The Commodity Futures Trading Commission has issued proposed
rules that would substantially modify the position limit and
position accountability rules that currently apply to the trading
of various agricultural, energy and metals derivative products. The
proposed rules were originally considered at the CFTC's public
meeting on December 16, but were not brought to a vote at that time
due to concerns expressed by the Commissioners. At the January 13
public meeting, the Commissioners voted in favor of publishing the
proposed rules; however, Commissioner Sommers dissented, while
Commissioners Dunn and O'Malia both expressed reservations
about the adoption of the proposed rules.
Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (Dodd-Frank) requires the CFTC to establish
federal speculative position limits for both "exempt
commodities" (including energy and metals products) and
"agricultural commodities" (which would include the
agricultural products for which the CFTC has historically set
position limits, as well as an expanded range of agricultural and
"soft" commodities). To implement these new requirements,
the CFTC proposes to withdraw its Part 150 Regulations, which set
out the CFTC's current position limit and aggregation policies,
and replace them with a new Part 151. Among the changes that would
be effected by the CFTC's proposed regulations are the
following:
- Phased implementation of aggregate speculative position limits
for derivatives (including futures, options and swaps) on specified
commodities across trading venues.
- Modifications to the "bona fide hedging" exemption
from position limits, including its applicability to swap
dealers.
- Expanded position visibility and aggregation requirements,
including the elimination of the "independent account
controller" exemption.
New Position Limits
As revised by Dodd-Frank, the Commodity Exchange Act (CEA)
mandates that the CFTC establish federal position limits for
futures and options contracts traded on designated contract markets
(DCMs) within 180 days (in the case of contracts on exempt
commodities) or 270 days (in the case of contracts on agricultural
commodities) after Dodd-Frank's enactment. In addition, the
Dodd-Frank amendments require the CFTC to establish aggregate
position limits for other derivatives on such commodities that
would include, in addition to the futures and options contracts
described above: (i) swaps that are traded on a DCM or swap
execution facility (SEF); (ii) swaps that are economically
equivalent to DCM-traded futures or options contracts that are
subject to position limits; (iii) swaps not traded on a DCM or SEF,
but which are determined to perform or affect a "significant
price discovery function"; and (iv) foreign board of trade
(FBOT) contracts that are price-linked to a DCM or SEF contract and
made available via direct access from within the United
States.
To implement this expanded mandate under Dodd-Frank, the CFTC
proposal identifies 28 "core" physical delivery futures
contracts in proposed Regulation 151.2 ("core referenced
futures contracts"),1 and would apply aggregate
limits on a futures equivalent basis2 across all
derivatives that are (i) directly or indirectly linked to the price
of a core referenced futures contract, or (ii) based on the price
of the same underlying commodity for delivery at the same delivery
location as that of a core referenced futures contract, or another
delivery location having substantially the same supply and demand
fundamentals (such derivative products are collectively defined as
"referenced contracts").3 In response to
concerns that the CFTC lacks sufficient data about the physical
commodity swap markets to implement aggregate non-spot-month
position limits for all markets, the CFTC proposal contemplates a
phased implementation of the new position limit requirements for
referenced contracts, as further described below.4
Spot-Month Limits. The CFTC proposes to impose aggregate
spot-month position limits for physical delivery referenced
contracts at a level equal to 25% of estimated deliverable supply,
consistent with current CFTC policy. During the initial
implementation phase, the limits for referenced contracts would be
set at the level determined by the applicable DCM to be equal to
25% of estimated deliverable supply, and would be reset annually.
In the second phase of implementation, the limit levels would be
based upon the CFTC's determination of estimated deliverable
supply (which could be based on DCM-provided estimates or the
CFTC's own estimates).
For cash-settled contracts, the CFTC proposal would implement a
conditional spot-month limit equal to five times the spot-month
limit for the corresponding physically settled contract. In order
to qualify for the conditional limit, a trader must not hold (i) a
position in excess of the applicable single-month (non-spot)
position limit for such cash-settled contract; (ii) any spot-month
position in the corresponding physically settled contract; or (iii)
physical or forward commodity positions in the same commodity in
the spot-month that exceed 25% of the estimated deliverable
supply.
Non-Spot-Month Limits. Unlike spot-month limits, the CFTC
does not propose to implement non-spot-month limits for referenced
contracts during the initial implementation phase, but rather
intends to implement such limits only as part of the second phase
of implementation. Under the CFTC proposal, separate non-spot-month
limits would be established for (i) DCM futures and options
contracts (the "futures class") and (ii) cleared and
uncleared swaps (the "swaps class"), as well as (iii) an
aggregate limit across the futures and swaps classes. At both the
class and aggregate levels, the single-month limit would be set at
the same level as the all-months combined limit, and would be
calculated as a percentage of overall open interest in the
applicable referenced contracts. Specifically, the limits would be
set at a level equal to (i) 10% of the first 25,000 contracts of
average all-months combined aggregate open interest, and (ii) 2.5%
of the average all-months combined aggregate open interest in
excess of 25,000 contracts. With respect to the agricultural
commodities that are currently subject to CFTC position limits
under CFTC Rule 150.2, the CFTC proposal would implement legacy
limits equal to the current all-months-combined limits for such
commodities, and would increase the corresponding single-month
limit to equal the all-months-combined limit.
"Bona Fide Hedging" Exemption
Under the CFTC proposal, a new "bona fide hedging" exemption would be created under proposed CFTC Regulation 151.5, and referenced contracts would no longer be subject to the bona fide hedging provisions contained in CFTC Regulation 1.3(z).5 The bona fide hedging exemption under the new rules would be largely consistent with that currently contained in Regulation 1.3(z), with the following exceptions:
- Under the proposed regulations, a position would be recognized
as a bona fide hedge only if it represents a
substitute for a cash market transaction. (Regulation 1.3(z)
recognizes a position as a bona fide hedge if it normally
represents such a substitute.)
- The proposed regulations would explicitly recognize positions
established to reduce the risk of a swap position as bona fide
hedges, provided that either (i) the counterparty to such swap
position would have qualified for a bona fide hedging transaction
exemption (i.e., on a "look through" basis), or (ii) the
risk-reducing positions offset a swap that qualifies as a bona fide
hedging transaction.
The CFTC proposal would establish new application, recordkeeping and reporting requirements for traders relying upon bona fide hedge exemptions. Unlike the position limit rules proposed by the CFTC in January 2010 for energy contracts, the bona fide hedging provisions in the new proposal do not include a "crowding out" provision, which would have limited the ability of a trader relying upon a bona fide hedge exemption or acting as a swap dealer to also establish speculative positions.
Revised Aggregation Requirements
The proposed Part 151 Regulations would also materially modify
the position aggregation rules and exemptions currently embodied in
the Part 150 Regulations. The CFTC proposal would continue the
current practice of evaluating aggregation requirements on the
basis of both ownership and control, requiring aggregation of all
positions in accounts in which a trader either (i) holds a direct
or indirect ownership interest of 10% or more, or (ii) controls
trading, by power of attorney or otherwise. However, the CFTC's
proposed regulations would apply aggregation requirements more
aggressively to investors in pooled investment vehicles than is
currently the case, presumptively requiring aggregation for pool
investors who hold an interest of 10% or more in a pool (without
regard to whether such investors are affiliates of the pool
operator), unless disaggregation relief is available, and requiring
aggregation by pool investors who hold an interest of 25% or more
in a pool (without regard to whether the pool operator is
registered or exempt from registration as a commodity pool
operator) with no possibility of disaggregation. The CFTC proposal
also would withdraw the "independent account controller"
exemption that currently appears in the Part 150 regulations,
replacing it with narrower disaggregation alternatives, as
described below.
In place of the existing disaggregation relief provided by the Part
150 regulations, which is largely self-executing, the proposed Part
151 regulations would set out three bases for disaggregation, which
would be conditioned upon application to, and approval by, the
CFTC. First, disaggregation would be available to passive pool
investors having an interest of between 10% and 25% in a pool (and
who are therefore presumptively required to aggregate the
pool's positions for position limit purposes), provided that
the investor does not supervise or control the pool's trading
and the pool operator has written procedures in place to prevent
the investor from gaining knowledge of the pool's trading or
positions and has applied for and received disaggregation relief
from the CFTC. Disaggregation would also be available upon
application by futures commission merchants (FCMs) with respect to
discretionary accounts participating in an FCM customer trading
program where the FCM does not control trading and maintains
minimum control over the accounts, and the trading decisions for
the accounts are made independently of trading decisions for the
FCM's other accounts.
Finally, the proposed Part 151 Regulations would create a new
"owned non-financial entity" exemption, which would allow
an entity to disaggregate the positions of a non-financial entity
(generally, a non-financial operating company) in which it owns a
10% or greater interest if the applying entity can demonstrate that
the owned non-financial entity is independently controlled and
managed. The proposed regulations include a non-exclusive list of
indicia of independence for purposes of this exemption, including
that the two entities have no knowledge of each other's trading
decisions, that the owned non-financial entity have written
policies and procedures in place to preclude such knowledge, and
that the entities have separate employees and risk management
systems. However, these criteria are not exhaustive, and an
applicant for this exemption would be permitted to describe any
relevant circumstances that it believes would warrant
disaggregation.
Position Visibility
The CFTC proposal also includes new position visibility requirements for non-agricultural referenced contracts, establishing reporting requirements (including information about both cash market and derivatives activities) for traders who exceed the specified visibility levels. The CFTC expects that the proposed visibility levels for referenced base and precious metals and energy contracts generally will affect approximately 20 to 30 traders annually.
Grandfathering of Existing Positions
The CFTC proposes to allow traders to hold positions in DCM
futures and options contracts in excess of the new position limits,
provided that such positions were established in good faith prior
to the effective date of the new limits. However, the trader would
not be permitted to increase its size in any such position after
the new limits take effect. With respect to swaps, the CFTC
proposal would not apply position limits to Dodd-Frank
pre-effective date swaps, and would also allow swap dealers who
have previously been granted hedge exemptions to continue to manage
the risk of a swap portfolio that exists upon implementation of the
new regulations consistent with the exemption, provided that no new
swaps thereafter would be covered by the exemption.
The CFTC has requested comment on all aspects of its proposed
rules, which can be found here. The comment period closes on
March 28.
Footnotes
1These core referenced futures contracts include: Chicago Board of Trade Corn, Oats, Rough Rice, Soybeans, Soybean Meal, Soybean Oil and Wheat; Chicago Mercantile Exchange Feeder Cattle, Lean Hogs, Live Cattle and Class III Milk; Commodity Exchange, Inc. Gold, Silver and Copper; ICE Futures U.S. Cocoa, Coffee C, FCOJ-A, Cotton No.2, Sugar No. 11 and Sugar No. 16; Kansas City Board of Trade Hard Winter Wheat; Minneapolis Grain Exchange Hard Red Spring Wheat; and New York Mercantile Exchange Palladium, Platinum, Light Sweet Crude Oil, New York Harbor No. 2 Heating Oil, New York Harbor Gasoline Blendstock and Henry Hub Natural Gas.
2Guidance regarding the CFTC's proposed methodology for converting and aggregating swaps on a futures equivalent basis is available in Appendix A to the CFTC's proposed rulemaking on position reporting for physical commodity swaps, which is available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2010-27538a.pdf .
3For contracts that are not subject to a federal limit under the CFTC proposal, trading facilities would generally be required to adopt limits based on the same methodology proposed by the CFTC with respect to referenced contracts, but would have the option to implement flat single-month or all-months-combined levels of 1,000 contracts for non-energy tangible commodities and 5,000 contracts for energy products and non-tangible commodities, or to utilize position accountability rules for major foreign currency contracts and certain excluded commodities.
4The CFTC does not specify dates for either the implementation phases contemplated in its proposal; however, the proposal notes that the CFTC does not intend to adopt specific limits pursuant to the formulas set out in the proposed regulations until the first quarter of 2012 (unless the CFTC determines that there is sufficient data to implement certain limits at an earlier date).
5The definition set out in CFTC Regulation 1.3(z) would still apply with respect to "excluded commodities."
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