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CFTC Staff Report on Commodity Swap Dealers and Index Traders

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CFTC Staff Report on Commodity Swap Dealers and Index Traders Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations COMMODITY FUTURES TRADING COMMISSION SEPTEMBER 2008 Table of Contents EXECUTIVE SUMMARY ............................................................................................................ 1 Findings: ..................................................................................................................................... 3 Preliminary Recommendations: .................................................................................................. 6 1. Introduction ................................................................................................................................. 8 2. Development of Swap Markets and Swap Dealers ................................................................... 10 3. Swaps Exemption from Federal Speculative Position Limits.................................................. 13 4. The Commission‘s Special Call to Swap Dealers.................................................................... 15 A. Scope of the Special Call .................................................................................................... 16 B. Potential Limitations of the Special Call............................................................................. 19 5. Findings.................................................................................................................................... 20 A. Notional Value of Commodity Index Trading .................................................................... 21 B. NYMEX WTI Crude Oil ...................................................................................................... 22 C. CBOT Wheat ........................................................................................................................ 24 D. CBOT Corn .......................................................................................................................... 27 E. ICE Futures-U.S. Cotton ..................................................................................................... 29 F. Other Commodity Findings ................................................................................................. 31 6. Preliminary Recommendations .............................................................................................. 32 Appendix A ................................................................................................................................... 36 COMMODITY INDEX INVESTMENT ................................................................................. 36 Appendix B ................................................................................................................................... 37 The Purposes of Futures Trading on DCMs: Hedging and Price Discovery ............................ 37 Appendix C ................................................................................................................................... 39 Speculation and Price Discovery in Futures Markets ............................................................... 39 Appendix D ................................................................................................................................... 44 Commitments of Traders Report .............................................................................................. 44 Appendix E ................................................................................................................................... 52 History of Speculative Position Limits ..................................................................................... 52 Appendix F.................................................................................................................................... 57 Special Call Letter to Commodity Swaps Dealers .................................................................... 57 Appendix G ................................................................................................................................... 60 Commissioner Bart Chilton Dissent ......................................................................................... 60 GLOSSARY ................................................................................................................................. 63 EXECUTIVE SUMMARY The following is a CFTC staff report on the special call survey of swap dealers and index traders, with several preliminary Commission recommendations. Major changes in the composition of futures market participants have developed over the last 20 years. Specifically, there has been an influx of new traders into the market – commodity index traders (including pension and endowment funds) that seek exposure to commodities through passive long-term investment in commodity indexes, and swap dealers that seek to hedge price risk resulting from their over-the-counter (OTC) activity. In addition to those changes, volume growth on futures markets has increased fivefold in the last decade, and in the last year, the price and volatility of oil and other commodities have reached unprecedented levels. In light of these developments, the Commodity Futures Trading Commission (CFTC or Commission) staff has undertaken a survey of swap dealers and commodity index funds to better characterize their activity and understand their potential to influence the futures markets. This type of a compelled survey relating to off-exchange activity is unprecedented, but the growth and evolution in futures market participation and growing public concern regarding off-exchange activity supported the need for this extraordinary regulatory inquiry. The development of the OTC swap industry is related to the exchange-traded futures and options industry in that a swap agreement can function as a competitor or complement to futures and option contracts. Market participants often use swap agreements because they offer the ability to customize contracts to match particular hedging or price exposure needs. Conversely, futures markets typically involve standardized contracts that, while often traded in very liquid markets, may not precisely meet the needs of a particular hedger or speculator. The swap dealer, which is often affiliated with a bank or other large financial institution, has emerged to serve as a bridge between the OTC swap market and the futures markets. Swap dealers act as swap counterparties both to commercial firms seeking to hedge price risks and to speculators seeking to gain price exposure. In essence, swap dealers function as aggregators or market makers, offering contracts with tailored terms to their clients before utilizing the more standardized futures markets to manage the resulting risk. The bilateral contracts that swap dealers create vary widely - from contracts tailored to customer needs, to relatively standardized contracts (some virtually identical to an exchange-traded futures contract). Because swap agreements can be highly customized and the liquidity for a particular swap contract can be low, swap dealers often rely on a variety of means, including other swaps, physical market positions, and futures contracts to offset the residual market risks in their swap book. Since 1991, the Commission has granted hedge exemptions to swap dealers (in regulated futures markets that have Federal speculative position limits) to manage the price risk on their books that results from serving as a market maker to OTC clients. Separately, the Commission has classified the trading activity of swap dealers as commercial rather than noncommercial in its weekly public Commitments of Traders report (COT) because swap dealers use futures markets for the commercial purpose of hedging their price risk. As this survey shows, futures market trades by swap dealers are essentially an amalgam of hedging and speculation by their clients. 1 Thus, any particular trade that a swap dealer brings to the futures market may reflect information and decisions that originated with a hedger, a speculator, or some combination of both. A commodity index trader, which includes pension and endowment funds seeking exposure to commodities, is a passive, transparent investor in commodity markets. The investment objective of a commodity index trader is to track an index of commodities over time by acquiring long positions via OTC swap contracts, index funds, or exchange-traded futures. The larger commodity index traders typically gain commodity exposure through swap dealers. In June 2008, Commission staff initiated a special call to futures traders, which included 43 requests issued to 32 entities and sub-entities. These entities include swap dealers engaged in commodity index business, other large swap dealers, and commodity index funds. The special call required all entities to provide data relating to their total activity in the futures and OTC markets, and to categorize the activities of their customers, for month-end dates beginning December 31, 2007 through June 30, 2008, and continuing thereafter. All entities complied. The scope of the survey attempts to answer the following questions: How much total commodity index trading is occurring in both the OTC and on- exchange markets? How much commodity index trading is occurring by specific commodity in both the OTC and on-exchange markets? What are the major types of index investors? What types of clients utilize swap dealers to trade OTC commodity transactions? To what extent would swap clients have exceeded
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