On January 13, 2011, the Commodity Futures Trading Commission ("CFTC") held its ninth public meeting to consider proposed rulemakings implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. The CFTC approved for public comment proposed rules addressing:

  • Position limits for physical commodity derivatives, and
  • Swap trading relationship documentation for swap dealers and major swap participants.

The following is based on the discussion at the CFTC's public meeting and related material published by the CFTC. Public comments on both proposed rules are due 60 days after publication in the Federal Register. As of the preparation of this briefing, the proposed rules have not been published in the Federal Register.

Position Limits for Physical Commodity Derivatives

In one of the most contested Dodd-Frank proposed rulemakings to date, the CFTC approved proposed rules establishing phased implementation of speculative position limits for 28 exempt (energy and metals) and agricultural commodity futures and option contracts (the "core referenced futures contracts")1and their "economically equivalent" swaps (together, the "referenced contracts").2 The proposal was first considered during the Commission's December 16, 2010 meeting, but action was abruptly delayed due to Commissioner concerns.

Although the proposed position limit rules were approved by a 4-1 vote, during the meeting Commissioners expressed continued concern about the lack of data relating to swap markets, the potential impact of position limits on liquidity, the absence of reliable economic analysis tying speculation to market impact, and the fact that the proposed rules do not consider the possibility of setting different position limits for different classes of traders. In support of the proposal, Chairman Gensler indicated that its implementation would prevent excessive speculation and manipulation in the derivatives markets.

Phased Implementation

The proposed rules would establish position limits for the referenced contracts over time to enable the Commission to gather data on physical commodity swaps. Because designated contract markets ("DCMs") currently set spot-market limits based on estimates of deliverable supply, the Commission believes spot-market limits can be implemented expeditiously. Accordingly, the Commission proposed an initial "transitional" phase where the Commission would establish only spot-month position limits for the referenced contracts. The Commission proposed to defer imposition of non-spot-month limits based on open interest levels until after it gathers additional position data concerning physical commodity swaps.3 Collection of relevant data is expected to commence during the third quarter of 2011, and the specific limits will be established by order anticipated to occur during the first quarter of 2012.4

Spot-Month Position Limits

The proposed rules would establish spot-month position limits set at 25% of estimated deliverable supply, as determined by the Commission, for the 28 core referenced futures contracts. During the transition phase, the limits would be set at current levels determined by DCMs (the levels are identified in Appendix A of the proposed rule). The limits also would apply on an aggregate basis to economically equivalent derivatives, including futures, options and swaps that are price-linked to a core referenced futures contract or that settle on the price of the same commodity at the same delivery location.

The proposed regulations establish separate spot-month position limits for physically-delivered contracts and cash-settled contracts, allowing a trader to hold up to the established limit in both. The proposal also includes a conditional spot-month limit that, under certain conditions, allows traders with positions exclusively in cash-settled contracts to hold positions at levels five times the spot-month limit.

Non-Spot-Month Position Limits

During the second phase of implementation, the Commission would institute non-spot-month position limits for each referenced contract based on a percentage of the overall open interest in a market. The proposed regulations establish a so-called "10, 2.5% formula" for setting non-spot-month position limits, pursuant to which a single trader could hold no more than 10% of the open interest in a market up to the first 25,000 contracts and no more than 2.5% thereafter.

The limits would apply both in the aggregate and to two "classes" of contracts: all listed futures and options and all swaps. The proposed framework thus creates six possible non-spot-month position limits: 1) listed futures and options single-month; 2) listed futures and options all-months-combined; 3) swaps single-month; 4) swaps all-months-combined; 5) aggregate single-month; and 6) aggregate all-months-combined. Netting of positions would be permitted under certain circumstances. Nonspot- month positions limits will be set annually by the CFTC.5

Exemptions

The proposed rules provide exemptions for positions established in good faith prior to the effective date of the proposed regulations and for bona fide hedging transactions and positions. The proposal amends the Commission's current definition of a bona fide hedge for the purposes of obtaining a position limit exemption, consistent with the new, narrower statutory definitions. Under the proposed rules, a transaction would be considered a bona fide hedge only if, among other requirements, it represents a substitute for transactions made or to be made in a physical marketing channel. In addition, the proposed regulations provide an explicit exemption for transactions that reduce the risk of a swap position, so long as the swap counterparty would have qualified for a bona fide hedging exemption or the position offsets a swap that qualifies as a bona fide hedging transaction.

Account Aggregation Standards

The proposal includes broad new account aggregation standards requiring the aggregation of positions of all entities that share a 10% or greater common ownership interest. Similarly, all accounts under the direct or indirect control of a trader would be required to be aggregated as well as positions held by two or more traders acting pursuant to an express or implied agreement.

Limited exemptions from the aggregation requirements are provided, including an exemption allowing entities to disaggregate the positions of an independently controlled and managed trader that is not a financial entity. Commission approval would be required to operate under an account aggregation exemption with the applicant bearing the burden to demonstrate that the owned non-financial entity's trading is independently controlled and managed. Financial entities are not eligible for similar relief.

The proposed regulations include a list of factors that indicate an owned non-financial entity is independently controlled and managed. The factors include lack of knowledge of trading decisions among affiliates, trading decisions being exclusively controlled by the owned non-financial entity, written policies and procedures which preclude the sharing of such information and separate risk management systems.

Position Visibility Reporting

The proposed regulations create a position visibility reporting regime in the markets for referenced base and precious metals and referenced energy contracts. The visibility reporting rules, which are similar to current reporting obligations for large bona fide hedgers, are designed to provide the Commission with better information concerning the positions of large traders in those markets.

Under the proposal, all traders exceeding established visibility levels would be subject to reporting obligations, including requirements to submit additional information to the CFTC regarding cash market and derivatives activity. The Commission anticipates approximately 30 unique owners being subject to the visibility levels established for the NYMEX Light Sweet Crude Oil and Henry Hub Natural Gas contracts and 20 unique owners being subject to the visibility limits applicable to other contracts.

Surveillance Directive

In December 2010, in response to the urging of Commissioner Chilton to establish interim "position points," Chairman Gensler directed the CFTC staff to identify large traders with positions in the futures markets above the 10% and 2.5% position levels set out in the proposed position limit rules and to collect additional information from those traders, including information about positions held in economically equivalent swaps. Chairman Gensler indicated that this new surveillance procedure would help the CFTC better understand the market and instructed the CFTC staff to report its findings to the Commission monthly during its regular market surveillance meetings.

During the January 13th meeting, Chairman Gensler and Commissioner Dunn engaged in a colloquy regarding the surveillance directive, during which Chairman Gensler stated that the surveillance was consistent with the CFTC's current market surveillance practices. Under questioning from Chairman Gensler, the CFTC's General Counsel, Dan Berkovitz, stated his opinion that the surveillance directive is consistent with the requirements of the Commodity Exchange Act ("CEA") and the Administrative Procedures Act. Chairman Gensler noted that the procedure would not be a "substitute" for position limits and would not automatically trigger additional regulatory action. Commissioner O'Malia expressed concern about the new surveillance procedure and asked several questions concerning the status and implementation of the directive and the circumstances under which the Commission would order the liquidation of positions. General Counsel Berkovitz, in response, indicated that the surveillance directive did not establish official Commission policy, only internal policy, and that the liquidation of positions would occur only under emergency circumstances, as set forth in the CEA.

Documentation Standards for Swap Dealers and Major Swap Participants

Under the authority provided in section 731 of Dodd-Frank, which adds a new section 4s to the CEA regarding the registration and regulation of swap dealers and major swap participants, the CFTC unanimously adopted a proposed rule prescribing documentation standards for all trading relationships that swap dealers and major swap participants enter into among themselves or with any other counterparties. The proposed rule also will require swap dealers and major swap participants to obtain documentation from any counterparty seeking to exercise the end-user exemption.

Trading Relationship Documentation

The proposed rule creates rather substantial documentation obligations for swap dealers and major swap participants with respect to their swap trading relationships. Specifically, swap dealers and major swap participants would be required to establish policies and procedures that ensure that, before they enter into any swaps with counterparties, the parties have agreed in writing to all terms governing their trading relationship, such as credit support arrangements (e.g., initial and variation margin requirements and custodial arrangements).

Swap dealers and major swap participants would also be required to maintain written documentation on the methods, procedures and inputs that will determine the value of each swap from the time of execution to the end of life of the swap. Although the rules do not prescribe a specific valuation method, they require that the agreed-upon procedures and inputs must establish a complete and "independently verifiable" methodology for valuing each swap executed between the parties. Moreover, the methodology must include alternative methods for valuing the swaps should the methodology's inputs become unavailable or fail (e.g., during times of market disruption or illiquidity). Finally, if valuation disputes are not resolved within the established timeframe, swap dealers and major swap participants would be required to notify the CFTC.

The required documentation must address insolvency-related defaults. Specifically, the documentation must include an agreement that each party will not exercise termination, liquidation or netting rights until the next business day following the insolvency-related default if the defaulting party is subject to an insolvency proceeding under a special resolution regime in which positions can be transferred to a performing third party (e.g., a bridge bank, bridge institution or government institution). Each party would be required to consent to the transfer of swaps to the performing third party before the close of the next business day following the default.

Swap dealers and major swap participants would be required to create certain records whenever they submit a swap to a derivatives clearing organization ("DCO") for clearing. These records include a statement that the original swap was replaced by equal and opposite swaps between the DCO and clearing members in accordance with the DCO's rules. Terms of cleared swaps would be required to conform to templates established by the DCO.

Finally, the proposed rules require annual auditing of the above trading relationship documentation to ensure that the entity complies with its internal procedures and CFTC regulations.

End-User Exemption Documentation

In addition to the trade relationship documentation required above, the proposed regulations require swap dealers and major swap participants to obtain documentation relating to swaps with counterparties that seek to invoke the end-user exemption (click here for additional analysis of the proposed regulations addressing the scope of the end-user exemption). Specifically, if the swap is a type that is normally subject to the mandatory clearing requirement (if not for the end-user exemption), swap dealers and major swap participants must obtain documentation sufficient to provide the swap dealer or major swap participant with a "reasonable basis to believe" that the counterparty meets the statutory end-user definition. How the proposed rule applies this "reasonable basis" standard will be particularly important to the industry. Without clear rules setting forth a swap dealer's ability to rely on documentation submitted by end-users, such entities may be willing only to enter into cleared swaps (or swaps that do not require clearing) with end-users, effectively gutting the end-user exemption. Accordingly, market participants affected by the end-user exemption may want to consider carefully the implications of this rule as soon as it is publicly available.

Chairman Gensler expressed support for the proposed rule because it would establish a regulatory framework that would reduce risk, increase transparency and promote market integrity by establishing procedures that promote legal certainty, allow for early resolution of valuation disputes and increase operational efficiency. He emphasized that the proposed rule addresses valuation disputes that contributed to the credit crisis of 2008 by requiring swap dealers to report the disputes to their senior management and regulators. Commissioner Sommers approved the proposed rule indicating that it is a "critical component to a well-functioning swaps market." In response to Commissioner Dunn's inquiry regarding whether the CFTC had sufficient resources to implement the requirements, CFTC staff indicated that if additional funding is not provided by Congress, the agency may transfer some of its oversight responsibilities to the National Futures Association.

Footnotes

1 The exempt commodities covered by the proposed regulations include, but are not limited to, gold, silver, copper, platinum, crude oil, natural gas, heating oil and gasoline. The covered agricultural commodities include, but are not limited to, corn, oats, rice, soybean meal, soybean oil, wheat, feeder cattle, live cattle, lean hogs, milk, cocoa, coffee, orange juice, sugar and cotton.

2 Under the proposed rule, a swap may be "economically equivalent" to a futures contract when either (1) the price of the swap refers to a covered contract settlement price, or (2) the swap is priced on the same commodity delivered at the same location, or another location, so long as the other delivery location has similar supply-and-demand characteristics as that of a covered contract.

3 The Commission has proposed regulations requiring position reports on economically equivalent swaps from clearing organizations, their members, and swap dealers. Position Reports for Physical Commodity Swaps, 75 Fed. Reg. 67,258 (2010).

4 The proposal also includes new requirements and standards applicable to position limits and accountability levels established by registered entities.

5 In addition to the described limits, the CFTC proposed application of legacy position limits for certain referenced agricultural commodities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.