CFTC Issues Final Rule on Position Limits for Futures and Swaps

in Derivatives

By Adia M. Goss

Pursuant to Section 737 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and Section 4(a) of the Commodity Exchange Act, the Commodity Futures Trading Commission (the “CFTC”) issued a final rule to establish position limits for “28 exempt and agricultural commodity derivatives, including futures and options contracts and the physical commodity swaps that are economically equivalent.”[1]  The final rule also implements a new statutory definition of “bona fide hedging” transactions and revises the standards for aggregation of positions.  This rule is effective as of January 17, 2012.

Because the CFTC’s jurisdiction only extends to certain commodities that are traded in the US, the position limits do not apply to holdings entities may have in international markets.

On December 2, 2011, the International Swaps and Derivatives Association, Inc. (“ISDA”) and the Securities Industry and Financial Markets Association (“SIFMA”) filed a lawsuit in the District Court for the District of Columbia, alleging that the CFTC: i) erred in establishing position limits pursuant to Dodd-Frank without an initial determination that they were necessary; ii) failed to consider all evidence in setting position limits; iii) failed to conduct an adequate cost-benefit analysis; and iv) conducted a flawed rulemaking process that did not allow commentators to fully participate.

On September 28, 2012, the District Court for the District of Columbia issued a ruling on the lawsuit, vacated the CFTC’s final rule on position limits and remanded the rule back to the CFTC for reconsideration.  Specifically, the Court agreed with the ISDA and SIFMA argument that the CFTC was required to make a finding that position limits were necessary before establishing them.  However, the Court acknowledged that Dodd-Frank was ambiguous regarding whether, and to what extent, the CFTC must set position limits.  Therefore, the Court stated that the CFTC ought to recognize and resolve the amiguities within the statute by offering an explanation for how its interpretation of Dodd-Frank with respect to position limits furthered the policy objectives of the Act.  The summary below is of the now-vacated final rule on position limits.

 

Referenced Contracts

 

The position limits will apply to specified futures contracts in agricultural commodities, metals commodities and energy commodities (the “Referenced Contracts”).[2]  These limits also apply to economically equivalent swaps.[3]  A swap is economically equivalent when it is 1) “directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of that particular Referenced Contract;” or 2) “directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of the same commodity underlying that particular Referenced Contract for delivery at the same location or locations as specified in that particular Referenced Contract.”[4]

In the commodities market, contracts have standardized terms and are designed by the designated contract market (“DCM”) on which they are traded.  For example, “a corn futures contract designed and sponsored by the Chicago Board of Trade calls for the delivery of No. 2 (grade) yellow corn in the quantity of 5,000 bushels during one of a number of specified future months.”[5]  This means that the positions limits established by this rule apply to the number of standardized contracts an entity may hold in any given commodity covered by a Referenced Contract.

 

Spot-Month Limits[6]

 

The final rule applies spot-month position limits separately for physically-delivered contracts and cash-settled contracts (cash-settled futures and swaps).  When this rule becomes effective, spot-month position limits will be as follows:

Contract

Spot-month limit

ICE Futures U.S. Cocoa

1,000

ICE Futures U.S. Coffee C

500

Chicago Board of Trade Corn

600

ICE Futures U.S. Cotton No. 2

300

ICE Futures U.S. FCOJ–A

300

Chicago Mercantile Exchange Class III Milk

1,500

Chicago Mercantile Exchange Feeder Cattle

300

Chicago Mercantile Exchange Lean Hog

950

Chicago Mercantile Exchange Live Cattle

450

Chicago Board of Trade Oats

600

Chicago Board of Trade Rough Rice

600

Chicago Board of Trade Soybeans

600

Chicago Board of Trade Soybean Meal

720

Chicago Board of Trade Soybean Oil

540

ICE Futures U.S. Sugar No. 11

5,000

ICE Futures U.S. Sugar No. 16

1,000

Chicago Board of Trade Wheat

600

Minneapolis Grain Exchange Hard Red Spring Wheat

600

Kansas City Board of Trade Hard Winter Wheat

600

Commodity Exchange, Inc. Copper

1,200

New York Mercantile Exchange Palladium

650

New York Mercantile Exchange Platinum

500

Commodity Exchange, Inc. Gold

3,000

Commodity Exchange, Inc. Silver

1,500

New York Mercantile Exchange Light Sweet Crude Oil

3,000

New York Mercantile Exchange New York Harbor Gasoline Blendstock

1,000

New York Mercantile Exchange Henry Hub Natural Gas

1,000

New York Mercantile Exchange New York Harbor Heating Oil

1,000

After January 1 of the second year of the effective date, the spot month limits will be set by the CFTC at 25 percent of estimated deliverable supply.[7]  The same position limits that apply to physically-delivered Referenced Contracts will apply to cash-settled contracts, except for natural gas contracts.  Natural gas contracts will have a class limit and aggregate limit of five times the limit of cash-settled contracts.  Entities cannot net positions across physical-delivery contracts and cash-settled contracts, but they can net positions in cash-settled contracts in the same Referenced Contract commodity in order to determine whether position limits have been reached for that Referenced Contract commodity.

 

Because the CFTC received numerous comments challenging the proposed position limits for cash-settled contracts, it decided to accept additional comments regarding position limits for cash-settled contracts through January 17, 2012.  Therefore, the spot-month limits for cash-settled contracts are considered an interim final rule, so they may change in the future.

 

Non-Spot-Month Limits

 

The spot month is the month in which a futures contract matures and becomes deliverable.  The non-spot-month is any month, other than the current month, in which a contract could be deliverable.  Aggregate non-spot month position limits are intended to prevent a speculative trader from acquiring excessively large positions and to, therefore, prevent market manipulation, squeezes and corners.  The all-months-combined aggregate and single-month position limits for non-legacy referenced contracts will be 10 percent of the first 25,000 contracts of average all-months combined aggregated open interest with a marginal increase of 2.5 percent thereafter.

 

of the open interest for the first 25,000 contracts and 2.5 percent of the open interest thereafter.[8]  The single-month position limits will be the same as the all-months-combined position limits.  The CFTC will apply position limits on an intraday basis, meaning that position limits cannot be exceeded at any point in the day.

 

Bona Fide Hedging and Other Exemptions

 

A transaction is a bona fide hedge, and thus not subject to position limits, when it:

  1.                                                               i.      “represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel;[9]
  2.                                                             ii.      is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and
  3.                                                           iii.      arises from the potential change in the value of one or several” –
    1. assets;
    2. liabilities;
    3. services that a person provides or purchases; or
    4. “reduces risks attendant to a position resulting from a swap that – (A) was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction” according to the above requirements; or (B) meets the above requirements on its own.[10]

 

In addition, for any transaction to qualify for the bona fide hedging exemption, it must be “established and liquidated in an orderly manner in accordance with sound commercial practice ….”  This allowance for hedging means that a market participant can hedge either on a one-to-one transactional basis, or on a portfolio level.

 

The bona fide hedging exemption only applies for the following enumerated hedging transactions and positions: 1) sales and purchases of Referenced Contracts that do not exceed specified limits;[11] 2) offsetting sales and purchases of Referenced Contracts that do not exceed specified limits;[12] 3) “purchases or sales by an agent who does not own or has not contracted to sell or purchase the offsetting cash commodity at a fixed price,” so long as the agent is responsible for the merchandising of the cash position being offset and has a contract with the person who owns the commodity or holds the cash market position being offset; 4) anticipated merchandising hedges;[13] 5) anticipated royalty hedges; 6) anticipated service hedges; and 7) cross-commodity hedges.[14]

 

In addition, positions in futures or swaps for Referenced Contracts will qualify as bona fide hedging transactions if they reduce the risk of pass-through swaps.[15]  There is also an exemption under section 151.5(j) of the CEA for market positions to exceed position limits in situations involving financial distress.

 

The reporting requirements for bona fide hedging are as follows: within three business days of exceeding a position limit, an entity must file a report with the CFTC containing information about the hedging transaction, and it must file additional data in a monthly report thereafter.

 

It should be noted that the CFTC allows market participants to request exemptions to allow transactions to qualify for bona fide hedging even if they are not listed in the enumerated hedges.


Position Visibility

 

If an entity holds or controls positions in certain metal or energy Referenced Contracts that exceed limits set by the CFTC, the person must file a form with the CFTC providing information about the entity’s positions.[16]

 

Aggregation of Positions

 

The final rule requires an entity to aggregate positions for all accounts in which it has a greater than 10 percent ownership or equity interest, directly or indirectly, as well as for all accounts that the entity controls.  This means that a financial holding company would have to aggregate positions across all of its proprietary trading accounts, including the accounts of its subsidiaries.  The rule also categorizes positions held by two or more entities acting under an express or implied agreement or understanding as if they were held by one entity.  Entities are also required to aggregate positions in accounts that have identical trading strategies.  This rule also applies for multiple accounts, pools or index funds (even passively managed index funds) if they have identical trading strategies, even if the 10 percent ownership threshold is not met.

 

Eligible entities can disaggregate client positions held by an Independent Account Controller (“IAC”); however, proprietary positions must be aggregated.  For example, if an advisor maintained various client accounts that were traded by independent managers, it could use the IAC exemption to disaggregate the positions held across multiple client accounts.  In addition to the IAC exemption, the CFTC allows disaggregation when an ownership interest above the 10 percent threshold is related to underwriting securities.  Also, entities can petition the CFTC for disaggregation relief by providing notice and an opinion of counsel stating that aggregation across commonly-owned affiliates would require information sharing that would violate federal law.  There is also a commodity pools exemption – an entity that is a limited partner or shareholder in a commodity pool does not have to aggregate positions as long as the entity does not control the trading decisions.[17]  In addition, if an entity owns 10 percent or more of a non-financial entity, positions can be disaggregated if the entity can show that the non-financial entity is independently controlled and managed.

 

In order to take advantage of the exemptions, an entity has to file a notice with the CFTC indicating that it intends to use a particular exemption as well as a certification that it meets the relevant requirements.  The notice will be effective upon filing, but the CFTC can audit the entity to make sure that it is in compliance with the rule.

 

Preexisting Positions

 

There is a good-faith exemption for pre-existing positions for futures and swaps that allows pre-existing positions above the limitations imposed by this rule, as long as they were established in good faith prior to the effective date.  However, the trader would not be able to further that position after the effective date without also taking offsetting positions.

 

In addition, the rule provides a broader good faith exemption for swaps entered before the effective date of Dodd-Frank, which is July 16, 2011.

 

Requirements for DCMs and Swap Execution Facilities

 

The final rule also requires DCMs and swap execution facilities to establish and enforce position limits at levels no greater than what the CFTC has established under section 151.4 of the CEA, as summarized above.



[1] Supplementary Information, Federal Register, Vol. 76, No. 223, p. 71662.

[2] The Referenced Contracts are: Chicago Board of Trade Corn; Chicago Board of Trade Oats; Chicago Board of Trade Soybeans; Chicago Board of Trade Soybean Meal; Chicago Board of Trade Soybean Oil; Chicago Board of Trade Wheat; ICE Futures U.S. Cotton No. 2; Kansas City Board of Trade Hard Winter Wheat; Minneapolis Grain Exchange Hard Red Spring Wheat; Chicago Mercantile Exchange Class III Milk; Chicago Mercantile Exchange Feeder Cattle; Chicago Mercantile Exchange Lean Hog; Chicago Mercantile Exchange Live Cattle; Chicago Board of Trade Rough Rice; ICE Futures U.S. Cocoa; ICE Futures U.S. Coffee C; ICE Futures U.S. FCOJ-A; ICE Futures U.S. Sugar No. 11; ICE Futures U.S. Sugar No. 16; Commodity Exchange, Inc. Copper; Commodity Exchange, Inc. Gold; Commodity Exchange, Inc. Silver; New York Mercantile Exchange Palladium; New York Mercantile Exchange Platinum; New York Mercantile Exchange Henry Hub Natural Gas; New York Mercantile Exchange Light Sweet Crude Oil; New York Mercantile Exchange New York Harbor Gasoline Blendstock and New York Mercantile Exchange New York Harbor Heating Oil.

[3] For the purposes of this summary, an “economically equivalent swap” includes a futures contract, options contract, swap or swaption (option to enter a swap).

[4] 17 CFR 151.1.

[5] Philip McBride Johnson & Thomas Lee Hazen, Derivatives Regulation (2004 & Supp. 2012), available at CCH IntelliConnect.

[6] The spot-month is the nearest delivery month in which delivery can be made on a futures contract.  The non-spot-month is any  non-delivery month.

[7] According to the CFTC website, the deliverable supply is the “total supply of a commodity that meets the delivery specifications of a futures contract.”  Since a futures contract includes where and when the commodity is to be delivered, the deliverable supply for any given commodity would be limited to the particular DCM on which it is traded.

[8] “Open interest” is the total number of options and/or futures contracts that are not closed or delivered on a particular day.

[9] A “physical marketing channel” is the cash market for a physical commodity.

[10] 17 CFR 151.5(a)(1).

[11] To qualify for the bona fide hedging exemption, sales of Referenced Contracts cannot exceed the “ownership or fixed-price purchase of the contract’s underlying cash commodity by the same person; and … [u]nsold anticipated production of the same commodity, which may not exceed one year of production for an agricultural commodity, by the same person provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts.”  17 CFR 151.5(a)(2(i)(A) – (B).

To qualify for the bona fide hedging exemption, purchases of Referenced Contracts cannot exceed the “fixed-price sale of the contract’s underlying cash commodity by the same person; [t]he quantity equivalent of fixed-price sales of the cash products and by-products of such commodity by the same person; and [u]nfilled anticipated requirements of the same cash commodity, which may not exceed one year for agricultural Referenced Contracts, for processing, manufacturing, or use by the same person, provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts.”  17 CFR 151.5(a)(2)(ii)(A) – (C).

[12] To qualify for the bona fide hedging exemption, offsetting sales and purchases cannot exceed “that amount of the same cash commodity that has been bought and sold by the same person at unfixed prices basis different delivery months, provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts.”  17 CFR 151.5(a)(2)(iii).

[13] A transaction qualifies as an anticipated merchandising hedge so long as the offsetting sales and purchases in Referenced Contracts do not exceed the “current or anticipated unfilled storage capacity owned or leased by the same person during the period of anticipated merchandising activity, which may not exceed one year; the offsetting sales and purchases in Referenced Contracts are in different contract months, which settle in not more than one year; and [n]o such position is maintained in any physical-delivery Referenced Contract during the last five dayso f trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts.”  17 CFR 151.5(a)(2)(v)(A) – C).

[14] A cross-commodity hedge is when a trader offsets a sale or purchase in a Referenced Contract with sale or purchase in a different commodity, provided that “[t]he fluctuations in value of the position in Referenced Contracts are substantially related to the fluctuations in value of the actual or anticipated cash position; and [n]o such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts.”  17 CFR 151.5(a)(2)(viii)(A) – (B).

[15] A pass-through swap is a swap “that was executed opposite a counterparty for whom the swap transaction would qualify as a bona fide hedging transaction” pursuant to the definition of bona fide hedging, as summarized above.

[16] An entity is deemed to have ownership or control over accounts when it directly or indirectly holds an ownership or equity interest of 10 percent or greater, or when it controls trading.

[17] A commodity pool is “an investment trust, syndicate, or similar form of enterprise operated for the purpose of trading commodity futures or option contracts.  [It is] [t]ypically thought of as an enterprise engaged in the business of investing the collective or ‘pooled’ funds of multiple participants in trading commodity futures or options, where participants share in profits and losses on a pro rata basis.”  CFTC website.

Previous post:

Next post: