Why we can’t have nice things (like safer commodity markets)

The tension between the obvious need for financial regulatory reform and the reality of the weak tea we have been served is rooted in the politics of the regulatory process. The usual culprit is the most obvious one – aggressive lobbying by industry trade groups and others who go to work directly on lawmakers in order to shape laws and rules to reflect their clients’ interests. Another common pressure point for lobbyists is their participation in the public comment process embedded in the process of developing new regulations.

The third area gets much less attention but can be equally effective (if more costly). If an industry is unsuccessful in having a law or set of regulations changed to its liking, it can always sue in court in the hope of having the rule overturned. That is exactly what happened earlier this year, when a judge handed the derivatives industry a victory by blocking the Commodity Futures Trading Commission from implementing its proposed rules on position limits.

By way of background, the rules in question were part of the Dodd-Frank overhaul of banking and finance regulation, and were drafted to address the problem of concentration in commodity markets. As recent lawsuits against JP Morgan and Barclays have shown, commodity markets are vulnerable to manipulation, especially when individual traders or firms become too large relative to other participants. The fact that these same markets act as the central pricing mechanism for basic goods like energy and food makes the problem particularly acute.

Through Dodd-Frank, Congress instructed the CFTC to extend its prior authority to impose limits on the positions of firms and traders by specifying more clearly the parameters of those limits. Prior to Dodd-Frank, the law in question had simply given the CFTC the right to impose such limits “from time to time” and “as the Commission finds are necessary.” The CFTC amended the rule with several pages of granular detail on exactly what kinds of limits it would enact, and made clear that the new position limits were to be a permanent feature of commodity and other derivatives markets.

Both the industry and several of the CFTC commissioners were strongly and vocally opposed to the new rules. However, their opposition was insufficient to overcome the agency’s general interpretation that they were forced to act by Congressional decree, and the rules were ultimately passed by a majority vote of the commissioners.

This is where the industry reached for its final option. Two trade groups (ISDA and SIFMA) filed a joint suit questioning whether CFTC had acted with the appropriate authority in enacting the laws, and claimed that the agency had overstepped its mandate by doing so without establishing that they were strictly necessary. Amazingly, their suit hinged on the following highlighted language from the amended Act that created the CFTC (presented here with the Judge’s emphasis):

For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits on the amounts of trading which may be done or positions which may be held by any person . . . under contracts of sale of such commodity for future delivery on or subject to the rules of any contract market or derivatives transaction execution facility, or swaps traded on or subject to the rules of a designated contract market or a swap execution facility, or swaps not traded on or subject to the rules of a designated contract market or a swap execution facility that performs a significant price discovery function with respect to a registered entity, as the Commission finds are necessary to diminish, eliminate, or prevent such burden.

The dozens of provisions that follow this paragraph were all added as part of Dodd-Frank, and specify exactly how the new limits are meant to work. Crucially, they also draw their authority from the paragraph above, which is treated as providing the CFTC the right to impose such limits in general.

What the industry successfully claimed was that the language in the paragraph did no such thing. Instead, they claimed, the language gives the CFTC that power only if it can show the laws are necessary. The CFTC argued that Congress itself mandated that the agency move forward with new rules. While no one involved was under any other impression, the ambiguity in the language (which led to all sorts of verbal contortions on both sides) was sufficient for the judge to block the new rules and send them back to the CFTC for more work.

I have only recently started reading legal and regulatory documents so this sort of sloppy language comes as an unwelcome surprise. The entire paragraph I quote above is a single sentence, and is one in which exactly what word is modifying what is extremely slippery. But this is hardly unique in that regard – there is even an established legal doctrine called the Rule of the Last Antecedent that attempts to clarify how judges and counsel should approach such situations. The fact that the body of laws and regulations that govern our daily lives is often so poorly written that they can be challenged on that basis is absurd.

The other unwelcome surprise in this case was the poverty of the CFTC’s arguments in support of its authority. The agency’s counsel put forward a number of reasons for why the agency could act, but (according to Judge Wilkins) none were substantive. Instead, they relied on word placement, Congressional intent and other factors, none of which answered the central question of whether they were acting in accord with their governing rules.

This case may end well – the CFTC has announced that it is appealing the ruling, which hopefully means that the agency has found a much stronger set of arguments (I believe strongly in the need for position limits, so I am biased in this regard). Until then, speculators are free to amass enormous positions, all thanks to a combination of sloppy wording and an industry willing to exploit every loophole imaginable.

Those interested in a more legal explanation should click over to this excellent summary by Keith Bishop.