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E-MailOn Tuesday, October 18, the U.S. Commodity Futures Trading Commission (CFTC) voted 3-2 to adopt final rules imposing speculative position limits on certain agricultural, metals and energy futures and swaps contracts, pursuant to Section 737 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The final rules have not yet been published. The following discussion is based on statements made by CFTC staff and commissioners at the October 18 meeting as well as the CFTC-issued fact sheet and Q&A about the final rules.
Opening Statements by Commissioners
At the meeting, Commissioners Scott O’Malia and Jill Sommers made statements opposing the final position limits rule for many reasons, including that the rule was contrary to the Commodity Exchange Act (CEA), as amended by Dodd-Frank. Commissioners O’Malia and Sommers voted against the rule. Commissioner Michael Dunn issued an opening statement noting that he did not believe imposing position limits would have any effect on prices and may actually increase price volatility as well as costs to hedgers, but that Congress had required the CFTC to impose position limits. Despite Commissioner Dunn’s conclusion that “position limits are, at best, a cure for a disease that does not exist or a placebo for one that does,” he voted in favor of the proposal. Commissioner Bart Chilton supported the final rule, emphasizing that although the rule would not please everyone, it would ensure more efficient and effective markets devoid of fraud, abuse and manipulation. Chairman Gary Gensler, who cast the final vote in favor of the proposal, asserted in his statement that Congress had directed the CFTC to impose position limits and narrow the bona fide hedge exemption.
Scope of Contracts Subject to Position Limits
The final rules will establish speculative position limits for 28 physical commodity futures contracts — 19 agricultural contracts, [1] 5 metals contracts [2] and 4 energy contracts [3] (Core Referenced Futures Contracts) — as well as futures and swaps that are economically equivalent to those contracts (collectively, Referenced Contracts). A swap will be considered “economically equivalent” to a futures contract if it is: 1) a “look-alike” contract (i.e., it settles off a Core Referenced Futures Contract or a contract based on the same commodity with the same delivery location as the Core Referenced Futures Contract); 2) a contract with a reference price based on the combination of one or more Referenced Contract prices and one or more prices in the same or substantially the same commodity as that of the Core Referenced Futures Contract (provided that the contract is not a locational basis swap); 3) an intercommodity spread contract with two reference price components, at least one of which is based on a Referenced Contract, or 4) a contract priced at a fixed differential to a Core Referenced Futures Contract.
Types of Position Limits
Two types of speculative limits would be imposed on the Referenced Contracts: spot-month limits and non-spot-month limits. Spot-month limits will be based on 25 percent of CFTC-determined deliverable supply, and will apply separately to physically delivered and cash-settled contracts. In the initial phase of implementation, the CFTC will use current designated contract market (DCM) estimates of deliverable supply to impose spot-month limits. These initial limits will become effective 60 days after the term “swap” is further defined in a CFTC/SEC joint rulemaking. Thereafter, spot-month limits will be updated annually for energy and metals contracts and every two years for agricultural contracts, based on estimates of deliverable supply that DCMs will be required to submit to the CFTC.
The CFTC’s final regulations do not incorporate the proposed “conditional-spot-month position limit” that would have allowed a trader to hold cash-settled contract positions up to five times the spotmonth limit (i.e., 125 percent of the deliverable supply) and 25 percent of the deliverable supply of the physical commodity provided that the trader did not hold any physically delivered contract positions. The CFTC’s final regulations will allow a trader in only one type of contract — the NYMEX Henry Hub Natural Gas contract — to hold cash-settled contract positions up to five times the spotmonth limit. However, the trader also will be subject to an aggregate five-times limit that applies to the trader’s total cash-settled and physically delivered contract positions. Thus, if a trader wants to hold physically delivered contracts up to the spot-month limit, the trader would have to make sure the trader’s cash-settled contract positions do not exceed four times the spot-month limit. Alternatively, a trader could hold no positions in the physically delivered contract, but five times the limit in the cash-settled contract alone and still be in compliance with the aggregate limit.
Non-spot-month position limits (i.e., limits applied to positions in all contracts months combined or in a single contract month) will be set at 10 percent of a contract’s open interest (combined futures and swaps open interest) for the first 25,000 contracts and 2.5 percent thereafter. The CFTC will impose initial non-spot-month limits by CFTC order after the CFTC has received one year of open interest swaps data under the swaps large trader reporting rule. These non-spot-month limits will then be adjusted every two years by applying the 10/2.5 formula to two years of open interest data. The CFTC, however, will take a different approach with respect to non-spot-month limits in “legacy” agricultural Referenced Contracts that are currently subject to CFTC limits. The level of non-spotmonth limits for legacy contracts will be specified in the final CFTC rulemaking and will go into effect 60 days after the term “swap” is further defined.
Exemptions
In terms of exemptions from position limits, the CFTC’s final regulations recognize a bona fide hedging exemption and an exemption for pre-existing positions (i.e. positions established in good faith prior to the effective date of the initial limits established under the regulations). The CFTC essentially codified the Dodd-Frank amended definition of “bona fide hedging,” which requires in part that a bona fide hedging transaction or position represent a substitute for a transaction or position in the physical marketing channel. Additionally, the “bona fide hedging” definition recognizes a “pass-through” exemption for a trader who uses Referenced Contracts to offset the risk of a swap that itself qualifies as a bona fide hedge. The CFTC also included a list of enumerated hedging transactions that would be eligible for a bona fide hedge exemption and extended the proposed list to certain narrowly defined anticipated merchandising transactions, royalties and service contracts.
During a break in the meeting, the commissioners apparently negotiated an amendment that might allow for greater flexibility in seeking “bona fide hedging” exemptive relief. Under the amendment, traders who are engaged in risk-reducing practices commonly used in the industry (that do not appear to be specifically enumerated) may petition the CFTC staff or the CFTC for relief from position limits under the CFTC’s broad exemptive authority in CEA Section 4a(a)(7). A prior version of the final rule would have only allowed such traders to ask for interpretive guidance as to the status of their hedging practices. This amendment will be incorporated in the final rule release, which should be available in several days according to Chairman Gensler.
Account Aggregation
The CFTC’s final regulations adopt a modified version of its existing account aggregation rules, including the longstanding independent account controller exemption to aggregation. One modification to the current aggregation policy appears to be the inclusion of an “identical trading strategy” aggregation rule, as the CFTC had proposed. That rule will require a trader to aggregate positions in multiple accounts or pools, including passively managed index funds, if those accounts or pools have “identical trading strategies.” Thus, a trader would be subject to an aggregation requirement if the trader holds one or more shares in multiple long-only index funds. Whether the trader would be required to aggregate a pro rata portion of the positions or all of the funds’ positions remains unclear, pending the text of the final rules. CFTC staff indicated that the goal of the “identical trading strategy” aggregation requirement was to ensure that a trader who may hold less than a 10 percent interest in various index funds nevertheless does not amass a large position across those funds.
Position Visibility Levels
The CFTC’s final regulations adopt a position visibility reporting regime that will apply to traders exceeding a CFTC-set, non-spot-month position visibility level in energy and metals Referenced Contracts. Such traders will be required to submit quarterly reports regarding their physical and swaps portfolios. The CFTC expects that the position visibility reports will provide it with a better understanding of trading activity in the physical commodity futures and swaps market and, accordingly, will enable the CFTC to more effectively enforce position limits and/or adjust the position limit framework as needed.
Registered Entity Position Limits and Accountability Levels
The CFTC’s final regulations will include Acceptable Practices for DCMs and swap execution facilities for setting position limits for the 28 Referenced Contracts, as well as position limits for all other listed contracts and accountability rules for certain excluded commodities.
Staff Comments
There were several noteworthy comments from the CFTC staff regarding the final position limit rulemaking. For instance, when asked whether it had a working definition for “excessive speculation” — the term used, but not defined in the statute — the staff responded that it did not. The staff also acknowledged that it had not identified any situations where excessive speculation had caused unreasonable or unwarranted price fluctuations or price volatility in the markets. However, the staff asserted that it did not need to find a nexus between excessive speculation and price because Congress had already found that excessive speculation constitutes an undue burden on commerce. The staff further noted that there are ongoing internal and external studies on commodity index funds and index traders, but so far staff have not yet reached a “firm quantitative conclusion” as to the effect (if any) of such market participants on prices or price volatility.
In response to questions about the objective and potential effects of position limits, the staff said that speculative limits were not designed to blunt or affect a particular trader’s impact on prices at any given moment — that is, the limits are not designed to mitigate price fluctuations or stabilize price volatility. Instead, the staff explained, position limits are targeted at position size in order to prevent traders from amassing concentrations of large positions.
The staff also provided clarification regarding actions by the CFTC and market participants that the final position limit rules would not preclude. For one, the staff clarified that an exchange would be permitted to self-certify changes to exchange-set position limits (based on updated deliverable supply) at any time, including the period before initial federal spot-month position limits are imposed. Moreover, staff indicated that the rules do not prevent an exchange from counting supply that is readily available for delivery as part of deliverable supply even if the supply is subject to a long-term agreement. The CFTC, however, will retain the discretion to evaluate deliverable supply or reassess limits. (The staff stated that guidance regarding the scope of deliverable supply will appear in the final rulemaking regarding DCM core principles rather than the final position limit rulemaking.) In addition, the staff clarified that the CFTC has the plenary authority to adjust position limits at any time it sees fit notwithstanding the timetable for readjusting limits set forth in the final position limit rules.
Endnotes
[1] The affected agricultural contracts are in two groups: “legacy” and “non-legacy” contracts. The nine legacy contracts are: (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). The non-legacy contracts are: (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).
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[2] The affected metals contracts are: (1) COMEX Copper (HG); (2) COMEX Gold (GC); (3) COMEX Silver (SI); (4) NYMEX Palladium (PA); and (5) NYMEX Platinum (PL).
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[3] The affected energy contracts are: (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).
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