The United States pushed through its toughest measures yet to curtail speculation in commodity markets in a tight vote on Tuesday, likely shifting the focus of a fierce four-year debate from the regulators to the courts.
In a measure decried by Wall Street and trading companies as a misguided political attempt to cap soaring oil and grain prices, the Commodity Futures Trading Commission voted 3-2 to approve position limits that will cap the number of futures and swaps contracts that any single speculator can hold.
The rule offers some relief for the industry, relenting on several highly contentious provisions, as expected.
But that will do little to temper frustration over a plan that could force banks like Morgan Stanley and traders including grains giant Cargill to scale back business, and could stanch the flow of financial capital into commodities.
The divisiveness was stark from the opening, making a legal challenge potentially more likely. That would be another hurdle for CFTC Chairman Gary Gensler, who is struggling against emboldened Republicans and a hostile Wall Street to put in place the rules required by recent financial reforms.
Swing vote Michael Dunn, a Democrat whose term has already expired, said he would follow the Dodd-Frank financial reform law but blasted the limits as a dangerous distraction from bigger issues.
Position limits are a sideshow that has unnecessarily diverted human and fiscal resources away from actions to prevent another financial crisis, said Dunn, who is serving past his term until Congress confirms his successor. Markets may become riskier and hedging more difficult, he said.
As expected, the commission's two Democrats, Dunn and Bart Chilton, voted with Gensler, while Republicans Jill Sommers and Scott O'Malia opposed the measure. O'Malia said the agency had overreached its mandate and echoed the industry's argument that there was no empirical evidence to substantiate the rule.
The lack of proof that excessive speculation leads to high prices is at the heart of the issue. Without evidence of any damage wrought by failing to limit traders, it may be difficult to demonstrate the net benefit of the measure.
Dozens of academic, government and bank studies on the subject have differed on whether speculators -- in particular the institutional investors who have poured some $300 billion into commodity markets over the past decade -- influence prices or whether prices simply respond to market conditions.
The CFTC's own economists have yet to produce any economic evidence to connect speculators to price spikes.
Some politicians, however, have clamored for the CFTC to clamp down since early 2008, as oil and grain prices were shooting toward historic peaks.
(This) will be subject to legal challenge, said Craig Pirrong, a professor and a director for the Global Energy Management Institute at the University of Houston and a long-time critic of the limits. The lack of a finding that there has been excessive speculation will provide the basis.
Other regulators are already facing the legal backlash.
After an eight-month battle, the Securities and Exchange Commission in July had its first Dodd-Frank rule overturned when a federal appeals court found the SEC had conducted a flawed analysis to support a rule that would make it easier for shareholders to nominate directors to corporate boards.
The position-limits rule may be challenged on similar grounds -- that the costs outweigh the benefits of a plan that many industry officials say will make markets riskier by driving trade to less-regulated overseas venues. The CFTC estimated the measure would cost the industry $100 million in the first year.
We need to be very careful, but I believe we're on very solid legal ground, Chilton told Reuters Insider on Tuesday.
It was not immediately clear who might bring a lawsuit, but the limits will affect dozens of major commodity traders and exchanges. Normally there is a limited period of two or three months after a rule is published in which a suit can be filed, though some of the rules will not take effect until late 2012.
One key question may be whether the parties seek an injunction to prevent the rules coming into force, said Michael Greenberger, a law professor at the University of Maryland and the CFTC's former director of trading and markets.
If a temporary stay is granted it will be a de facto death knell for the rules, he told Reuters. If denied, the rules will have an immediate therapeutic impact that will as a practical matter save them from being permanently overturned.
Gensler will also need to encourage overseas regulators to keep up with the CFTC to prevent the regulatory arbitrage many fear may ensue. A meeting of global regulators in London on Friday to discuss high-frequency trading will offer him a chance to encourage others to prevent loopholes.
France failed at the weekend to force mandatory curbs on energy and food commodities at a global level. However, a draft European Union reform due on Thursday would give supervisors from the 27-country bloc powers to impose position limits temporarily during market turmoil.
Britain's Financial Services Authority -- which oversees most of the major non-U.S. commodity exchanges -- has maintained a staunch opposition to mandated limits but could be overridden under the EU draft.
If the U.S. rules go into effect, expect the EU and other countries to reverse course and follow the CFTC lead in two years' time, Greenberger said.
The rule covers 28 commodities from coffee to crude to copper, including nine crop markets that were already subject to limits, using a predetermined formula based on deliverable physical supply or open interest in the market. It includes for the first time contracts in the $600 trillion swaps market.
All the rules will be phased in over time, with the final limits for all contract months set only after the agency has collected a year's worth of swaps data, a process likely to be finished late into 2012, officials said.
The limits may temper investors who have poured over $300 billion into commodity markets, often via index swaps with banks. Under the new rules, banks will no longer be given an exemption for such speculative swaps, although they will be able to hedge on behalf of corporate customers.
Several key provisions were eliminated from the CFTC's original proposal in January, as Reuters reported.
One key change relaxed the requirement that big commodity players aggregate all the positions held by any hedge funds or subsidiaries in which they have a stake. Instead, it retains the independent account controller regime currently in place, which views separately run trading books independently.
Another eliminates a proposed conditional limits measure that would have allowed speculators in commodity markets that are settled in cash to accumulate positions of five times the limit for similar physical delivery contracts.
That rule had riled the CME Group, which feared losing business to rival cash-settled contracts, some of which are listed by the IntercontinentalExchange. The CFTC maintained this measure for the Henry Hub natural gas market, however, where cash contracts -- and in particular the ICE look-alike contract -- are already highly liquid.