Dissenting Statement of Commissioner Dan M. Berkovitz Regarding Proposed Rule on Position Limits for Derivatives

Introduction

I dissent from today’s position limits proposal (“Proposal”).  The Proposal would create an uncertain and unwieldy process with the Commission demoted from head coach over the hedge exemption process to Monday-morning quarterback for exchange determinations.[1]  The Proposal would abruptly increase position limits in many physical delivery agricultural, metals, and energy commodities, in some instances to multiples of their current levels.  It would provide no opportunity for the Commission to monitor the effect of these increases, or to act if necessary to preserve market integrity.  The Proposal provides inadequate explanation for other key approaches in the document, including the use of position accountability rather than numerical limits for energy and metals commodities in non-spot months.  The Proposal also ignores Congress’s mandate in the Dodd-Frank Act, and reverses decades of legal interpretations of the Commodity Exchange Act (“CEA”) by the Commission and the courts regarding the Commission’s authority and responsibility to impose position limits.  It would require, for the first time, the Commission to find that position limits are necessary for each commodity prior to imposing limits.

I Support an Effective Position Limits Framework with Transparency and Certainty

Position limits is one of the last remaining items in the Commission’s reform agenda arising from the Dodd-Frank Act.  In the wake of the 2008 oil price spike to $147 per barrel, the Amaranth hedge fund’s dominance of the natural gas futures and swaps market, the rise of commodity index funds, and the financial crisis, Congress mandated that the Commission promptly establish, as appropriate, position limits and hedge exemptions for exempt and agricultural commodities and economically equivalent swaps.  We must not forget the lessons from the financial crisis or prior episodes of excessive speculation, nor be lulled back into the belief that unfettered markets yield optimal outcomes.  A meaningful, effective position limits regime was important to the reform agenda in 2010, and it must remain our goal today.

I support an effective position limits regime that includes both effective limits on speculative positions and appropriate bona fide hedge exemptions to meet market participants’ legitimate commercial needs.  Position limits are critical to preventing market manipulation or distortion due to excessively large speculative positions.  Together, position limits and bona fide hedge exemptions promote the market integrity and the price discovery process, while enabling producers, end-users, merchants, and others to use the futures and swaps markets to manage their commercial risks.  The Dodd-Frank Act, adopted by Congress in 2010 in the midst of the financial crisis, affirmed Congress’s commitment to federal speculative position limits and its determination that the Commission should act decisively to address excessive speculation in physical commodity markets.

Since joining the Commission, I have traveled the country to meet with market participants in many segments of the physical commodity markets.  I have been to soybean farms and rice mills in Arkansas, feedlots in Colorado, dairy co-ops and cornfields in Minnesota, and grain mills and elevators in Kansas, Arkansas, Colorado, and Minnesota.  I have met with coffee and cocoa graders in New York, energy companies in Texas, cotton merchandisers from Tennessee, and many others to understand how end-users participate in our markets.  I have visited the CME in Chicago, ICE in New York, and the Minneapolis Grain Exchange in Minneapolis.  The fundamental purpose of the commodity markets we oversee is to enable end-users to manage the price risks they face in their businesses.  I am committed to ensuring that this rule is workable for end-users and provides them with sufficient clarity, predictability, and transparency.

In my view, a position limits rule must meet three basic criteria.  First, the rule must provide effective limits on speculative positions.  Second, the rule must recognize legitimate bona fide hedging activities.  The Commission should provide market participants with certainty regarding which activities constitute bona fide hedging and establish a workable, transparent process for qualifying additional types of activities as bona fide hedging.  Such a process should recognize both the traditional role of the Commission in determining, generally, which activities constitute bona fide hedging, and the role of the exchanges in determining whether the specific activities of particular commercial market participants fall within such bona fide hedging categories as determined by the Commission.

Third, from a legal perspective, a final rule must recognize that Congress has authorized and directed the Commission to promulgate position limits—without a predicate finding that position limits are necessary to prevent excessive speculation—and that the Commission has the flexibility to determine the appropriate tools and limits to accomplish that Congressional directive.

Unfortunately, the Proposal fails to satisfy any of these criteria.  The Proposal would greatly increase position limits in many physical delivery agricultural, metals, and energy commodities in spot and individual non-spot months, with no opportunity to monitor for or guard against adverse market impacts.  Although I am pleased that the Proposal would no longer recognize risk management exemptions as bona fide hedges for physical commodities,[2] the higher limits allowed under the Proposal could accommodate substantially more speculative positions,[3] with potentially adverse impacts on markets.  There is solid evidence that the financialization and growth of commodity index investments can raise commodity prices and negatively affect end-users in the real economy.[4]

The Proposal departs from the well-established roles of the Commission and exchanges in the bona fide hedge framework.  As affirmed by the Dodd-Frank Act, it is the Commission’s responsibility to define what constitutes a bona fide hedge.[5]  For practical reasons, including limited Commission resources, I support delegating to exchanges the authority to determine whether a particular position, under the particular facts and circumstances presented, constitutes a bona fide hedge as defined by the Commission.  The exchanges are well suited for this role and have decades of experience in making such determinations.  However, the initial legal and policy determination of what types of positions constitute bona fide hedges must remain the Commission’s responsibility.

The Proposal carries forward all of the bona fide hedges currently enumerated in the Commission’s rules, adds several additional categories to the list of enumerated hedges, and opens the door to an unlimited number of additional, undefined non-enumerated exemptions.  The Proposal states, “the proposed enumerated hedges are in no way intended to limit the universe of hedging practices which could otherwise be recognized as bona fide.”[6]  The “universe” is a very large place indeed.

On the other hand, the Proposal does not address practices that market participants have urged the Commission to recognize as bona fide hedges, including practices currently recognized by the exchanges.  The Proposal thus deprives end-users and other market participants of legal certainty regarding what constitutes a bona fide hedge for various practices currently permitted by the exchanges as bona fide hedges.

Rather than determine whether to recognize these practices as bona fide hedges through notice and comment in today’s rulemaking, the Proposal contemplates that additional non-enumerated bona fide hedges should first be considered by the exchanges, and then reviewed by the Commission during a cramped 10-day retrospective review period.[7]  Determination of what constitutes a bona fide hedge for non-enumerated hedges would begin anew each time that an exchange must decide whether a purported bona fide hedge held by a market participant is consistent with the CEA, and then await the Commission’s retrospective review.  Market participants should be able to discern whether particular types of practices qualify as bona fide hedging by reading the Commission’s rules and regulations rather than by engaging lawyers and lobbyists to guide them through an opaque, non-public process through the halls of the Commission’s headquarters in Washington DC.

The Commission has almost 40 years of experience with exchange implementation of position limits for energy and metals commodities, and more for agricultural commodities.  Based on this experience, I support many of the types of bona fide hedges that exchanges recognize in these markets today.  However, the Commission should recognize these exemptions in its own rules through prospective, notice and comment rulemaking, not delegate these determinations to the exchanges.

The legal analysis in this Proposal is a convoluted and confusing legal interpretation of the Dodd-Frank Act that defies Congressional intent.  It is implausible that in the aftermath of the financial crisis and the run-up to oil at $147 per barrel, Congress made it more difficult for the Commission to impose position limits.  Yet that is the result of the Commission’s revisionist interpretation that a predicate finding of necessity (i.e., that position limits are necessary) is required for the imposition of a position limit for each commodity.  Moreover, the Proposal’s finding of necessity for the 25 core reference futures contracts subject to the rule is unpersuasive both economically and legally, and is highly unlikely to survive legal challenge.  The necessity finding largely consists of general economic statistics about the importance of the physical commodities underlying these futures contracts to commerce, together with statistics about open interest and trading volume in those futures contracts.  These statistics bear little rational relationship to why position limits are necessary to prevent excessive speculation in derivative contracts for these commodities.  For example, the imposition of limits on cocoa futures is justified on the basis that “in 2010 the United States exported chocolate and chocolate-type confectionary products worth $799 million to more than 50 countries around the world.”[8]  There is a simpler, more logical, and defensible path forward, as I will outline later in this statement.

I thank the Commission staff for working with my office on the Proposal.  Although I am not able to support it as currently formulated, I look forward to working with my colleagues and staff to improve the Proposal so that it effectively protects our markets from excessive speculation and provides end-users and other market participants with the regulatory certainty they need.  I encourage market participants to comment on the Proposal.

Additional Flaws in the Proposal

1. No Phase-In for Large Increase in Speculative Position Limits

The Proposal would generally increase existing federal or exchange spot month position limits for 25 physical delivery agricultural, metals, and energy commodities by a factor of two or more.[9]  It would substantially increase existing federal single month and all months combined limits for the nine legacy agricultural commodities.  As examples, spot month limits on ICE’s frozen concentrated orange juice contract would increase from 300 to 2,200 contracts, and single month and all months combined limits on CBOT soybean meal would increase from 6,500 to 16,900 contracts.[10]  Single month and all months combined limits for CBOT corn would increase to 57,800 contracts.[11]  The proposed increases are largely due to increases in deliverable supply, and the new spot and non-spot month limits continue to reflect the Commission’s 25% and 10% / 2.5% of deliverable supply formulas.

The Proposal does not provide for phasing in the new, higher limits or for otherwise providing a transition period.[12]  It presents no analysis of the market’s ability to absorb these large increases without disruption, and no analysis of how large new speculative positions may affect the price discovery process.

Large increases in the amounts of speculative activity in individual non-spot months have the potential to disrupt the convergence process and distort market signals regarding storage of commodities.  The Proposal provides no analysis of whether these potential price distortions and their attendant detrimental consequences could be avoided by distributing the large increases in the numerical limits across several non-spot months, rather than permit such large positions in individual months.  Instead, the Proposal would codify an abrupt increase 365 days after publication of any final rule in the Federal Register.  A transition period or lower individual spot month limits would give the Commission the time and ability to mitigate any issues that may arise if markets are unable to absorb the higher limits in an orderly manner, and prevent disruption if necessary.  It is a prudent measure that the Commission should adopt in any final rule.

2. Absence of Non-Spot Month Limits for Exempt and Certain Agricultural Commodities

I am concerned with the Proposal’s failure to adopt federal non-spot limits for 16 energy, metals, and certain agricultural commodities included in the Proposal.[13]  CEA section 4a(a)(3) directs that the Commission “shall set limits” on positions held not only in the spot month, but also “each other month” and “for all months,” “as appropriate.”[14]  Despite this directive, the Proposal does not adopt non-spot month limits for these commodities.  It includes virtually no analysis of why the Commission believes that non-spot limits are not appropriate.

Exchanges have demonstrated an ability to manage speculation and maintain orderly markets with position accountability in non-spot months.  However, experiences such as the collapse of the Amaranth hedge fund in 2006 demonstrate how large trades in the non-spot month can also distort markets, widen spreads, and increase volatility.[15]  I believe the exchanges have learned from the Amaranth experience and that position accountability can be an effective tool, where appropriate.  The Proposal, however, also fails to demonstrate why accountability levels, rather than numerical limits, are appropriate in light of the statutory directives in the CEA.  It provides no discussion of the effect of applying the 10/2.5% formula to the energy and metals contracts covered by the Proposal, and why the application of this traditional formula would not be appropriate.  Similarly, there is no analysis regarding the numerical limits that could result from applying the four factors specified in 4a(a)(3), and why such numerical limits would not be appropriate.

3. Definition of Economically Equivalent Swap

The Proposal would define an economically equivalent swap as a swap that “shares identical material contractual specifications, terms, and conditions with the referenced contract . . . .”[16]  The Proposal offers several rationales for this narrow definition that could potentially lend itself to evasion through financial engineering.  One such rationale is that it would reduce market participants’ ability to net down their speculative positions through swaps that are not materially identical.  While this and other rationales proffered in the Proposal have merit, the Commission must also ensure that economically equivalent swaps are not structured in a manner to evade federal or exchange regulation through minor modifications to material terms.  I invite public comment on this issue.

4. The Proposal’s Necessity Finding Misconstrues the CEA as Amended by the Dodd-Frank Act

The Proposal states that, for any particular commodity, “prior to imposing position limits, [the Commission] must make a finding that they are necessary.”[17]  This is a reversal of prior Commission determinations.[18]  Neither the statutory language of CEA section 4a(a)(2), nor the district court’s decision in ISDA v. CFTC, compels this outcome.[19]  The Commission should not adopt it.

Title VII of the Dodd-Frank Act amended CEA section 4a and directed in 4a(a)(2)(A) that “the Commission shall” establish position limits for agricultural and exempt physical commodities “as appropriate.”[20]  In ISDA v. CFTC, the district court directed the Commission to resolve a perceived ambiguity in section 4a(a)(2)(A) by bringing the Commission’s “experience and expertise to bear in light of the competing interests at stake . . . .”[21]  That experience includes over 80 years of position limits rulemakings, as described below.  It provides ample practical and legal bases to determine that Congress intended the Commission to adopt federal position limits for certain commodities pursuant to CEA section 4a(a)(2).

Starting in 1936, and across multiple iterations of the CEA and its predecessors, the CEA has consistently and continuously reflected Congress’s finding that excessive speculation in a commodity can cause sudden, unreasonable, and unwarranted movements in commodity prices that are undue burden on interstate commerce.[22]  Congress also has declared that “[f]or the purpose of diminishing, eliminating, or preventing such burden,” the Commission shall . . . proclaim and fix such [position] limits” that the Commission finds “are necessary to diminish, eliminate, or prevent such burden.”  In plain English, Congress has found that excessive speculation is a burden on interstate commerce, and the CFTC is directed to impose position limits that are necessary to prevent that burden.  Congress did not direct the Commission to study excessive speculation, to prepare any reports on excessive speculation, or to second-guess Congress’s finding that excessive speculation was a problem that needed to be prevented.  Rather, Congress directed the Commission to impose position limits that the Commission believed were necessary to accomplish the statutory objectives.

Following the passage of the 1936 Act, the Commission set position limits for grains in 1938, cotton in 1940, and soybeans in 1951.  As the Proposal recognizes, in these rulemakings the Commission did not publish any analyses or make any “necessity finding,” other than to include a “recitation” of the statutory findings regarding the undue burdens on commerce that can be caused by excessively large positions.  These rulemakings then set numerical limits on the amounts of commodity futures contracts that could be held.

Court decisions from the 1950s through the 1970s in cases involving the application of the position limits rules reflect a common-sense reading:  the statute mandates that the Commission establish position limits, while providing the Commission with discretion as to how to craft those limits.  In Corn Refining Products v. Benson,[23] defendants challenged the suspension by the Secretary of Agriculture of their trading privileges on the Chicago Board of Trade for violating position limits in corn futures on the grounds that the statutory prohibition only applied to speculative positions.  The U.S. Court of Appeals for the Second Circuit denied the appeal, stating in part:

The discretionary powers of the Commission and the exemptions from the ‘trading limits’ established under the Act are carefully delineated in § 4a.  The Commission is given discretionary power to prescribe ‘*  *  *  different trading limits for different commodities, markets futures, or delivery months, or different trading limits for the purposes of buying and selling operations, or different limits for the purposes of subparagraphs (A) (i.e., with respect to trading during one business day) and (B) (i.e., with respect to the  net long or net short position held at any one time) of this section * * *’ . . . .

Although § 4a expresses an intention to curb ‘excessive speculation,’ we think that the unequivocal reference to ‘trading,’ coupled with a specific and well-defined exemption for bona-fide hedging, clearly indicates that all trading in commodity futures was intended to be subject to trading limits unless within the terms of the exemptions.[24]

In United States v. Cohen,[25] the defendant challenged his criminal conviction for violating CEC trading limits in potato futures contracts.  In upholding the conviction, the court of appeals stated that “[t]rading in potato futures, as for other commodities, is limited by statute and by regulations issued by the Commission.  The statute here requires the Commission to fix a trading limit . . . .”[26]  The court of appeals further observed: “Congress expressed in the statute a clear intention to eliminate excessive futures trading that can cause sudden or unreasonable fluctuations.”[27]

In CFTC v. Hunt,[28] the Hunt brothers challenged the validity of the agency’s position limit on soybeans of three million bushels on the basis that the agency “made no analysis of the relationship between the size of soybean price changes and the size of the change in the net position of large traders.  They argue[d] that there is no direct relationship between these phenomena, and, therefore, the regulation limiting the positions and the trading of the large soybean traders is unreasonable.”[29]  Fundamentally, the Hunts alleged that the agency failed to demonstrate that the limits were a reasonable means—or, alternatively put, “necessary”—to prevent unwarranted price fluctuations in soybeans.  “The essence of the Hunts’ attack on the validity of the regulation is their substantive contention that there is no connection between large scale speculation by individual traders and fluctuations in the soybean trading market.”[30]

The U.S. Court of Appeals for the Seventh Circuit denied the Hunt brothers’ challenge.  It held, “[t]he Commodity Exchange Authority, operating under an express congressional mandate to formulate limits on trading in order to forestall the evils of large scale speculation, was deciding on whether to raise its then existing limit on soybeans. . . .  There is ample evidence in the record to support the regulation.”[31]

The Hunt case also illustrates the difference between the requirement for a predicate finding of necessity and the requirement that the Commission’s rulemakings be supported by sufficient evidence.  Under the Administrative Procedure Act (“APA”), the Commission’s regulations must not be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”[32]  To make this finding, “the court must consider whether the decision was based on a consideration of the relevant factors and whether there has been a clear error of judgment.”[33]

In 1981, following the silver crisis of 1979-1980, the Commission adopted a seminal final rule requiring exchanges to establish position limits for all commodities that did not have federal limits.[34]  In the final rulemaking, the Commission determined that predicate findings are not necessary in position limits rulemakings.  It affirmed its long-standing statutory mandate going back to 1936:  “Section 4a(1) represents an express Congressional finding that excessive speculation is harmful to the market, and a finding that speculative limits are an effective prophylactic measure.”^[35]  The 1981 final rule found that “speculative position limits are appropriate for all contract markets irrespective of the characteristics of the underlying market.”[36]  It required exchanges to adopt position limits for all listed contracts, and it did so based on statutory language that is nearly identical to CEA section 4a(a)(1).[37]

In the 1981 rulemaking, the Commission also responded to comments that the Commission had failed to “demonstrate[] that position limits provided necessary market protection,” or were appropriate for futures markets in “international soft” commodities, such as coffee, sugar, and cocoa.  The Commission rejected comments that it was required to make predicate necessity findings for particular commodities.  The Commission stated:

The Commission believes that the observations concerning the general desirability of limits are contrary to Congressional findings in sections 3 and 4a of the Act and considerable years of Federal and contract market regulatory experience. . . .

*  *  *

As stated in the proposal, the prevention of large and/or abrupt price movements which are attributable to extraordinarily large speculative positions is a Congressionally endorsed regulatory objective of the Commission.  Further, it is the Commission’s view that this objective is enhanced by speculative limits since it appears that the capacity of any contract market to absorb the establishment and liquidation of large speculative positions in an orderly manner is related to the relative size of such positions, i.e., the capacity of the market is not unlimited.[38]

In the “Legal Matters” section of the preamble, the Proposal would jettison the interpretation that has prevailed over the past four decades as the basis for the Commission’s position limits regime.  Relying on a non sequitur incorporating a double negative, the Preamble brushes off nearly forty years of Commission jurisprudence:

[B]ecause the Commission has preliminarily determined that section 4a(a)(2) does not mandate federal speculative limits for all commodities, it cannot be that federal position limits are ‘necessary’ for all physical commodities, within the meaning of section 4a(a)(1), on the basis of a property shared by all of them, i.e., a limited capacity to absorb the establishment and liquidation of large speculative positions in an orderly fashion.[39]

In 2010, Congress enacted Title VII of the Dodd-Frank Act and amended CEA section 4a by directing the Commission to establish speculative position limits for agricultural and exempt commodities and economically equivalent swaps.^[40]  Congress also set forth criteria for the Commission to consider in establishing limits, including diminishing, eliminating, or preventing excessive speculation; deterring and preventing market manipulation; ensuring sufficient liquidity for bona fide hedgers; and ensuring that price discovery in the underlying market is not disrupted.^[41]  Congress directed the Commission to establish the required speculative limits within tight deadlines of 180 days for exempt commodities and 270 days for agricultural commodities.

It defies history and common sense to assert that the amendments to section 4a enacted by Congress in the Dodd-Frank Act made it more difficult for the Commission to impose position limits, such as by requiring predicate necessity findings on a commodity-by-commodity basis.  This is particularly true given Congress’s repeated use of mandatory words like “shall” and “required” and the tight timeframe to respond to the new Congressional directives.  In light of the run up in the price of oil and the financial crisis that precipitated the legislation, it is unreasonable to interpret the Dodd-Frank amendments as creating new obstacles for the Commission to establish position limits for oil, natural gas, and other commodities whose significant price fluctuations had caused economic harm to consumers and businesses across the nation.  The Commission’s interpretation is revisionist history.

The Commission’s necessity finding that follows its legal analysis is sure to persuade no one.  Unless substantially modified in the final rulemaking, it will likely doom this regulation as “arbitrary, capricious, or an abuse of discretion” under the APA.  The necessity finding for the 25 core referenced futures contracts selected for this rulemaking boils down to simplistic assertions that the futures contracts and economically equivalent swaps for these contracts “are large and critically important to the underlying cash markets.”[42]  As part of the necessity finding for these 25 commodities, the Proposal presents general economic measures, such as production, trade, and manufacturing statistics, to illustrate the importance of these commodities to interstate commerce, and therefore for the need for position limits.  On the other hand, the Proposal fails to present any rational reason as to why the economic trade, production, and value statistics for commodities other than the 25 core referenced futures contracts are insufficient to support a similar finding that position limits are necessary for futures contracts in those other commodities.

For example, the Proposal justifies the exclusion of aluminum, lead, random length lumber, and ethanol as examples of contracts for which a necessity finding was not made on the basis that the open interest in these contracts is less than the open interest in the oat futures contracts.  This comparison has no basis in rationality.  The need for position limits for commodity futures contracts in aluminum, lead, lumber, and ethanol is not in any way rationally related to the open interest in those commodity futures contracts relative to the open interest in oat futures.  The Proposal is rife with other such illogical statements.

Fundamentally, general economic measures of commodity production, trade, and value are irrelevant with respect to the need for position limits to prevent excessive speculation.  The Congress has found that position limits are an effective prophylactic tool to prevent excessive speculation for all commodities.  The Congressional findings in CEA section 4a regarding the need for position limits are not limited to only the most important or the largest commodity markets.  General economic data regarding a commodity in interstate commerce is irrelevant to the need for position limits for futures contracts for that commodity.

The collapse of the Amaranth hedge fund in 2006 is another strong example of why a position limits regime is necessary to prevent excessive speculation, in this case in non-spot months.  Amaranth was a large speculative hedge fund that at one point held some 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year.  As the Commission has explained in other position limits proposals since 2011, the collapse of Amaranth was a factor in the Dodd-Frank’s amendments to CEA section 4a.

The Commission has ample practical experience and legal precedent to resolve the perceived ambiguity in CEA section 4a(a)(2) as instructed by the district court in ISDA v. CFTC without making the antecedent necessity finding now incorporated in the Proposal.  Our remaining task is to design the overall position limits framework, including determining the appropriate limit levels, defining bona fide hedges through prospective rulemaking, and appropriately considering other options such as position accountability and exchange-set limits.

Conclusion

In CEA section 4a, Congress directed the Commission to establish position limits and appropriate hedge exemptions to prevent the undue burdens on interstate commerce that result from excessive speculation.  Congress has also entrusted to the Commission’s discretion the appropriate regulatory tools to meet this mandate.  Congress’ overarching policy directive for position limits is straightforward and has been remarkably consistent for 84 years.  The Commission has had ten years, three prior proposals, one supplemental proposal, and hundreds of pages of comment letters to define bona fide hedge exemptions.  Now is the time to finish the job, and to do it the right way.