CFTC Adopts Speculative Position Limits on Physical Commodities

Transcription

1 December 8, 2011 Practice Groups: Derivatives and Structured Products Investment Management Hedge Funds and Venture Funds Broker-Dealer CFTC Adopts Speculative Position Limits on Physical Commodities By Lawrence B. Patent, Charles R. Mills, Gordon F. Peery I. Introduction Culminating a process that took almost two years to complete, the Commodity Futures Trading Commission ( CFTC ), by a 3-2 vote on October 18, 2011, adopted regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ) imposing so-called hard position limits on a wide range of commodity interest contracts based upon underlying agricultural, metal and energy products. 1 On December 2, 2011, the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association initiated a legal challenge to the CFTC s regulations by both filing a suit in the federal district court in the District of Columbia and filing a petition for review of the regulations in the U.S. Court of Appeals for the District of Columbia Circuit. They allege that the CFTC violated the Administrative Procedure Act by (1) concluding that Dodd- Frank required it to establish position limits without first determining whether they were necessary; (2) failing to present a reasoned analysis or consider all evidence before adopting the regulations; (3) failing to conduct an adequate cost-benefit analysis; and (4) conducting a flawed rulemaking process that prevented commenters from meaningfully participating. They will seek guidance from the courts regarding which court is the correct forum for their challenge. The new regulations effectively cap the net speculative position (long or short) that a trader may hold -- even on an intraday basis -- of each of 28 specified futures contracts, options on those futures contracts, and economically equivalent swaps. 2 The regulations refer to those 28 futures contracts as Core Referenced Futures Contracts. 3 Such contracts and their economically equivalent options on futures and swaps will be referred to collectively as Referenced Contracts. Positions in Referenced Contracts that meet the CFTC s definition of bona fide hedges are exempt from the limits, provided a trader files a notice with the CFTC to claim the exemption. 1 Section 737(a)(4) of Dodd-Frank added Sections 4a(a)(2) and (3) to the Commodity Exchange Act ( CEA ) to authorize the CFTC to adopt position limits on exempt commodities (generally, energy and metals) and agricultural commodities. 2 A swap is deemed economically equivalent if it is: 1) 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); (2) 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; (3) an intercommodity spread contract with two reference price components, one or both of which are based on Referenced Contracts; or (4) priced at a fixed differential to a Core Referenced Futures Contract. For example, a swap settled to the price of the New York Mercantile Exchange ( NYMEX ) Heating Oil Calendar Swap Futures Contract would be economically equivalent because the floating price of the futures contract is equal to the monthly average settlement price of the first nearby contract month for the NYMEX New York Harbor No. 2 Heating Oil Contract. 3 The CFTC has created a new Part 151 for these regulations. The CFTC selected the 28 futures contracts as Core Referenced Futures Contracts because they (1) have high levels of open interest and significant notional value, or (2) serve as a reference price for a significant number of cash market transactions. (See our Appendix, hereto.) Basis contracts and commodity index contracts are not included in the definition of Referenced Contract, except Regulation states in defining commodity index contract that a commodity index contract used to circumvent speculative position limits shall be considered to be a Referenced Contract for the purpose of applying the position limits.

2 The CFTC did not set position limits for contracts on excluded commodities, which generally include contracts on securities and financial instruments, rates and indices. The CFTC position limits also do not apply to positions in exchange-traded funds on physical commodities. In addition to the new hard limits, the CFTC also adopted new visibility levels for specified metals and energy contracts. These levels do not trigger position limits, but reaching them will require traders to report information about their positions to the CFTC. As expected, the Commission vote split along party lines. Chairman Gensler and the other two Democratic appointees -- Commissioner Chilton and outgoing Commissioner Dunn -- voted in favor of the final regulation, while the two Republican appointees -- Commissioners Sommers and O Malia -- voted against the final regulations. Commissioner O Malia had voted to publish the proposals for comment in January, but at the time he had indicated that he was not necessarily committed to their adoption. 4 II. A Two-Phase Implementation The position limits will be implemented in two phases. During the first phase, the futures exchanges current spot-month position limits will become the hard limits for those months. 5 In addition, for each of those agricultural commodities that are already subject to CFTC limits (so-called legacy agricultural commodities), the final rules impose an identical limit for all months combined (including the spot month) and for any single month other than the spot month. These first phase limits will become effective sixty days after the CFTC adopts and makes effective its definition of the term swap. 6 In the second phase, the CFTC will determine limits for all months combined (including the spot month) and for any single month (other than the spot month) for all commodities other than the legacy agricultural commodities. Here again, each commodity s all-months-combined and single month limits will be identical. The initial limits will be established within a month after the CFTC obtains or estimates 12 months of open interest for futures, options on futures and swaps, pursuant to the CFTC s recently adopted final regulations governing large trader reporting for physical commodity swaps. 7 Following the completion of the second phase, limits will be adjusted biannually on staggered intervals throughout the year and published on the CFTC s website. The CFTC s published limits generally will adhere to the following formula: (1) for the spot month, 25% of deliverable supply, and 4 76 Fed. Reg (January 26, 2011). 5 These limits are set forth in Appendix A to new Part 151 of the CFTC s regulations. 6 The CFTC and the Securities and Exchange Commission have an ongoing rulemaking to further define the terms swap and security-based swap, which also addresses such issues as the treatment of forward contracts and currency products. 76 Fed. Reg (May 23, 2011). The CFTC has recognized that these product definitions will impact the other regulations related to swaps and thus has generally extended the compliance date for the regulation of swaps until the end of 2011, and has recently proposed a further extension until July 16, Fed. Reg (July 14, 2011) and 76 Fed. Reg (October 25, 2011), respectively Fed. Reg (July 22, 2011). During the second phase, the respective limits for spot-month contracts for both physically settled and cash-settled contracts will be 25% of deliverable supply. The cash-settled contract limit set forth in Regulation 151.4(a)(2) has been adopted as an interim final rule, with the CFTC accepting comments thereon through January 17, The deliverable supply figure will be re-set biannually and will be based upon the greater of the preceding 12-month or 24-month average, derived from exchange estimates and any CFTC revisions to them. However, there is one exception to the general rule of parity for physically-settled and cash-settled contracts. The limit for cashsettled contracts on Henry Hub natural gas will be five times greater than the limit for physically-settled contracts, provided that this higher cash-settled contract limit may not exceed the level of any single-month position limit, which will be set in accordance with the formula described herein. 2

3 (2) for all-months-combined/any single month, (a) 10% of open interest up to the first 25,000 contracts, plus (b) 2.5% of the open interest above 25,000 contracts. 8 III. The Non-Hedge Positions Subject to the Limits A. New Definition of Bona Fide Hedging The new position limits apply only to speculative positions, i.e., positions in futures, options on futures, and swaps that do not qualify as bona fide hedges under the CEA s and the CFTC s regulations. New CFTC Regulation sets forth a new, narrower definition of bona fide hedging to govern application of the new position limit regulations. Under this definition, bona fide hedging is limited to (1) positions that represent a substitute for positions taken or to be taken at a later time in a physical marketing channel, i.e., the cash market, and (2) positions entered into to mitigate the risk of a swap if the swap was executed opposite a counterparty that itself entered into the swap as a bona fide hedge. The latter qualification is referred to as a pass through swap because the qualification of one party s swap for bona fide hedging treatment will pass through to the counterparty when the counterparty enters into another position to offset the risk of the swap. 9 Thus, for example, if a swap dealer enters into a swap with an energy producer and the energy producer s use of the swap qualifies as a bona fide hedge, the swap dealer may treat any position it enters into to hedge the risk of the swap as a bona fide hedge position exempt from the application of the position limits. 10 The CFTC s pre-existing and broader definition of bona fide hedging in Regulation 1.3(z) will continue to apply only to excluded commodities. Accordingly, that broader hedging definition will still apply to such products as broad-based stock indices and interest rate instruments when used to manage the risk of a securities portfolio or to adjust the duration of a fixed-income portfolio. B. Portfolio Hedging Portfolio hedging will continue to qualify as bona fide hedging under the new CFTC definition described above. Portfolio hedging refers to positions that hedge the risk associated with several (or a portfolio of) cash market transactions. Traders therefore will not be required to link each commodity interest position to a discrete cash market transaction or position, as long as the aggregate positions claimed to be bona fide hedges can be linked to the aggregate portfolio of cash market risks. C. Exemptions From Position Limits Relating to Agents, Anticipatory Hedging, Royalties, Service Contracts and Financial Distress CFTC Regulation enumerates certain types of positions that will qualify as bona fide hedges. Four of these are the traditional hedges set forth in current regulations that involve ownership of physical commodities, fixed-price commitments on them, unfixed price commitments on them for 8 Open interest is the total number of contracts that have been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. 9 The CFTC stated that, for the pass-through to apply, the direct counterparty must be able to claim a hedge exemption. Therefore, a swap dealer could not claim this exemption by relying upon a series of transactions where the hedger was not its direct counterparty on the swap, but was only a party to a transaction in the series linked to the swap. 10 In this example, the swap dealer may rely upon this exemption from position limits if the energy producer provides a written representation that the swap qualifies in good faith as a bona fide hedge when executed. This representation must be retained by the parties for at least two years following expiration of the swap and furnished to the CFTC upon request. In addition, the energy producer must keep and make available to the CFTC upon request all relevant books and records supporting its representation for the same length of time, i.e., at least two years following expiration of the swap. 3

4 different delivery months, and cross-commodity hedges for commodities closely correlated in terms of market risk. The CFTC further expanded the list of enumerated transactions that will be deemed bona fide hedges or otherwise exempt from the application of position limits. They include, subject to conditions, positions entered into to hedge a merchandising agent s risks, anticipated merchandising activity, royalty payments (a type of asset), the hedging of service contracts, and circumstances where a trader is in financial distress. We discuss each of these in turn below. Agents Regulation 151.5(a)(2)(iv) provides that positions entered into by an agent to hedge risks associated with merchandising its principal s commodities will qualify as bona fide hedges. Anticipatory Hedging The CFTC will recognize an anticipatory merchandising transaction as a bona fide hedge, provided the following conditions are met: (1) the hedger owns dedicated capacity; (2) the hedge is only to the extent of unfilled dedicated capacity; (3) the hedge is in the form of a calendar spread (and utilizing a calendar spread is economically appropriate to manage the risks associated with anticipated merchandising activity); and (4) no such position is maintained in any physical delivery referenced contract during the last five days of trading of the Core Referenced Futures Contract for physical delivery of agricultural or metal contracts or the spot month for other physical delivery contracts. The anticipatory merchandising hedge exemption may extend for only one year forward for referenced agricultural contracts. The CFTC makes clear that an anticipatory hedge qualifies as such only as long as the trader is reasonably certain that it will engage in the anticipated activity. Further, the CFTC has clarified that the concept of unfilled capacity will include expected unfilled capacity over extended periods of merchandising, such as the circumstances of a grain elevator being emptied and replenished during harvest season, and thus this concept is not limited by the physical amount of unfilled storage capacity at a given point in time. Royalty Contracts New Regulation 151.5(a)(2)(vi) treats the positions of owners of royalty rights arising out of the production, manufacturing, processing, use or transportation of the commodity underlying a Referenced Contract as bona fide anticipatory hedges to the extent they are substantially related to anticipated royalty revenues. For the purpose of this section, a royalty right would include, among other things, rights to receive volumetric production payments. Service Contracts Regulation 151.5(a)(2)(vii) provides that positions entered into by a party to a service contract will qualify as a bona fide hedge only if the contract (1) arises out of the production, manufacturing, processing, consumption or transportation of the commodity underlying the referenced futures or futures-equivalent contract or substantially similar commodities, and (2) the hedge s value is substantially related to the anticipated payments or revenues from a contract for services. The preamble to the new regulations notes that crop insurance providers and other agents that provide services in a physical marketing channel could qualify for a bona fide hedge if their service contracts arise out of the production of the commodity. 4

5 Financial Distress Exemption In response to comments on the proposals, the CFTC has adopted what it refers to as the financial distress exemption. This will be available in circumstances involving the potential default or bankruptcy of a customer, affiliate or potential acquisition target of the person or persons requesting the exemption. Such an exemption will become effective only if a person specifically requests it and the CFTC issues an order granting it. Obtaining CFTC Guidance on Other Types of Hedge Positions The CFTC has revoked Regulation 1.47, which provided a means for traders to request bona fide hedge treatment for specific transactions and positions other than those enumerated in the regulations. The CFTC indicated, however, that traders seeking guidance regarding whether certain positions involving agricultural and exempt commodities would qualify as bona fide hedges may (a) approach the staff for guidance informally, (b) request relief pursuant to Regulation , or (c) petition the CFTC for issuance of a specific order or for rulemaking to expand the list of qualifying hedges. D. Filing Requirements -- Perfecting Hedge Exemptions and Form 404 and 404A Disclosures To perfect the enumerated bona fide hedge exemptions, a trader must file a notice with the CFTC using Form 404 claiming the exemption within three business days after exceeding a position limit. The exemption will become effective upon mailing. Form 404 must include data on cash market positions and Referenced Contracts used to hedge those positions. Thereafter, these data must be reported on Form 404 for each business day, but to lessen the reporting burden, the Form need only be filed on a monthly basis. For anticipatory hedges, the notice of a claim of exemption must be filed on Form 404A ten days in advance of a date the trader expects to exceed the position limit, and the notice will be effective after that ten-day period unless the CFTC otherwise notifies the trader. This notice must include information concerning anticipated activities that would be appropriate to justify a bona fide hedge classification. The CFTC may require the trader to submit such other information, before or after the effective date of the notice, that the CFTC deems necessary to determine whether the positions fall within the scope of bona fide hedges. IV. Aggregation of Positions A. General Rule Speculative position limits apply to a single trader and to a group of affiliated traders. Positions held by two or more traders acting pursuant to an express or implied agreement or understanding are treated the same as if the positions were held by a single trader. A trader must aggregate all positions in accounts in which the trader (1) directly or indirectly holds an ownership or equity interest of 10% or greater, (2) controls trading, by power of attorney or otherwise, or (3) has any interest and such accounts use identical trading strategies to those other owned or controlled accounts. Accordingly, a trader must aggregate, for example, all of its positions in commodity interests held in any commodity pools, separately-managed accounts, and passively-managed index funds in which the trader has any interest (i.e., where the 10% threshold requirement for determining ownership interest does not apply), to the extent that such pools or accounts use identical trading strategies to the accounts the trader has a 10% ownership interest in or over which it has trading control. 5

6 B. Commodity Pools The CFTC s new regulations retain the current disaggregation exemption from position limits related to interests in commodity pools. Accordingly, except for a pool s commodity pool operator ( CPO ), a participant in a commodity pool need not aggregate the commodity pool s positions with the participant s own positions held outside the pool, as long as the participant does not control the commodity pool s trading decisions and the participant and the pool do not use identical trading strategies. This is true also for a trader who is a principal or affiliate of a pool s CPO, provided that the trader does not control or supervise the commodity pool s trading and the CPO has proper informational barriers between the commodity pool s trading and the trader. In addition, the current rule that requires aggregation of a pool s positions with the positions of a pool participant that has a 25% ownership interest in a pool will continue to apply to small pools (as defined in the regulations) whose operators are exempt from CPO registration requirements. 11 C. Independent Account Controllers The CFTC did not adopt one of its more controversial proposals, which would have eliminated the existing disaggregation exemption for accounts of the same entity that are independently controlled by different persons, known as independent account controllers ( IACs ). Pursuant to the CFTC s IAC exemption provision, as retained, an eligible entity, which includes mutual funds, banks, CPOs, commodity trading advisors ( CTAs ) and insurance companies, may disaggregate from its proprietary positions those positions that are managed by an IAC if certain conditions are satisfied. Those conditions are that an IAC must (1) trade independently of the eligible entity and of any other IAC trading for the eligible entity, (2) have no knowledge of the trading decisions by any other IAC, and (3) be registered as a futures commission merchant, introducing broker or CTA, or as an associated person of any of the foregoing registrants, or be a general partner of a commodity pool whose operator is exempt from CPO registration. Importantly, however, aggregation of the positions of all IACs is required during the spot month in a physical-delivery Referenced Contract. In determining whether the IAC trades independently of an entity, the CFTC will consider the degree to which there is a functional separation (a) between the proprietary trading desk of the eligible entity and the IAC s trading operations and (b) between the research functions supporting an eligible entity s proprietary trading desk and those supporting the IAC s trading decisions. An eligible entity s research information concerning fundamental demand and supply factors and other data may be made available to an IAC. However, the trader would not retain IAC status if specific trading recommendations of the eligible entity contained in such research information were substituted for a trader s independently-derived trading decisions. If the person who directs trading in an account of an eligible entity regularly follows the trading suggestions disseminated by the eligible entity, such trading activity will be evidence that the account is controlled by the eligible entity. A sufficient informational firewall separating the trading and research functions is necessary to qualify for the IAC exemption. 11 An exempt small commodity pool for these purposes is a pool that has (i) no more than 15 participants, and (ii) total gross capital contributions that do not exceed $400,000. In addition, a CPO need not register as such under the CEA if (i) it operates only one pool at a time, (ii) it receives no compensation, except reimbursement for ordinary administrative expenses, (iii) there is no advertising of the pool, and (iv) it is not otherwise required to register, nor is it an affiliate of any person required to register, under the CEA. CFTC Regulation 4.13 currently provides two additional CPO registration exemptions not limited by the number of participants, amount of capital contributions or compensation to the CPO (although subject to investor qualifications and, in one case, limits on the amount of commodity interest trading), so it is unlikely that a single investor would own 25% of such pools. The CFTC has proposed to revoke these latter two exemptions. 6

7 Additional requirements apply if the IAC is affiliated with the eligible entity or another IAC. 12 In these cases, each of the affiliated entities must take the following steps: (i) enforce written procedures to preclude the affiliated entities from having knowledge of, gaining access to, or receiving data about, trades of the other -- these procedures must include document routing and other procedures or security arrangements, including separate physical locations, to maintain independence; (ii) trade such accounts pursuant to separately developed and independent trading systems; (iii) market such trading systems separately; and (iv) if CFTC regulations require them to use disclosure documents to solicit funds for such trading, such solicitations must be made by using separate disclosure documents. In addition, it is important to recognize that, under the CFTC s IAC exemption, the IAC must aggregate, like every other trader, all of the speculative positions in accounts in which it owns at least 10%, for which it controls trading, or in which it has any interest and which uses identical trading strategies. Thus, when an IAC s aggregate speculative position for all such accounts approaches or reaches the limit, its ability to trade on behalf of existing or new clients will be correspondingly constrained. For example, if a CPO engages an IAC to direct the trading of the pool, positions entered in other third-party accounts managed by the IAC will be aggregated with those of the pool, and, if they collectively trigger a position limit, that will restrict the size of any position the IAC might establish for the CPO s pool thereafter. D. Affiliates The CFTC s general rule is that all accounts in which a trader directly or indirectly has a 10% or greater ownership or equity interest must be aggregated. In order to mitigate the impact of the aggregation requirements that apply to commonly-owned entities or accounts, however, the CFTC has adopted two new provisions that were not previously proposed. First, Regulation 151.7(g) will allow a person to disaggregate when ownership above the 10% threshold is associated with the underwriting of securities. Second, Regulation 151.7(i) will provide for disaggregation relief, subject to notice filing and an opinion of counsel, in instances where aggregation across commonly-owned affiliates (above the 10% ownership threshold) would require sharing position information that could result in the violation of federal law, such as restrictions imposed by bank regulators, the Federal Energy Regulatory Commission, and the antitrust laws. The CFTC notes, however, when a trader has actual knowledge of the positions of an affiliate, that trader is required to aggregate all such positions. This implies that a trader relying on this provision must maintain information barriers between itself and the affiliate. E. Filings to Claim Exemption From Aggregation Requirements To obtain an exemption from aggregation, a trader must file a notice with the CFTC within five business days of the time the trader claims a disaggregation exemption, which notice is effective upon submission. This differs from the existing self-effectuating exemption from aggregation requirements and from the CFTC s proposal, which would have required that the CFTC approve an application for exemption and annual renewal. The notice required under the new regulations must include a description of the relevant circumstances that warrant disaggregation as well as the trader s certification that it meets the relevant conditions for the exemption claimed. The CFTC may require a trader to provide additional information concerning the claim for exemption. 12 The IAC is affiliated with an eligible entity or another IAC where one party directly or indirectly controls, is controlled by or is under common control with the IAC, which would include parent, subsidiary and sister company relationships. 7

8 V. Class Limits The CFTC decided not to adopt class limits (i.e., separate limits for different classes of transactions -- swap, futures, options on futures). Accordingly, compliance with non-spot month position limits will be determined in reference to a trader s net speculative position with respect to a particular commodity across its aggregate positions in Core Referenced Futures Contracts and economically equivalent options on futures and swaps. VI. Preexisting Positions A. In General Regulation provides a limited exemption for preexisting positions that are in excess of the position limits, provided that they were established in good faith prior to the effective date of a position limit. Therefore, if a trader s preexisting positions acquired in good faith exceeded the limit, the trader would not be deemed to be in violation of the limit. Such a trader, however, would not be allowed to enter into new, additional contracts in the same direction, but could enter into offsetting positions and thus reduce its net position. If the trader s preexisting position were below the limit, and the trader adds contracts in the same direction after the limit becomes effective, the CFTC, for purposes of determining position limit compliance, will combine the trader s preexisting Core Referenced Futures Contracts, and options on such futures, and the trader s post-effective-date contracts in such futures and options and economically equivalent swaps. Accordingly, a trader could not violate position limits based upon preexisting positions alone, but preexisting futures and options contracts that were below the limit would be included in the computation of the trader s overall position after the effective date of the limit. The CFTC will also permit swap dealers to continue to rely on the exemption recognized in the now repealed Regulation 1.47 for open swaps, so that swap dealers may continue to manage the risk of their swap portfolio that exists at the time of implementation of the new limits, but new swaps would need to comply with the new requirements for exemption to be excluded from the computation of the swap dealer s position under the new regulations. B. Index Funds For index funds that roll over their existing positions as a new delivery month approaches, any newlyestablished positions as a result of a rollover that occur after the effective date of a new position limit will not qualify for the preexisting position limit exemption. Further, although several commenters recommended that commodity index funds be generally exempted from position limits, the CFTC stated that more analysis is needed before it would create a general exemption or adopt a separate position limit regime for any group or class of traders such as commodity index funds. The CFTC release invited the submission of additional studies in this area. As explained above, the CFTC s aggregation requirements for positions in managed accounts with identical trading strategies will include positions in passively-managed index funds. VII. Foreign Boards of Trade Regulation provides that the position limits also encompass a trader s positions in referenced contracts executed on, or pursuant to the rules of, a foreign board of trade ( FBOT ), subject to the following conditions: (1) the contract, agreement, or transaction must settle against the price of a contract executed or cleared pursuant to the rules of a U.S. exchange; and (2) the FBOT must make 8

9 such linked contracts available to its members or other participants located in the United States by direct access to its electronic trading and order matching system. VIII. Position Limits Set by Registered Entities Regulation requires each commodity exchange in the United States to establish hard position limits for Referenced Contracts that are no higher than the CFTC position limits. For non-referenced Contracts, exchanges may adopt the CFTC s general formula referred to above for establishing position limits. Exchanges are also provided a safe harbor whereby they may adopt non-spot-month limits of up to 1,000 contracts for tangible commodities other than energy products and up to 5,000 contracts for energy products and non-tangible commodities, including contracts on financial products, provided that the notional quantity per contract is no larger than a typical cash market transaction in the underlying commodity. Each exchange must apply the CFTC s new account aggregation standards and bona fide hedging definition with respect to exempt and agricultural commodities. As alternatives to the above-described limits for non-referenced Contracts, the exchanges have discretion to establish position accountability levels. For agricultural or exempt commodities that are outside of the new Referenced Contract framework, U.S. exchanges have the discretion to establish position accountability levels in lieu of position limits if: (1) average month-end open interest is 50,000 or more contracts; (2) average daily trading volume is 5,000 or more contracts; and (3) there is a highly liquid cash market. Position accountability levels also may be established with respect to excluded commodities if (a) the contract involves a major currency for which there is no legal impediment to delivery and for which a highly liquid cash market exists, or (b) the excluded commodity is an index or measure of inflation, or other macroeconomic index or measure, or meets the definition of excluded commodity under CEA Sections 1a(19) (ii), (iii) or (iv). 13 For all other excluded commodities (interest rates, exchange rates, non-major currencies, broad-based security indices, credit risks or measures, and debt or equity instruments), an exchange must present either a position limit or an accountability level to the CFTC, which will determine if it meets the core principles under the CEA. When position accountability levels are reached, exchange staff typically contact traders to inquire about their trading and sometimes request that they reduce their positions, but reaching these levels is not a violation of exchange rules or CFTC regulations. As noted above, the definition of bona fide hedging applicable to positions in excluded commodities will continue to be the definition in CFTC Regulation 1.3(z), except that exchanges may also continue to provide exemptions for risk-reducing and risk-management transactions consistent with existing CFTC guidance. 14 The CFTC will continue to recognize prior exemptions granted by the CFTC staff for positions that did not meet the definition of bona fide hedging in Regulation 1.3(z). In addition, U.S. exchanges are authorized to grant exemptions for positions that do not meet the definition of bona fide hedging exempt transactions, subject to Commission review. 13 These excluded commodities relate to indexes or measures of commodities with no cash market, that are based upon prices, rates, values or levels beyond the control of any party to the contract, and so-called event contracts, respectively. 14 See Clarification of Certain Aspects of Hedging Definition, 52 Fed. Reg (July 20, 1987); and Risk Management Exemptions from Speculative Position Limits Approved under CFTC Regulation 1.61, 52 Fed. Reg (September 14, 1987). 9

10 IX. Position Visibility Levels The CFTC has established position visibility levels for Referenced Contracts on energy and metals, which are calculated on the basis of a trader s total position in such contracts in all months combined, including bona fide hedge positions. Once a trader crosses a position visibility level, the trader must file quarterly reports with the CFTC that disclose the trader s physical and derivatives portfolio in that commodity and substantially the same commodities as the Referenced Contract. The CFTC believes that the position visibility levels will enhance its surveillance capabilities and permit it to better understand the positions of the largest traders for referenced energy and metals contracts, as well as better enable the CFTC to set and adjust subsequent position limits. The position visibility levels will be approximately 50% of the position limit, with the exception of crude oil and Henry Hub natural gas, where the levels have been set lower. The CFTC s final regulations require reporting of uncleared swaps only if visibility levels are reached in any single month of those uncleared swaps (rather than requiring all related positions). X. Conclusion The CFTC s new position limit regulations under Dodd-Frank will, when they take effect, impose hard federal limits for many commodities where such limits have previously not existed, a narrower definition of bona fide hedging for these limits, and new visibility levels and corresponding reporting requirements. Some of the CFTC s original proposals, such as separate specific class limits on futures, options on futures, and swaps were not adopted, and the CFTC elected to retain the current disaggregation exception for IACs. The market impact of these new limits remains to be seen and may not be known for some period of time. The limits on new positions in other than the spot month will not take effect until Phase II, which will not begin before Traders should therefore utilize this transition period to review their trading strategies and make any necessary adjustments to minimize the impact of the new regulations. 10

11 Appendix Commodities Subject to Position Limits The commodities subject to the position limit rules include: The nine agricultural products with existing limits -- corn, cotton, oats, soybeans, soybean meal, soybean oil, and three wheat contracts that are traded in Chicago, Kansas City (hard winter wheat) and Minneapolis (hard red spring wheat) (these are know as the legacy agricultural products); Ten additional agricultural products -- milk, feeder cattle, live cattle, lean hogs, rough rice, cocoa, coffee, frozen concentrated orange juice, and two sugar contracts; Four energy products -- crude oil, gasoline, heating oil, and Henry Hub natural gas; and Five metals -- copper, gold, silver, palladium, and platinum. The definition of Referenced Contract in final Rule expressly excludes commodity index contracts [which are indexes] comprised of prices of commodities that are not the same nor substantially the same. Thus, diversified commodity index positions are excluded from the position limit regime. However, single commodity index contracts fall within the scope of the position limit regime. Authors: Lawrence B. Patent Charles R. Mills Gordon F. Peery