Statement of Dissent by Commissioner Rostin Behnam Regarding Position Limits for Derivatives; Proposed Rule

January 30, 2020

Introduction

The ceremony for the 92^nd Academy Awards will air in a little over a week.  I haven’t seen too many movies this year given my two young girls and hectic work schedule, but I did see “Ford v Ferrari.”[1]  “Ford v Ferrari” earned four award nominations, including best motion picture of the year.  The film tells the true story of American car designer Carroll Shelby and British-born driver Ken Miles who built a race car for Ford Motor Company and competed with Enzo Ferrari’s dominating and iconic red racing cars at the 1966 24 Hours of Le Mans.[2]  This high drama action film focuses foremost on the relationship between Shelby and Miles—the co-designers and driver of Ford’s own iconic GT40—and their triumph over the competition, the course, the rulebook, and the bureaucracy.  Even if you aren’t a car enthusiast, the action, acting, and accuracy of the story are well worth your time. However, there is a lot more to this movie than racing.

There is a great scene where Miles is talking to his son about achieving the “perfect lap” –no mistakes, every gear change, and every corner perfect.  In response to his son’s observation that you can’t just “push the car hard” the whole time, Miles agrees, pensively staring down the track towards the setting sun.  He says, “If you are going to push a piece of machinery to the limit, and expect it to hold together, you have to have some sense of where that limit is.”

It’s been nine years since the Commission first set out to establish the position limits regime required by amendments to section 4a of the Commodity Exchange Act (the “Act” or “CEA”)[3], under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.[4]  While I would like to be in a position to say that today’s proposed rule addressing Position Limits for Derivatives (the “Proposal”) is leading us towards that “perfect lap,” I cannot.  While the Proposal purports to respect Congressional intent and the purpose and language of CEA section 4a, in reality, it pushes the bounds of reasonable interpretation by deferring to the exchanges[5] and setting the Commission on a course where it will remain perpetually in the draft, unable to acquire the necessary experience to retake the lead in administering a position limits regime.

In 2010 and the decades leading up to it, Congress understood that for the derivatives markets in physical commodities to perform optimally, there needed to be limits on the amount of control exerted by a single person (or persons acting in agreement).  In tasking the Commission with establishing limits and the framework around their operation, Congress was aware of our relationship with the exchanges, but nevertheless opted for our experience and our expertise to meet the policy objectives of the Act.

Right now, we are pushing to go faster and just get to the finish line, making real-time adjustments without regard for even trying for that “perfect lap.”  It is unfortunate, but despite the Chairman’s leadership and the talented staff’s hard work, I do not believe that this Proposal will hold itself together.  I must therefore, with all due respect, dissent.

Deference to our Detriment

While I have a number of concerns with the Proposal, my principal disagreement is with the Commission’s determination to in effect disregard the tenets supporting the statutorily created parallel federal and exchange-set position limit regime, and take a back seat when it comes to administration and oversight.  In doing so, the Commission claims victory for recognizing that the exchanges are better positioned in terms of resources, information, knowledge, and agility, and therefore ought to take the wheel.  While the Commission believes it can withdraw and continue to maintain access to information that is critical to oversight, I fear that giving way absent sufficient understanding of what we are giving up, and planning for ad hoc Commission (and staff) determinations on key issues that are certain to come up, will let loose a different set of responsibilities that we have yet to consider.

I believe the Proposal has many flaws that could be the subject of dissent.  I am focusing my comments on those issues that I think are most critical for the public’s review.  Based on consideration of the Commission’s mission, and Congressional intent as evinced in the Dodd-Frank Act amendments to CEA section 4a and elsewhere in the Act, I believe that (1) the Commission is required to establish position limits based on its reasoned and expert judgment within the parameters of the Act; (2) the Commission has not provided a rational basis for its determination not to propose federal limits outside of the spot month for referenced contracts based on commodities other than the nine legacy agricultural commodities; and (3) the Commission’s seemingly unlimited flexibility in proposing to (a) significantly broaden the bona fide hedging definition, (b) codify an expanded list of self-effectuating enumerated bona fide hedges, (c) provide for exchange recognition of non-enumerated bona fide hedge exemptions with respect to federal limits, and (d) simultaneously eliminate notice and reporting mechanisms, is both inexplicably complicated to parse and inconsistent with Congressional intent.

The Commission is Required to Establish Position Limits

The Proposal goes to great lengths to reconcile whether the CEA section 4a(a)(2)(A) requires the Commission to make an antecedent necessity finding before establishing any position limit,[6] with the implication that if a necessity finding is required, then the Commission could rationalize imposing no limits at all.  I do not believe it was necessary to rehash the legislative and regulatory histories to determine the Commission’s authority with respect to CEA section 4a.  Nor do I believe it was worthwhile here to reply in such great depth to the U.S. District Court for the District of Columbia’s opinion vacating the Commission’s 2011 final rulemaking on Position Limits for Futures and Swaps.[7]  The Proposal uses a tremendous amount of text to try and flesh out what is meant by “necessary”, and yet I fear it does not demonstrate the Commission’s “bringing its expertise and experience to bear when interpreting the statute,” giving effect to the meaning of each word in the statute, and providing an explanation for how any interpretation comports with the policy objectives of the Act as amended by the Dodd-Frank Act, as directed by the District Court.[8]  The Commission ought to avoid the temptation to retract when doing so requires the torture of strawmen.  Not only do we look complacent, but we invite criticism for our unnecessary affront to the sensibilities of the public we serve.

Looking back at the record, what is necessary is that the Commission complies with the mandate.[9]  In response to the District Court’s directive, the Commission could have gone back through its own records to the 2011 Proposal.  If it had done so, it would have found that the Commission provided a review of CEA section 4a(a)—interpreting the various provisions, giving effect to each paragraph, acknowledging the Commission’s own informational and experiential limitations regarding the swaps markets at that time, and focusing on the Commission’s primary mission of fostering fair, open and efficient functioning of the commodity derivatives markets.[10]  Of note, “Critical to fulfilling this statutory mandate,” the Commission pronounced, “is protecting market users and the public from undue burdens that may result from ‘excessive speculation.’”[11]  Federal position limits, as predetermined by Congress, are most certainly the only means towards addressing the burdens of excessive speculation when such limits must address a “proliferation of economically equivalent instruments trading in multiple trading venues.”[12]  Exchange-set position limits or accountability levels simply cannot meet the mandate.

In exercising its authority, the Commission may evaluate whether exchange-set position limits, accountability provisions, or other tools for contracts listed on such exchanges are currently in place to protect against manipulation, congestion, and price distortions.[13]  Such an evaluation—while permissible—is just one factor for consideration.  The existence of exchange-set limits or accountability levels, on their own, can neither predetermine deference nor be justified absent substantial consideration.  The authority and jurisdiction of individual exchanges are necessarily different than that of the Commission.  They do not always have congruent interests to the Commission in monitoring instruments that do not trade on or subject to the rules of their particular platform or the market participants that trade them.  They do not have the attendant authority to determine key issues such as whether a swap performs or affects a significant price discovery function, or what instruments fit into the universe of economically equivalent swaps.  They are not permitted to define bona fide hedging transactions or grant exemptions for purposes of federal position limits.  It is therefore clear that CEA section 4a, as amended by the Dodd-Frank Act “warrants extension of Commission-set position limits beyond agricultural products to metals and energy commodities.”[14]

Unsupportable Deference

In spite of all of this—the foregoing mandate; the clear Congressional intent in CEA section 4a(a)(3)(A); and the Commission’s real experience and expertise (including its unique data repository)—the Commission only proposes to maintain federal non-spot month limits for the nine legacy agricultural contracts (with questionably appropriate modifications), “because the Commission has observed no reason to eliminate them.”[15]  Essentially, in the Commission’s reasoned judgment, “if it ain’t broke, don’t fix it.”  And so, the Commission, in keeping with this relatively riskless course of action, similarly was able to conclude that federal non-spot month limits are not necessary for the remaining 16 proposed core referenced futures contracts identified in the Proposal.

The Commission provides two reasons in support of its determination, and neither sufficiently demonstrates that the Commission utilized its experience and expertise.  Rather, the Commission backs into deferring to the exchanges’ authority to establish position limits or accountability levels.  This course of action ignores the reality that Commission-set position limits serve a higher purpose than just addressing threats of market manipulation[16] or creating parameters for exchanges in establishing their own limits.[17]  The Proposal advocates that there is no need to disturb the status quo, despite the fact that we have nothing to compare it to.  The Commission places a higher value on minimizing the impact on industry—which it appears to have not quantified for purposes of the Proposal—than actually evaluating the appropriateness of limits in light of the purposes of the Act and as described in CEA section 4a(a)(3).

The first reason the Commission submits in defense of not proposing federal limits outside of the spot month for the 16 aforementioned contracts is that “corners and squeezes cannot occur outside the spot month…and there are other tools other than federal position limits for deterring and preventing manipulation outside of the spot month.”[18]  The “other tools” include surveillance by the Commission and exchanges, coupled with exchange-set limits and/or accountability levels.  As laid out in several paragraphs of the Proposal, the Commission would maintain a window into the setting of any limits or accountability levels that in its view are “an equally robust” alternative to federal non-spot month speculative position limits.  In describing how accountability levels implemented by exchanges work, the Commission touts the flexibility in application because they provide exchanges—and not the Commission—the ability to ask questions about positions, determine if a position raises any concerns, provide an opportunity to intervene—or not—etc.[19]

While all of this reads well, it ignores Congressional intent.  The Proposal never considers that Congress directed the Commission to establish limits—not accountability levels.  Given the Commission’s “decades of experience in overseeing accountability levels implemented by the exchanges,” Congress would have been well aware that this alternative path would be a viable option if it were truly as robust in choosing the legislative language.  But the Commission has failed to make that case.  Foremost, federal position limits are aimed at diminishing, eliminating, and preventing sudden and unwarranted price changes.  These sudden price changes may occur regardless of manipulative, intentional or reckless activity—both within and outside of the spot month.  The Commission provides no explanation regarding how exchange-set limits or accountability levels would compare, in terms of effectiveness, to federal position limits, which among other things, must apply in the aggregate as mandated by CEA section 4a(a)(6).  It is difficult to measure the robustness of a regime when there is nothing to compare it to.  As well, the Commission’s observation that exchange-set accountability levels have “functioned as-intended” until this point time, ignores the wider purpose and function of aggregate position limits established by the Commission, and is shortsighted given the ever expanding universe of economically equivalent instruments trading across multiple trading venues.  Not to belabor the point, but it seems odd to conclude that Congress envisioned that its painstaking amendments to CEA section 4a were a directive for the Commission to check the box that the current system is working perfectly.

The Commission’s second reason is that layering federal non-spot limits for the 16 contracts on top of existing exchange-set limit/accountability levels may only provide minimal benefits—if any—while sacrificing the benefits associated with flexible accountability levels.[20]  The Commission, again, ignores that Congress was clearly aware of the possible layering effect, and did not find it to be comparable let alone as robust.[21]  Moreover, the Commission fails to support or otherwise quantify its argument with data.  Presumably, the Commission could calculate anticipated non-spot month position limits—based on the formula in the proposed part 150.2(e) (and described in section II.B.2. e. of the Proposal)—for the 16 proposed core referenced futures contracts that have never been subject to such limits.  The Commission could have based its determination on aggregate position data it collects through surveillance, and it could have provided a rough estimate of the potential impact that limits may have, absent consideration of any of the proposed enumerated bona fide hedges or spread exemptions.  While I am not sure such evidence if presented would have changed my mind, it certainly would have been helpful in determining the reasonableness of the Commission’s determination.

What if?

When muscles are overly flexible, they require appropriate strength to ensure that they can perform under stress.  In addition to largely deferring to the exchanges in addressing excessive speculation outside of the spot-month for the majority of the 25 core referenced futures contracts, the Proposal also incorporates flexibility in a multitude of other ways.  The Proposal would provide for significantly broader bona fide hedging opportunities that will be largely self-effectuating; it would defer to the exchanges in recognizing non-enumerated bona fide hedging; and it would eliminate longstanding notice and reporting mechanisms.  In proposing these various provisions, the Proposal flexes and contorts to accommodate each piece.  In doing so, it seems the Commission will be left insufficient strength to accomplish its mandated role of exercising appropriate surveillance, monitoring, and enforcement authorities—and this will be to the detriment of the derivatives markets and the public we serve.

The main point to get across here is that while I support enhancing the cooperation between the Commission and the exchanges, the Commission here is cooperating by dropping back and promising to remain in the draft—never able to fully compete, or take advantage of a “slingshot effect.”  We will simply never gain the necessary direct experience with the new regime.  The Commission lacks experience in administering spot month limits for 16 of the 25 core referenced futures contracts and lacks familiarity with both common commercial hedging practices for the 16 contracts and the proliferation of the use of the dozen or so self-effectuating enumerated hedges and spread exemptions (also largely self-effectuating) being proposed.  While prior drafts of the Proposal admitted this as recently as two weeks ago, the Commission determined to change course and quickly let go of the line.  The Commission’s decision to essentially give up primary authority to recognize non-enumerated bona fide hedges, and to rely on the exchanges to collect and hold relevant cash market data for the Commission’s use only after requesting it, seems both careless and inconsistent with Congressional intent.

For example, while the Proposal provides the Commission with the authority to reject an exchange’s granting of a non-enumerated bona fide hedge recognition, this determination must be in the form of a “Commission action,” and it must take place in the span of ten business days (or two in the case of sudden or unforeseen circumstances).  Furthermore, the Proposal offers no guidance as to what factors the Commission may consider, or the criteria it may use to make the determination.  This narrow window of time likely will not provide Commission staff with a reasonable timeframe to prepare the necessary documentation for the full Commission to deliberate and either request additional information, stay the application, or vote to accept the recognition.[22]  It seems more likely that the Commission will be unable to act within the ten or two-day window and the recognition will default to being approved.  Regardless of what the Commission determines—even if it ultimately determines that a position for which an application for a bona fide hedge recognition does not meet the CEA definition of a bona fide hedge or the requirements in proposed part 150.9(b)—the Commission could not determine that the person holding the position has committed a position limits violation during the Commission’s ongoing review or upon issuing its determination.  I have so many “what ifs” in response to this set up that I feel trapped.

In the Proposal, the Commission requires exchanges to collect cash-market information from market participants requesting bona fide hedges, and to provide it to the Commission only upon request.  The Proposal also eliminates Commission Form 204, which market participants currently file each month when they have bona fide hedging positions in excess of the federal limits.  This form is a necessary mechanism by which market participants demonstrate cash-market positions justifying such overages.  These changes may be well-intentioned, but they are ill-conceived in consideration of the various changes being proposed to the federal position limits regime.

Foremost, under the Proposal, the Commission would receive a monthly report showing the exchange’s disposition of any applications to recognize a position as a bona fide hedge (both enumerated and non-enumerated) or to grant a spread or other exemption (including any renewal, revocation of, or modification of a prior recognition or exemption).[23]  While the Proposal argues that the monthly report would be a critical element of the Commission’s surveillance program by facilitating its ability to track bona fide hedging positions and spread exemptions approved by the exchanges,[24] it would not itself appear to be useful in discerning any market participants ongoing justification for, or compliance with, self-effectuating or approved bona fide hedge, spread, or other exemption requirements.  While the contents of the report may prompt the Commission to request records from the exchange, it is unclear what may be involved in the making of, and response to, such requests—including time and resources on both sides.  Not to mention that the Proposal opines that exchanges would only collect responsive information on an annual basis,[25] and part 150.9(e) does not require exchanges to notify the Commission of any renewal applications.  Of course, the Proposal posits that the Commission would likely only need to make such requests “in the event that it noticed an issue that could cause market disruptions.”[26]  My guess is that our surveillance staff and Division of Enforcement may have other ideas, but I will leave that with the “what ifs.”

Conclusion

The 24 Hours of Le Mans awards the victory to the car that covers the greatest distance in 24 hours.  While the Proposal shoots for victory by similarly attempting to achieve a great amount over a short time period, I am concerned that all of it will not hold together.  The Proposal attempts to justify deferring to the exchanges on just about everything, and in-so-doing it pushes to the back any earnest interpretation of the Commission’s mandate or the guiding Congressional intent.  This is not cooperation, this is stepping-aside, backing down, giving way, and getting comfortable in the draft.  I am not comfortable in this or any draft.  It’s my understanding that the Commission has the tools and resources to develop a better sense of where federal position limits ought to be in order to achieve the purposes for which they were designed, while maintaining our natural, Congressionally-mandated lead.  The Proposal fails to recognize that Congress already set the course in directing us that our derivatives markets will operate optimally with limits—we just need to provide a sense of where they are.  Perhaps the Proposal was just never aiming for the “perfect lap.”