Buried deep in the proposal to set position limits on oil and gas futures is a possible "land mine" that could force the industry's biggest traders to make a stark choice: Keep your hedging exemptions, or keep your speculative book.
But you can't keep both.
Weeks after the Commodity Futures Trading Commission unveiled its long-awaited proposal to prevent concentration in energy markets, industry executives have zeroed in on a little-noticed clause that would force big players to exit speculative trading positions if they wrest an exemption from regulatory limits on their hedging operations.
That could be a big blow to traders at the likes of oil giant BP PLC or Swiss trading house Vitol, who regularly use futures contracts both to protect themselves from risks on physical market positions and to make bets on prices.
And it could be wrenching for swaps dealers, such as Goldman Sachs or Morgan Stanley.
Large dealers may need to back away from some swaps business to avoid hitting the limit, spawning new players that customers fear will add costs and risk.
"Unless you're willing to drop your speculative trading desk altogether, this effectively ends exemptions, for all practical purposes," said a Washington-based industry source who has examined the proposal in detail.
CFTC Commissioner Bart Chilton, a strong proponent of position limits, was unapologetic, arguing exemptions have given too much flexibility to players without stakes in the physical commodity.
"There should be zero patience for trading on your own book, if you have an exemption," Chilton told Reuters, defending the new proposal as a safeguard against the impact of large traders roiling markets by making risky bets for their own accounts.
"Perhaps, if our proposal goes into effect, some will have to choose a business model," he said. "Are they a speculator, a swaps dealer or a hedger? Part of the problem we have had over the years is that some wanted to be everything to everybody."
The proposal is another source of discomfort to companies nervous about the Obama administration's proposed "Volcker rule," which seeks to ban banks from proprietary trading.
The exemption restrictions would likely face the same logistical challenges as the Volcker proposal — the line between prop trading for your own account, versus taking on customer business or hedging, is often extremely blurry.
The exemption rules have rattled experts who initially dismissed the CFTC plan as a fairly light touch.
"It's absurd," said Dennis Gartman, publisher of the closely followed Gartman Letter, a newsletter for traders, who first raised awareness of the issue in a report this month. "The ability to transact business would be greatly inhibited."
It also heightens the risk that hedgers and swaps dealers who also have proprietary trading desks may forced to take their business off U.S. exchanges into unregulated, over-the-counter or overseas markets, hurting transparency and liquidity and undermining the very aim of the regulations.
"At this point it's very unclear how a bank would be able to use the proposed hedge exemption process and still serve customers," one Wall Street dealer told Reuters. The measure "is definitely a source of confusion for the major dealers."
When the CFTC first released its proposal, traders were relieved the limits were set so high that they seemed only to restrict a handful of big traders, a far cry from the hard-edged crack-down they feared amid the political furor over oil's surge to $147 in 2008.
And, after all, companies needing to hedge physical positions could apply for exemptions to the limits based on demonstrated needs, as could large swaps dealers, limited to two times the normal limits.
But when the proposal was published for public comment, traders were surprised to find an important catch. Triggering those exemptions would mean giving up speculative positions.
For example, if a limit for a non-spot month was set at 1,000 contracts, a dealer could hold any mix of speculative positions and hedge positions for clients under that level.
But, if the dealer asked for and was granted a CFTC exemption, and put on more than the 1,000 positions, the dealer could not hold any speculative positions at all.
"I view it as one of those things ... that probably didn't look like a big deal, but it's a potential land mine," said Craig Pirrong, an oil market expert and a professor at the University of Houston.
Traders say the reality of making a market is not always so black and white, and they need more clarity on how the CFTC would discern what trades are speculative.
"It's so grey in terms of when you're putting a position on and putting on the offsetting hedge," said Adam Felesky, head of BetaPro Management in Toronto, manager of the second-largest natural gas exchange-traded fund in North America.
"If you have client flow going the other way, sometimes it's a timing issue of minutes or seconds or hours. It may be more efficient for you to hold the position," Felesky said.
If the cap was rigidly enforced, risk managers would have to spend more time ensuring they weren't putting on positions that could be deemed speculative, said Gartman, forcing them to widen bid-offer spreads and driving up costs to customers.
Now exposed, the question is whether the CFTC will provide the detail that industry participants need in order to assess implications that remain far from clear.
"They have done a very poor job of explaining this 'crowding-out' concept and it is very difficult for people to follow," a Washington-based derivatives lawyer said.
The CFTC is seeking comment on the position limit proposal until April 26 to help it hone its proposal, and then commissioners will weigh whether and how to move forward.
Three of five CFTC commissioners have expressed concerns about the overall proposal, noting the limits could drive volumes outside regulated markets, unless Congress gives the CFTC power to oversee OTC markets.
Traders said they hoped the commission would rethink the rules, or wait until Congress decides whether to broaden the CFTC's authority before applying them.
President Barack Obama's offensive against the banking industry and anti-bank populist sentiment have given added impetus to any measures that will curtail excessive risk-taking.
"The atmosphere now is so charged against banks and so charged against speculators," Gartman said.
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