On May 26, 2016, the Commodity Futures Trading Commission (“CFTC”) unanimously approved a proposed supplement (“Supplemental Proposal”) to its December 2013 proposal to establish position limits on futures and economically equivalent swaps.1 The primary focus of the Supplemental Proposal is the definition of bona fide hedging positions exempt from speculative position limits. The CFTC proposes to expand the definition of bona fide hedging to recognize commercial hedging strategies as bona fide hedging. Separately, the Supplemental Proposal relieves designated contract markets (“DCM”) and swap execution facilities (“SEF”) of the requirement to establish speculative position limits in certain limited circumstances. The Supplemental Proposal includes a 30-day public comment period that will begin once the proposal is published in the Federal Register, which we expect to occur in early June 2016.
Chairman Massad described the Supplemental Proposal as an important measure to “ensure that commercial end-users can continue to engage in bona fide hedging efficiently for risk management and price discovery.”2 Commissioner Giancarlo, who has expressed a keen interest in the matter as sponsor of the Energy & Environmental Markets Advisory Committee, also supports the Supplemental Proposal as a means to “leverage exchange expertise and resources to enable exemptions to be granted in an efficient and timely manner without sacrificing market integrity.”3
The key aspect to the Supplemental Proposal is the flexibility to recognize non-enumerated hedging strategies as bona fide hedging. Under the 2013 Position Limits Proposal, the CFTC limited the definition of bona fide hedging to an exhaustive list of enumerated hedging strategies. If a hedging strategy was not on the enumerated list, it did not qualify as a bona fide hedge. Many commenters argued that this rigid structure excluded legitimate hedges commonly used by commercial enterprises and would prevent the development of new hedging strategies.
The Supplemental Proposal authorizes the exchanges to establish rules allowing market participants to apply for non-enumerated hedge exemptions. Market participants can apply for non‑enumerated hedge exemptions not only from exchange limits, but also from CFTC-set limits. The exemption is available for one year, after which a market participant must renew it. Under the Supplemental Proposal, the CFTC retains the ability to review any non-enumerated hedge exemption application either before an exchange makes a determination or after an exchange grants an exemption. However, if the CFTC revokes an exemption granted by the exchange, the recipient of the exemption has an opportunity to reduce its position below the applicable limit to prevent a violation. As a matter of practice, the CFTC expects the exchanges to review applications in the first instance with the CFTC potentially reviewing the exchange process after the fact. If an exchange recognizes a non-enumerated hedge exemption, the CFTC requires that the exchange post a summary of the general hedging strategy to its website (without revealing the identity of the hedger).
The Supplemental Proposal includes guidance regarding the general definition of bona fide hedging for the exchanges to follow in granting non-enumerated hedge exemptions. This guidance essentially mirrors the statutory definition of bona fide hedging in Section 4c(2) of the Commodity Exchange Act, as amended by the Dodd Frank Act (“CEA”). Finally, the CFTC proposes to limit the authority to review a non-enumerated hedge exemption application to exchanges: (1) on which a derivative contract is “actively traded;” and (2) with at least one year of experience administering exchange-set position limits.
Elimination of Certain Restrictions to Bona Fide Hedging
The 2013 Position Limits Proposal included a requirement that a market participant establish and liquidate a bona fide hedge in an “orderly manner.” The CFTC proposes to eliminate this obligation in the Supplemental Proposal, explaining that it is not aware of a denial of a bona fide hedge due to a lack of orderly trading on the exchange. Indeed, the CFTC conceded that a commercial entity engaging in disruptive trading would be acting contrary to its economic interests. However, the CFTC also noted that market participants would remain subject to other provisions within the CEA, such as restrictions on disruptive trading and manipulation.
The CFTC further proposes to eliminate the requirement from the 2013 Position Limits Proposal that the risks offset by a commodity derivative contract be “incidental” to the position holder’s commercial operations. However, bona fide hedging positions would still need to be “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise.” The CFTC confirmed that it continues to read this “economically appropriate” test to refer to price risk only, and does not include other risks such as execution, logistics, or credit risk. Finally, the Supplemental Proposal authorizes the exchanges to recognize anticipatory hedge exemptions, although it is unclear how the filing requirements specified in the 2013 Position Limits Proposal for anticipatory hedging interact with or supplement the newly proposed exchange application requirements for anticipatory hedging.
The Supplemental Proposal authorizes the exchanges to establish rules governing spread exemptions from federal and exchange-set position limits. For example, an exchange may grant exemptions for calendar spreads, quality differential spreads, processing spreads (e.g. energy “crack” spreads), and product/by-product spreads.
However, the Supplemental Proposal does not change the 2013 Position Limits Proposal prohibiting risk management exemptions. Market participants still cannot rely on an exemption to hedge exposure to commodity index contracts (e.g., exposure to the Goldman Sachs Diversified Commodity Index) with a component of the commodity index (e.g., a futures contract component of the index).
Delay for Exchange-Set Position Limits for Swaps
The CFTC proposes to “temporarily” delay the requirement for an exchange to establish position limits on swaps where the exchange “lack[s] access to sufficient swap position information.” Based upon the language in the preamble of the Supplemental Proposal, the CFTC does not expect DCMs or SEFs to have sufficient swap position information to monitor swap positions against a limit. This likely means that there will not be position limits on SEFs in the near future, and that DCM-set position limits will be limited to futures contracts.
CFTC to Use its Swaps Large Trader Reporting Data
The CFTC noted improvements in the swap position data that it receives pursuant to its Part 20 swaps large trader reporting regulation. In light of these improvements, the CFTC plans to use this data to calculate the initial levels of federal non-spot month position limits. In the 2013 Proposed Position Limits Rule, the CFTC proposed to establish non-spot month position limits for futures and economically equivalent swaps based upon a percentage of the total open interest for the particular derivative contract. However, the initial limits proposed in the 2013 Proposed Position Limits Rule did not include swap open interest data due to concerns about the accuracy of swap data the CFTC receives under Part 20. The decision in the Supplemental Proposal to include Part 20 swaps data in the open interest calculation may raise the size of the non-spot month limits in any CFTC final rule.
The Supplemental Proposal is a significant step in the right direction for commercial hedgers. The CFTC recognized that its 2013 Position Limits Proposal was overly prescriptive and intends that the Supplemental Proposal provide more flexibility to accommodate hedging. The Supplemental Proposal also places the flexibility in the hands of the experts – i.e., the exchanges with years of experience administering limits and understanding the nature of hedging activity. That said, the Supplemental Proposal retains a role for the CFTC to review the decisions of the exchanges.
In light of the expanded role for the exchanges, one area that the CFTC does not address is the extensive CFTC filing requirements for market participants relying on a bona fide hedge exemption. Given the application requirements discussed in the Supplemental Proposal, the Commission should consider streamlining the various forms from the 2013 Position Limits Proposal to prevent redundant, burdensome, and unnecessary filing requirements.