficiently find those willing

to take on that risk. While we understand that futures markets must

instill confidence in all key stakeholders, it is also important to

recognize that changes made to ensure public confidence without

comprehensive analysis of the potential effects, may undermine

otherwise well functioning markets that have earned their status

as global benchmarks for price discovery and risk management.

Confidence clearly will not be enhanced by measures that impair

liquidity and efficiency and that incentivize traders to utilize less

transparent or offshore venues. We believe the approach outlined

in this White Paper addresses public concerns and protects the

competitiveness and transparency of our domestic energy markets.

We look forward to working with the CFTC, Congress and other

registered exchanges to put these recommendations into practice.
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