WEEKLY COMMENTARY

August 27, 2002

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Speculative Position Limits

By Theodore Butler

This is a follow-up to the recent letters and e-mail exchanges with the CFTC and the COMEX regarding my allegations of manipulation in the silver market. It seems that, no matter how hard I try to solicit response to my very specific allegations, the CFTC and COMEX dance around the issue. Since I consider this the most important matter currently impacting the price of silver, I thought I might expand on this issue of speculative position limits. What are they, why do they exist, and what do I think is wrong with COMEX silver speculative position limits.

As the term clearly states, the purpose of this body of commodity law is to limit the size of the positions that speculators may hold in any regulated futures market. (Silver is such a regulated futures market). This is not meant as discrimination against speculators, but to ensure that the key reason that futures markets exist, is not compromised. Although some may think that the futures industry is just a form of legalized gambling, serious students of the market know that the real economic purpose for futures markets is to allow hedging - the transfer of price risk away from real producers and users to those who willingly accept that risk, speculators. It is this principal of risk transfer that stands behind the futures markets, much like the principals of risk-sharing that legitimatize the insurance industry. It takes two to tango, and without speculators, the futures market could not exist. Without speculators, the real producers and users would have no one to transfer their price risk to.

Yet, even allowing for the necessity of speculators as a prime ingredient in the market equation, a strong component of commodity law has evolved over the past 100 years, that seeks to control the influence that speculators can exert on prices. That component is speculative position limits. Here's the reasoning why this has evolved - real producers and users must invest much capital and time and effort to develop and run real businesses. In our free market economy, it is the law of supply and demand that must determine prices, and our entire economic body of law seeks to make illegal anything that would constrain trade and hinder or artificially influence prices. No one would argue with the principals of this economic legal process.

In commodity futures trading, because of the leverage created by the requirement of only a small down-payment, or margin, it is easy for a speculator with a large pool of capital to deal in quantities that would dwarf the quantities that real producers and users dealt in. This was true a hundred years ago, and is more true today. Common sense should tell you that whoever dealt in bigger quantities, would have a bigger influence on prices. That's just the law of the world. Therefore, a mechanism had to be created in order to insure that speculators didn't deal in larger quantities than did the real producers and users. The framers of commodity law came up with the no-nonsense solution of speculative position limits - set a definitive and logical actual limit on how many contracts any one speculator could control at any time, net long or short. That solution has stood the test of time, and exists to this day. Both the CFTC and the COMEX, by their very own words, embrace speculative position limits to be a cornerstone, or even, the cornerstone to commodity trading regulation. Unfortunately, while their words about speculative position limits are fine, their actions and deeds are leave a lot to be desired.

Here's my gripe - While the CFTC and COMEX proclaim and embrace the importance of speculative position limits, in general terms, they both allow the law to be violated when it comes to COMEX silver futures. How so? By allowing the COMEX insiders to set speculative position limits at such absurdly high limits, the COMEX has been able to evade the law requiring such limits in regulated commodities. Let's face it - limits are supposed to limit, or restrict, otherwise why have them at all? We wouldn't tolerate a speed limit in an elementary school zone of 100 mph. We would see immediately that the limit was set so high as to be counterproductive. Worse, in the case of COMEX silver speculative position limits, not only are the limits set at the equivalent of a 100 mph speed limit in a school zone, there is no enforcement even when the 4 or less traders break that limit by double. Please hear me out.

If speculative position limits are designed to limit the price influence that speculators exert on prices, such limits must be set in relation to what real producers and consumers make and use in the real world. Quite simply, this means that speculators must not be allowed to control more than the quantities of what AVERAGE-SIZED real producers and users deal in. I've added the emphasis of "average-sized" because commodity law is incredibly clear on this point. Commodity law intends for speculators to be limited to no more than what average-size producers and users make and use, by specifically including, in the law, exemptions to speculative position limits by bona-fide hedgers. The law further spells out, in incredibly clear language, just what constitutes an exemption to the speculative position limits by a bona fide hedger, namely, such a hedger could hold more than the rigid existing spec position limits, but only up to 12 months' production or consumption, or existing inventory. In essence, the framers of commodity law were so smart and logical, that in allowing an exemption from speculative limits by bona fide hedgers, that they still set a limit on these exempt hedgers. The framers of commodity law did not want anyone to have the ability to go long or short in unlimited quantities, because they knew that anyone having the power to buy or sell in unlimited quantities would, by definition, manipulate prices. The framers of commodity law, must be rolling in their graves, over how the 4 or less COMEX insiders have distorted and evaded that law.

The mechanism that the COMEX insiders used to circumvate the clear intent of commodity law, was the passage, some 10 or 15 years ago, with the full approval of the CFTC, of a new type of speculative position limit for silver and other commodities traded on that exchange. Out went the old limits (which were too high anyway) and in came something known as "accountability" limits. To this day, I don't know what that word means. All I know is that the accountability limit is 7500 contracts (there is a seperate 1500 contract limit in the spot delivery month). 7500 contracts is equal to 37.5 million ounces. It is equal to a 100 mph school zone speed limit. You can count on one hand the number of producers AND consumers, combined, who make or use that quantity annually. An accountability limit of 37.5 million ounces limits no one. It gives speculators (especially the New York dealers) complete dominance over real world producers and consumers. It isn't even close to what commodity law intends.

Worse, according to the COTs, this no-limit limit of 37.5 million ounces isn't even observed by the 4 or less traders. They held 260 million ounces net short recently, for an average (if there were really 4, and not less traders) of 65 million ounces each, or 13 thousand contracts. These traders were driving 180 mph through the school zone, and the regulator state troopers from the CFTC and the COMEX didn't blink an eye.

What would compromise legitimate speculative position limits in COMEX silver? Well, if you look at representative silver producers, such as Coeur d'Alene, Hecla and Pan American silver, their annual production runs between 8 and 15 million ounces a year. They're not the largest producers of silver in the world, but they are much more than average-size producers. This can be a discussion for reasonable people, but commodity law would dictate that no one speculator should have more price influence on silver than any of these miners. Therefore, a 5 million ounce speculative position limit, or 1000 COMEX contracts, would seem to be a reasonable limit. This is the limit I siggested in my first letter this year to the Chairman of the CFTC, on Feb 12. Remember, larger producers and consumers can get an exemption to to the 1000 contract limt, if they want. Let's be honest - allowing, as current "limits" do, speculators to hold positions many, many times larger than the above mentioned miners, is nuts and against everything in commodity law.

Anyone who can buy and sell in unlimited quantities of futures contracts controls the price. Period! That's why commodity law dictates speculative position limits. Setting speculative position limits so high, as to not limit anyone, is a cheap end run-around the law. The CFTC and COMEX must stop dancing around this issue and institute and enforce legitimate speculative position limits in silver.

E-mail addresses:

Neal L. Wolkoff, Executive Vice President N.Y. Mercantile Exchange – nwolkoff@nymex.com

Michael Gorham, Director of Market Oversight, CFTC – mgorham@cftc.gov

(This essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)