A recent public statement by Timothy Massad, the Chairman of the Commodity Futures Trading Commission (“CFTC” or “Commission”) indicates that the CFTC still plans to finalize its position limits rule before the end of the year. The rule, which is many years in the making, has taken multiple forms since first being proposed in response to the enactment of the Dodd-Frank Act and struck down by a court. It is intended to limit speculative trading, thereby mitigating risks of market disruptions or manipulation. Most recently, the CFTC issued a Supplemental Proposal that would delegate to the exchanges (or, in CFTC parlance, “Designated Contract Markets”) the ability to grant bona fide hedge exemptions from not only the exchanges’ own position limits but also federal position limits set by the CFTC.
Many comments filed on the Supplemental Proposal praised the concept of delegating this function to the exchanges, which have experience implementing limits and understand the markets in which contracts are traded on their platforms. This concept initially was seen as welcome relief from a relatively narrow list of enumerated bona fide hedge exemptions proposed previously by the CFTC. But, concerns remain about details of the proposal, including potential restrictions on what the exchanges can and cannot declare to be a bona fide hedge, boundless CFTC review of determinations made by the exchanges, intrusion into the exchanges’ traditional role of granting exemptions from their own limits (such as when those exchange limits fall below federal limits or there are commodity contracts without a federal limit), new data requirements, and reporting burdens.
Below are a few examples of concerns raised in comments:
- Restraining Commission Reversal of Exemptions. A common concern relates to the CFTC’s proposal to review at any time and potentially reverse an exchange’s decision to grant an exemption. Commenters were troubled particularly by the CFTC’s announcement that if the CFTC disagreed with an exchange’s decision to grant an exemption, the market participant who applied for the exemption would have to unwind its position in potentially less than one business day. Among other reforms, commenters suggested that: (1) a time limit be set on Commission review to promote regulatory certainty; (2) any Commission review be noticed to the public with an opportunity for comments; (3) an appeals process be established; (4) a hedge be added to the CFTC’s list of enumerated bona fide hedges for all similarly-situated hedgers to rely upon if the Commission affirms a previously non-enumerated bona fide hedge; and (5) the required unwind time be significantly longer than one business day, especially when a market is illiquid or approval is necessary from an energy market participant’s governing board or state/local regulator to change a commercial risk management policy.
- Expanding list of enumerated bona fide hedges. Commenters urged the CFTC to expand the list of enumerated bona fide hedges to include cross-commodity and anticipatory merchandising hedges as well as to acknowledge explicitly, in the final rule, that an “economically appropriate” hedge is not limited to a hedge of a “price” risk and that a hedge can still be bona fide if it reduces another type of commercial risk, such as an operational risk, product quality risk, liquidity risk, credit risk, locational risk or timing risk.
- Removing quantitative correlation test. In a prior CFTC Notice of Proposed Rulemaking (“NOPR”), the Commission proposed a quantitative correlation test for cross-commodity hedges to ensure that “fluctuations in value of the position in the commodity derivative contract, or the commodity underlying the commodity derivative contract, are substantially related to the fluctuations in value of the actual or anticipated cash position or pass-through swap.” Specifically, pursuant to that NOPR, a cross-commodity hedge would only qualify as a bona fide hedge if the correlation between the daily spot price series for the target commodity and the price series for the commodity underlying the derivative contract (or the price series for the derivative contract used to offset risk) is at least 0.80 for at least 36 months. Natural gas is a fuel input to electric generation and it is common for electric utilities to engage in cross-commodity hedges. But, this test would likely disqualify the hedging of long-term electricity price exposure with natural gas derivatives contracts. Accordingly, commenters urged the CFTC to clarify that the exchanges are not bound by this test and such a cross-commodity hedge qualifies as a bona fide hedge.
- Removing Five-Day Hedging Restriction. Commenters urged the Commission to eliminate a previously-proposed "five-day" restriction from its definition of "bona fide hedging position," which would require early liquidation of some hedges due to limiting language providing that "no such position is maintained in any physical delivery commodity derivative contract during the lesser of the last five days of trading or the time period for the spot month in such physical-delivery contract" (i.e., "expiry period"). Commenters argued that this rigid limitation is unnecessary and could leave commercial market participants exposed to risk during the expiry period.
- Reducing burdens on end-users. Commenters asserted that the Commission should reduce regulatory burdens on end-users by, for example: (1) providing a mechanism for exchange determinations of bona fide hedges to be maintained (rather than having to continuously re-apply for them) and extended more broadly to other commercial firms facing similar risks (rather than limited only to the individual applicant applying for the exemption); (2) removing unnecessary data requirements, such as a proposed mandate that an applicant for a hedge exemption provide three years of cash market information; (3) avoiding duplicative recordkeeping and reporting requirements; (4) clarifying any position limits reporting forms that are required by creating a user’s manual for the forms; and (5) phasing in compliance deadlines.
- Refraining from Micromanaging Exchanges. Some commenters expressed concern that the Supplemental Proposal intrudes too far into the exchange’s operations, with a plethora of proposed new regulatory requirements that, at least in the absence of further clarification, might apply not only to exemptions from federal position limits set by the CFTC but also exemptions granted by the exchanges from their own limits. A few commenters urged the CFTC to simply use its existing authority to review and enforce exchange rules, rather than superimpose a new set of regulatory requirements on the exchanges.
Although it is anticipated that the CFTC may phase in compliance requirements, energy companies should get up to speed now on the CFTC’s proposal and ready themselves for the issuance of this final rule before the end of the year.