NYMEX regulation - the CFTC should be concerned

I wrote an entry on the the CFTC yesterday questioning the comments of a CFC commissioner. Now I have to side with the regulators given the evidence that was presented on the "self-regulation" of traders by the NYMEX futures exchange. The NYMEX has the authority to set accountability levels for trading positions in the energy markets.

Accountability levels are based on reporting levels set by the exchange. These rules include hard caps on the number of contracts that can be held on the three days before expiration of a contract and accountability levels which if exceeded could lead to the exchange asking for a freeze or a reduction in positions. Given these rules, there would be the expectation that few traders would exceed the accountability standards. While not a hard cap, traders would be put on notice that the exchange was monitoring these positions closely. Monitoring is important and should be a requirement for ensuring a well functioning market. Of course, some would argue that this is an infringement on the freedom of traders but the exchange has a responsibility to see that the markets are fair and orderly and that means that no one person can have an excessive amount of the open interest in a contract. The issue is what is the number of contracts that would be excessive. NYMEX set the number of contracts at 10,000 in a single contract month.

The CFTC noted that 43 traders exceeded the limit of 10,000 contracts in a single month in the last year. The average amount that these traders exceeded the standard was substantial. This was not an issue of a few contract above the limit for a few days. What should we think of the exchange for allowing this excess over their levels and not taking any action clear action. The logic is questionable when everyone has been watching this issue closely since the spike in oil prices last year.

NYMEX argues that these were set conservatively because they were just accountability standards and that hard limits would be higher. This still begs the question of why have these accountability limits if they would not take any action to stop or review in detail the behavior of traders. Market participants clearly did not believe there would be any repercussions based on exceeding the accountability standards.

The result of lax accountability is what we are now seeing, a regulator who will now ask for control of this process. After focusing on the idea that the exchanges should be best able to regulate their activities, the exchanges blew their freedom and they should pay for the consequences.

The sad part of this saga is that the link between excesses in position sizes and price manipulation may not be able to be clearly made. Hard position limits are now being discussed at levels that would be much tighter then imagined just a few weeks ago. There is little evidence for anyone to tell what is the appropriate level of position limits and we may not be able to get to this key question in the current environment.