The US Congress has finally passed the Dodd-Frank Act, an elaborate (and sometimes incoherent) response to the meltdown in financial markets during 2008 and 2009, which required a federal rescue package running into hundreds of billions of dollars.
The new law readily acknowledges that the bulk of this emergency occurred in recesses of the financial system that had been liberated from pesky regulation because they were run by the best and the brightest among us.
The markets and professionals that remained under regulation required exactly zip from the state. So, the latter are safe from the clampdown, right, since they did not participate in the cataclysm?
First, there is a hint of the Congress’s sense of humour or playfulness in the Act. It prohibits trading futures or options on movie box office receipts. The ban was included at the behest of the Motion Picture Association of America – a body seldom confused with the national moral compass.
It is unclear why this step was taken, as movie box office receipts are only the second asset to be categorically banned by statute from US futures markets. The other forbidden fruit is onions, which were the subject of my article for FOW 10 years ago, entitled Allium cepa Libre!
CFTC to set position limits
Next, the law awards the task of setting speculative position limits to the Commodity Futures Trading Commission.
In the past, that responsibility was shared between the CFTC and exchanges. The CFTC prescribed “spec limits” for farm products, while the exchanges set them for all other futures and options.
The system of limits included soft “accountability thresholds” in non-delivery months that triggered more intense surveillance by the exchange but did not necessarily involve a cap on position size.
Now the CFTC will be the final arbiter, although the exchanges can also continue to impose limits if they are stricter than the federal standards.
In a move with uncertain ramifications, the CFTC has also been assigned a more activist role in setting minimum and maintenance margins for listed futures and options.
Over nearly 50 years of personal observation, I have found that the exchanges defend no power more aggressively than their right (theirs alone, barring an emergency) to set margin levels.
The exchanges have always feared that federal intervention on margins, which might be politically motivated, could disrupt the role of supply and demand in determining prices. Now, the CFTC may invoke its authority to alter exchange rules in an effort to pressure changes in margin levels.
And, while the CFTC’s authority is expanding, at the same time it is threatened, by a provision in the new law that appears to allow the Federal Energy Regulatory Commission to regulate certain markets – including futures and options – involving energy products. The trades concerned are those conducted either bilaterally or on markets owned or controlled by FERC-regulated regional transmission organisations or independent system operators.
While FERC does not appear to gain any authority over CFTC-regulated energy futures or options markets, it may now be able to develop a parallel universe of markets in competition with the New York Mercantile Exchange, ICE Futures and others.
In that case, there will be growing pressure (as there is with respect to common CFTC-SEC matters) to harmonise the two agencies’ policies, standards and interpretations, further compromising what since 1975 had been the CFTC’s sole and exclusive jurisdiction over this activity.
Finally, a new notion of market manipulation could emerge, as the Congress has imposed on the CFTC a standard of “manipulative or deceptive device or contrivance”, borrowed from the SEC’s statutes.
Until now, the courts construing the CFTC law have held that proving manipulation in futures and options markets requires proof that the culprit deliberately set about to skew prices.
The SEC standard is more subtle. If the conduct is found to be deceptive, a court is allowed to deduce from the totality of the evidence that the accused knew or should have known that prices would be affected by its actions.
The tougher CFTC standard discouraged regulators and private claimants from suing for manipulation unless the offender had been caught with a smoking gun. Claimants may become more aggressive if the burden of proof is lowered.
Speculators, in particular, may grow wary of trading in these markets if they fear that their losing transactions will go unnoticed, while their profitable activities are examined with a microscope by both the government and the private Bar.
Is my licence good any more?
New licensing rules for ‘swap dealers’ and ‘major swap participants’ could raise doubts about whether other types of CFTC licences in use for decades may no longer be valid.
Registered floor traders who make markets on regulated exchanges can now trade listed swaps – but, in doing so, they might inadvertently become swap dealers, which would entail capital requirements and many other duties that have not applied to floor traders.
Or the operator of a commodity pool registered with the CFTC, which manages a large amount of swaps, could become a major swap participant, bringing many new responsibilities.
And so, after sparing the American taxpayer many billions of dollars in bailout money, and despite being used by the Congress as the principal model for reform of the over-the-counter derivatives business, the CFTC-regulated futures and options market is suffering its own lashing.
The adage “no good deed goes unpunished” comes to mind.
Philip McBride Johnson is head of the listed derivatives regulatory practice at Skadden, Arps, Slate, Meagher & Flom in Washington and a past chairman of the Commodity Futures Trading Commission.