In the wake of unusually high volatility and negative prices in the light sweet crude oil futures contracts (WTI) for delivery in May, the U.S. Commodity Futures Trading Commission (CFTC) has spoken out against pricing fluctuations. The public statement was directed to exchanges, brokers, and clearers with the goal to remind them of their obligations to ensure orderly trading and commodity pricing. The CFTC’s letter, sent on the penultimate day of trading last month, reaffirms all parties’ commitment to the basic obligations in what amounted to an astounding warning to the Chicago Mercantile Exchange (CME). Below is a glimpse into what the CFTC called for and how exchanges are responding to the Covid-19 pandemic.
Principally, the CFTC noted that the coronavirus has significantly disrupted markets and increased volatility across many of the contracts it is responsible for regulating, including agricultural, energy, and financial contracts. In particular, the letter highlighted unprecedented volatility in contracts calling for physical delivery, such as WTI, as a source of special concern and the primary focus for the industry. Specifically, the CFTC reminded futures exchanges they are legally responsible for preventing a host of misconduct covering, “manipulation, price distortion, and disruptions of the delivery or cash-settlement process”, to ensure markets remain competitive and fair by utilizing “market surveillance, compliance, and enforcement practices and procedures”.
Along with volatility concerns, the letter focused on the behavior of market participants and prices in the run-up to contract expiry, warning futures exchanges of their obligation to, “monitor the supply of the commodity and its adequacy to satisfy the delivery requirements”. Exchanges were instructed to make “a good-faith effort to resolve conditions that threaten the adequacy of supplies or the delivery process,” to quell WTI deliverability concerns. In response to blaming volatility on the inability to make physical deliveries of oil, exchanges were ordered to establish position limits and accountability levels to prevent market manipulation and blockage at the delivery point. In sum, the CFTC directed exchanges to tailor contracts to be fit for purpose, with a sufficient capacity to make or take delivery, while imposing restrictions on overt manipulation.
The letter reminds futures commission merchants (FCMs) of their obligation to maintain effective risk-management systems associated with their clients’ role in futures contracts, with the purpose of protecting customer funds. Brokers are instructed not to allow customers to run positions close to expiry by requiring them to monitor positions as a contract gets closer to the expiration date to ensure customers meet their financial obligations and make timely delivery. The decision to restrict trading to the liquidation of existing positions, and some FCMs prohibiting smaller customers from opening new positions, reflects a concern about the rise in volatility and risks arising from the Cushing Oklahoma delivery point bottleneck. The warning aims to facilitate limited trading by smaller customer accounts in near expiry WTI contracts.
Despite the well-known potential for volatility in the run-up to expiry, many futures contracts remained open for delivery near the expiry of May, which caused a rush that contributed to congestion and worsened volatility. Futures contracts are supposed to have multiple layers of protection to ensure their smooth operation in maintaining position limits that prevent large numbers of positions being taken close to expiry under active monitoring. This is where FCMs and other intermediaries come in, whose job it is to dissect their customers’ intention and ability to take physical delivery while keeping purely financial traders from expiry. Even with several layers of protection, the system failed last month as risky oil investments crashed the market. Hopefully the CFTC’s letter pushes industry leaders to reinforce those protective layers to ensure they don’t fail again.