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Senator Lincoln Explains How Position Limits Work in Derivatives Provisions of Dodd-Frank

By Jim Hamilton

The Dodd-Frank Act grants broad authority to the Commodity Futures Trading Commission to once and for all set aggregate position limits across all markets on non-commercial market participants. Senator Blanche Lincoln believes that the adoption of aggregate position limits, along with greater transparency, will help bring some normalcy back to the financial markets and reduce some of the volatility we have witnessed over the last few years. But the senator also recognizes that there are limits, and that regulators must balance the needs of market participants, while at the same time ensuring that markets remain liquid so as to afford end users and producers of commodities the ability to hedge their commercial risk. (Cong. Record, July 15, 2010, pp. S5519-5520)

Senator Lincoln also believes that there is a legitimate role to be played by market participants willing to enter into futures positions opposite a commercial end-user or producer. Through this process, the markets gain additional liquidity, she noted, and accurate price discovery can be found for end-users and producers of commodities. However, the senator still holds some reservations about these financial market participants and the negative impact of excessive speculation or long only positions on the commodities markets.

While there are concerns about the role these participants play in the markets, said the Senate Agriculture Committee Chair, important distinctions in setting position limits on these participants are warranted. In implementing section 737 of Dodd-Frank, the senator encouraged the CFTC to give due consideration to trading activity that is unleveraged or fully collateralized, solely exchange-traded, fully transparent, clearinghouse guaranteed, and poses no systemic risk to the clearing system. This type of trading activity is distinguishable from highly leveraged swaps trading, she reasoned, which not only poses systemic risk absent the proper safeguards that an exchange traded, cleared system provides, but also may distort price discovery. The CFTC was also encouraged consider whether it is appropriate to aggregate the positions of entities advised by the same advisor when such entities have different and systematically determined investment objectives.

Sen. Lincoln also pointed out that section 719 of Dodd-Frank calls for a study of position limits to be undertaken by the CFTC. In conducting that study, the senator expects the CFTC to address the soundness of prudential investing by pension funds, index funds and other institutional investors in unleveraged indices of commodities that may also serve to provide agricultural and other commodity contracts with the necessary liquidity to assist in price discovery and hedging for the commercial users of such contracts.

Full post as published by Jim Hamilton's World of Securities Regulation on August 07, 2010 (boomark / email).