Brad's Desktop

Written by Brad Zigler
Monday, 30 March 2009 18:00

Real-time Inflation Indicator (per annum): 8.6%

Ah, those were the days, weren't they?

Remember last year's heady rise in commodity prices? Do you also recall the cacophony of catcalls that accompanied it? Citizens and industry participants alike wanted to put so-called "index speculators" to the lash for heedlessly snatching up futures contracts and running up prices. At least, that was the story being told to Congress (see "Congress Blames Index Speculators").

Long-only exchange-traded funds (ETFs), Congress was told, were amassing such large holdings of crude oil, corn and other commodity futures, that they bumped up against speculative position limits - barriers to market cornering imposed by Commodity Futures Trading Commission (CFTC) rules. To get around the restrictions, some commodity ETF managers went to dealers in unregulated over-the-counter index swaps to get the futures exposure they needed.

In a swap, an index fund obtains a commodity return from an investment bank in exchange for a stream of interest payments, tied typically to the London InterBank Offered Rate (LIBOR). With a swap, the fund doesn't go to the futures market itself to buy futures, but the dealer selling the swap might do so to hedge its resulting exposure. If a swap dealer can establish that a genuine risk is being hedged through futures, it's exempted from speculative position limits.

While this so-called "bona fide hedge exemption" imposes no limit on the size of a hedge, dealers are still required to make daily reports of their aggregated large positions to the CFTC. Present-day rules do not, however, require a dealer to give up the identity of the customer for which a hedge is sought. Or, for that matter, make any representation about the size of a customer's futures positions.

That opacity may soon clear if recommendations made by CFTC staffers are adopted. Last week, the CFTC published a concept release - a sort of regulatory backgrounder - on new rules proposed in last September's "Staff Report on Commodity Swap Dealers and Index Traders with Commission Recommendations." One of the report's recommendations directed the CFTC to consider replacing swap dealers' hedge exemptions with new limited risk management rules. The new exemptions would oblige swap dealers to make reports to regulators whenever their speculative customers' positions reach certain levels or to certify that none of their customers' futures positions exceed specified limits.

While the proposed rules don't require a give-up of a swap counterparty's name, they would still provide something of a "look-through" to the size of a fund's futures footprint.

Public comment on the concept release will be received by the CFTC through May 26. There's no word yet from regulators when these new rules may be implemented, though. Hopefully, they'll be in place before the next commodity price run-up. And that may not be far away, by our reckoning (see "Is The Reflation Trade In?").