Last week's court decision against Commodity Futures Trading Commission rules imposing position limits in 28 derivatives markets represents a new high water mark in regulatory review that may reverberate across other efforts to implement the Dodd-Frank Act.
An important implication to come out of this ruling is that regulatory agencies need to make sure that the regulations being implemented are necessary to address the problem they were intended to address in legislation – in this specific case, mitigating perceived excessive speculative activity, particularly in markets such as oil.
The pivotal question on which the ruling hinges has to do with the CFTC's interpretation of a single word. The Dodd-Frank Act amendment to the Commodity Exchange Act states that the agency "shall" establish limits to rein in speculative activity in markets. The CFTC read this as a mandate. But the same sentence contained the phrase "as appropriate," which the plaintiffs successfully argued modified the "shall," giving the CFTC leeway to not impose limits at all.
Since this amendment to CEA was enacted, the CFTC has aggressively pursued a path toward imposing a broad umbrella of position limits on certain derivatives markets under the belief that excessive speculative activity was at the heart of instances of high volatility as exemplified by the 2007-2008 price shocks in a number of commodity markets. This perspective has been fueled in part by a number of studies focusing on a simple relationship between the growth in commodity index trading and commodity prices.
That commodity prices and the growth in index trading did rise sharply together in the 2007-2008 period is indisputable. However, establishing a causal linkage between the two is subject to empirical assessment and, not surprisingly, one can find an extensive list of studies on both side of the issue readily available on the CFTC's own website.
Several studies over the last few years have offered arguments, and some limited empirical evidence, for speculation as a primary cause for the commodity shocks experienced in 2007 and 2008. However, the one igniting this side of the debate was by Masters and White in 2008. The paper outlined an argument that the "financialization" of commodities, largely by the rapid growth of commodity index fund trading, conspired to artificially inflate demand for commodities and, according to this argument, led to price spikes across a number of commodities. But upon deeper review of the body of work on both sides of the issue, those studies making the claim that market fundamentals rather than speculative activity explain commodity prices stand on firmer empirical ground due to better data and methodology.
The court did not slam the door shut on the CFTC in its quest to impose position limits. And it is unlikely that the CFTC, as aggressive as it has been on this issue, will simply roll over. Whether an appellate court will reverse the ruling is an open issue if the CFTC pursued such a course. But more important is that the agency now needs to justify why position limits are critical to stemming excessive speculation.
For the CFTC, a small agency with a correspondingly small economics arm, establishing a clear case supported by rigorous economic analysis that position limits are warranted is a tall order. Nonetheless, what is needed is an objective analysis of the issue that brings together leading academics from all vantage points to study the implications of position limits on affected markets, the impact of speculation on commodity pricing and associated benefits from subjecting commodity derivatives to limits.
Capping various commodity derivative instruments and tagging activities as speculative ignores a number of critical positive aspects of such activity on commodity markets and for investors. For instance, commodity index funds, like other broad-based investment funds (such as S&P 500 index mutual funds or total market bond index funds), enable retail investors to access markets not normally available to someone with only thousands rather than millions of dollars to put to work. Moreover, adding a commodity index fund to a portfolio of equities and fixed-income assets would be expected to improve the risk of the portfolio as defined by its volatility, assuming the assets are not perfectly correlated. Other benefits include the availability and access to viable hedge instruments for risk management.
Moreover, position limits would tend to retard the beneficial effects of improved liquidity and price discovery brought by such trading activity. In some cases, imposing position limits may actually increase risk if some activities migrate abroad to shadowy, less-regulated markets. At this point, the body of analysis needed to understand these impacts – and more importantly, inform regulators – is lacking.
Beyond the implications of the court ruling for the CFTC's efforts to impose position limits on a variety of commodity derivatives lays a broader policy issue for financial markets generally. Regulators charged with implementing Dodd-Frank face a daunting task in executing Congress's mandate for financial regulatory reform. However, the court's ruling on CFTC position limits underscores the criticality of conducting an economic impact analysis of proposed regulations individually and collectively before rushing into rules that actually harm markets.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.