ANALYSIS-CME, ICE brace for renewed fight on esoteric trading rule

Tom Polansek and Ann Saphir
Thursday, 7 Nov 2013 | 2:56 PM ET

* Highlights regulatory fallout, years after financial crisis

* May be a sign of bigger wars to come between futures-exchange titans

* CME's Duffy vows not to "stand idly by"

* Differences between physical and cash-settled contracts in spotlight

CHICAGO/SAN FRANCISCO, Nov 7 (Reuters) - CME Group Inc and the IntercontinentalExchange Inc are gearing up to revisit a high-stakes battle in an obscure corner of commodities rule-making, highlighting the fallout still emerging from Washington five years after the financial crisis.

As ICE prepares to complete its $10 billion takeover of NYSE Euronext, one of the transatlantic giant's first orders of business may be to defend the advantage gained from one aspect of new U.S. rules meant to limit speculation in raw materials.

CME Executive Chairman Terrence Duffy for his part is already taking aim, on Thursday calling the decision to reinstate so-called conditional position limits "the most absurd thing I've ever heard in my entire life."

At issue is a proposal earlier this week from the U.S. futures regulator to apply much weaker curbs on trading in commodity contracts that are settled in cash rather than with delivery of the physical commodity.

What the Commodity Futures Trading Commission's proposal leaves unsaid - but which has not gone unnoticed by CME and ICE, the two titans of world futures trading - is that at least in energy-related contracts, CME primarily deals in physical contracts, and ICE deals in cash-settled ones.

On Tuesday, the CFTC relaunched its plan to cap the number of contracts that a single trader can hold in energy, metal and agricultural markets. The initial proposal, put out two years ago, was vacated by a court in 2012.

While most aspects of the rule are unaltered, the new plan includes an exception that allows traders to hold five times as much of a cash-settled contract as of a physically settled contract.

"This is a big issue for CME Group," CME's Duffy said at a futures industry conference in Chicago. "I think this is something that we will obviously not stand idly by."

He did not quantify the potential loss of liquidity for CME's New York Mercantile Exchange, where energy contracts are traded, if conditional limits are implemented.

An ICE spokeswoman declined to comment.

The brewing battle may be a sign of far bigger wars to come as the two behemoths vie for dominance in all areas of the lucrative derivatives markets. The two also compete head-to-head in clearing over-the-counter derivatives, a $600 trillion business that in the years since the financial crisis has become subject to much more rigorous regulation.


Energy trading is only one part of both exchanges' vast business, but still brings in millions of dollars a day in revenue for both ICE and CME, based on figures in their earnings reports.

Cash-settled contracts, the reasoning goes, are less susceptible to manipulation than contracts that are filled by a delivery of 10,000 million British thermal units of natural gas, or a load of silver.

In the past, traders have tried to buy up raw materials to illegally inflate futures prices; cash, on the other hand, cannot readily be hoarded.

ICE's WTI crude oil contract, settled in cash but otherwise identical to CME's contract, now routinely accounts for about one-fifth of the total trade in WTI-linked contracts. ICE's U.S. natural gas swap, which is cash-settled, is also a major competitor to NYMEX's Henry Hub contract, which is paid with delivery of the gas.

CFTC Chairman Gary Gensler said Wednesday that he felt "very good" about the proposed rule, which may be his last before his term at the agency expires in January. The CME's position "is just one comment," Gensler said.

But some saw signs of potential compromise.

In its 459-page proposal, the regulator said it believes the looser standards for cash-settled contracts would not affect the price discovery that takes place in the physically settled contracts, but it also asked for additional industry comment on the issue.

"I consider that telling: There's a good possibility they might eliminate this exemption" or reduce the gap between the rules for cash-settled and physically settled contracts, said Tabb Group analyst Neeraj Batra. Still, he said, the logic behind having a gap is "somewhat rational."


CME fought - and mostly won - this battle before, after the CFTC put out its initial version of the anti-speculation curbs more than two years ago. In the face of vehement opposition from CME, CFTC rolled back its planned exemption for cash-settled contracts to cover just natural gas, rather than the broader group of contracts it wanted to cover.

Now the CFTC again wants separate, higher limits for a broad range of cash-settled commodity futures.

In the end, this battle may turn out to be a tempest in a teapot. After all, the CFTC's plan to curb commodity speculation actually imposes looser standards than CME already enforces in its own markets.

And CME's physically settled contracts have a natural advantage because traders need them for price discovery. Cash-settled contracts can stray from real-world prices, making them of little value if they are not somehow tied to the underlying commodity, as ICE's contracts are to CME's.

Still, the coming battle is bound to be fiercely fought, as it was during the last go-round.

(Editing by Matthew Lewis)

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