Price discovery in commodity markets is based on the balance between actual production and actual consumption. Nobody can estimate future commodity prices based on the secret manipulations of a few hedge funds that never disclose their positions. If someone corners the market on the exchange, he can subvert that price discovery mechanism. And though extreme price volatility harms producers and consumers, it works to the benefit of savvy traders.
Traders at Enron manipulated gas prices to the harm of consumers in Los Angeles. They manipulated gas prices when they worked at Enron, and they manipulated gas prices after they left Enron, and worked at hedge funds. A report prepared by Carl Levin's staff on Senate Permanent Subcommittee on Investigations showed how two hedge funds founded by former Enron employees--Amaranth and Centaurus--went to extreme lengths to manipulate gas prices and subvert the price discovery function of the exchanges. They were able to get away with it as long as they could, because Mr. and Mrs. Enron, aka Phil and Wendy Gramm, neutered the CEA, first with a secret side deal with Goldman, then by circumventing the rules to exempt Enron's energy trading business, and then with legislation, passed in 2000, known as the Enron Loophole.
Consequently, the CFTC's ability to protect the integrity of the commodity markets through position limits had become virtually a dead letter, prior to the enactment of Dodd-Frank. While exchanges like the NYMEX erratically enforced rules on position limits, trading of identical contracts on electronic exchanges, like the defunct EnronOnline and the ICE, were exempt from any kind of real CFTC oversight or rulemaking. The reason why Amaranth and Centaurus were able to manipulate gas prices so shamelessly was because of their dark trading on the ICE, which had no position limits.
The CFTC's Response to Dodd-Frank
Dodd-Frank reverses much of the Enron Loophole, and expands upon the legal mandate for imposing position limits first set forth in the Commodity and Exchange Act of 1936.
What is "Excessive Speculation"? As CFTC Chairman Gary Genzler explained in in his Senate testimony:
This most recent rule really used a formula that we put in place through notice and public hearings in the late 1980s and early 1990s, so it is about 20 years ago, and it is roughly 2.5 percent of the speculators. The speculators could not each have more than 2.5 percent... In the oil or natural gas markets, about 13 to 18 percent of the market are producers and merchants, and the other 80-plus percent are hedge funds and swap dealers and other financial actors. What we do is we use our authorities to police against fraud and manipulation and ensure transparency, that people see that price function, and then also to have positions to help prevent against manipulation, corners and squeezes, as I mentioned, help ensure the integrity of the market with regard to the all-months combined, that no one speculator has an outsize position. [Emphasis added.]
The CFTC studied the issue of position limits at length. It held numerous open hearings and meetings, and reviewed more than 15,000 comments, including those submitted by ISDA, over a span of 11 months. The process of ascertaining the proper position limits to curtail excessive speculation is described, in about 98,000 words, in the Federal Register. It included an extended cost/benefit analysis to establish, among other things, that such position limits would not impair market liquidity.
Dodd-Frank also imposes something new and specific. The CFTC must also set posiion limits, to the maximum extent practicable to deter and prevent market manipulation, squeezes, and corners.
Framing A Decision Around Republican Denial of The Truth
However Republican members of the Commission, seeking to neutralize financial reform, denied the existence of anything that refuted their agenda. They denied that there was evidence of a problem with excessive speculation; they denied that the CFTC had performed any kind analysis prior to setting certain position limits; they denied that the CFTC had the authority to impose such limits without first making initial "necessity findings." Wilkins frames his decision around these denials, in pursuit of the same agenda.
Wilkins quotes departed Commissioner Michael V. Dunn, who claimed that:
[T]o date CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the market we regulate or that position limits will prevent excessive speculation.
Wilkins quotes a GOP Commissioner Scott D. O'Malia, whose written dissents dissents are almost certainly ghostwritten by an outside law firm, as detailed by a reporter from Reuters. O'Malia lied when he said:
The Commission voted on this multifaceted rule package without the benefit of performing an objective factual analysis based on the necessary data to determine whether these particular limits . . . will effectively prevent or deter excessive speculation.
O'Malia also deceptively claimed:
[T]he Commission ignores the fact that in the context of the Act, such discretion is broad enough to permit the Commission to not impose limits if they are not appropriate.
Finally, Wilkins quotes Jill Sommers, who, while working at the CME, helped draft the Enron Loophole, and who opposes the parts of Dodd-Frank that reverse the Enron Loophole. She did "not believe position limits will control prices or market volatility."
In fact, the CFTC evaluated a mountain of evidence demonstrating how increased volatility and market manipulation was enabled by excessive speculation, by the absence of position limits, and by certain statutory loopholes. (See a list of a few of those studies here and a few at the end of this piece.) The GOP commissioners deemed this evidence to be "not credible." Instead, they point to industry-funded studies that drew different conclusions.
Anyone familiar with the energy markets knows that hedge funds, mutual funds and ETFs have dominated trading on the exchanges. And Wall Street insiders trade around the trading activities of these funds. Denying the magnitude of speculation in the energy markets is like denying the drug trade in Mexico. And if the CFTC gives stronger weight to some studies over others, that is within the agency's discretion, not the Court's.
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