On December 5, the Commodity Futures Trading Commission issued final regulations regarding the aggregation of commodity derivatives positions for assessing compliance with CFTC position limits requirements and re-proposed regulations regarding position limits.
The final aggregation rules are scheduled to be effective 60 days after their publication in the Federal Register, during which time the CFTC will accept comments on the proposed position limit rules.
Aggregation Final Rules
In general, in order to assess a person’s compliance with applicable speculative position limits – whether imposed by the CFTC or any exchange – the person is required to aggregate all futures and related options positions (on a futures equivalent basis) and accounts in which the person directly or indirectly controls trading with (1) all positions and accounts in which the person holds a 10 percent or more ownership or equity interest and (2) the positions of any other person with which the person trades pursuant to an express or implied agreement. Limited exemptions from aggregation requirements (subject to conditions) exist today under CFTC and exchanges' rules, including positions (1) in a pooled account where the person with the 10 percent or more ownership interest is a limited partner, limited member, shareholder or similar type or pool participant or (2) that are carried for certain designated eligible entities (e.g., commodity pool operators and commodity trading advisors and their separate organized affiliates) in the separate account or accounts of an independent account controller – the so-called Independent Account Controller (IAC) exemption.
Owned Entity Exemption
As part of its November 2013 proposed position limits and aggregation requirements, the CFTC introduced the concept of an owned entity exemption (OEE) under which an entity that owned at least 10 percent up to no more than 50 percent of another independently traded entity could disaggregate positions with such owned entity for position limits purposes, subject to a notice filing with the Commission. (Click here for background on the CFTC’s 2013 aggregation and position limits proposals in the article, “CFTC Proposes New Position Limit Rules: Addresses Absolute Limits of 28 Core Futures Products, Aggregation, and Bona Fide Hedging” in the November 5, 2013 edition of Between Bridges.) This proposal was refined in late 2015 in a supplemental proposal by the CFTC to, among other things, remove the 50 percent cap. (Click here for further information on this re-proposal in the article, “CFTC Revises Aggregation Proposal Related to Position Limits” in the September 27, 2015 edition of Bridging the Week.)
Since then, at least two exchange organizations, CME Group and ICE Futures U.S., have adopted their own version of the OEE. (Click here to access the article, “CME Group Amends Position Limits Aggregation Rules to Conform With Pending CFTC Regulation Change” in the March 27, 2016 edition of Bridging the Week and here to access the article, “IFUS to Adopt CFTC Proposed Aggregation Rule as Its Own in Advance of CFTC Adoption” in the March 13, 2016 edition of Bridging the Week.) The exchanges' rules were similar to the disaggregation provision re-proposed by the CFTC in 2015.
Under the new CFTC OEE, a person with any ownership or equity interest of 10 percent or more in an owned entity will not be required to aggregate the account or positions of the owned entity provided the person and its owned entity:
- do not have knowledge of or share employees that control the trading decisions of the other entity;
- trade according to separately developed and independent trading systems;
- maintain and enforce written procedures that prohibit each from “having knowledge of, gaining access to, or receiving data about, trades of the other.” These procedures must mandate security arrangements, including separate physical locations, to help ensure independence. The CFTC, in commentary, made clear that this does not require that relevant personnel be in separate buildings. It solely requires that there be a physical barrier between personnel – such as locked doors with restricted access – that prevents access that might compromise their independence; and
- do not have risk management systems that allow the sharing of trades or trading strategies with the employees of the other entity that control its trading decisions. According to CFTC commentary, this would not preclude the sharing of accountants, risk managers, compliance and other mid- and back-office personnel between entities provided the employees do not “control, direct or participate in the entities’ trading decisions.” Likewise, trading and position information could be shared among such persons for risk management or surveillance purposes but not used for trading purposes or shared with trading staff.
In addition to the OEE exemption, the CFTC approved disaggregation of positions in connection with underwriting (i.e., where ownership is based on ownership of securities that derive from an unsold allotment to or subscription by a participant in the distribution of the securities by the issuer or through an underwriter) and with certain broker-dealer activity that might otherwise be required to be aggregated (where ownership arises because of the ownership of securities acquired during the ordinary course of business, provided the broker-dealer has no knowledge of the trading decisions of the owned entity). The CFTC also approved disaggregation of positions or accounts of an owned entity where the sharing of information associated with aggregation could violate state or federal law or the law of a foreign jurisdiction or relevant regulation.
In most cases, a person seeking an aggregation exemption associated with CFTC position limits must file with the CFTC a notice in advance describing the relevant circumstances that warrant disaggregation that contains a statement of a senior officer certifying that the requirements for the applicable exemption have been met. The exemption will be effective upon submission. However, a late filing of a notice of disaggregation would not constitute a violation of a CFTC position limit provided the notice was filed by five business days after a person was aware or should have been aware that a notice was not timely submitted. The CFTC’s Division of Market Oversight may call for additional information from a person claiming any disaggregation exemption.
As drafted, it appears that persons currently relying on an existing IAC exemption would have to file a notice with the CFTC by the effective date of the new aggregation rule in order to maintain such exemption in connection with the nine agricultural futures and related options positions currently under the CFTC’s direct oversight.
Position Limits Re-Proposal:
Separately, the CFTC re-proposed its position limits rules. Compared to its November 2013 proposed rules, the Commission’s newly re-proposed requirements:
- reduce the number of core agricultural, energy and metals futures contracts and their economically equivalent futures, options and swaps (collectively, “referenced contracts”) subject to express oversight by the Commission for position limits purposes from 28 to 25;
- revise spot month, single and all-months positions limits on the 25 referenced contracts;
- define bona fide hedging to more closely parallel the definition in applicable law and to address many concerns raised in response to the CFTC’s 2013 proposal; and
- authorize persons to apply for non-enumerated hedging exemptions from qualified exchanges, even for referenced contracts.
Bona Fide Hedging
The CFTC’s current re-proposal incorporates many provisions regarding the definition of bona fide hedging and the process for persons to apply for non-enumerated hedging exemptions that the Commission previously made in its November 2013 proposal as amended by a May 2016 supplemental rule making. (Click here for more details regarding this supplemental notice in the May 27, 2016 edition of Between Bridges.)
As in its supplemental proposal earlier this year, the CFTC now proposes to eliminate a general requirement contained in its November 2013 proposal that all positions constituting bona fide hedging (and thus exempt from speculative positions limits) must be for the purpose of offsetting price risks incident to commercial cash, sport or forward operations (the so-called “incidental test”) and must be established and liquidated in accordance with sound commercial practices (the so-called “orderly trading” requirement. Disruptive trading is separately prohibited under applicable law; click here to access Sec. 4c(a)5 of the Commodity Exchange Act , 7 USC § 6c(a)(5)).
For derivatives contracts based on excluded commodities (i.e., financial contracts) a bona fide hedge would constitute positions that are:
- “economically appropriate” for the reduction of risk in the conduct and management of a commercial enterprise and are expressly enumerated by the Commission or
- recognized as a bona fide hedge by a designated contract market (DCM) pursuant to such exchange’s rules submitted to the Commission, which rules may include certain risk management positions consistent with separate guidance issued by the Commission.
For derivatives contracts based on physical commodities (i.e., agricultural commodities, energy products and metals), the CFTC’s definition of bona fide hedging positions would more closely conform to applicable law than proposed in 1983. (Click here to access CEA Sec. 4a, 7 USC § 6a.) Positions would have to:
- represent a substitute for transactions made or positions to be taken in the future in the physical marketing channel;
- be economically appropriate for the reduction of risks in the conduct and management of a business; and
- arise from the potential change in value of assets, liabilities or services now or anticipated in the future.
A bona fide hedge position would also include a position that reduces risks associated with a swap opposite a counterparty for which the transaction would constitute a bona fide hedge (“pass through swap offset”) or itself be a swap executed opposite a pass-through swap counterparty provided the risk of that swap is also offset.
To constitute a bona fide hedge, a position in a commodity derivatives contract in a physical contract would also have to be one of eight expressly enumerated hedges (subject to applicable conditions, if any); a pass through swap offset (subject to certain timing limitations), or a position that has been otherwise recognized as a non-enumerated bona fide hedging position by either a DCM or a swap execution facility. The CFTC declined to enumerate a cash and carry trade as a bona fide hedge position. The Commission proposed, however, that commodity trade options be considered equivalent to other cash positions for purposes of a bona fide hedging position provided they were adjusted on a futures equivalent basis, and removed a previously proposed 12-month restriction on certain anticipatory hedges for agricultural commodities. The CFTC also authorized cross-commodity hedges subject to certain conditions.
Non-Enumerated Hedge Exemptions
Additionally, the Commission proposed rules that potentially authorize qualified exchanges to recognize certain derivatives positions as constituting bona fide hedges (including anticipatory hedges) in connection with referenced contracts even if such positions are not expressly enumerated by the CFTC. These proposed rules are materially identical to those proposed in May 2016 in the CFTC’s supplemental proposal.
As previously proposed, the CFTC would have after-the-fact authority to disallow any previously granted enumerated hedge exemption. In such case, the impacted person would have to liquidate positions in excess of a speculative position limit in a “commercially reasonable amount of time” – which the Commission suggests will typically be less than 24 hours.
The CFTC also proposed to grant exchanges authority to recognize certain spread positions as justifying an exemption from speculative position limits too.
In order to grant non-enumerated hedge exemptions, relevant exchanges would have to demonstrate active trading in the relevant derivatives contract as well as of at least one-year experience setting position limits for the relevant commodities. In commentary, the CFTC made clear that, in order to not limit competition or bar entry of new exchanges, an exchange’s experience could be demonstrated by the requisite experience of surveillance staff rather than by the exchange itself. Persons seeking enumerated hedge exemptions could not apply after a position limits breach and would have to reapply at least annually for renewals of previously granted non-enumerated exemptions.
In its current proposal, the CFTC also added an exemption from position limits for a company in financial distress (subject to the Commission’s prior approval), as well as for certain swaps entered into prior to July 21, 2010, through 60 days after publication of the final position limit rules in the Federal Register.
As proposed by the CFTC, spot month position limits in referenced contracts would be set at 25 percent of estimated deliverable supply or at a lower level recommended by a DCM. In the re-proposed rules, the CFTC made its recommendation of what should be initial spot month levels. These would be adjusted every two years. Non-spot month and all month combined limits for referenced contracts would be set at 10 percent of open interest in futures and spots for the first 25,000 contracts and 2.5 percent thereafter.
The CFTC also proposed requirements and acceptable practices for DCMs and SEFs to set position limits for the 25 referenced contracts (i.e., no lower than the CFTC-set limits) as well as acceptable practices for position limits and accountability levels in all other contracts. DCMs and SEFs would be temporarily relieved from establishing position limits on swaps that are subject to CFTC position limits where such exchanges lack position information on such swaps.
Revised and New Forms for Hedgers
The Commission additionally proposed updating the form currently used by hedgers in all the nine existing agricultural futures contracts currently under the CFTC’s direct oversight (except for cotton) to identify certain of their hedged positions (i.e., CFTC Form 204 – Statement of Cash Positions in Grains, Soybeans, Soybean Oil and Soybean Meal) as well as the form used by merchants and dealers in cotton (i.e., CFTC Form 304 – Statement of Cash Positions in Cotton). The Form 204 would be expanded to included hedgers in all referenced contracts (and renamed the Statement of Cash Positions for Hedgers), while the Form 304 would pertain only to merchants and dealers of cotton holding or controlling positions for futures delivery in cotton that is reportable (and renamed the Statement of Cash Positions for Unfixed-Price Cotton "On Call"). Both the Forms 204 and 304 would (1) seek additional information about submitters; (2) be required to be filed with the CFTC electronically; and (3) be required to be certified by the reporting trader as true and correct. The Commission would also require the filing of forms by certain other hedgers: CFTC Form 504 (Statement of Cash Positions for Conditional Month Exemptions); CFTC Form 604 (Statement of Pass-Through Swap Exemptions) and CFTC Form 704 (Initial Statement and Annual Update for Anticipatory Bona Fide Hedging Positions).
In its commentary accompanying its re-proposed rules, the CFTC argued that under the applicable provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act (click here to access CEA Sec. 4a, 7 USC § 6a) it was obligated to impose position limits on futures and options contracts on agricultural, metals and energy commodities traded on or subject to the rules a regulated exchange, and economically equivalent swaps, without first making a determination that it was necessary to do so to prevent excessive speculation. However, the CFTC conceded that in enacting the relevant provision of law, Congress did not make this view clear “with ideal clarity.” Notwithstanding, “without prejudice,” the Commission concluded that its proposed position limits rules “are necessary to achieve their statutory purpose.” The Commission based this on two incidents – the so-called “Hunt” and “Amaranth” incidents – where market participants acquired “massive” futures positions in silver and natural gas, respectively, which enabled them “to cause sudden and unreasonable fluctuations and unwarranted changes in the prices of those commodities.”
The Commission indicated that the compliance date for any final position limit rules would not be until January 3, 2018, at the earliest. This date corresponds to the compliance date of somewhat equivalent position limit rules under the European Markets in Financial Instruments Directive II.
In voting to issue the re-proposed regulations regarding position limits, current Commissioner J. Christopher Giancarlo noted that he had “always been open to supporting a well-conceived and practical position limits rule that restricts excessive speculation.” Although he suggested there was more refinement that needed to be undertaken to the proposed rules, he indicated that the CFTC’s current re-proposed requirements “provide the basis for the implementation of a final position limits rule that I could support.”
For more information, see:
Final Aggregation Rule: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister120516a.pdf Re-Proposed Position Limits Rule: http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister120516.pdf
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of December 11, 2016. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made.