Commodity Futures Trading Commission Proposes Position Limits for Commodity Derivatives

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1 To Our Clients and Friends Memorandum friedfrank.com Commodity Futures Trading Commission Proposes Position Limits for Commodity Derivatives Summary The Commodity Futures Trading Commission (the Commission or CFTC ) is proposing to establish a framework for implementing position limits for certain physical commodity derivatives, including exchange-traded futures and options on futures contracts and swaps that are economically equivalent to such contracts, in accordance with Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( Dodd-Frank Act ). The proposal also includes: (i) amendments to the bona fide hedging exemption; (ii) an exemption for positions established in good faith prior to the effective date of specific limits that could be adopted in final rules; (iii) new account aggregation standards; (iv) position visibility levels and associated reporting requirements for traders with positions exceeding specified thresholds in certain metal and energy commodities; and (v) rules imposing requirements and standards for position limits and accountability rules that are implemented by exchanges. Comments on the Notice of Proposed Rulemaking ( NPRM ) are due on or before March 28, Proposed Position Limit Framework The Commission is proposing to establish position limits in a new Part 151 of its Rules in two phases in view of the Dodd-Frank Act s rulemaking deadlines. Phase One For phase one, the Commission would establish interim spot month limits for referenced contracts, 1 determined by futures exchanges, a/k/a designated contract markets ( DCMs ), to be equal to 25% of estimated deliverable supply. Since the DCMs are currently able to provide such estimates, the 1 Referenced contracts refers to futures, options, swaps or swaption contracts, in or linked to a list of 28 specified agricultural, metal and energy commodities. The agricultural contracts are cocoa, coffee, cotton No. 2, feeder cattle, frozen concentrated orange juice, lean hogs, live cattle, class III milk, oats, rough rice, soybeans, soybean meal, soybean oil, sugar No. 11, sugar No. 16, CBOT wheat, hard red spring wheat, and hard winter wheat. The metal and energy contracts are copper, gold, palladium, platinum, silver, light sweet crude oil, gasoline, natural gas, and No. 2 heating oil. For this purpose, referenced contracts mean derivatives that: (i) are directly or indirectly linked to the price of a listed futures or options contract under Rule ( Rule listed contract ); or (ii) are based on the price of the same commodity for delivery at the same location(s) as that of a Rule listed contract, or another delivery location with substantially the same supply and demand fundamentals as the delivery location of a Rule listed contract. Copyright 2011 Fried, Frank, Harris, Shriver & Jacobson LLP 02/14/2011 A Delaware Limited Liability Partnership

2 Commission can implement spot month limits relatively expeditiously in this transitional phase while waiting to receive the necessary data to implement non-spot month limits in the second phase. Phase Two For phase two, the Commission would establish non-spot month limits (i.e., single month and all months combined limits) for reference contracts based on open interest levels and would replace the interim spot month limits with Commission-determined spot month limits. Spot month position limits would be set at 25% of estimated deliverable supply for a given commodity, as determined by the Commission, with a conditional spot month limit of five times that amount for entities with positions exclusively in cash-settled contracts. In setting Commission-determined spot month limits during the second phase of implementation, the Commission will evaluate DCM estimates as well as its own data regarding the deliverable supply of the relevant commodities. The Commission is requesting comment on how broadly or narrowly it should consider what constitutes deliverable supply in a given commodity; whether the Commission should adopt the proposed conditional spot month limits or instead a uniform spot month limit; or whether the proposed conditional spot month limit should be set at a higher level relative to the level of deliverable supply and if so, why. Non-spot position limits (including aggregate single month and all months combined limits that would apply across DCM futures and options, and all swaps, as well as single month and all months combined position limits separately for DCM futures and options and all swaps) would be set for each referenced contract at 10% of open interest in that contract up to the first 25,000 contracts, and 2.5% thereafter. The Commission is requesting comment on, among other things, whether the 10, 2.5% formula should be uniformly applied to all referenced contracts or whether the Commission should set limits at a higher level, such as a 10, 5% formula based on open interest, in particular given that single month and all months combined position limits are not currently in place for energy and metal markets, and also whether additional classes, such as separate class categories for cleared and uncleared swaps, should be adopted to ensure that large positions that result in excessive concentration of positions in a submarket are not acquired. The Commission is proposing to retain the all months combined position limits for the enumerated agricultural commodities in CFTC Rule (e.g., corn, cotton, soybeans, wheat) as an exception to the general open interest-based formula. The single month limit could be increased to the same level as the legacy all months combined limit, with the elimination of the calendar month spread exemption. Exemptions for Reference Contracts The referenced contracts subject to the proposed position limit framework would be subject to the bona fide hedging exemption provisions in proposed Rule and would no longer be subject to the bona fide hedge exemption provisions in Rule 1.3(z), which would remain available only for positions in excluded commodities such as interest rates and currencies. Consistent with the Commission s interpretation of Dodd-Frank Act amendments to Section 4a of the Commodity Exchange Act (the CEA ), the hedging definition in proposed Rule is narrower than the definition in current Rule 1.3(z) in that risk-reducing transactions or positions in the referenced contracts could qualify as bona fide hedging only if they represent a substitute for cash market transactions, and offset cash market risks, as opposed to the traditional recognition of bona fide hedging transactions and positions under Rule 1.3(z) as a riskreducing activity that normally, but not necessarily, represents a substitute for cash market transactions or positions. In this regard, the Commission is also proposing that a transaction or position in a referenced contract entered into to reduce risks related to a swap transaction could qualify as bona fide hedging only if: (i) the swap transaction was executed opposite a counterparty for whom the existing swap transaction would qualify as a bona fide hedging transaction under the new definition; or (ii) the swap transaction meets the requirements of a bona fide hedging transaction under the new definition. The NPRM notes that the Commission has previously granted certain swap dealers hedge exemptions 2

3 under current Rules 1.3(z) and 1.47, without regard to the purposes or hedging needs of swap dealer counterparties. The Commission intends to permit such dealers to continue to manage the risk of a swap portfolio that exists at the time of implementation of the new rules, but no new swaps will be covered. Position Visibility Levels The Commission is proposing to establish position visibility and reporting requirements for referenced contracts other than referenced agricultural contracts, i.e., referenced base and precious metal and referenced energy contracts. These reporting requirements are intended to make the physical and derivatives portfolios of the largest traders in referenced contracts visible to the Commission. A trader holding or controlling a position in a referenced contract above a specified threshold would have to submit reports to the Commission requiring: (i) additional information about cash market and derivatives activity, including data relating to substantially the same commodity (e.g., different grades or formulations); (ii) additional information on its uncleared swaps in substantially the same commodity; and (iii) information about cash market positions in substantially the same commodity. 2 The Commission is soliciting comments on whether position visibility requirements should also be imposed on referenced agricultural contracts. Aggregation of Accounts The proposed regulations also would amend the Commission s current account aggregation standards in a number of significant respects. Specifically, proposed Rule 151.7: (i) does not retain the independent account controller exemption in existing Part 150 of the CFTC s rules; (ii) requires a trader to aggregate positions in multiple accounts or pools, including passively managed index funds, if those accounts or pools have identical trading strategies even if they are separately traded; (iii) establishes a limited exemption, subject to Commission approval, for: (a) positions in pools in which a person who is a limited partner or shareholder has an ownership or equity interest of between 10% and 25%, if the person does not have control over, or knowledge of, the pool s trading; (b) the positions held by a futures commission merchant ( FCM ) or its affiliates in a customer discretionary account, if it maintains only minimum control over trading in the relevant account and if the trading decisions made for that account are independent from trading decisions in the FCM s or affiliates other accounts; and (iv) establishes a limited exemption for entities to disaggregate the positions of an independently controlled and managed trader that is an owned non-financial entity. 3 Under this approach, a passive pool participant with a 25% or greater ownership or equity interest would have to aggregate the pool s positions, even if the pool participant does not have control over, or knowledge of, the pool s trading. Without the independent account controller exemption in Part 150, (i) a multi-advisor pool would have to aggregate all trading conducted for the pool by each of its advisors, including non-spot month positions, even if each of the advisors is trading independently of the others on the pool s behalf; and (ii) a passive ownership interest of 10% or more by one entity in a financial entity such as an investment adviser could require aggregation of the positions traded by, or on behalf of, the financial entity, even if there are robust information barriers in place and the acquiring entity does not have control over, or knowledge of, the owned financial entity s trading, whether direct or indirect. The Commission is soliciting comments on all aspects of the proposed account aggregation standards, including in particular the definition of owned non-financial entities and the criteria used to determine the independence of such entities. The Commission is also soliciting comments on whether and under what circumstances it should grant exemptions from account aggregation under its exemptive authority pursuant to Section 4a(a)(7) of the CEA. 2 3 The Commission notes that the proposed position visibility reporting regime is similar to current reporting obligations for large bona fide hedgers in certain agricultural commodities under Part 19 of the CFTC s rules. This term means any entity that is not a financial entity (e.g., financial institution, insurance company, investment company, commodity pool, employee benefit plan, broker-dealer, FCM, floor broker, floor trader, commodity trading advisor, or investment adviser), and in which another entity directly or indirectly has a 10% or greater ownership or equity interest. 3

4 Preexisting Positions and Exemptions The Commission intends to provide a limited exemption for positions in DCM futures or option contracts that are in excess of a position limit in proposed Rule 151.2, provided that the positions were established in good faith prior to the effective date of a position limit set by rule, regulation or order. Such persons would not be allowed to enter into new, additional contracts in the same direction but could take offsetting positions and thereby reduce their total combined net position. The new position limits on proposed Rule would not apply to Dodd-Frank Act pre-effective date swaps. Also, the Commission would allow pre-effective date swaps to be netted with post-effective date swaps for the purpose of complying with the position limits. As noted earlier, the Commission intends to permit swap dealers to continue to rely upon hedge exemptions to manage the risk of a swap portfolio that exists at the time of the implementation of the proposed regulations, but no new swaps will be covered by these exemptions. The Commission is seeking comments on what additional reporting requirements, if any, it should impose on swap dealers that were granted a hedge exemption. Foreign Boards of Trade Proposed Rule would apply the proposed aggregate position limits to a trader s positions in referenced contracts executed on, or pursuant to the rules of, a foreign board of trade ( FBOT ) only if: (i) the FBOT contract agreement or transaction settles against the price of a contract executed or cleared pursuant to the rules of a registered entity such as a DCM, a swap execution facility, or a derivatives clearing organization; and (ii) the FBOT makes such a linked contract available to its members or other participants located in the United States by direct access to its electronic trading and order matching system. Registered Entity Position Limits For referenced contracts registered entities would have to establish position limits at a level no higher than Commission-imposed position limits and follow the same account aggregation standards and bona fide hedging exemption standards established by the Commission with respect to exempt (i.e., metal and energy) and agricultural commodities. For excluded commodities, registered entities would have the discretion to establish position accountability levels in lieu of position limits for contracts meeting certain eligibility criteria and to provide exemptions from their position limits for bona fide hedging, as defined in amended Rule 1.3(z). Consistent with current DCM practice, registered entities may continue to provide exemptions for riskreducing and risk management transactions or positions in accordance with existing Commission guidelines. The Commission also will continue to recognize prior Commission determinations relating to bona fide hedge exemptions for non-enumerated transactions or positions under Rule 1.3(z)(3), and registered entities may recognize non-enumerated hedge transactions subject to Commission review, even though the Commission is proposing to remove the procedure for applying for bona fide hedge exemptions for such non-enumerated transactions or positions under Rule 1.3(z). * * * We will continue to monitor and report on developments in this area. 4

5 Authors: David S. Mitchell Russell L. Kamerman Mark Molle Contact: This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or the attorneys listed below: David S. Mitchell Partner New York Washington, DC London Paris Frankfurt Hong Kong Shanghai friedfrank.com 5