25 March 2010, 6:15 p.m. EST
By Kitco News

Washington (Kitco News) --Position limits can serve multiple functions in futures markets and don’t need to be considered a one size fits all type of regulation.

Mike Masters, managing member and portfolio manager of Masters Capital Management told a U.S. Commodity Futures Trading Commission panel on possible trading curbs in metals futures markets on Thursday that position limits can be used to both prevent manipulation and excessive speculation.

In written testimony Master said limits can be imposed to reduce the potential threat of market manipulation by simply limiting position size for traders who might want to have greater influence. Secondly, capping positions could prevent speculators as a whole from having a greater percentage of the total open interest than commercial entities. “The goal is not the restraint of any one trader, but rather an overall reduction in speculation to remove the potential for consumable commodities derivatives markets to experience speculative price bubbles,” Masters wrote.

To mitigate the threat of manipulation, he said, regulators should put the cap of individual positions “at a specified percentage of open interest. This will ensure a minimum number of market participants, while limiting the ability of any single participant to manipulate prices.”

To prevent excessive speculation, this group of investors should not represent more than 50% of the open interest as to not “dominate the price discovery function,” he said.

In using the term “consumable commodities” Masters differentiates between commodities like food and energy – he lumps copper in this category, too – and commodities like gold and silver, which he says can be used as a financial instrument. It’s this difference where regulators need to be nimble. Consumable commodities can be susceptible to both manipulation and excessive speculation, he said.

He suggested markets dominated by physical producers and consumers do not experience speculative price bubbles, but that the derivatives markets for consumable commodities are suffering now from excessive speculation. He said the average commodity market was 25% speculative as a percentage of the open interest in 1998, but by 2008 65% was made up of speculators. “Every man, woman and child in America suffered unnecessarily due to the 2008 bubble in oil prices,” he wrote.

Gold and silver are considered more investments than consumables, so their regulation should differ, he said. The type of regulation for these markets should focus on preventing manipulation.

Lastly, he also deemed passive speculation, sometimes called index investing, as “an invasive species” to the futures markets. “This strategy is completely blind to the supply and demand realities in the market… (which) actually destroy the price discovery function,” he said.

--By Debbie Carlson, contributing to Kitco News