The initial deadlines imposed by Dodd-Frank are looming but the intended implementation of the regulatory overhaul is still far from decided.
Both the House and Senate are currently consider bills that would delay new rules coming into effect while they are analyzed further for potential unintended consequences. No corner of the proposed capital markets overhaul has been more contentious that the treatment of over-the-counter swap transactions.
Efforts by the US Commodities and Futures Trading Commission (CFTC) to regulate the commodity swap markets in particular have meet blistering criticism from industry insiders Michael Cosgrove, the Managing Director of Strategic Initiatives in Commodities And Energy at GFI Group, has been particularly vocal in his assessment of these proposed changes. In January Cosgrove published a letter to the Commission [see below for a copy of the letter] detailing his concerns over the impact of position limits for cash-settle commodity swaps.
Cosgrove was a key figure in the development of the energy derivatives markets over the past three decades. After a stint in television broadcasting in the 1970s, he joined the nascent Amerex in 1981, which rapidly grew to be a powerful player in global oil market with Cosgrove leading the firm's London operation where he developed the firm's product reach into all aspects of the traded energy markets. In 2006 GFI Group acquired Amerex and Cosgrove assumed responsibility for energy and commodity markets for the GFI globally. Last month Cosgrove spoke with InstitutionalInvestor.com Contributing Editor Andrew Barber about the impact that proposed regulations might have on the commodity markets, and why he opposed them.
Institutional Investor: Your letter to the CFTC and your public presentations have been broadly critical of the Commission’s proposed regulations. But beyond just the potential unintended consequences that these proposed rules might create, you also seem to take aim at the logic that was employed to formulate these proposals in the first place.
Michael Cosgrove: I actually support the Commission’s principal objectives of reducing risk through clearing and improving competition and transparency. I am opposed to the notice of proposed rulemaking that would treat all futures and swap positions the same in regard to position limits. There is a great distinction between cash-settled swaps and cash-settled futures on the one hand and those that provide a physical delivery option on the other. While I believe that it is very important that position limits exist for physically deliverable contracts I think that to impose position limits --particularly in the manner that has been proposed by the Commission, for cash settled swaps will very likely cause many of the very things that the rule is intended to mitigate.
In my letter to the Commission I borrowed a good deal of analysis that was provided by others who have also submitted testimony, and I think there are a number of simple facts that this analysis brings to light that are being treated as though they don't exist. In particular we looked at the impact of, or the bias of, small commodity traders over a very long period of time. Using the CFTC's own data we demonstrated that, in aggregate, small natural gas traders are almost always long the market. I think that anyone that has been engaged in these markets in a meaningful way for any period of time would agree with this view based on their experience. Small position traders tend to go long, not short the market, they tend to run in packs, they tend to be options buyers not sellers, and they tend to be liquidity takers as opposed to liquidity providers.
What the Commission is seeking to accomplish here is to create a greater sort of plurality in the markets by limiting the size of positions that can be taken in the market and, of course, if you cap what the large position takers can do you are going to directly increase the influence of the smaller participants and introduce a bullish bias in the North American natural gas market. So I don't understand why, since the Commission is not in the business of setting prices but of ensuring fair markets, they would seek to impose position limits on cash settled swaps. It makes as much sense as turning on the air conditioning because you are too cold. This proposal is simply bereft offactual or logical basis.
II: ETFs have been blamed as a primary factor in commodity market distortion, with lots of unsophisticated investors flocking to the easy access provided by the fund structures - reminiscent of the criticism of passive institutional swaps buyers in years past. What's your take on the impact of ETFs?
MC: Commissioner Chilton has been referring to ETFs as "massive passives" --he gave a speech in Florida recently in which he characterized high-frequency traders as cheetahs and ETFs as "massive passives". It is Commissioner Chilton's view that ETFs may be distorting prices because they are always long, they are very large and they exert an upward bias on prices. I have a lot of respect for Commissioner Chilton. He works very hard to insure fair and efficient markets but we completely disagree on this issue. There are many people who have expressed the opinion that excessive speculation is distorting commodity markets but these are mere opinions. If a Senator, Congressman, business or sports personality claims that commodity prices are being distorted by excessive speculation that is their opinion. But we don’t make critical decisions based solely on opinions. There are well established practices for analyzing data to determine correlation and causation and I am unaware of a single, credible statistical study that has shown statistically significant evidence of even the weakest correlation between the presence of large position-takers or speculators and either the price or volatility of energy commodities. Rather than take an opposing view based upon research and analysis, Chairman Gensler in his introduction to the proposed rule for position limits has stated that the Commission isn’t required to make a definitive finding that excessive speculation exists or, if it does exist, that it’s causing any effect whatsoever. The Chairman has said ‘we’re charged with proactively ensuring that excessive speculation doesn’t damage the market, so we’re acting preventatively.’
Now with regard to the ETFs in particular, there are certain facts about these ETFs that seem to be going unnoticed and unaddressed in this debate. The first is that an ETF is quite the opposite of a large trader in the respect of a large trader having a restricted locus of decision-making. If you look at any of the big energy trading companies, there are a few big decision makers who are able to deploy large sums of capital based on the decisions that they make. If on the other hand you look at an ETF like UNG that you will find that in 2009 they had about 600,000 shareholders. So, I really don’t understand how they could be regarded as a large entity, a large trader. I believe a fairer description of the ETFs is “mass transit” rather than “massive passive” because the ETFs have created an economical way for many small investors to gain exposure to these commodity prices. If in fact you do force the large ETFs to liquidate in order to meet position limits you will - as a mathematical certainty - increase the amount of leverage deployed in these markets, and, in fact, it was the extraordinary degree of leverage that exacerbated the disaster that we faced in 2007-2008. So why we would choose to force the only people in the market who pay the full notional cost of the commodity to open a futures account and trade with leverage? That just doesn’t make any sense. That rule alone will as an absolute mathematical certainty increase the amount of leverage deployed in these markets. How can that possibly be good?
So to reiterate, I think that for cash-settled swaps it is generally a bad idea to impose position limits and it makes no sense at all to treat ETFs as a single-entity with regard to position limits.
II: OK, but even though there is no obligation to make physical delivery in a cash-settled instrument, there is a logical flow-through to the underlying markets. There is therefore the argument to be made that it does provide the potential for a concentration of risk. Put simplistically, if there was a single institution that had the right credit profile and decided to take a huge flyer then they could execute cash-settled swaps with multiple counterparties or dealers at the same time. In other words if we allow cash settled instruments to avoid position limits are we relying on the common sense of participants not to take on exposures that would inevitably be disruptive to the underlying markets?
MC: It is no more possible to use a cash settled instrument to squeeze a market than it is to influence the outcome of a sporting event by betting on its outcome. I agree that cash settled instruments send price signals to their underlying markets but ultimately it is supply and demand and the perception of supply and demand that generally determines price. I would enforce hard position limits in those physically-deliverable markets and leave the cash settled markets unfettered by unnatural constraints that produce no benefit but are disruptive, bullish, and volatility boosting.
Now there is a bit more to this that is worth understanding. In a market with sufficient contango and availability of storage, someone with access to the storage and physical supply can buy the physical commodity, store it and sell a cash settled-swap or cash settled future in a forward month against their physical long. If that’s the case then stocks build right? If the long-only funds are really creating forward demand, then stocks have to build, otherwise the ETF longs are being taken out by those who have essentially an opposing view and who are expressing that view with a cash settled swap, right? There has to be - I don’t know who coined the term, but anytime there’s a squeeze there has to be a corpse, and anytime the long ETFs are really creating a demand there has to be a storage build.
It has been a critical, strategic objective of every U.S. administration for over thirty years to build storage of crude oil and petroleum products to serve as a buffer against supply disruptions. And so from a strategic standpoint, to prohibit long ETFs to be in the market is essentially refusing to allow someone to accomplish from a purely commercial standpoint what the US government has spent -I don’t know - how many billions of dollars attempting to accomplish from a strategic standpoint.
II: Not to belabor a point but, when we talk about disruptive forces in the commodities markets it’s inevitable that we consider the Hunt brothers’ scenario where there is an attempt to intentionally distort the supply side in a market and...
MC: (interjecting) Indeed, but the big difference with the Hunt brothers was that they hoarded an enormous amount of physical silver. They filled jets full of silver and flew them to London and put them in secure warehouses. There’s a big difference between hoarding a physical commodity and buying a cash settled swap.
II: But there is an obvious relationship between the physical settled and cash settled markets because dealers typically need to offset in the underlying regardless of settlement type. In other words, do we allow purely financial players like hedge funds, small bank prop desks --to use cash settled instruments as a surrogate to allow an end-run around the futures markets?
MC: I don’t think that there should be a need to end run position limits for cash settled instruments because there shouldn’t be position limits in the first place. Also, while there is insufficient data to make a definite determination my suspicion is that a very small percentage of cash settled instruments are hedged with the underlying physical. Most cash settled long positions are offset by cash settled shorts and a virtually unlimited number of cash settled long and cash settled short positions can be created at any time without creating a molecule of new demand or supply.
II: If that is the case, do the pure financial players present a systemic risk if the total amount outstanding in cash settled swaps exceeds the current physically deliverable market? We tend to assume that these markets are primarily traded by the large naturals, the producers and consumers, but cash settled will bring in financial players as well.
MC: To me the systemic issue is one of leverage, not of position; if we required everyone who traded these markets to pay the full notional value, then I think it would eliminate systemic risk because if someone wants to go long a $100 barrel of crude oil and they put up $100, then the buyer cannot pose any credit risk. If the seller is also required to escrow either the crude or the full value of the crude and maintain that full value until settlement then there is no credit risk from the seller either. The full price of the commodity has been paid or guaranteed by both the buyer and the seller. If someone pays you the full value for something, you don’t care if they go out of business, right? You have your cash. So I see the systemic issue much more as a leverage issue.
You asked another question which I think is a good one. I think that if you ask the CFTC who these markets are for they’ll say that these markets are for hedgers. The speculators are necessary insomuch as they provide the necessary liquidity for the hedgers to do their business, and that these markets really were originally created to serve the legitimate hedging needs of natural market participants. Having said that, I don’t know from a practical standpoint how you can have “just enough speculation but not too much.” The lawmakers who are complaining of excessive speculation truly have no idea at all what they are talking about. They are simply trying to appear to those whose votes they require to be “doing something” about the high price of motor fuels and heating oil. This is disappointing because it diverts attention from legitimate issues. .
II: Returning to the leverage issue you identified, who is the ultimate arbiter there for the dealers of cash settled instruments. Would it be the CFTC, would it be the exchanges or would it be banking regulators?
MC: Clearinghouses set the minimum margin levels for futures in the U.S. and the FCMs can decide to require more than the minimum from their customers. For securities the Fed sets the level of margin. This has worked well for many, many years. I see no reason to change it. At least not for commodities.
II: OK but let's speak about leverage for swap dealers specifically rather than other participants.
MC: In this case, let’s discuss the proposed regulations that the CFTC and the SEC have issued. Under the proposals that deal with this particular issue, assuming they will be put forward largely as they have been proposed, the dealers are going to be required to fully margined all of their hedge transactions. They will have to execute all of their cleared swaps on a designated contract market like the CME or on a swap execution facility like the ones offered by GFI, ICAP, Bloomberg and others.
So there will be generally less leverage, heightened transparency and there will also be a requirement that dealers report all of their transactions to a swap data repository which will have to provide some very sophisticated, robust and responsive tools that CFTC and the SEC can use on a real-time basis to determine what all the dealers’ positions are. In addition to reduced leverage there are going to be multiple levels of transparency that didn't exist before and this is a very positive development..
I think that over the years the energy markets in particular have performed very well. In 2008 we had a spike in energy prices and then prices fell away and I believe there are some very good fundamental reasons for why that happened. I think that speculators are being made out to be the boogie man because our elected officials do not want to say, “Oh, well the reasons that prices are going up so much is that we just pumped a trillion and a half dollars into the economy and whenever you substantially increase the money supply you can expect that the price of the things that money supply is chasing will go up." It's simple supply and demand. There's really no willingness on the part of elected officials to say, "You know, if we keep printing money then the price of things denominated in that money will rise."
Admittedly, the spike on 2008 was not a result of easing policy, there were fundamental drivers, but I would say that the energy markets in general work very well. They are sometimes very volatile and sometimes prices are distressingly high, sometimes distressingly low, but I don't know how we can legislate perpetual sanity in markets – all markets are prone to excessive volatility from time to time. I don't really know what can be done about that, but I think that it is unfair that we look to the energy markets in particular and claim that there are manipulators dialing the price up and down and taking the common consumer for a ride. While this has populist appeal it is simply not true
Andrew Barber is the director of strategic investments for Waverly Advisors, a Corning, NY based asset management firm. Waverly advisors actively invests in the commodities and futures markets.
