Presenting, the ‘physical loophole’ | FT Alphaville

Presenting, the ‘physical loophole’

First there was the London loophole. Now, it appears, the development of another entirely new loophole is underway. Let’s call it the physical loophole.

From Intercontinental Exchange CEO Jeffrey Sprecher’s Tuesday testimony to the CFTC on the matter of position limits and the influence of speculators on the price of commodities:

ICE offers the following recommendations to the Commission regarding the application of position limits, accountability levels, and hedge exemptions in energy derivatives markets:
1. That any aggregate system of position limits, accountability levels and hedge exemptions should be set and administered by the CFTC;
2. That any position limits and accountability levels should be determined by the CFTC using market neutral and transparent methodologies and in a manner to preserve competition;
3. That financially settled contracts and physically deliverable contracts should be treated differently in any revised regime; and
4. That the CFTC should maintain the distinction between expiration month position limits and future month accountability levels.

And specifically on the matter of physicality:

In determining final month position limits, the CFTC should delineate between financially settled and physically deliverable contracts. Currently, the CFTC is encouraging exchanges to adopt hard position limits for financially settled contracts that are equal to the position limits for physically deliverable contracts.

Any position limit regime should closely examine this practice, as market participants use the physical and financial markets for different purposes. Imposing limits on cash-settled products is problematic for those trying to hedge the settlement price and may create a convergence problem. The energy market created an OTC financially settled WTI swap contract, specifically to allow hedgers, who reference CME’s WTI futures settlement price in their physical contracts, to hedge the expiration price of the WTI futures contract.

Without such a mechanism, it is impossible to hedge the final futures settlement price, as holders of the futures contract receive physical oil at expiration — not dollars. ICE recognized the need for hedging CME’s price and listed this financial contract on its energy futures exchange. The CME and a number of other exchanges and trading platforms have followed suit and such contract has found widespread adoption among commercial market participants.

If the Commission’s regulatory concern is arbitrage between the physical and financial contracts, then a simple solution may be to allow large positions to be held in the financially-settled contract to facilitate perfect hedging of the final settlement price, but prohibit holders of such large positions from trading in the physically-settled futures contract market during the crucial settlement period, when physical players, with positions below the hard position limits in the final trading days, would determine the expiration settlement price. Such a rule would promote contract convergence and eliminate the need for the significant number of hedge exemptions that exist in the energy futures market.

So that means, under Sprecher’s proposition, that those operating in the physical domain would pretty much have the final say on determining the expiration settlement price. Holders of the financial-contract would see their positions “converge” to the physical.

Now, if you believe price distortion is coming into the market via financial speculators, then that is indeed a very nifty solution — although not much different to how things are now. However, if you’re more inclined to believe the price distortion is coming from the physical side — as market commentators like Chris Cook, former head of compliance at the International Petroleum Exchange maintain, have suggested — then that provides for yet more influence of physical players via the OTC market.

This is also quite convenient for those who are both physical and financial operators in the market, those like Goldman Sachs, Morgan Stanley and soon to be physically positioned GLG Partners.

While it’s only right that the physical market should drive the financial derivative market, there is one issue.

Ever decreasing volumes in benchmark grades like Brent BFOE— which go on to influence the price of WTI via spreads — present a very small clique of physical traders with the opportunity to have a somewhat distorting effect on oil prices around the world.

Related links:
GLG goes physical
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Evil commodities speculators in the dock
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A forward curve proposition
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Who’s in the wake for shipping losses?
– FT Alphaville