The CFTC has issued a supplemental proposed rulemaking (the “2016 Supplement”) that would give futures exchanges (“Exchanges”) greater authority over exemptions if the CFTC finalizes its long-pending proposed new speculative position limits that it published in December 2013 (the “Limits Proposal”). In an effort to be responsive to severe criticism of the Limits Proposal, particularly by commercial users of derivatives in the energy and agricultural sectors, the 2016 Supplement, if finalized, would provide a process for Exchanges to exempt certain bona fide hedging, and certain spread, positions from the CFTC’s proposed new position limits.
The position limits world today
Today, the CFTC sets speculative position limits for 9 agricultural commodity futures contracts and options thereon. By statute, “bona fide hedging positions” are exempt from these limits. By rule, the CFTC has identified a set of “enumerated” bona fide hedging positions that need not be counted in determining whether a trader has exceeded the CFTC’s position limits.
The CFTC’s current rules also include a streamlined process (with specific deadlines) whereby traders in these 9 agricultural commodity contracts can ask the CFTC to recognize other types of positions as bona fide hedging (and thus similarly exempt from CFTC limits), even though they do not fall within the enumerated bona fide hedging categories. These are referred to as “non-enumerated” bona fide hedging positions (“NEBFH positions”).
Finally, today, the Exchanges set position limits for other futures and options that are not subject to the CFTC’s limits. The Exchanges process requests to recognize bona fide hedging exemptions from their limits – and they typically do so promptly and efficiently.
The Limits Proposal
The CFTC’s Limits Proposal from 2013 would make several substantial changes to the position limits world of today. It proposed, among other things, to:
- Impose CFTC position limits on 19 additional futures and option contracts (and economically equivalent swaps) in physical commodities such as energy, agriculture, and metals; and
- Eliminate the streamlined process for obtaining NEBFH exemptions from the CFTC with respect to these new CFTC limits.
As a result, traders faced the prospect that if their hedging activities did not fit into an enumerated bona fide hedging category – which is frequently the case – then such positions, although hedging, still would count against the trader’s position limits. The Exchanges would not be able to provide relief, since these limits would now be set by the CFTC.
To be sure, the Limits Proposal provided that traders could formally petition the CFTC for a NEBFH exemption (including a public notice-and-comment period) or ask Staff for no-action relief. But in neither event was there a proposed deadline for the CFTC or Staff to respond to such a request – or even a requirement that they respond at all. Such a cumbersome “process” was incompatible with the way that commercial entities run their businesses – and the comment letters on the Limits Proposal said as much.
The 2016 Supplement’s proposed NEBFH process
The 2016 Supplement proposes to allow Exchanges to recognize NEBFH exemptions for contracts subject to CFTC-set position limits. Once a trader’s application to recognize a NEBFH exemption is complete, the Exchange would be required to notify the applicant “in a timely manner” whether the request is:
- Granted, including its terms and any conditions;
- Rejected, including the reasons for the rejection; or
- Submitted to the CFTC, which may or may not agree to review it.
Significantly, the position would be recognized as a NEBFH position, and thus need not be counted towards position limits, when the Exchange provides notice of such a determination. The trader could rely on that determination unless and until it is notified otherwise.
The 2016 Supplement would permit an Exchange to recognize a NEBFH exemption during the spot month. But it requests comment on whether to prohibit NEBFH exemptions during the spot month (or the last five days of trading), or to condition such an exemption upon additional filings to the Exchange about the trader’s cash market holdings in the spot month.
An Exchange would be required to post information regarding NEBFH exemptions that it recognizes on its website, including a summary of the position and the basis for recognition. Such information would have to be posted at least quarterly to provide transparency to other traders as to the types of hedging activities that qualify as NEBFH positions on that Exchange.
The CFTC’s accommodation to commenters on this issue, though, would not come without conditions and obligations – for Exchanges and traders alike:
Conditions on Exchanges: To be permitted to recognize NEBFH exemptions, an Exchange would have to, among other things:
- Have rules for doing so that are approved by, or self-certified to, the CFTC;
- Recognize NEBFH positions only in actively-traded derivatives contracts for which it has one year of experience in administering position limits;
- Comply with CFTC recordkeeping requirements; and
- Not recognize a NEBFH position involving a commodity index contract.
Requirements on traders: To obtain recognition of a NEBFH exemption from an Exchange, a trader would have to, among other things:
- Provide certain information to the Exchange, including detailed information: i) regarding its activity in the cash markets for the underlying commodity for the past 3 years; and ii) demonstrating how the position meets the definition of a bona fide hedging position;
- Obtain recognition of a NEBFH exemption before it exceeds position limits;
- Re-apply for recognition of its NEBFH exemption at least annually; and
- Report to the Exchange when it owns or controls derivatives positions recognized as NEBFH positions, and its offsetting cash positions (and update and maintain the accuracy of these reports).
Reporting by Exchanges: To be permitted to recognize NEBFH exemptions, Exchanges would have to provide the following, among other things, to the CFTC:
- On a weekly basis: Information regarding each NEBFH position recognized during the week including, among other things: i) the identity of the applicant and the underlying cash commodity; ii) the maximum size of the derivatives position recognized as a NEBFH position; and iii) a summary of the applicant’s activities in the cash markets; and
- On a monthly basis: The reports that traders file with the Exchange when they own or control derivatives positions recognized as NEBFH positions.
Review by CFTC: The 2016 Supplement emphasizes repeatedly that the CFTC would exercise the ultimate responsibility for NEBFH exemptions. It would exercise that responsibility through its review of:
- The rules submitted by Exchanges to govern their recognition of NEBFH exemptions;
- The Exchanges’ performance of their self-regulatory functions generally, called “rule enforcement reviews;” and/or
- Individual NEBFH determinations by Exchanges (the 2016 Supplement states that the CFTC could undertake such a review at any time, but acknowledges that it likely would do so after an Exchange already has made a NEBFH determination).
If the CFTC rejects an Exchange’s NEBFH determination, it must: i) state the issues it has with the determination; and ii) give the trader a “commercially reasonable time” to liquidate the position or otherwise come into compliance. However, the 2016 Supplement states that the CFTC believes a “commercially reasonable time” would be less than one business day.
Exchange authority over other exemptions
The 2016 Supplement also proposes processes for Exchanges to recognize enumerated anticipatory bona fide hedging (“EABFH”) positions, and to grant certain spread exemptions, in physical commodity contracts that would be subject to CFTC position limits.
EABFH positions: Exchanges would be permitted to recognize EABFH positions for:
- Unfilled anticipated requirements;
- Unsold anticipated production;
- Anticipated royalties;
- Anticipated service contract payments or receipts; and
- Anticipatory cross-commodity hedge positions.
Generally, the process for Exchange recognition of EABFH exemptions would mirror the process for Exchange recognition of NEBFH exemptions described above. However, because the CFTC has already enumerated EABFH positions as bona fide hedging, an Exchange would not have to post any notices about recognized EABFH exemptions on its website.
Spread exemptions: Exchanges would be permitted to grant exemptions for, among others:
- Calendar spreads;
- Qualify differential spreads;
- Processing spreads (such as energy “crack” or soybean “crush” spreads); and
- product or by-product differential spreads.
Again, the process for Exchanges to grant spread exemptions would generally be similar to the process for Exchange recognition of NEBFH exemptions described above.
The 2016 Supplement would permit Exchanges to grant spread exemptions in the spot month, which would be a departure from the CFTC’s current approach as well as the Limits Proposal. It also specifically calls out the “cash-and-carry” spread exemption, which currently is allowed by ICE Futures US, as potentially inconsistent with the statutory standards governing such exemptions. Yet the 2016 Supplement still proposes that Exchanges be permitted to grant cash-and-carry exemptions. However, it states that the CFTC is considering: i) prohibiting spread exemptions in the lesser of the last 5 days of trading or the spot month, and/or prohibiting cash-and-carry exemptions; or, alternatively, ii) requiring additional reporting or other suitable safeguards to be in place for such exemptions.
Other provisions in the 2016 Supplement
Definition of “bona fide hedging position”: The 2016 Supplement proposes to amend the definition of the term “bona fide hedging position” that was contained in the Limits Proposal. However, this change is unlikely to have a material impact on traders.
As proposed in the Limits Proposal, any bona fide hedging position, among other things, had to: i) offset price risks incidental to commercial cash, spot, or forward operations (the “incidental test”); and ii) be established and liquidated in an orderly manner in accordance with sound commercial practices (the “orderly liquidation” requirement). The 2016 Supplement proposes to eliminate these two requirements for establishing a bona fide hedging position.
Yet, the 2016 Supplement notes that:
- The incidental test is largely redundant because the same concept is encompassed within the separate prong of the definition requiring that a bona fide hedging position be “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise”; and
- Exchanges still have the authority to protect their markets by limiting bona fide hedging positions if they cannot be established and liquidated in an orderly fashion, even if that is not an explicit part of the bona fide hedging definition.
For these reasons, the deletion of these two prongs of the definition is unlikely to materially enhance a trader’s ability to establish the existence of a bona fide hedging position.
Technical amendments to definitions: The 2016 Supplement also proposes technical amendments to the definitions of the terms “futures equivalent” positions, “intermarket spread position,” and “intramarket spread position” that were contained in the Limits Proposal. The changes would expand the definitions of intermarket and intramarket spread position in order to clarify that Exchanges can recognize spread exemptions involving more than one commodity and involving a commodity’s products or by-products.
Trading facilities: Finally, unrelated to bona fide hedging or spread exemptions, the 2016 Supplement addresses a separate issue raised by several comments on the Limits Proposal. That is, under the 2016 Supplement, swap execution facilities, and futures exchanges with respect to swap contracts, would not have to comply with statutory requirements regarding position limits at this time. The basis for this change from the Limits Proposal is the CFTC’s recognition that these trading facilities do not presently have sufficient access to swap position information to administer a position limits regime for swaps.
What the 2016 Supplement does not do
The 2016 Supplement, at its core, is a “process proposal.” It does not address, for example, the substantive limitations on exemptions from position limits that were contained in the Limits Proposal, and that have been heavily criticized in public comments. Thus, the 2016 Supplement proposes no changes to:
- The list of what would be, and what would not be, an enumerated bona fide hedging position;
- The details of the trading activities included in the enumerated bona fide hedging categories; or
- The definition of a bona fide hedging position in the context of non-physical commodities such as currencies, interest rates, etc.
The CFTC does not seek any further comment on these issues in the 2016 Supplement.
The road ahead
By providing a generally workable process for market participants to obtain recognition of NEBFH and EABFH exemptions, and certain spread exemptions, the 2016 Supplement represents a substantial improvement over the Limits Proposal – at least as far as it goes. Comments on the 2016 Supplement will likely focus on any parts of the prescribed processes that market participants find unduly onerous, such as, perhaps, some of the reporting requirements or the short timeframe allowed for liquidating positions when the CFTC rejects an Exchange’s exemption after-the-fact. But, while some of the requirements in the 2016 Supplement may be new (and appear onerous) to those who trade only contracts that are currently subject to Exchange limits, several of these requirements are drawn from the CFTC’s requirements for the agricultural commodity contracts for which it sets position limits today.
The comment period on the 2016 Supplement will be open until July 13, 2016. As for the timing of any final position limits rulemaking, CFTC Chairman Massad’s Statement on the 2016 Supplement states twice that the agency is working to complete the position limits rule by the end of this year. (Note, though, that any final rule would include an implementation period, so that new limits probably would not take effect until sometime in mid-2017.) On the other hand, the CFTC has several other significant proposed rulemakings on its plate as well – so that, with the comment period on the 2016 Supplement extending into mid-July, fulfilling the Chairman’s wish may prove to be a tall order.