The Commodity Futures Trading Commission (CFTC) recently issued a concept release (the “Concept Release”) on whether to eliminate the bona fide hedge exemption from speculative position limits for certain swap dealers and create in its place a new limited risk management exemption. The CFTC is considering whether the new exemption would reduce the degree to which market participants evade speculative position limits on exchange-traded futures transactions by engaging in the analogous activity in the over-the-counter derivatives (OTC) market. Through the Concept Release, the CFTC is also seeking feedback on what form the limited risk management exemption should take. The Concept Release can be found at 74 Fed. Reg. 12282 (March 24, 2009).
What Is the Background of the Concept Release?
Speculative position limits are a long-standing regulatory tool to reduce excessive speculation in commodities through exchange-traded futures contracts. Transactions covered by an exemption, such as the bona fide hedging exemption, are permitted to exceed the speculative position limits.
Since 1991, when the CFTC last adopted a significant amendment to the exemptions from speculative position limits, considerable changes have occurred in trading patterns and practices in the futures markets. In particular, there has been an increase in prominence of two key groups of traders that do not transact in the physical commodities market. The first group, which includes entities such as managed funds, pensions and other institutional investors, seeks financial returns tied to the commodities markets as a way of diversifying portfolios that might otherwise be limited to stocks and interest rate instruments. These traders typically engage in commodity index transactions. The second group of traders consists of swap dealers using the futures market to hedge their exposure from OTC contracts. Counterparties to the swap dealers’ OTC contracts may include entities hedging price risk in the physical commodities market and investors (including the first group of traders described above) seeking commodity-linked returns in the OTC market.
The growth of swap dealers’ participation in the futures market raises concern because commodity market investment through OTC transactions may result in greater overall speculative positions with respect to the underlying commodity than would be the case if the transactions were done directly in the futures market. OTC transactions are not subject to speculative position limits. When a swap dealer hedges an OTC contract through a futures transaction that comes within the bona fide hedging exemption, the futures transaction is not subject to speculative position limits either. If the counterparty on the OTC contract were to engage directly in a futures transaction, rather than the OTC contract, the transaction would have to comply with speculative position limits.
As an additional, related concern, swap dealers and other futures traders who do not engage in physical commodity transactions represent a significant portion of the futures market positions in a number of major physical commodity futures contracts. There has been suggestion that the increase in positions held by commodity index traders and swap dealers contributed to the volume, volatility and high prices last summer of some futures contracts.
In response to these concerns, the CFTC issued a special call to swap dealers and index traders, which remains ongoing, for data relating to their off-exchange trading activity, so that the CFTC could assess whether swap dealer activity in the futures market is properly classified as hedging or as speculative. Based on the data collected, the CFTC issued its September 2008 Staff Report on Commodity Swap Dealers and Index Traders with Commission Recommendations, which included the recommendation to review whether to eliminate the bona fide hedge exemption for swap dealers and create a new limited risk management exemption. The CFTC’s staff was instructed to develop an advance notice of proposed rulemaking that would review whether to eliminate the exemption. The Concept Release serves as the advance notice of proposed rulemaking and a request for public comment.
The Limited Risk Management Exemption
A limited risk management exemption for swap dealers would be conditioned upon, among other things, (i) the swap dealer’s obligation to report to the CFTC and applicable self-regulatory organizations when “noncommercial” OTC counterparties (parties not involved in the production, processing or marketing of the underlying commodity) reach a certain position level and/or (ii) the swap dealer’s certification that none of its noncommercial OTC counterparties exceeds position limits in related exchange-traded futures contracts. The intention is to look through the swap dealer’s futures activities to its OTC counterparties’ activities to ensure that noncommercial traders are not evading speculative position limits.
Although the limited risk management exemption is directed at the activities of swap dealers, it may also impact other participants in the OTC market. For example, if swap dealers are limited with respect to the futures transactions they can enter into, they would have to reduce their OTC contracts or find an alternative hedge for those contracts. There will also be greater transparency to OTC contracts if swap dealers are required to report them.
Request for Comments
The CFTC is seeking a general reaction to the limited risk management exemption as a replacement for the bona fide hedge exemption. In addition, the CTFC is requesting comment on a number of specific questions, including (i) whether to establish a limited risk management exemption; (ii) the scope of commodities that should be included in the new exemption; (iii) how to categorize the swap dealers’ OTC counterparties between commercial and noncommercial parties, and how to verify that counterparties are being placed in the appropriate category; (iv) whether noncommercial entities should be further classified depending upon the nature of their activity (for example, speculative traders, index funds trading for passive investors, and intermediary swap dealers); (v) how to look through to the counterparties of intermediary swap dealers; (vi) what level of OTC activity should trigger reporting by the swap dealer; and (vii) whether there should be an overall limit on the size of a swap dealer’s futures and options positions regardless of their classification as commercial or noncommercial.
How to Provide Comments to the CFTC
Comments may be submitted electronically to firstname.lastname@example.org and must be received on or before May 26, 2009.