Position limits are being proposed as a way to protect against “excessive speculation” and prevent large positions that could cause unwarranted cost increases to consumers around the world. Professor Craig Pirrong of the University of Houston says that new limits being proposed could ironically have the exact opposite effect.

How will the regulatory chess match surrounding position limits play out?

With the comment period on the Commodity Futures Trading Commission’s (CFTC) proposed rule set to close, we will soon know more. But taking a deeper look at the current proposal and the perceived issue reveals that we may be looking at a solution in search of a problem.

According to the CFTC’s website, the intended purpose of position limits is to “protect futures markets from excessive speculation that can cause unreasonable or unwarranted price fluctuations.”

In modern derivatives markets, much speculation takes place through pools that aggregate large numbers of individual speculators. If regulations constrain these pools, the pools could not fully exploit their economies of scale and they would incur higher costs. This would raise the cost of speculation by small investors, which would effectively reduce the amount of speculation they undertake. A regulation intended to constrain the big would actually constrain the small.

The CFTC’s currently contemplated limits would set maximum position size as a percentage of open interest. Therefore, permissible individual position sizes in big markets (e.g., crude oil) would be larger than those in smaller markets (e.g., wheat). But scale economies relate to absolute size, not percentages of total market size. Consequently, the kind of constraint under consideration would have a much smaller effect on the amount of speculation in big markets than in small markets, regardless of the elasticity of speculation with respect to transaction cost.

In his recent book, The Big Short, author Michael Lewis describes how a handful of traders bet against the real estate bubble. If such a bubble exists, we want people to lean against it. But position limits, and those based on concentration in particular, would constrain just that kind of contrarian trading. So if you worry about bubbles driven by mass speculation, position limits would do little to restrict the “flash mob,” and would make it harder for those not suffering from the popular delusion to trade in ways that limit the price distortions resulting from it.

To its credit, the CFTC has set out specific ways in which large, concentrated positions can inefficiently destabilize markets. These circumstances could be described as a “Hunt brothers scenario,” in which a levered player takes a large concentrated position in a market. As the events leading up to 1980’s Silver Thursday illustrate, such a leveraged player may be forced to liquidate, and the liquidation of such a large position can cause extreme price moves and, perhaps, pose a systemic risk.

This indeed presents a dangerous situation, but the CFTC in its position limits proposal does not identify any other ways in which large positions can cause “unwarranted” price fluctuations, which is the root of its position limit mandate. In other words, the major problem with the proposed position limits is that they are over-inclusive – they would constrain the trading of many market participants who in no way pose the dangers of a neo-Hunt situation.

The proposal would particularly hinder trading by exchange-traded funds and pension funds, in which trades are driven by the decisions of large pools of investors and function far differently than a single trading entity like the Hunts. Over-the-counter (OTC) market making – a legitimate activity – would feel the pinch as well. OTC deals (hedged by exchange transactions) are often the most economical way for some market participants to take on the investment or speculative positions they desire, and there is no reason to penalize this activity.

By limiting liquidity, the proposed rule threatens to exacerbate large price moves in response to shocks. Prices have to move more in less-liquid, less-flexible markets in order to accommodate big shocks, so stifling liquidity would be counterproductive. Moreover, position limits could drive business into the physical markets, which would distort the prices producers receive and consumers pay. Again, this would pose an unintended consequence, since the alleged purpose of the limits is to prevent and diminish such distortions.

Ironically, the oft-evoked sentiment that speculation caused the price spikes of 2007-2008, or that it is causing the current run-up in commodity prices, is not explicitly addressed in the CFTC’s current proposal. More important, though, I fear the proposal on the table would impede legitimate conduct that poses none of the risks the CFTC believes warrant regulation.

A replacement rule, if ultimately deemed necessary, should target the specific ill the CFTC identifies. Otherwise, we will be quaffing down a “cure” for a malady before the practitioners have pinpointed a diagnosis.

Dr. Craig Pirrong is a professor of finance at Bauer College of Business of the University of Houston and serves as energy markets director of the school’s Global Energy Management Institute.