The spectacular collapse of the $9 billion Amaranth Advisors hedge fund in September, 2006, sparked a debate that continues to rage in U.S. regulatory circles: should electronic over-the-counter markets like the Intercontinental Exchange (ICE) enforce position limits that prevent traders from taking on excessive risk?

It is not an idle question. The New York Mercantile Exchange (NYMEX), ICE's chief competitor in the energy derivatives market, has just those limits. In fact, according to some reports, NYMEX contacted Amaranth one month before the blow-up and "encouraged" them to reduce their bets on the natural gas market. Amaranth did so at the NYMEX, but they pressed their bets on the ICE, and ultimately, that cost them.

Should the ICE have had similar limits? Or did the financial system work just like it's supposed to? That's a debate that continues to play out in the halls of regulators like the Commodity Futures Trading Commission (CFTC), and increasingly, in the hall of the U.S. Congress itself.

The outline of the debate follows.

Betting Big

The story of Amaranth is familiar to most investors. The popular hedge fund had a star energy trader, Brian Hunter, who made a fortune for investors betting on natural gas futures in 2005, in the aftermath of Hurricane Katrina. But Hunter pressed his bets in 2006.

The exact details seem so mundane. Hunter made a bet - using 8X leverage - that the spread between March and April futures for 2007/2008 would widen. Why? I'm sure he had his reasons. But whatever they were, they were wrong ... way wrong. Between August and September 2006, the spread between the March and April 2007 contracts tightened sharply, from $2.40/contract to just $0.58/contract.

The result? Amaranth lost $6.5 billion, with a "b." The fund dropped 65 percent of its value in a few weeks; it was forced to liquidate its trading portfolio; and it later shut down. (A much smaller fund, MotherRock, shut down in August 2006 for similar reasons.)

To put those losses in perspective: $6.5 billion is substantially more than the $4.6 billion that Long-Term Capital Management lost in 1998.

As with any major hedge fund collapse, the spectacular implosion of Amaranth raised calls for increased regulation and oversight. In this case, those calls focused on a single question: Should Hunter have been allowed to make such large trades in the first place?

Trading Restrictions or Laissez-Faire?

As mentioned, there are two major energy derivatives exchanges operating in the U.S. (and indeed, the world): the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE). The two firms could not be more different.

The NYMEX is the old-line firm, tracing its roots back to the late-1800s, when a group of dairy farmers got together and founded the Butter and Cheese Exchange of New York. That later morphed into the NYMEX, which grew into the largest physical commodities exchange in the world. Until earlier this year, it was the only place U.S. investors could trade crude oil contracts, the most liquid energy contract in the world.

The ICE, by contrast, is the fast-moving upstart. The firm only officially launched in 2000, but its business plan of offering fast, electronic-only trading has helped it grab market share hand-over-fist. The firm now challenges the NYMEX for title of "largest energy derivatives market in the world." It is in the process of acquiring the New York Board of Trade (NYBOT), a move which will push it into agricultural commodities as well.

Those different histories and different market structures place NYMEX and ICE under different regulatory regimes.

NYMEX, as a traditional U.S. derivatives exchange, is subject to regulation by the U.S. Commodity Futures Trading Commission, or CFTC - the derivatives equivalent of the Securities and Exchange Commission.

ICE entered the energy markets in 2001 when it acquired the UK-based International Petroleum Exchange (IPE). Although the company is based in Atlanta, GA, IPE's legacy as a British exchange means that it is regulated by the UK's Financial Services Authority (FSA), and not the CFTC.

Furthermore, ICE is mostly considered an "over-the-counter market," and not a traditional "exchange," meaning it is largely exempt from any oversight by the CFTC at all.

The differences in the regulatory burden are sharp. At the NYMEX, traders are required to keep five years worth of reports, and they must report large trading positions to the CFTC. In addition, the group places limits on the size of those positions; in the case of the natural gas futures, NYMEX limits traders to holding 12,000 contracts at any given time (worth about $600 million at current prices.)

ICE is subject to no such audit requirements, and no such position limits.

In other words, some contend, Hunter would have had a much harder time losing $6.5 billion on the NYMEX, as the position limits would have prevented him from making such a large bet, and the required reporting would have alerted regulators to the risk.

Beyond that, some say that the lack of an audit trail on ICE has encouraged rogue speculators like Hunter to move into the market - something they wouldn't do if ICE was subject to the reporting requirements of the NYMEX.

Calls For Reform

In the wake of Amaranth, calls went up quickly calling for an overhaul of the regulatory regime.

The CFTC "has avoided analyzing trade and data on these markets and has allowed companies like MotherRock and Amaranth to accumulate huge holdings that wouldn't be permitted on a U.S.-regulated exchange," said Michael Greenberger, a law professor at the University of Maryland and a former regulator with the Commodities Futures Exchange Commission, in an interview with the Associated Press.

California Senator Dianne Feinstein quickly filed a bill on September 27, 2006, called the Oil & Gas Trader's Oversight Act (S.2642), which would apply the same oversight given to traditional futures exchange to new over-the-counter operations like ICE. The senator vowed to push the legislation forward once Democrats take control of the Senate in January 2007.

"The market has to have the same standards throughout regardless of how trading is done," she Feinstein, in a New York Times article. "To create trading loopholes is to allow chicanery."

The Flip Side

Would position limits and reporting requirements have limited Hunter's ability to place such large bets? Possibly.

But does that mean position limits are a good thing?

That's a harder question to answer. Unlike previous hedge fund debacles, such as Long-Term Capital Management, there was no broad-based fallout from the Amaranth implosion. Sure, there were losses by investors - that's what happens on Wall Street - but the system was threatened, and few companies or institutions were destroyed (although Refco shareholders would disagree). And of course, any limit on the size of positions makes Wall Street that much less efficient, and that much less free.

It's a tough balance to find, but that, in the end, is what regulation is all about.

Interest in position limits has faded a bit as Amaranth stories fade deeper into the news archives. But it's sure to rev up again once Democrats take control on Congress in January.

Should there be position limits on our derivative exchanges, or should investors be able to risk their money as they see fit? It's definitely one of the hot topics in the industry today.

For another perspective on the question of OTC markets, regulation and position limits, see page 22 of this FTSE Global Markets magazine.