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CFTC proposal holds harsh surprise for asset owners

Aggregation limit on some commodities has potential for trouble

Willa Cohen Bruckner
Willa Cohen Bruckner said the proposal would mean pension funds would have to ‘monitor their trading for compliance with position limits.’

A little-publicized part of the latest CFTC proposal for speculative position limits on certain physical commodities could make it difficult for asset owners to comply.

At issue is the proposed aggregation limit, which would be set at 10% of trading control of a commodity whether an investor does the speculating themselves or it's done via external managers. And pension funds that currently exceed that limit could have to petition the CFTC for an exemption.

“A pension (fund) that uses outside managers will have to set up arrangements with its managers so as to fit” within the aggregation requirement, said Willa Cohen Bruckner, partner, financial services, at the law firm of Alston & Bird LLP, New York. “Otherwise the pension (plan) will have to aggregate positions across all managers in determining whether it has exceeded position limits. If aggregation is required, managing compliance with position limits across unrelated managers could be quite difficult.”

Added Deborah Monson, hedge fund partner at the law firm of Ropes & Gray LLP, Chicago: “I think (pension funds) need to know. I think most people know this position limit proposal is lurking, but the aggregate exemption filing requirement is under the radar a bit.”

The aggregation limit is part of the Commodity Futures Trading Commission's third attempt to impose speculative position limits in 25 core physical commodity futures contracts and their “economically equivalent” futures, options and swaps, according to the agency when it released the final proposal Dec. 5.

Along with the aggregation limit, the proposal would ban investors from owning more than 25% of a commodity's estimated deliverable supply — the amount that meets the delivery specifications of a futures contract — in a month, and would apply to all market participants, including exchanges. Those limits could actually be lower in some cases than the current limits that have been established by some exchanges.

“The proposal broadens the scope of commodities subject to position limits and also the type of financial instruments through which exposure to commodities is obtained, so the investment community is more likely to be impacted by position limits if the proposed rule is adopted,” said Ms. Bruckner.

The CFTC first proposed position limit rules in October 2011, as recommended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, but the proposal was vacated a year later after a U.S. District Court in Washington ruled in favor of the International Swaps and Derivatives Association in a lawsuit against the CFTC opposing the rules. Then in November 2013, the agency introduced a revised position limits proposal. The current proposal, originally issued in May 2016, now takes into account comments made on that proposal last summer.

Aggregation component

What makes the aggregation component of the proposal so important is that it would require a pension fund and its manager “to aggregate all positions in accounts or funds for which that investor directly or indirectly either controls trading or holds a 10% or greater ownership interest, as well as the positions of any other investor with whom (they) trade,” said Jeremy Liabo, hedge fund associate at Ropes & Gray, Chicago. “Given the breadth of the aggregation requirement, many managers and pension funds are looking to see whether they qualify for an exemption from aggregation.”

Currently market participants like pension funds and money managers can petition exchanges for exemptions from position limits, but the CFTC proposal would shift responsibility of approving or rejecting those requests to the agency, Mr. Liabo said. “The concern is that under this construct, exemption applications that are appropriate for a given market will be denied solely because of the criteria set at the federal level,” Mr. Liabo said.

Much of the complaints about the proposal generally involve the view that it's too vague, lacking specificity on the actual position limits and what commodities would be directly affected by them. The Securities and Financial Markets Association in its comment letter to the CFTC has said the overall proposal can't have a “one-size-fits-all” approach to setting limits and instead should look at exactly what the agency considers to be excessive speculation.

Money managers including AQR Capital Management LLC and Pacific Investment Management Co. have filed comment letters with the CFTC opposing the position limits proposal. AQR said in its letter that “the commission should first request comment on implementing accountability levels — rather than hard limits — as the exchanges have already done. Accountability levels have been used by exchanges for years to identify and understand large positions, and this regulatory tool allows exchanges to carry out responsible market surveillance without impacting liquidity or unduly limiting beneficial risk management activities of market participants.”

PIMCO in its letter said the proposal “would significantly restrict the ability of PIMCO's clients, which … include millions of individuals and thousands of large institutions in the United States and globally, and the many other important and significant market participants to use and provide liquidity to commodity derivative markets for effective risk management, investment and hedging purposes.”

Concern over market liquidity was among the issues stated by CME Group Inc. in its comment letter opposing the proposal. “If the commission were to impose position limits, its reproposed federal position limit regime would harm market liquidity and market integrity as well as the interests of commercial end-users and those who rely on our markets' price discovery,” the CME comment letter stated.

Compliance issues

Alston & Bird's Ms. Bruckner said pension funds with their own derivatives trading desks “will have to monitor their trading for compliance with position limits” if the proposal is approved. “If their current trading strategy and volume would put them over some position limits, they will have to change their trading, which could have an adverse impact on their returns,” she said.

So far, none of the comment letters to the latest CFTC proposal posted on the agency's website have come from pension funds, including plans like the $320.7 billion California Public Employees' Retirement System, Sacramento, or $202.8 billion California State Teachers' Retirement System, West Sacramento, which operate their own derivatives trading desks. Nor has there been comment from pension funds that have externally managed commodities allocations, like the $31.3 billion Indiana Public Retirement System, Indianapolis, which had a 7.7% allocation to the asset class as of March 31. Spokesmen for CalSTRS and INPRS said plan officials would not comment; officials at CalPERS did not respond to requests for comment.

One pension fund executive thinks it's uncertain that the CFTC will approve the current proposal because of the importance of speculation in the market.

“In its current form, I don't anticipate significant impact; however, without speculators in the marketplace, there would likely be less ability for investors to hedge,” said Jeremy Wolfson, chief investment officer for the $10.3 billion Los Angeles Water & Power Employees' Retirement Plan. “Fundamentals should ultimately still be the material driver of pricing in the marketplace.”

The plan has a commodities suballocation in its 5% real return portfolio.

This article originally appeared in the May 29, 2017 print issue as, "CFTC proposal holds harsh surprise for asset owners".