May 14, 2020 / 1:23 PM / 13 days ago

Column: U.S. commodities watchdog issues blunt warning over oil volatility

LONDON (Reuters) - The U.S. Commodity Futures Trading Commission (CFTC) has written to exchanges, brokers and clearers in unusually forthright terms to remind them of their obligation to ensure orderly trading and commodity pricing.

Pump jacks operate at sunset in Midland, Texas U.S. February 11, 2019. REUTERS/Nick Oxford

The CFTC’s letter, sent on Wednesday, was issued in the wake of unusually high volatility and negative prices in the light sweet crude oil futures contract (WTI) for delivery in May on the penultimate day of trading last month.

The detailed restatement of basic obligations, which should not need reminding, amounted to an extraordinary public warning to the Chicago Mercantile Exchange (CME), which operates the WTI futures contract.

The Commission’s decision to issue a public caution illustrates the depth of concern about what happened in the run-up to the expiry of the May futures contract, and determination it must not be allowed to happen again.

FAIR AND ORDERLY

In its letter, the Commission noted that the coronavirus pandemic has badly disrupted markets and increased volatility across many of the agricultural, energy and financial contracts that it is responsible for regulating.

But it singled out unprecedented volatility in contracts that call for physical delivery, like WTI, as a source of special concern (“CFTC Letter No. 20-17” May 13, 2020).

The Commission reminded futures exchanges they are legally responsible for preventing “manipulation, price distortion, and disruptions of the delivery or cash-settlement process”.

Futures exchanges must ensure markets remain competitive, orderly and fair by employing “market surveillance, compliance, and enforcement practices and procedures”.

CONTRACT EXPIRIES

The letter focused on the behaviour of market participants and prices in the run-up to contract expiry, another sign of official concern about what happened ahead of last month’s WTI expiry.

Futures exchanges were reminded of their obligation “to monitor the convergence between the contract price and the price of the underlying commodity” as expiry nears.

Even more pointedly, exchanges were warned they must “monitor the supply of the commodity and its adequacy to satisfy the delivery requirements”.

In a reference to problems with the deliverability of WTI, exchanges were instructed they must make “a good-faith effort to resolve conditions that threaten the adequacy of supplies or the delivery process”.

The extreme volatility in WTI futures last month has been blamed, in part, on the shortage of capacity to make or take physical delivery of crude oil at the contract’s delivery point at Cushing in Oklahoma.

Exchanges were also reminded they must establish and enforce position limits and accountability levels to prevent market manipulation or congestion around the delivery point.

In effect, the Commission told exchanges that their contracts must be fit for purpose, with an effective mechanism and sufficient capacity to make or take delivery, and not simply free from overt manipulation.

EXCHANGE POWERS

The letter notes that exchanges must enforce rules designed “to protect the market and market participants from abusive practices including fraudulent, noncompetitive or unfair actions, committed by any party”.

Sometimes futures markets are characterised as laissez-faire, but in fact trading is heavily regulated, and the Commission has reminded exchanges they are responsible for preventing a broad range of unacceptable practices.

In a signal that it expects exchanges to get tougher, the Commission reminded them they have the power to intervene in an emergency – without needing to state that it expects those powers to be used if necessary.

The letter notes exchanges have the power, among other things, to liquidate or transfer any open positions; suspend or curtail trading; and impose special margin requirements to ensure markets remain orderly and fair.

CLIENT POSITIONS

The letter also contains several reminders to futures commission merchants (FCMs) of their responsibility to manage risks associated with their clients’ positions in futures contracts.

FCMs are reminded of their obligations to maintain effective risk-management systems to protect customer funds, including on an intra-day basis, especially “in light of recent events”.

Crucially, brokers must monitor positions as a contract gets closer to the expiration date to ensure customers can meet their financial obligations and make or take delivery on the futures contract.

It is an unsubtle reminder brokers should not allow customers to run positions close to expiry unless they are satisfied the customer has the logistical ability to make or take physical delivery.

Since last month’s upsurge in volatility, some futures commission merchants have already prohibited smaller customers from opening new positions in June and July WTI futures.

The decision to restrict trading to the liquidation of existing positions reflects a concern that risks arising from congestion at Cushing have become unmanageable for smaller and less sophisticated customers.

The Commission’s warning will likely cause (and was probably intended to encourage) more brokers to limit trading by smaller customer accounts in WTI contracts near expiry.

DEFENCE IN DEPTH

It remains unclear why so many contracts remained open for delivery in the run-up to the expiry of the May futures contract, which caused a rush to close them on the penultimate trading day and worsened volatility.

The potential for volatility in the run-up to expiry has always been well understood, but futures contracts are supposed to have multiple layers of protection to ensure they continue to operate smoothly.

Exchanges maintain position limits to prevent large numbers of positions being taken close to expiry, and actively monitor open positions to understand traders’ plans for settling them.

FCMs and other intermediaries are required to understand whether their customers have the intention and ability to make/take physical delivery, and keep purely financial traders well away from expiry.

Exchanges also monitor the delivery infrastructure - tank farms and pipelines - to ensure it can make or take the required deliveries.

Somehow all those multiple layers of protection failed last month. The market blew through them all. The CFTC’s letter is intended to reinforce those protective layers to ensure they do not fail again.

The opinions expressed here are those of the author, a columnist for Reuters. 

Related columns:

- Oil traders shun WTI amid continuing concerns about delivery (Reuters, May 13)

- Oil futures markets need more transparency (Reuters, May 1)

- Extreme volatility raises questions over WTI (Reuters, April 24)

- Price plunge casts doubt over future of U.S. crude futures (Reuters, April 21)

Editing by Jan Harvey

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