CFTC Proposes New Position Limits and Aggregation Rules for Derivatives

The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication by David J. Gilberg, Kenneth M. Raisler, John M. Miller, and Ryne V. Miller.

On November 5, 2013, the Commodity Futures Trading Commission (the “CFTC” or “Commission”) held a public meeting during which it:

  • Voted 3-1, with commissioner O’Malia dissenting, to propose for public comment a new set of rules on position limits (the “Proposed Rules”) applicable to options, futures, and swaps contracts (“derivatives”) related to 28 agricultural, metal, and energy commodities;
  • Confirmed that it will voluntarily dismiss its appeal of the September 2012 decision from the United States District Court for the District of Columbia (the “Court”) vacating the Commission’s previous attempt at imposing position limits across derivatives (the “Original Position Limit Rules”); and
  • Voted unanimously to propose separately for public comment rules that would expand the availability of aggregation exemptions, as compared to the Original Position Limit Rules, from the CFTC’s aggregation standards applicable to position limits for futures and swaps (the “Proposed Aggregation Rules”).

This summary and overview is based on the fact sheet and frequently asked questions distributed by the CFTC during its public meeting, as well as on the comments made by the CFTC Commissioners and staff during the public meeting. We expect to issue a further, more detailed memorandum on the Proposed Rules and the Proposed Aggregation Rules following the CFTC’s issuance of the Federal Register releases.

New Position Limits Proposal

A. Response to the District Court Decision

In September 2012, the Court vacated the Original Position Limit Rules. Responding in part to the Court’s decision, the CFTC’s General Counsel, Jonathan Marcus, explained at the public meeting that the CFTC’s Proposed Rules would rely on the Commission’s “experience and expertise” to review the perceived ambiguities in its statutory authority to set position limits under the Commodity Exchange Act (“CEA”) and conclude that, based on its review of the legislative history and various pre-enactment drafts of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and the CFTC’s approach to statutory construction, Congress has mandated that the Commission impose position limits for physical commodities. Marcus also indicated that the Proposed Rules would conclude that the words “as appropriate,” in the CEA phrase “the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate,” refer to the CFTC’s discretion on setting limit levels, and not to whether or not the CFTC should impose position limits.

However, the CFTC Proposed Rules also include a general finding that position limits for physical commodities are “necessary” as a prophylactic measure to prevent sudden or unreasonable fluctuations or unwarranted changes in the price of a commodity. The necessity finding is general to physical commodities and does not address any specific commodity. The CFTC’s justification of the necessity finding relies largely on a review of the price movements and observed positions in the silver market in 1979 and in the natural gas markets in 2006 and the CFTC’s conclusion that the Proposed Rules would have, had they then been in effect, limited the size of the positions held by the alleged manipulators, therefore reducing the potential impact on prices of those positions.

B. New Position Limits Proposed Rules

The new Proposed Rules, which will be published in the Federal Register for public comment, are expected to largely follow the structure, format, and rule text used in the vacated Original Position Limit Rules. The Proposed Rules would impose limits on positions in the spot month—generally, the period immediately before delivery obligations are incurred for physical-delivery contracts or a period immediately before contracts are liquidated by the clearinghouse based on a reference price for cash-settled contracts—based either on the spot-month position limit levels currently in place at designated contract markets (“DCMs”), or, alternatively, on estimates of deliverable supply submitted by a DCM, if verified by the CFTC. The spot-month limits would be set at 25% of deliverable supply, and would apply separately for physical-delivery contracts and cash-settled contracts. For a trader that did not hold positions in the physical-delivery spot-month contract in a given commodity, it would be permitted to hold cash-settled contracts up to five times the level of the general cash-settled limit.

The Proposed Rules also include all-months-combined and any-single-month position limits, with initial limit levels to be set based on open interest in futures and swaps that are significant price discovery contracts. The open interest calculation will include the sum of futures open interest, cleared swaps open interest, and uncleared swaps open interest. The levels would be set via a formula as 10% of the open interest, up to the first 25,000 contracts of open interest, and 2.5% of the open interest in excess of 25,000 contracts of open interest.

Like the Original Position Limit Rules, the Proposed Rules would impose position limits on “Referenced Contracts,” which include “Core Referenced Futures Contracts”—28 specific futures contracts identified in the proposal and traded on CFTC-registered designated contract markets—as well as any other derivative that is economically equivalent to a Core Referenced Futures Contract. The Proposed Rules also:

  • Include certain exemptions from the position limits for bona fide hedging transactions, as follows:
    • Exemptions for bona fide hedging positions in physical commodities based on the Dodd-Frank Act’s new requirements for such positions, and new exemptions for unfilled anticipated requirements for resale by a utility, royalties, and service contracts, and
    • According to statements made by Commissioner O’Malia and a review of his dissenting statement, we understand that the Proposed Rules would narrow the scope of available bona fide hedge exemptions when compared to those that have historically been available, and that the Proposed Rules would limit the availability of hedge exemptions (as compared to the Original Position Limit Rules) in the context of anticipatory hedging activity;
  • Include the provisions from the Original Position Limit Rules that permit a “pass-through swap” exemption for a trader when it enters into a swap with a counterparty for which the swap qualifies as a bona fide hedge, provided the trader subsequently offsets the trade, and subject to certain conditions;
  • Exempt (i) certain preexisting positions established in good faith prior to the effective date of the initial limits that would be established by the Proposed Rules and (ii) positions assumed related to the financial distress of another entity; and
  • Require market participants to aggregate their interests in commodity derivatives across accounts and positions that they own or control, subject to a set of exemptions that would be expanded under the Proposed Aggregation Rules.

According to the discussion at the public meeting, the Proposed Rules will not include a specific provision permitting market participants to petition for bona fide hedge exemptions beyond those enumerated in the proposal; however, the CFTC indicated that its position limits exemptive authority under CEA section 4a(a)(7) would still be available.

The Proposed Rules also include requirements and acceptable practices for DCMs and swap execution facilities that are trading facilities for setting position limits for the Referenced Contracts, as well as position limits or accountability rules in all other listed contracts, including excluded commodities.

Proposed Aggregation Rules

Generally, the CFTC’s approach to position limits includes standards that govern when positions held by consolidated entity for purposes of the limits. Subject to a few exemptions, the Original Position Limit Rules included a general presumption that one entity’s control of or ownership of more than a 10% interest in another entity resulted in the two entities’ positions being aggregated. It appears that the Proposed Rules will refer to the CFTC’s existing aggregation standards in part 150 of the Commission’s regulations, rather than propose a new aggregation regime. Part 150 includes aggregation exemptions applicable to futures commission merchants, commodity pool operators, and independent account controllers, subject to conditions. The Proposed Aggregation Rules would then broaden the scope of aggregation exemptions from those available in the existing part 150 rules. The Proposed Aggregation Rules would provide four key exemptions from aggregation where:

  • Sharing of information would violate or create reasonable risk of violating Federal, state or foreign jurisdiction law or regulation;
  • One entity’s ownership interest is no greater than 50 percent in another entity whose trading is independently controlled;
  • One entity’s ownership interest is greater than 50 percent in another non-consolidated entity whose trading is independently controlled and an applicant certifies to the CFTC that the second entity’s positions either qualify as bona fide hedging positions or do not exceed 20 percent of any position limit; or
  • Ownership in another entity results from broker-dealer activities in the normal course of business as a dealer, but is limited to ownership levels of less than 50%.

CFTC Public Meeting

As noted above, at the public meeting, the Commission voted 3-1 to issue the Proposed Rules, with Commissioner O’Malia providing a dissenting vote. In his dissenting statement, Commissioner O’Malia questioned the legal analysis employed by the Commission to conclude that Congress has mandated the imposition of position limits for physical commodities; expressed concern that the proposed rules do not provide sufficient flexibility for commercial end-users to hedge their risks; and was troubled by the failure to include a process for end-users to seek hedge exemptions beyond those enumerated in the Proposed Rules.

As noted above, we expect to issue a further, more detailed memorandum on the Proposed Rules and the Proposed Aggregation Rules following the CFTC’s issuance of the Federal Register releases.

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