The mildly awaited CFTC post...

I have been trying to get my head around what I would do if I was King and in charge of the issues confronting the CFTC. After sniveling about watching my marketing plan - which essentially consisted of forward pricing at the wrong times - go up in smoke after March 7 when Cargill ran out of interest in paying my margin calls, I have pondered long and deep ponders about what to do.

Others have too. One idea is to extend the speculative limit to the newer market participants.

The speculators, now so bullish, are mainly the index funds. To see how their influence on the market has become outsized, just look at how they operate. Nearly $9 out of every $10 of index-fund money is not traded directly on the commodity exchanges, but instead goes through dealers that belong to the International Swaps and Derivatives Association (ISDA). These swaps dealers lay off their speculative risk on the organized commodity markets, while effectively serving as market makers for the index funds. By using the ISDA as a conduit, the index funds get an exemption from position limits that are normally imposed on any other speculator, including the $1 in every $10 of index-fund money that does not go through the swaps dealers.

The purpose of position limits on speculators, which date back to 1936, is clearly stated in the rules: It’s to protect these relatively small markets from price distortions. An exemption is offered only to "bona fide hedgers" (not to be confused with "hedge funds"), who take offsetting positions in the physical commodity.

The basic argument put forward by the CFTC for exempting swaps dealers is that they, too, are offsetting other positions — those taken with the index funds.

Position limits on speculators, in some commodities specified by CFTC rules and in others by the exchanges, are generally quite liberal. For example, the position limit on wheat traded on the Chicago Board of Trade is set at 6,500 contracts. At an approximate value of $60,000 worth of wheat per contract, a speculator could command as much as $390 million of wheat and still not exceed the limit.

But at least one index fund that does trade the organized commodity markets directly and must therefore abide by the rules — PowerShares DB Multi-Sector Commodity Trust (DBA) — recently informed investors that it was bumping up against position limits and therefore would change its strategy.

No such information is available from individual swaps dealers. But based on CFTC data on their total position in a commodity like wheat, together with the fact that only four dealers account for 70% of all the trading from the ISDA, it is quite clear that if the exemption were ever rescinded, the dealers’ trading in these markets would no longer be viable.

Speculators also use the older commodity pools, whose position is likewise tracked on the charts. The pools, open to sophisticated investors, are flexible enough to sell short as well as buy long and are subject to position limits. But since they are generally trend-followers, they will almost always go long in bull markets. Through most of the recent period, then, the pools have been adding to the price distortions caused by the index funds. Add the pools’ bets to those of the index funds, and speculative money forms 58% of all bullish positions.

To get a further idea of the impact of these speculative bets, Barron’s asked Briese to measure them against production in the underlying markets. He calculates that in soybeans, the index funds have effectively bought 36.6% of the domestic 2007 crop, and that if you add the commodity pools, the figure climbs to 59.1%. In wheat, the figures are even higher — 62.3% for the index funds alone, and the figure jumps to a whopping 83.6% if you add the pools. Betting against them as never before are the commercials, who deal in the physical commodity.

The CFTC provides these figures on index trading for only 10 commodities. Why are such major commodities as crude oil, gold, and copper excluded? The agency’s rationale, which even certain insiders question, is that it would be hard to get reliable information on these other commodities from the swaps dealers. [More]

The concept as I understand it is to slow or divert the avalanche of fund money into these relatively small markets. Other ideas include new rules to promote, even force convergence of cash and futures.

Another issue likely to dominate the hearing is the notion of "convergence" and whether financial investors have distorted it. A futures contract is an agreement by one side to buy, and the other side to sell, a commodity at a set price on a set date. Often traders make offsetting trades to get out of their bets, but if they don't, futures contracts often result in physical delivery of a commodity. As a futures contract gets closer to its expiration date, the price is supposed to converge with the price that actual wheat or corn, for example, is trading at on the open "cash" market. The commission will be looking some instances of discrepancies in those prices. [More]

I find the attraction of "fixing" something powerful, and apparently so do regulators and politicians. The only problem for me is I really cannot come up with an idea that does not carry enormous risks to an already skittish market in a time of production questions of the first magnitude.

Above all, I have learned to respect mightily the power of Really Big Money to skirt any government rule. Consider campaign finance "reform" - whoo, boy! We really cleaned up that act. In fact, it was the astonishing success of the Paul and Obama campaigns to use micro-finance with million of small contributors to thumb their noses at big donors that gave me an analogy to work with. This problem needs some nerds and some Internet thrown at it, methinks.

So, here is my One Point Plan for Government Relief:

1. Don't do anything.

I have several reasons for inaction. First, this is not simply a fallback to textbook laissez-faire economics. I have no problem with taking appropriate action when rules are poorly drawn up and hampering the market flow. But here we have too much flow, not too little.

Second, I don't think anyone has the faintest idea of all the unforeseen consequences of say limiting index investment, but surely one would be to greatly reduce the fund dollars in the market. This strikes me as a bad thing. While too much liquidity has made some pretty hairy trading days, those days have been at prices I would have sold my grandmother for a coupla years back.

Kicking people out of the pits because they have too much money is a form of refusing to stand ready to trade anytime, anywhere - something US producers work hard to promote as part of our brand.

Finally, I don't want the CFTC to come up with an answer; I want some clever entrepreneur(s) to find one (or several). In fact, I have recently been persuaded that work-arounds and incremental mitigation are bubbling up from grain merchandisers, traders and people who see an opportunity to make a few millions from an obvious market inefficiency.

For example, to get back to my marketing problem, what if my customer devised a way to bring in a separate funding source to alleviate both our bank accounts? What if forward contracting became a reward for valued and loyal suppliers (farmers) in exchange for a stronger supply ties? You can't tell me the brains in the grain business are looking at a narrowing future supply of corn (and other commodities) and not spurring the MBA's in the upper floors to find vehicles of some sort to solve this issue.

Best off all, we could have many different solutions to these risk issues and the market can sort out the winers and losers. And much if not all of this business can be funded by those very speculators who want to own our output for whatever reason.

Which is a good thing, remember.

If I could honestly embrace with enthusiasm some regulatory/legislative fix, I would. But my instinct when I can't find that idea anywhere is to first do no harm. Then we start the iterative process of experimentation by innovators to see what works. It will happen anyway, especially as the stakes continue to grow. And it's as American as a Toyota.

[Thanks, Chris and Art]