April 28, 2010
Ken Silverstein
EnergyBiz Insider
Editor-in-Chief
Long opaque, hedge funds are now in the spotlight. The focus: curbing the number of natural gas and oil contracts they can hold so as to prevent market abuses.
At the heart of the matter is the Commodity Futures Trading Commission (CFTC), which until recently has also been inconspicuous. Now, though, that's changed with all the attention given to unregulated financial instruments called derivatives and swaps as well as all the hoopla over limiting market speculation.
With Wall Street's wallet and its connections into American political life, it has nearly always succeeded in getting what it wants. But the attention given to the Goldman Sachs allegations is now giving the Obama administration's point man and CFTC Chairman, Gary Gensler, the leverage he needs to enact more oversight into hedge fund activities, particularly the largest ones controlled by the big banks.
"The CFTC does not set or regulate prices," says Gensler, who used to be a Goldman Sachs executive. "Rather, the commission is directed to ensure that commodity markets are fair and orderly. It is for that reason that I support the staff's recommended rulemaking regarding position limits in the energy markets and exemptions for swap dealer risk management transactions."
In January, the commission voted to set limits on the number of natural gas contracts that hedge funds can hold as well as to give regulators more power to monitor the trading of derivative contracts. The comment period has just ended and rules are expected next year.
The position limits are a function of $4 a gallon of gasoline and the accusations that speculators forced those prices that high in 2008. So, the very biggest players would be required to exit the market if it is determined that they can distort prices based on the number of contracts they hold. According to Gensler, the proposed energy limits would be responsive to the size of the market and administratively reset on an annual basis, rather than remaining unchanged until a new rule is issued.
As far as over-the-counter derivatives, Gensler says that they can lead to excessive risk taking -- something enhanced by the fact that they are traded out of sight of regulators and market participants. Therefore, he says that regulatory reform must bring transparency to this dark marketplace to both cut risk and improve pricing. That's something that should be done through congressional legislation and in the current banking reform bill now pending.
Industrials were once the primary entities buying oil and natural gas futures so as to guarantee the prices they paid for energy. But then Wall Street got involved. While it provided liquidity, those firms never actually took possession of the end product. And, it never had to divulge its holdings. If Congress passes legislation, it would force these bank-controlled hedge funds to perform all trades openly and on public exchanges.
Fine Line
The big banks and hedge funds caution against over-regulation in energy markets, noting that they create robust activity. And while they try to profit from price volatility, they are responsible for product innovation. That, in turn, creates efficiencies and prices are eventually a truer reflection of supply and demand.
The CFTC plan "is unduly onerous, will significantly limit the usefulness of the U.S. futures markets to international traders, and is premature in light of pending congressional legislation," says Hans Ephraimson, chief executive of Deutsche Bank Commodity Services, in a comment letter.
Hedge funds, which are essentially unregulated mutual funds comprised of sophisticated investors, seek to find "arbitrage" opportunities whereby they might buy power for a low price in one region and sell it for a higher price in another. They often carry out "over-the-counter" transactions that are private and outside the purview of regulators. In July 2009, CFTC was given congressional powers to limit the number of natural gas contracts that such hedge funds can hold but only on the Intercontinental Exchange.
That move closed the so-called Enron loophole and had been in response to the collapse of Amaranth in 2008, a hedge fund that at one time had held 40 percent of all outstanding natural gas contracts on the NYMEX. Critics maintain that such market powers forced consumers to pay $40 billion extra in energy costs -- something to which the Government Accountability Office and the Federal Energy Regulatory Commission generally agree.
The CFTC, in fact, says that if the proposed trading limits had been in effect during the time Amaranth was distorting markets, the crisis could have been prevented. Nevertheless, Gensler and crew have had to water down their original trading limits to affect only the largest banks and their wholly-owned hedge funds. Among them: Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo.
The CFTC compromised with the other, smaller hedge funds, reasoning that they could take their trades to international exchanges to avoid the scrutiny of U.S. regulators. At the same time, the commission is still asking Congress to give it the authority to regulate bilateral agreements that may be formed between parties that would want to avoid the transparency of the regulated exchanges.
"The CFTC should set aggregate trader position limits on energy contracts over all markets," says Rep. Bart Stupak, D-Mich., chair of the House Energy and Commerce Subcommittee on Oversight and Investigations. "With the growing number of markets, speculators can currently comply with exchange specific position limits on several exchanges, while still holding an excessive number of total contracts taken together."
Fostering free markets while preventing market abuses is the fine line government must walk. It's not an easy role but one that must be accomplished if consumer confidence is to be restored and the economy is to expand.
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