On October 18, 2011, the Commodity Futures Trading Commission (“Commission”) adopted, by a vote of 3 to 2, a final rule regarding position limits for certain physical commodity derivatives (“Final Rule”) pursuant to the Commodity Exchange Act (“CEA”), as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).1
Although the text of the Final Rule is not yet available, the Commission has stated its intent to phase-in position limits in two parts following effectiveness of the Commission’s final rulemaking regarding the further definition of “swap.”
- Phase one: Spot-month position limits will be effective sixty days following effectiveness of the Commission’s final rule further defining the term “swap” under the Dodd-Frank Act. This means that the first phase of position limits imposed by the Final Rule is likely not to become effective until at least mid-April 2012.2
- Phase two: Non-spot-month position limits will not be implemented until after the Commission has received one year of swaps open interest data regarding the relevant contracts, likely not until sometime in 2013 or later.3
The Commissioners expressed a wide range of opinions for and against adoption of the Final Rule, in particular with respect to the effects on commodities markets of imposing position limits on contracts not previously subject to limits. Chairman Gensler expressed strong support for the Final Rule, but noted that the rule is in no way intended or able to control pricing. Despite voting in favor of the Final Rule, Commissioner Dunn suggested that there was little economic evidence that speculation in previously unregulated contracts caused higher market prices for underlying commodities, and suggested that position limits may impair price discovery and the ability of commercial entities to adequately hedge their business risks. Commissioner Chilton expressed some dissatisfaction with the Final Rule, but indicated his belief that it is consistent with the intent of Congress in the Dodd-Frank Act of imposing position limits on swaps and previously unregulated futures contracts.
Commissioner Sommers, voting against adoption of the Final Rule, noted that many commenters expressed a strong desire for the Commission to impose position limits and appeared to believe, wrongly, that position limits are a “panacea” for rising commodity prices. Commissioner Sommers stressed the importance of the continued availability of bona fide hedging exemptions for market participants who need to hedge their commercial activities.
Commissioner O’Malia also voted against adoption of the Final Rule and issued a 15-page written dissent.4 According to Commissioner O’Malia, the central purpose of setting position limits should be to facilitate the Commission’s market surveillance obligations. Commissioner O’Malia stressed that Section 737 of the Dodd-Frank Act accords the Commission discretion in determining whether position limits are necessary to prevent “excessive speculation” and, consistent with Section 4a(a)(1) of the CEA, the Commission is required to (and to avoid unintended consequences, should) make a finding that position limits are “necessary and effective in relation to the identifiable burdens of excessive speculation on interstate commerce.”5
- Requirements of the Dodd-Frank Act With Respect to Position Limits
Section 4a(a)(1) of the CEA, as amended by Section 737 of the Dodd-Frank Act, requires the Commission to extend position limits beyond futures and option contracts to (i) swaps traded on a designated contract market (“DCM”) or swap execution facility (“SEF”), and (ii) swaps not traded on a DCM or SEF that perform or affect a “significant price discovery function” (“SPDCs”) with respect to regulated markets.
In addition, new section 4a(a)(5) of the CEA requires the Commission to establish aggregate position limits for swaps that are economically equivalent to futures and options on futures contracts subject to Commission-set position limits. Similarly, new section 4a(a)(6) of the CEA requires the Commission to apply position limits on an aggregate basis to contracts based on the same underlying commodity across: (1) DCMs; (2) with respect to foreign boards of trade (“FBOTs”), contracts that are price-linked to a DCM or SEF contract and made available from within the United States via direct access; and (3) SPDCs.
II. Scope of the Final Rule
A. Covered Contracts
The Final Rule establishes position limits for 28 physical commodity futures contracts (“Core Referenced Futures Contracts”) as well as futures, options and swaps that are economically equivalent to those contracts (collectively “Referenced Contracts”).6
The 28 Core Referenced Futures Contracts include the following contracts, by commodity category:
(i.) Nine “legacy” agricultural contracts: (1) CBOT Corn (C); (2) CBOT Oats (O); (3) CBOT Soybeans (S); (4) CBOT Soybean Meal (SM); (5) CBOT Soybean Oil (BO); (6) CBOT Wheat (W); (7) ICE Futures U.S. Cotton No.2 (CT); (8) KCBT Hard Winter Wheat (KW); and (9) MGEX Hard Red Spring Wheat (MWE).
(ii.) Ten non-“legacy” agricultural contracts: (1) CME Class III Milk (DA); (2) CME Feeder Cattle (FC); (3) CME Lean Hog (LH); (4) CME Live Cattle (LC); (5) CBOT Rough Rice (RR); (6) ICE Futures U.S. Cocoa (CC); (7) ICE Futures U.S. Coffee C (KC); (8) ICE Futures U.S. FCOJ-A(OJ); (9) ICE Futures U.S. Sugar No. 11 (SB); and (10) ICE Futures U.S. Sugar No. 16 (SF).
(iii.) Four energy contracts: (1) NYMEX Henry Hub Natural Gas (NG); (2) NYMEX Light Sweet Crude Oil (CL); (3) NYMEX New York Harbor Gasoline Blendstock (RB); and (4) NYMEX New York Harbor Heating Oil (HO).
(iv.) Five metal contracts: (1) COMEX Copper (HG); (2) COMEX Gold (GC); (3) COMEX Silver (SI), (4) NYMEX Palladium (PA); and (5) NYMEX Platinum (PL).
B. “Economically Equivalent” Contracts
According to the Commission, a swap, futures or option contract is “economically equivalent” to a Core Referenced Futures Contract when:
(i.) it is a “look-alike” contract (i.e., it settles off of the Core Referenced Futures Contract or contracts that are based on the same commodity for the same delivery location as the Core Referenced Futures Contract);
(ii.) it is a contract with a reference price based on only the combination of at least one Referenced Contract price and one or more prices in the same or substantially the same commodity as that underlying the relevant Core Referenced Futures Contract, provided that such a contract is not a locational basis swap;
(iii.) it is an inter-commodity spread contract with two reference price components, one or both of which are based on Referenced Contracts; or
(iv.) it is priced at a fixed differential to a Core Referenced Futures Contract.
C. Pre-Existing Positions
The Final Rule is expected to clarify that futures, options and swaps positions entered into in goodfaith prior to the effective date of the Final Rule will not cause an entity to be in violation of the new limits based solely on those positions.7 To the extent an entity’s pre-existing futures, options or swaps positions would cause it to exceed the limit, the entity would not be permitted to further increase its position. However, an entity that established a net position below the limit prior to the enactment of the Final Rule would be permitted to increase its position, but only to the extent of its aggregate position, including the pre-existing positions.
D. Class Limits
The proposed rule regarding position limits (“Proposed Rule”)8 would have imposed separate limits on two “classes” of contracts – one class would have been comprised of all futures and option contracts executed pursuant to the rules of a DCM, and the second class would have been comprised of all swaps. Position limits would have been applied to each of the classes individually, as well as in the aggregate. It appears that the Final Rule will eliminate class limits outside of the spot-month, thus, allowing for the netting of swaps and futures positions in the non-spot-months.
III. Calculation of Applicable Position Limits in Spot- and Non-Spot-Months
The Final Rule sets forth two types of position limits: spot-month position limits and non-spot-month position limits. Spot-month position limits apply in the period immediately before delivery obligations are incurred for physical delivery contracts or a period immediately before contracts are liquidated by the clearinghouse based on a reference price for cash-settled contracts. The spotmonth period is specific to each Referenced Contract, need not correspond to a month-long period, and may extend through the period when delivery obligations are incurred.
A. Spot-Month Limits
Generally, the Commission has indicated that spot-month position limits for Referenced Contracts will be set at 25% of estimated deliverable supply. These limits will be applied separately for the following positions in the same commodity: (1) futures contracts that may be physically delivered, and (2) futures contracts and swaps that are cash-settled. For example, a trader’s position in all cash-settled futures and swaps Referenced Contracts will be combined to determine whether the trader’s position in cash-settled Referenced Contracts is below the limits.
In the original Proposed Rule, the Commission provided for a “conditional spot-month limit” of 5x the limit in any cash settled contract assuming two conditions were met (1) an entity was completely out of the physical delivery contract and (2) the entity owned less than 25% of the estimated deliverable supply of the cash commodity.
In a significant change from the Proposed Rule, the Commission has indicated that the Final Rule will not extend the conditional spot-month limit to all cash settled contracts, but rather will only allow the larger limit for the cash-settled NYMEX Henry Hub Natural Gas contract (extending across positions in both physical-delivery and cash-settled natural gas contracts), which would be set at five-times the limit that applies to the physical-delivery NYMEX Henry Hub Natural Gas contract.
Under the Final Rule, spot-month limits will be based on the spot-month position limit levels in effect at DCMs at the time spot-month limits become effective under the Final Rule. Thereafter, the spot-month limits will be adjusted biennially for agricultural contracts and annually for energy and metal contracts. These subsequent limits will be based on the Commission’s determination of deliverable supply (developed in consultation with DCMs). The Commission indicated that a DCM also can petition the Commission to adjust the limits at any time.
B. Non-Spot-Month Limits
The Commission has indicated that non-spot-month position limits will apply to positions a trader may have in all contract months combined or in a single contract month. For each Referenced Contract, non-spot-month limits will be set at 10 percent of open interest in the first 25,000 contracts and 2.5 percent thereafter. Open interest used in determining non-spot-month position limits will be based on futures open interest, cleared swaps open interest, and uncleared swaps open interest. Non-spot-month limits will be reviewed biennially based on current open interest data. Generally, initial non-spot-month position limits will be phased-in by Commission order following receipt by the Commission of one year of open interest data pursuant to the large trader reporting rule for physical commodity swaps.
C. Position Visibility Requirements
The Final Rule also imposes quarterly position visibility reporting obligations on traders that exceed a non-spot-month position visibility level in a limited number of energy and metals Referenced Contracts. According to the CFTC, position visibility reports are intended to provide the Commission with additional surveillance capability with respect to the physical and swaps portfolios of the largest traders, as well as a better understanding of trading activity in the physical commodity futures and swaps markets. The Commission has suggested that such visibility would enable the Commission to make ongoing adjustments to the position limit framework to better achieve the statutory objectives of position limits.
IV. Aggregation of Accounts
In a significant change from the Proposed Rule and current regulations, the Commission indicated that it has eliminated from the Final Rule the exemption from aggregation for owned non-financial entities. Under current Commission regulations, exchanges require aggregation for non-agricultural commodities based solely on common control, not based on common ownership. Instead, the Commission elected to retain the existing independent account controller (“IAC”) exemption in generally the same form as it currently exists, with certain clarifications to ensure that the use of the IAC exemption is limited to client positions – i.e., it may only be used to the extent a trader is trading professionally for clients.9 Because the IAC exemption applies only to commodity pool operators, commodity trading advisors, banks or trust companies, insurance companies, or their separately organized affiliates, it appears that companies may not be permitted to disaggregate the independently managed and controlled positions of their commercial affiliates.
The Final Rule would require traders to file a notice, effective upon filing, setting forth the circumstances that warrant use of the IAC exemption and a certification that the traders’ use of the exemption meets the conditions required by the rule. On Commission special call, traders utilizing the IAC exemption pursuant to a notice filing must provide relevant information to the Commission concerning its use of the IAC exemption.
V. Bona Fide Hedging Transactions
Although the Commission went to great lengths to explain how, compared to the Proposed Rule, it has expanded the definition of bona fide hedging transactions and positions to include anticipated merchandising transactions, royalties, and service contracts, it remains unclear whether the end result will, nevertheless, be a substantially narrower definition of hedging than under current regulations.
In response to numerous comments expressing concern that the list of enumerated hedging transactions might not accommodate all legitimate hedging activity, the Commission agreed to a last minute amendment to add a provision to the Final Rule describing the process by which market participants may request a determination as to whether a transaction or class of transactions qualifies as an enumerated hedge. As described during the meeting, the new provision will resemble current Regulation 1.3(z)(3). In addition, the Commission noted that market participants may formally petition the Commission to amend the current list of enumerated hedges or the conditions therein. Such a petition should set forth the general facts surrounding such class of transactions, the reasons why such transactions conform to the requirements of the general definition of bona fide hedging, and the policy purposes furthered by the recognition of this class of transactions as the basis for enumerated bona fide hedges.