CFTC Re-Proposes Rules on Position Limits on Physical Commodity Derivatives

Transcription

1 CFTC Re-Proposes Rules on Position Limits on Physical Commodity Derivatives CFTC Publishes New Proposed Rules That Would Impose Position Limits on Futures and Economically Equivalent Swaps on 25 Energy, Metals and Agricultural Commodities INTRODUCTION On December 6, 2016, the Commodity Futures Trading Commission (the CFTC or Commission ) voted unanimously to re-propose for public comment rules on position limits applicable to positions in futures, options on futures and economically equivalent swaps (collectively, derivatives ) on 25 energy, metals and agricultural commodities (the Position Limit Proposal or Proposal ). This memorandum to clients represents our initial review and assessment of the release, which is 910 pages long and includes 1,733 footnotes. Once the Proposal is published in the Federal Register, it will be open for a 60-day public comment period. The Proposal largely follows the spot-month and non spot-month structure of the position limit rules that the Commission had previously proposed on December 12, 2013 (the 2013 Proposal ) and supplemented on June 13, 2016 (the 2016 Supplemental Proposal, together with the 2013 Proposal, the Prior Proposal ), subject to several important changes which we highlight below (in particular the changes to the scope of positions that will be eligible for the proposed exemption from the limits for bona fide hedging positions ). Contemporaneously, the Commission also unanimously adopted final rules addressing the aggregation standards applicable for purposes of position limits and large trader reporting (the Aggregation Final Rule ), which will be addressed in a separate memorandum. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 OVERVIEW Consistent with the Prior Proposal, 1 the new Proposal would make several key changes to the CFTC s historical approach to setting position limits. The Proposal would give more control over position limits and limit levels with respect to all enumerated physical commodities to the CFTC (rather than the exchanges), it would extend limits to over-the-counter swap positions for the first time, and it would incorporate a much more prescriptive approach to the definition of bona fide hedging. As noted above, the Proposal will be open for a 60-day public comment period once published in the Federal Register. We expect that the Commission will again receive a large number of comments and that commenters will continue to focus on the key elements of the proposal, including among others: the limit levels themselves, the terms of the conditional limit for natural gas positions (and the absence of a conditional limit for any other commodities), the scope of the proposed definition of bona fide hedging position, the extent to which a bona fide hedging exemption may be available for anticipatory hedges, the details of the process that will govern exchange eligibility for and granting of non-enumerated bona fide hedging positions, the extensive reporting requirements applicable when claiming an exemption and the ability of the Commission from a practical perspective to implement and monitor position limits for the swaps markets. The Proposal would specifically set separate limits for derivatives (i.e., futures, options on futures and economically equivalent swaps as explained in greater detail, below) on each of the 25 covered commodities as follows: (1) a limit for positions held during the spot-month, which is generally defined for a given contract and month as a specified number of days immediately preceding and including the last trading day for that contract prior to expiry; (2) a limit for positions held across all months combined; and (3) a limit for positions held during any single month other than the spot-month (in each instance subject to a proposed exemption from limits for certain positions that are in existence either prior to the CFTC s finalization of position limits rules or during any compliance transition period provided in the final rule). The Proposal includes proposed initial limits that are meaningfully higher in most instances than the analogous levels that had been included in the Prior Proposal. For certain financially settled natural gas positions held during the spot-month, the CFTC has also proposed a higher conditional limit provided that the market participant is not otherwise holding any relevant physically delivered natural gas futures contracts during that same time period. The Proposal includes a proposed exemption from limits for bona fide hedging positions, which is proposed to be defined to include eight enumerated bona fide hedging positions, certain cross-commodity hedges and certain positions associated with the offset of a position in a commodity trade option (and is 1 For more information on the Prior Proposal please see our memorandums to clients entitled CFTC Supplements Position Limits Proposal dated June 3, 2016; and CFTC Proposes New Position Limits dated November 18,

3 supplemented by two proposed appendices: one that provides 14 non-exhaustive examples of scenarios involving transactions that would meeting the proposed definition of bona fide hedging position, and one that would provide guidance on risk management exemptions for commodity derivative contracts in excluded commodities such as interest rates, currencies and any economic or commercial index other than a narrow based security index permitted under the revised definition of bona fide hedging position). The Proposal would also permit exchanges, including designated contract markets ( DCMs ) and swap execution facilities ( SEFs ), to recognize and grant exemptions for non-enumerated bona fide hedging positions, certain enumerated anticipatory hedge positions and spread positions, in each instance subject to CFTC review and subject to a series of conditions that must be met by market participants seeking an exemption and the exchange granting the exemption. In addition, the Proposal would provide an exemption for positions acquired from a party under financial distress, subject to a requirement to first request approval from the CFTC. The Proposal would also update and expand the various reporting requirements applicable to market participants relying on an exemption. The Proposal includes updated definitions (as compared to the Prior Proposal) for many of the terms used in the proposed rule text, additional proposed guidance for DCMs and SEFs addressing requirements and acceptable practices for their own position limit programs, including exchange set position limits, and a proposal to delay the compliance date of any final rule until no earlier than January 3, 2018, noting that this delay would provide time for market participants to gain access to adequate systems to compute futures-equivalent positions for swaps. REFERENCED CONTRACTS; PROPOSED LIMIT LEVELS A. REFERENCED CONTRACTS As noted above, the Proposal follows the general structure set forth in the Prior Proposal by seeking to impose limits for positions in derivatives that are Referenced Contracts on 25 energy, metals and agricultural contracts held during the spot-month, in all months combined and in any single month. Referenced Contracts will include any positions in: The 25 specific physically delivered futures contracts identified as Core Referenced Futures Contracts ; 2 and 2 The Core Referenced Futures Contracts are divided into legacy agricultural contracts Chicago Board of Trade ( CBT ) Corn, CBT Oats, CBT Soybeans, CBT Soybean Meal, CBT Soybean Oil, CBT Wheat, ICE Futures U.S. Cotton No. 2, Kansas City Board of Trade Hard Winter Wheat, and Minneapolis Grain Exchange Hard Red Spring Wheat; other agricultural contracts CBT Rough Rice, Chicago Mercantile Exchange Live Cattle, ICE Futures U.S. Cocoa, ICE Futures U.S. Coffee C, ICE Futures U.S. FCOJ-A, ICE Futures U.S. Sugar No. 11, ICE Futures U.S. Sugar No. 16; energy contracts New York Mercantile Exchange ( NYMEX ) Henry Hub Natural Gas, NYMEX Light Sweet Crude, NYMEX NY Harbor ULSD, NYMEX RBOB Gasoline; and metal contracts Commodity Exchange, Inc. Copper, Commodity Exchange, Inc. Gold, Commodity Exchange, Inc. Silver, NYMEX Palladium, and NYMEX Platinum. We have listed the initial position limit levels from the Proposal in an Appendix to this memorandum. The Prior Proposal would have set position limits on 28 core -3-

4 Any derivative (including options and swaps) that is directly or indirectly linked, including being partially or fully settled on the basis of, or priced at a fixed differential to, either: the price of a Core Referenced Futures Contract; or the price of the same commodity underlying a Core Referenced Futures Contract for delivery at the same location or locations as specified in the Core Referenced Futures Contract. A Referenced Contract would not include any basis contract, guarantee of a swap, a location basis contract, a commodity index contract, or a trade option meeting the requirements of CFTC Rule According to the Proposal, the initial 25 Core Referenced Futures Contracts were chosen because they either (i) have high levels of open interest and significant notional value of open interest or (ii) serve as reference prices for a significant number of cash-market transactions. B. PROPOSED POSITION LIMIT LEVELS 1. Spot-Month Levels a. Initial Levels The Proposal would establish initial spot-month 3 position limit levels based on estimated deliverable supply 4 levels submitted by DCMs for the Core Referenced Futures Contracts. A table showing the specific initial spot-month limit levels proposed by the CFTC, by Referenced Contract, is included as an Appendix to this memorandum. Notably, many of the limit levels, such as those for crude oil, natural gas and several agricultural commodities are higher than they had been in the Prior Proposal. Consistent with prior CFTC practice, each position limit will apply at all times, including on an intraday and end-of-day basis. b. Subsequent Levels Under the Proposal, the CFTC would fix (i.e., re-calculate) the level of the spot-month limit at least every two years based on, at its discretion, either (1) 25% of deliverable supply levels (either as submitted by DCMs or as determined by the CFTC) or (2) the level recommended by the exchange listing the Core Referenced Futures Contract, but in any event not greater than 25% of the estimated spot-month deliverable supply in the relevant Core Referenced Futures Contract. Unless the CFTC determines to rely on its own estimate of deliverable supply, it will use the estimated spot-month deliverable supply 3 4 referenced contracts; the three that are no longer included are the Chicago Mercantile Exchange Class III Milk, Chicago Mercantile Exchange Feeder Cattle and Chicago Mercantile Exchange Lean Hog futures contracts. Recall that the spot-month is generally described as the period of time beginning at the earlier of the close of business on the trading day preceding the first day on which delivery notices can be issued by the clearing organization of a DCM, or the close of business on the trading day preceding the thirdto-last trading day, until the contract expires. The term estimated deliverable supply is generally viewed as the amount of a commodity that can reasonably be expected to be readily available to short traders to make delivery at the expiration of a futures contract. -4-

5 provided by a DCM. DCMs will be required to estimate deliverable supply under guidelines set forth in the Proposal and will be required to submit deliverable-supply estimates to the CFTC. Consistent with the Prior Proposal, the Commission is proposing to require staggered submission, based on commodity type, of the deliverable supply estimates from exchanges in order to spread out the administrative burden of the proposed rules. If the CFTC elects to rely on its own estimates of deliverable supply, it will first publish those estimates for comment in the Federal Register. 2. All-Months-Combined and Any-Single-Month Levels a. Initial Levels The Proposal would set initial all-months-combined and any-single-month position limits based on a combination of swap position data reported to the CFTC under 17 CFR Part 20 and data on open interest in physical commodity futures and options provided by certain exchanges for two 12-month periods of data, covering a total of 24 months. A table showing the specific initial any- and all-month limit levels proposed by the CFTC, by Referenced Contract, is included as an Appendix to this memorandum. b. Subsequent Limit Under the Position Limit Proposal, the CFTC will fix (i.e., recalculate) the level of the single-month limit and the all-months-combined limit at least every two years, and as with the proposed initial limit levels, the Commission expects that both sets of limits will be fixed at the same level. The limits will be based on 10% of the estimated average open interest in Referenced Contracts, up to the first 25,000 contracts open interest, with a marginal increase of 2.5% of open interest for the level of open interest exceeding 25,000 contracts (e.g., if open interest is determined to be 45,000 contracts, the formula would result in a limit level of 3,000 contracts; that is, 10% of 25,000 plus 2.5% of 20,000). Notably, the Prior Proposal had stated that, While the Commission does not currently possess all data needed to fully enforce the position limits proposed herein, the Commission believes that it should have adequate data to reset the overall concentration-based percentages for the position limits two years after initial levels are set. It is unclear whether the CFTC now takes the view that it does (or will) possess the necessary data that it will require to adjust limit levels. The Proposal notes that: The Commission has determined that certain part 20 large trader position data, after processing and editing by Commission staff... [,] is reliable. However, the Proposal also notes that: The Commission has determined that it is not yet practicable to use data from swap data repositories. Notwithstanding the open-interest calculation and change process, the Proposal notes that the Commission is proposing a minimum non-spot-month limit level of 5,000 contracts so that market participants would be certain that in no circumstance would the limit level fall below that figure. The proposal also notes that, because exchanges can set limits at levels below the federal limit level, a change in the federal limit may not necessarily have an effect on exchange limit levels. -5-

6 3. Proposed Conditional Spot-Month Limits for Financially Settled Natural Gas Contracts The only conditional spot-month exemption included in the Proposal would apply in the natural gas markets. This conditional exemption would only be available to traders who do not hold or control positions in the spot-month physical-delivery Referenced Contract. The rule in the Proposal allows market participants to exceed the position limit provided that (1) such positions do not exceed 10,000 contracts (i.e., five times the proposed initial spot-month limit of 2,000 contracts for natural gas), and (2) the person holding or controlling such positions does not hold or control positions in the spot-month natural gas physical-delivery Referenced Contract. The Proposal would require enhanced reporting of cash-market holdings of traders availing themselves of the conditional spot-month limit exemption (the reporting requirement is discussed below); however, there is no requirement or restriction that would limit the amount of cash market positions that a market participant relying on the conditional limit may have. EXEMPTIONS FOR BONA FIDE HEDGING POSITIONS; OTHER GENERAL EXEMPTIONS AND PROVISIONS A. BONA FIDE HEDGING POSITIONS 1. Overview Proposed Bona Fide Hedging Position Definition CEA section 4a(c) provides generally that federal position limits do not apply to positions that are shown to be bona fide hedging positions. CEA section 4a(c)(2), added by Dodd-Frank, directs the CFTC to narrow the scope of what constitutes a bona fide hedging position (as compared ot the CFTC s historical definition in CFTC rule 1.3(z)) for position limits on physical commodities. In the 2013 Proposal, the CFTC proposed a new definition of bona fide hedging position that included an incidental test and an orderly trading requirement, which together would have required (1) that the risks offset by a commodity derivative position must be incidental to the position holder s commercial operations and (2) that a bona fide hedge position be established and liquidated in an orderly manner in accordance with sound commercial practices. The 2016 Supplemental Proposal eliminated the incidental test and the orderly trading requirement. Instead, the Supplemental Proposal included a general definition that incorporates only the standards of CEA section 4a(c) (i.e., positions that are appropriate to the reduction of risks in the conduct and management of a commercial enterprise) and included exceptions to position limits (1) for eight enumerated bona fide hedging positions; (2) for offsets of pass-through swaps; (3) for certain crosscommodity hedges; and (4) for non-enumerated bona fide hedge positions (which exchanges would have been permitted to recognize). The Proposal follows the approach set forth in the 2016 Supplemental proposal with respect to the bona fide hedging definition that would apply in the context of physical commodities while also clarifying further the discretion of exchanges in recognizing risk management exemptions for excluded commodities. -6-

7 2. General Definition of Bona Fide Hedging Position The proposed general definition of bona fide hedging position includes a position that: (i) represents a substitute for transactions made or to be made, or positions taken or to be taken, at a later time in a physical marketing channel; (ii) is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; or (iii) arises from the potential change in the value of: (1) assets which a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; (2) liabilities which a person owes or anticipates incurring; or (3) services that a person provides, purchases, or anticipates providing or purchasing. Notably, this definition excludes the requirements that (i) the purpose of the position would have been to offset price risks incidental to commercial cash operations (the incidental test ) and (ii) the position would have to have been established and liquidated in an orderly manner in accordance with sound commercial practices (the orderly trading requirement ). 3. Enumerated Bona Fide Hedging Positions The proposed enumerated bona fide hedging positions are generally consistent with the Prior Proposal (as supplemented by the 2016 Supplemental Proposal), with certain changes, and they include: Hedges of inventory and cash commodity purchase contracts (i.e., short positions in commodity derivative contracts that do not exceed in quantity ownership or fixed-price purchase contracts in the contract s underlying cash commodity by the same person); Hedges of cash commodity sales contracts (i.e., long positions in commodity derivative contracts that do not exceed in quantity the fixed-price sales contracts in the contract s underlying cash commodity by the same person and the quantity equivalent of fixed-price sales contracts of the cash products and by-products of such commodity by the same person); Hedges of unfilled anticipated requirements (provided that such positions in a physical-delivery commodity derivative contract, during the lesser of the last five days of trading or the time period for the spot-month in such physical-delivery contract, do not exceed the person s unfilled anticipated requirements of the same cash commodity for that month and for the next succeeding month: (i) long positions in commodity derivative contracts that do not exceed in quantity unfilled anticipated requirements of the same cash commodity, for processing, manufacturing, or use by the same person; and (ii) long positions in commodity derivative contracts that do not exceed in quantity unfilled anticipated requirements of the same cash commodity for resale by a utility to its customers}; and Hedges by agents (i.e., long or short positions in commodity derivative contracts by an agent who does not own or has not contracted to sell or purchase the offsetting cash commodity at a fixed price, provided that the agent is responsible for merchandising the cash positions that are being -7-

8 offset in commodity derivative contracts and the agent has a contractual arrangement with the person who owns the commodity or holds the cash market commitment being offset). The Proposal also includes four additional enumerated bona fide hedging positions, provided that no such position is maintained in any physical-delivery commodity derivative contract during the lesser of the last five days of trading or the time period for the spot-month in such physical-delivery contract, as follows: Hedges of unsold anticipated production (i.e., short positions in commodity derivative contracts that do not exceed in quantity unsold anticipated production of the same commodity by the same person); Hedges of offsetting unfixed-price cash commodity sales and purchases (i.e., short and long positions in commodity derivative contracts that do not exceed in quantity that amount of the same cash commodity that has been bought and sold by the same person at unfixed prices: (i) basis different delivery months in the same commodity derivative contract; or (ii) basis different commodity derivative contracts in the same commodity, regardless of whether the commodity derivative contracts are in the same calendar month); Hedges of anticipated royalties (i.e., short positions in commodity derivative contracts offset by the anticipated change in value of mineral royalty rights that are owned by the same person, provided that the royalty rights arise out of the production of the commodity underlying the commodity derivative contract); and Hedges of services (i.e., short or long positions in commodity derivative contracts offset by the anticipated change in value of receipts or payments due or expected to be due under an executed contract for services held by the same person, provided that the contract for services arises out of the production, manufacturing, processing, use, or transportation of the commodity underlying the commodity derivative contract). 4. Commodity and Trade Option Hedges The definition of bona fide hedging position, as proposed, would also include certain cross commodity hedges (provided that the fluctuations in value of the position in the commodity derivative contract, or the commodity underlying the commodity derivative contract, are substantially related to the fluctuations in value of the actual or anticipated cash position or pass-through swap and no such position is maintained in any physical-delivery commodity derivative contract during the lesser of the last five days of trading or the time period for the spot-month in such physical-delivery contract) and positions that offset commodity trade options. -8-

9 5. Appendix Commentary on Examples of Bona Fide Hedging Positions Consistent with the 14 that were included in the 2013 Proposal, the Proposal would include an appendix to the rules describing, in a non-exhaustive list, 14 examples of bona fide hedging positions for physical commodities. The Proposal has updated and clarified the content of some of these examples based on prior feedback from commenters. 6. Exchange Recognized Risk Management Exemptions for Excluded Commodities The Proposal amends the proposed definition of a bona fide hedging position for an excluded commodity (such as an interest rate, currency and any economic or commercial index other than a narrow based security index) to clarify that the rules of a DCM or SEF may otherwise recognize risk management exemptions in an excluded commodity, without regard to the economically appropriate test. proposed appendix, the Proposal would provide non-exclusive interpretative guidance on the types of risk management exemptions for commodity derivative contracts in excluded commodities that exchanges would be permitted to recognize under the definition of bona fide hedging position, including balance sheet hedging, hedges of unleveraged synthetic positions, and hedges of temporary asset allocations. 7. Previously Granted Risk-Management Exemptions Under the Proposal, as in the case of the Prior Proposal, the CFTC would not permit risk-management exemptions granted by the Commission under existing CFTC Rule 1.47 to apply to swap positions entered into after the effective date of a final position limits rulemaking; i.e., the Proposal would revoke previously granted risk-management exemptions for new swap positions. The Proposal clarifies and expands the relief by (1) clarifying that such previously granted exemptions may apply to pre-existing financial instruments that are within the scope of existing 1.47 exemptions, rather than only to preexisting swaps and (2) recognizing exchange-granted non-enumerated exemptions in non-legacy commodity derivatives outside of the spot-month (consistent with the Commission s recognition of risk management exemptions outside of the spot-month), provided that such exemptions are granted prior to the compliance date of the final rule, once adopted, and apply only to pre-existing financial instruments as of the effective date of that final rule. The Proposal notes that these changes are intended to reduce the potential for market disruption by forced liquidations, since a market intermediary would continue to be able to offset risks of pre-effective-date financial instruments, pursuant to previously-granted federal or exchange risk management exemptions. The Proposal also clarifies that the Commission will continue to recognize the offset of the risk of a preexisting financial instrument as bona fide using a derivative position, including a deferred derivative contract month entered after the effective date of a final rule, provided that a nearby derivative contract month is liquidated. However, under the Proposal, such relief will not be extended to an increase in positions after the effective date of a limit, as that appears contrary to Congressional intent to narrow the definition of a bona fide hedging position. -9- In a

10 8. Reporting Requirements for Claiming a Bona Fide Hedge Exemption (Part 19) a. Generally The Proposal, like the Prior Proposal, would represent an overhaul of the reporting requirements applicable to market participants claiming a bona fide hedge exemption from position limits (or any other person claiming any exemption from federal position limits pursuant to proposed section 150.3) by largely re-writing Part 19 of the CFTC s rules. Exemptions from position limits would require the submission of series 04 reports as revised by the Proposal to include: Form 204, including proposed revisions, for data that must be provided by bona fide hedgers; Form 304, including proposed revisions, for data that must be provided by merchants and dealers in cotton; Proposed Form 504, for use by persons claiming the conditional spot-month limit exemption; Proposed Form 604, for use by persons claiming a bona fide hedge exemption for either of two specific pass-through swap position types; and Proposed Form 704, for use by persons claiming a bona fide hedge exemption for certain anticipatory bona fide hedging positions. b. Specific Form Requirements Under the Proposal, the series 04 reports would be required to be submitted as follows: Form 204 for identifying a related cash commodity position in connection with claiming a hedge exemption, commercial firms would measure their respective cash positions on one day per month and submit Form 204 as of the close of business on the last Friday of the month; Form 304 for merchants and dealers in cotton, this report showing their cash positions in cotton would be required to be filed weekly to provide data for the Commission s weekly cotton on call report (this is the same schedule under which the form is currently required); Form 504 persons claiming a conditional spot-month limit exemption must report on new Form 504 daily, by 9 a.m. Eastern Time on the next business day, for each day that person is over the spot-month limit in certain commodity contracts specified by the Commission. Form 504 would cover purchase and sales contracts through the delivery area for the Core Referenced Futures Contract and inventory in the delivery area and would initially only be required for persons claiming conditional spot-month limit exemptions in natural gas commodity derivative contracts; Form 604 a person relying on the pass-through swap exemption must submit a Form 604 for (i) a swap executed opposite a bona fide hedger that is not a referenced contract and for which the risk is offset with Referenced Contracts (must submit reports to the Commission on a monthly basis, as of the close of business on the last Friday of the month) and for (ii) a cash-settled swap executed opposite a bona fide hedger that is offset with physical-delivery Referenced Contracts held into a spot-month, or, vice versa, a physical-delivery swap executed opposite a bona fide hedger that is offset with cash-settled Referenced Contracts held into a spot-month (must file on Form 604 as of the close of business on each day during a spot-month, and not later than 9 a.m. Eastern Time on the business day following the date of the report); and Form 704 persons seeking to avail themselves of an exemption for any of the anticipatory hedging transactions enumerated in the proposed new definition of bona fide hedging positions would be required to file an initial statement on Form 704 with the CFTC at least 10 days in -10-

11 advance of the date that such positions would be in excess of proposed position limits. Unless rejected by the CFTC, Form 704 filings that conform to the requirements set forth in the Proposal would become effective 10 days after submission; and the Proposal would require an anticipatory hedger to file a supplemental report on Form 704 whenever its anticipatory hedging needs increase beyond that in its most recent filing. In addition, the Proposal would require any person who files an initial statement on Form 704 to provide (i) annual updates that detail the person s actual cash-market activities related to the anticipated exemption and (ii) monthly cash commodity position updates on Form 204. Each of these reports is proposed to be subject to a series of conditions that must be reviewed in connection with preparing and submitting any specific filing. c. Notes on Manner of Reporting i. Source commodities/physical inventory. Under the Proposal, as in the Prior Proposal, a reporting trader may exclude from a calculation of a cash position certain products or by-products in determining its cash positions for bona fide hedging (i.e., source commodities ) if the amount is de minimis, impractical to account for, and/or on the opposite side of the market from the market participant s hedging position. ii. Cross-commodity hedges. The Proposal sets forth instructions that are consistent with current Part 19 rules for reporting a cash position in a commodity that is different from the commodity underlying the futures contract used for hedging. The Proposal maintains the requirement that cross-hedged positions be shown both in terms of the equivalent amount of the commodity underlying the commodity derivative contract used for hedging and in terms of the actual cash commodity. This is unchanged from the Prior Proposal. iii. Standards and conversion factors. Under the Proposal, the standards and conversion factors used in computing cash positions for reporting purposes must be made available to the Commission upon request, including (i) hedge ratios used to convert the actual cash commodity to the equivalent amount of the commodity underlying the commodity derivative contract used for hedging and (ii) an explanation of the methodology used for determining the hedge ratio. This is unchanged from the Prior Proposal. 9. Delegation to Exchanges to Recognize Certain Positions as Non-Enumerated Bona Fide Hedges or Enumerated Anticipatory Bona Fide Hedges and to Exempt from Federal Position Limits Certain Spread Positions Consistent with the approach set forth in the 2016 Supplemental Proposal, the Proposal contains three sets of rules that would enable an exchange (i.e., a DCM or SEF, and either an Exchange ) to submit to the CFTC rules under which the Exchange could take action to: (i) recognize certain non-enumerated bona fide hedging positions ( NEBFHs ); (ii) grant exemptions to position limits for certain spread positions; and (iii) recognize certain enumerated anticipatory bona fide hedging positions. Each of the proposed rules would establish a formal CFTC review process that would provide the CFTC with the -11-

12 ongoing authority to review all such actions by the Exchange. Notably, the Proposal would therefore permit commercial end users to avail themselves of an Exchange s NEBFH application process in lieu of requesting CFTC approval of an NEBFH, which would have required seeking a CFTC staff interpretive letter under section of the CFTC s regulations or seeking CEA section 4a(a)(7) exemptive relief. The proposed delegations to the Exchanges would be subject to significant CFTC oversight. Each of the three proposed processes requires that: (i) an Exchange submit implementing rules subject to CFTC review; (ii) the Exchange s standards for receiving the recognition of a bona fide hedge position or other exemption conform to the requirements under the statute; (iii) each Exchange s actions under these processes be reviewed under the CFTC s rule enforcement review program; and (iv) all Exchange actions under such implementing rules (including the recognition of any exemption) be subject to CFTC review. a. Recognition of Certain Non-Enumerated Bona Fide Hedging Positions The Proposal, following the 2016 Supplemental Proposal, would permit Exchanges to recognize NEBFHs with respect to the proposed federal speculative position limits. Exchange recognition of a position as an NEBFH would allow the market participant to exceed the federal position limit, up to approved levels, to the extent that it relied upon the Exchange s recognition unless and until such time that the CFTC notified the market participant to the contrary. The Proposal would require market participants to report certain facts and circumstances attendant to a position to verify whether the position satisfies the requirements of the definition of a bona fide hedging transaction or position in the CEA. The Proposal also proposes to require that all applicants submit detailed information to demonstrate why the position satisfies the requirements of the definition of bona fide hedging in the CEA and any other information necessary for the Exchange to determine, and for the CFTC to verify, if it reviews the position, whether it is appropriate to recognize such a position as an NEBFH. An applicant intending to rely on an Exchange s recognition of a position as an NEBFH would be required to submit an application in advance of exceeding any applicable position limit and to reapply at least on an annual basis. The Proposal also would require Exchanges to promulgate reporting rules for applicants who own, hold or control positions recognized as NEBFHs. Also consistent with the 2016 Supplemental Proposal, the Proposal would permit an Exchange to establish a more streamlined application process for NEBFHs that have previously recognized as bona fide hedging positions (via a list of such determinations that would be published on the Exchange s website). Requests for NEBFHs based on novel facts and circumstances would require a more thorough Exchange review. The proposed delegations to the Exchanges would permit market participants to rely on an Exchange s recognition of an NEBFH, spread or anticipatory exemption until an Exchange or the CFTC notifies them to the contrary. -12-

13 In order to process NEBFH applications with respect to a commodity derivative position, Exchanges must meet certain requirements. In each case, the Exchange may elect to process NEBFH applications for positions in commodity derivative contracts only if: (i) the commodity derivative is a Referenced Contract ; (ii) such Exchange lists such commodity derivative contract for trading; (iii) such commodity derivative contract is actively traded on such Exchange; (iv) such Exchange has established position limits for such commodity derivative contract; and (v) the Exchange has at least one year of experience administering Exchange-set position limits for such commodity derivative contract. The Proposal would require Exchanges that elect to process NEBFH applications to keep certain records, including all pertinent data and memoranda, of all activities relating to the processing of such applications and the disposition thereof. Exchanges must keep all information and documents submitted by an applicant; records of oral and written communications between the Exchange and the applicant in connection with the application; and all information in connection with the Exchange s analysis of an action on such application. In addition, the Proposal would require Exchanges that elect to process NEBFH applications to submit a weekly report to the CFTC providing information regarding each commodity derivative position recognized by the Exchange as an NEBFH during the course of the week. This information would include the identity of the applicant seeking such recognition, the maximum size of the derivative position that is recognized as an NEBFH and, to the extent that the Exchange determines to limit the size of such bona fide hedge position under the Exchange s own speculative position limits program, the size of any limit established by the Exchange. The only changes from the 2016 Supplemental Proposal are certain clarifying language and a lowering of the requirement from three years of data supporting an NEBFH application to only one. b. Exemptions to Position Limits for Certain Spread Positions Also following the 2016 Supplemental Proposal, the Proposal would permit Exchanges, by rule, to exempt certain spread transactions from federal position limits. CEA section 4a(a)(1) provides the CFTC with authority to exempt from federal position limits transactions normally known to the trade as spreads or straddles or arbitrage or to fix limits for such transactions or positions different from limits fixed for other transactions or positions. The Proposal would permit Exchanges to process and grant applications for spread exemptions from federal position limits. Most DCMs already have rules in place to process and grant applications for such spread exemptions from Exchange-set position limits, and the Proposal would expand this ability to also cover federal limits. Similar to the delegation of authority to Exchanges with respect to recognizing NEBFHs, Exchanges would be required to file new rules or rule amendments with the CFTC to process spread exemption applications. In addition, the requirements related to the eligibility of Exchanges to process such applications are similar to those required for Exchanges to recognize NEBFHs noted above (generally, the Exchange must actively list for trading at least one contract that is either a component of the spread -13-

14 or a referenced contract that is a component of the spread, and such contract must have been subject to position limits of the Exchange for at least one year (unless waived following petition to the CFTC)). c. Recognition of Certain Enumerated Anticipatory Bona Fide Hedging Positions Incorporating the approach set forth in the 2016 Supplemental Proposal, the Proposal would permit certain Exchanges, as an alternative to the CFTC, to recognize exemptions from position limits for certain enumerated anticipatory hedging positions as set forth under the definition of bona fide hedging position, as proposed to be revised in the Proposal. The 2013 Proposal would have required market participants to file statements with the CFTC regarding certain anticipatory hedges, which would have become effective absent CFTC action or inquiry 10 days after submission. In contrast, the Proposal would permit Exchanges, as an alternative to the CFTC, to review requests for recognition of enumerated anticipatory bona fide hedging exemptions pursuant to Exchange Rules submitted to the CFTC. Like the 2013 Proposal, the Proposal includes as an enumerated list those anticipatory bona fide hedging positions that would be eligible for recognition, including unfilled anticipated requirements, unsold anticipated production, anticipated royalties, anticipated service contract payments or receipts, and anticipatory cross-commodity hedges. The requirements for Exchanges to recognize such positions are similar to those imposed on the Exchanges under the rules regarding NEBFHs. As noted above, with respect to processing applications for NEBFHs, the 2016 Supplemental Proposal would allow Exchanges to establish a less expansive application process for NEBFHs previously recognized and published on the Exchange s website than for NEBFHs based on novel facts and circumstances. However, the Proposal expressly noted that the CFTC would not permit such an expedited process for applications based on novel versus non-novel facts and circumstances with respect to recognition of enumerated anticipatory bona fide hedging positions. B. OTHER GENERAL PROVISIONS 1. Exemption for Pre-Existing Positions Outside of the Spot-Month The Proposal, consistent with the Prior Proposal, would conditionally exempt from the non-spot-month position limits any Referenced Contract position acquired by a person in good faith prior to the effective date of such limit, provided that such pre-existing Referenced Contract position will be attributed to the person if the person increases its directional position in that Referenced Contract after the effective date of such limit. The exemption would not be available for spot-month position limits. Notwithstanding this proposed approach to pre-existing positions, the Proposal also includes a standalone exemption (from both spot-month and non-spot-month position limits) for (i) pre-enactment swaps (swaps entered into prior to July 21, 2010 the date of the enactment of the Dodd-Frank Act the terms of which have not expired as of that date) and (ii) transition-period swaps (swaps entered into during the period commencing July 22, 2010, the terms of which have not expired as of that date, and ending 60 days after the publication of final position limit rules in the Federal Register). Under the Proposal, both -14-

15 pre-enactment and transition swaps would be permitted to be netted with positions acquired more than 60 days after publication of final position limit rules for the purpose of complying with any non-spot-month position limit. 2. Applicability to Contracts on Foreign Boards of Trade The Proposal would not permit foreign board of trade ( FBOT ) contracts that are linked contracts 5 to be made available to an FBOT s members and other participants located in the United States via direct access 6 unless the CFTC determines that the FBOT (or foreign authority overseeing the FBOT) adopts position limits that are comparable to the position limits adopted by the registered entity for the contract against which the FBOT contract settles. This is a change from the 2013 Proposal which had required that the same, not comparable, limits be adopted by the FBOT or foreign authority overseeing the FBOT. 3. Proposed Amendments to Rule Other Position Limit Exemptions The Prior Proposal and the Proposal are substantially similar in proposing to re-organize and substantively amend the existing exemptions provision in section of CFTC Rules. As explained in the Prior Proposal and the Proposal, the amendments would update cross references to newly proposed bona fide hedging and aggregation provisions, relocate and consolidate the independent account controller ( IAC ) exemption from aggregation with the Commission s separate proposal to amend the aggregation requirements of section 150.4, and delete the calendar-month spread provision which the CFTC has determined is unnecessary under proposed changes to set all-months-combined and anysingle-month position limits at the same level. For aggregation generally, the Proposal defers entirely to section 150.4, which is the subject of the Aggregation Final Rules. In addition, the proposed amendments to section would add exemptions from the federal speculative position limits for: (i) financial-distress situations (discussed below); (ii) certain spot-month positions in cash-settled Referenced Contracts (i.e., the conditional spot-month limit for natural gas contracts, discussed above); and (iii) grandfathered pre-dodd-frank and transition-period swaps (as discussed above). The proposed section amendments would also revise recordkeeping and reporting requirements for traders claiming any exemption from the federal speculative position limits. 4. Financial Distress Exemptions The 2013 Proposal included an exemption from position limits for market participants in financial distress circumstances, noting that the proposed financial-distress exemption was meant to codify the CFTC s prior exemptive practices in accommodating situations involving, for example, a customer default at an 5 6 A linked contract is a contract that settles against the price (including the daily or final settlement price) of one or more contracts listed for trading on a DCM or SEF. Direct access is when an FBOT makes a contract available in the U.S. through direct access to its electronic trading and order matching system through registration as an FBOT or via a staff no-action letter. -15-

16 FCM, or a potential bankruptcy. The Proposal includes the definition for this exemption as previously proposed, but notes that the circumstances under which a financial distress exemption may be claimed include, but are not limited to, the specific scenarios detailed in the definition. 5. Recordkeeping Requirements The recordkeeping requirements presented under the Proposal are substantially the same as those presented in the Prior Proposal. Pursuant to the Proposal, persons claiming exemptions under proposed section (i.e., the exemptions for bona fide hedging, financial distress, conditional spot-month, and grandfathered pre-enactment and transition swaps) must maintain complete books and records concerning all details of their related cash, forward, futures, option, and swap positions and transactions. Such records would be subject to special call by the CFTC, meaning that any person claiming an exemption under section must, upon request, provide to the CFTC such information as specified in the call relating to the positions owned or controlled by that person, trading done pursuant to the claimed exemption, the commodity derivative contracts or cash-market positions that support the claim of exemption, and the relevant business relationships supporting a claim of exemption. The Proposal clarifies that that the bona fide status of the pass-through swap counterparty may be determined at the time of the transaction or, alternatively, at such later time that the counterparty can show the swap position to be a bona fide hedging position. 6. Delay in Implementation and Monitoring for SEFs The Proposal follows the 2016 Supplemental Proposal in delaying the implementation of Exchange-set limits for swaps for SEFs that are Exchanges without sufficient swap position information. In the Proposal, the CFTC noted its belief that most Exchanges do not have access to sufficient swap position information to effectively monitor swap position limits and may consider granting DCMs and SEFs access to part 20 data or SDR data at a later time. Once the Exchange has sufficient swap position information, the guidance would no longer be applicable, and the Exchange would be required to file rules with the CFTC to implement the relevant position limits and demonstrate compliance with the rules requiring DCMs and SEFs, as applicable, to implement, and monitor position limits for swaps. The Proposal stated that an Exchange would have or could have access to sufficient swap position information to effectively monitor position limits if, for example, (1) it had access to daily information about its market participants open swap positions; or (2) it knows that its market participants regularly engage on its Exchange in large volumes of speculative trading activity, that would cause reasonable surveillance personnel at an Exchange to inquire further about a market participant s intentions and total open swap positions. Despite the proposed delay, federal position limits would still apply to swaps that are economically equivalent to futures contracts subject to federal position limits. Copyright Sullivan & Cromwell LLP 2016 * * * -16-

17 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 875 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Michael B. Soleta ( ; soletam@sullcrom.com) in our New York office. CONTACTS New York Whitney A. Chatterjee chatterjeew@sullcrom.com David J. Gilberg gilbergd@sullcrom.com Kenneth M. Raisler raislerk@sullcrom.com Rebecca J. Simmons simmonsr@sullcrom.com John M. Miller millerjo@sullcrom.com Ryne V. Miller millerry@sullcrom.com Christine Trent Parker parkerc@sullcrom.com Washington, D.C. Dennis C. Sullivan sullivand@sullcrom.com -17- SC1: