CFTC Proposes New Position Limits

Transcription

1 CFTC Proposes New Rules to Impose Position Limits on Derivatives on 28 Physical Commodities SUMMARY On November 5, 2013, the Commodity Futures Trading Commission (the CFTC or Commission ) held a public meeting during which it voted 3-1 to propose for public comment rules on position limits applicable to options, futures, and swaps contracts ( derivatives ) related to 28 agricultural, metal, and energy commodities (the Position Limit Proposal or Proposal ). The Proposal will be open for a 60-day public comment period following publication in the Federal Register. At the same meeting, the Commission confirmed that it would 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 (the Original Position Limit Rules ). The Commission also voted unanimously to propose for public comment rules that would provide five new exemptions from the CFTC s requirement to aggregate commonly owned or controlled positions for the purpose of calculating position levels (the Aggregation Proposal ). This memorandum to clients supplements our preliminary summary memorandum to clients on the Position Limit Proposal and the Aggregation Proposal. 1 In addition, we are also publishing a memorandum to clients supplementing our preliminary summary memorandum to clients with respect to the Aggregation Proposal. POSITION LIMITS PROPOSAL As noted above, the Commission approved the Position Limit Proposal by a vote of 3-1 during a public meeting on November 5, Chairman Gary Gensler and Commissioners Bart Chilton and Mark Wetjen provided the three affirmative votes, while Commissioner Scott O Malia provided the dissenting vote. Under the new Position Limits Proposal, the CFTC would set position limits for derivatives based on New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 28 different physical (agricultural, metal, and energy) commodities. As in the Original Position Limit Rules, there would be separate limits for the spot month (which is 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), for all months combined, and for any single month; and the limits would apply across economically equivalent futures, options, and swaps. The Position Limit Proposal would provide exemptions from the limits for bona fide hedging positions (as proposed to be defined), with respect to commercial physical commodity activities, including eight enumerated bona fide hedging positions; for offsets of pass-through swaps ; and for certain cross-commodity hedges. The proposed bona fide hedge exemptions are more restrictive than (i) the types of transactions that have historically been identified as bona fide hedging transactions, and (ii) the hedge exemptions that would have been available under the Original Position Limit Rules. The Proposal would also delete CFTC Rule 1.47, which permits a trader to seek non-enumerated bona fide hedge exemptions. In addition, the Proposal would provide an exemption for certain preexisting positions and certain positions acquired from a party under financial distress. FRAMEWORK OF THE PROPOSED RULE A. SUMMARY OF THE NEW FRAMEWORK The Position Limit Proposal would impose position limits on derivatives that are Referenced Contracts on the same 28 agricultural, metal, and energy commodities as specified under the Original Position Limit Rules. The limits would apply on a spot-month basis as well as on an all-months-combined basis and an any-single-month basis. B. REFERENCED CONTRACTS The Proposal maintains the construct of applying position limits to Referenced Contracts, which will include any position in: The 28 specific futures contracts identified as Core Referenced Futures Contracts 2 (in the Proposal, the CFTC notes that it anticipates proposing to expand the list of Core Referenced Futures Contracts to include additional physical commodities in subsequent releases); and Any derivative, other than a basis contract or contract on a commodity index, that is directly or indirectly linked, including being partially or fully settled on, 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, commodity index contract, or a guarantee of a swap. The CFTC characterizes its approach as a phase-in of position limits by limiting the Proposal to Referenced Contracts in 28 physical commodities (as opposed to all physical commodities). The CFTC asserts that the phased approach will (i) reduce the potential administrative burden by not immediately -2-

3 imposing position limits on all commodity derivative contracts in physical commodities at once, and (ii) facilitate adoption of monitoring policies, procedures and systems by persons not currently subject to positions limits. According to the Proposal, the initial 28 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. C. POSITION LIMITS AND PROPOSED IMPLEMENTATION PLAN 1. Initial Levels and Subsequent Levels a. Generally The Position Limit Proposal would establish initial spot-month 3 position limit levels at the existing levels set by designated contract markets ( DCMs ) for the Core Referenced Futures Contracts. The Proposal would set initial all-months-combined and any-single-month 4 position limits at the same levels, determined based on applying a formula to the CFTC s open interest calculations for calendar years 2011 and 2012 in futures contracts, options thereon, and in swaps that are significant price discovery contracts that were traded on exempt commercial markets. A table showing the specific limit levels proposed by the CFTC, by Referenced Contract, is included as an Appendix to this memorandum. Consistent with prior CFTC practice, each position limit will apply on both an intraday and end-of-day basis. Generally, and as discussed in greater detail below, the Proposal would set subsequent spot-month limits at 25% of estimated deliverable supply 5 and would set subsequent all-months-combined and any-singlemonth limits at 10% of the estimated average open interest in Referenced Contracts, up to 25,000 contracts, with a marginal increase of 2.5% thereafter. The initial set limits would become effective 60 days after the publication of a final rule in the Federal Register, and the CFTC would begin setting (i.e., recalculating) subsequent levels within two years. The subsequent levels would be set by the CFTC based on publication schedules described in the Proposal, with each new subsequent limit to become effective no less than two full months after publication. The Proposal notes that in setting subsequent levels, the CFTC will round up to the nearest 100 contracts. b. Conditional Spot-Month Limit; Alternative Proposals Unlike the Original Position Limit Rules, the Proposal does not include a unique larger spot-month limit for cash-settled Referenced Contracts based on Henry Hub Natural Gas, either initially or in setting subsequent levels. However, the Proposal includes an exemption that would provide a conditional spotmonth limit exemption to permit traders to acquire positions up to five times the spot-month limit (i.e., up to 125% of estimated deliverable supply) in Referenced Contracts based on any commodity if such positions are exclusively in cash-settled contracts. This conditional exemption would only be available to traders who do not hold or control positions in the spot-month physical-delivery Referenced Contract. Unlike a similar proposal that had preceded the Original Position Limit Rules, the new Position Limit Proposal would not require a trader to hold physical-commodity inventory of less than or equal to 25% of -3-

4 the estimated deliverable supply in order to qualify for the conditional spot-month limit. Rather, 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). The Proposal also notes that the CFTC is considering, and seeking public comment on, three alternatives to the proposed conditional spot-month limit. First, the CFTC is considering whether to restrict a trader claiming the conditional spot-month limit exemption to positions in cash-settled contracts that settle to an index based on cash-market transaction prices (as opposed to cash-settled contracts that settle to prices based on the underlying physical-delivery futures contract). This alternative would prohibit traders from claiming a conditional spot-month exemption if they held positions in the spot-month of a cash-settled contract that settles to prices based on the underlying physical-delivery futures contract. As a second alternative to the proposed conditional spot-month limit, the CFTC is considering setting an expanded spot-month limit for cash-settled contracts at five times the level of the limit for the physicaldelivery Core Referenced Futures Contract, regardless of positions in the underlying physical-delivery contract. This alternative would not prohibit a trader from carrying a position in the spot-month of the physical-delivery contract. As a third alternative, the CFTC is considering limiting application of an expanded spot-month limit to a trader holding positions in cash-settled contracts that settle to an index based on cash-market transaction prices in the same way as the first alternative. However, in contrast to the first alternative, under this approach, cash-settled contracts that settle to the underlying physical-delivery contract would not be prohibited altogether but instead would be restricted by a spot-month limit set at the same level as that of the underlying physical-delivery contract. The Proposal notes that, in connection with this third alternative, the CFTC is considering an aggregate spot-month limit on all types of cash-settled contracts set at five times the level of the limit of the underlying physical-delivery contract. c. Alternative Proposals for Initial Spot-Month Levels As noted above, the CFTC proposes to set the initial spot-month position limit levels for Referenced Contracts at fixed levels (see also the Appendix to this memorandum), which would be the existing DCMset levels for the Core Referenced Futures Contracts (set forth in proposed appendix D to Part 150), because the Commission believes this approach is consistent with the regulatory objectives from the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or Dodd-Frank ) 6 amendments to the Commodity Exchange Act (the CEA ) and many market participants are already familiar with these levels. As an alternative to the initial spot month limits in the proposed appendix D to Part 150, the CFTC notes that it will consider setting the initial spot-month limits based on estimated deliverable supplies that the CME Group submitted to the CFTC on July 1, Under this alternative, the CFTC notes that it would use the exchange s estimated deliverable supplies and apply a 25% formula to set the level of the spot -4-

5 month limits in a final rule if the Commission verifies the reasonableness of the exchange s estimates of deliverable supplies. For purposes of setting initial spot-month limits in a final rule, in the event the Commission is not able to verify an exchange s estimated deliverable supply for any commodity as reasonable, then the Proposal would permit the CFTC to determine to adopt the initial spot-month limits in proposed appendix D to Part 150 for such commodity, or at such higher level indicated by the Commission s estimated deliverable supply for such commodity, but not greater than would result from using the exchange s estimated deliverable supply. Under another alternative discussed in the Proposal, the CFTC would, in its discretion both for setting an initial spot-month limit and for subsequent spot-month limit resets use the recommended level, if any, of the spot-month limit as submitted by each DCM listing a Core Referenced Futures Contract (if lower than 25% of estimated deliverable supply). Under this alternative, the Proposal explains that the Commission would have discretion to set the level of any spot-month limit to any of (i) the DCM s recommended level, (ii) a level corresponding to 25% of estimated deliverable supply, or (iii) a level in proposed appendix D to Part 150. The Proposal specifically requested comment on these alternatives. 2. Proposed Process for Computing Subsequent Limit Levels; Publication Schedule a. Spot-Month Levels Under the Position Limit Proposal (and subject to the alternative approaches to spot-month limits described above), the CFTC would fix (i.e., re-calculate) the level of the spot-month limit at least every two years. The limits will be no greater than 25% of the estimated spot-month deliverable supply in the relevant Core Referenced Futures Contract. The CFTC noted that it will closely monitor the effects of its spot-month position limits. Unless the CFTC determines to rely on its own estimate of deliverable supply, it will use the estimated spot-month deliverable supply 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 on a staggered schedule through the year, based on commodity type (i.e., energy, metals, legacy agricultural, or other agricultural). b. All-Months-Combined and Any-Single-Month Levels 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 (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 25,000 contracts, with a marginal increase of 2.5% thereafter. The CFTC would estimate average open interest in Referenced Contracts based on the largest annual average open interest computed for each of the past two calendar years and would be permitted to use either month-end open contracts or daily open contracts over the relevant time period, as practical. -5-

6 Under the Proposal, the CFTC would use Part 16 futures data, and either Part 20 swaps large-trader reporting data or Part 45 swap data repository data, in its open-interest calculations; and the CFTC will publish estimates of average open interest in referenced contracts on a monthly basis, as practical, after such data is submitted to the CFTC. 7 According to the Proposal, the purpose of publishing the estimated average open interest levels on a monthly basis is to make it easier for market participants to estimate changes in levels of position limits. The Proposal notes, 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. Notwithstanding the open-interest calculation, the Proposal would set minimum position limits in any single month and in all months combined at the greater of (i) the spot-month limit and (ii) 1000 for referenced contracts, in an agricultural commodity, or 5000, for Referenced Contracts in an exempt commodity. 3. Other General Provisions a. Exemption for Preexisting Positions Outside of the Spot Month As with the Original Position Limit Rules, the Proposal would conditionally exempt from the non-spotmonth position limits any Referenced Contract position acquired by a person in good faith prior to the effective date of such limit, provided that such preexisting 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 preexisting 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 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 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. b. Applicability to Contracts on Foreign Boards of Trade The Proposal would apply position limits to foreign board of trade ( FBOT ) contracts that are linked contracts 8 made available to an FBOT s members and other participants located in the United States via direct access. 9-6-

7 4. Proposed Amendments to Rule Other Position Limit Exemptions The Position Limit Proposal would re-organize and substantively amend the existing exemptions provision in section of CFTC Rules. As explained in 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 any-single-month position limits at the same level. aggregation generally, the Proposal defers entirely to section 150.4, which is the subject of the Aggregation Proposal. In addition, the proposed amendments to section would add exemptions from the federal speculative position limits for (i) financial-distress situations, (ii) certain spot-month positions in cashsettled Referenced Contracts (i.e., the conditional spot-month limits 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. a. Independent Account Controller Exemption The Proposal would delete the IAC aggregation exemption from section because the IAC exemption is included, in substantially similar form, in section in the Aggregation Proposal. b. Financial-Distress Exemptions The Proposal notes that the proposed financial-distress exemption is meant to codify the CFTC s prior exemptive practices in accommodating situations involving, for example, a customer default at an FCM, or a potential bankruptcy. c. Previously Granted Risk-Management Exemptions Under the 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 riskmanagement exemptions for new swap positions. The Proposal states the CFTC s view that some transactions and positions previously characterized as risk-management and recognized as bona fide hedges are inconsistent with the revised definition of bona fide hedging positions in the Proposal and the purposes of the Dodd-Frank Act amendments to the CEA, specifically noting that (i) financial products are not substitutes for positions taken or to be taken in a physical marketing channel, and thus, (ii) the offset of financial risks arising from financial products is inconsistent with the proposed definition of bona fide hedging for physical commodities. The Proposal describes that one consequence of this approach will be that a swap dealer that serves as an intermediary to, for example, a pension fund seeking to enter into a -7- For

8 swap to receive the rate of return on a particular commodity index (such as the Standard & Poor s Goldman Sachs Commodity Index or the Dow Jones UBS Commodity Index) will no longer be able to obtain a bona fide hedge exemption for an offsetting position in single commodity derivatives that are Referenced Contracts. Per the Proposal, netting of commodity index contracts with individual Referenced Contracts would not be permitted as a bona fide hedging position because a commodity index contract is not a substitute for a position taken or to be taken in a physical marketing channel. d. Recordkeeping Requirements Under 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. D. BONA FIDE HEDGING POSITIONS 1. Overview Proposed Bona Fide Hedging Position Definition The structure of the bona fide hedge exemption under the Proposal includes a general exemption for bona fide hedging positions in proposed section 150.3, referring to a new proposed definition of bona fide hedging position in section In the context of the proposed definition of bona fide hedging positions, the Proposal includes certain substantive changes to the scope of recognized bona fide hedging activity as compared to the Original Position Limit Rules and prior Commission practice. Notably, the Proposal: Would delete section 1.3(z), the current definition of bona fide hedging transactions or positions, in its entirety and replace it with a new definition of bona fide hedging position in section 150.1, which would follow the more restrictive definition included in the CEA under Dodd-Frank; Would delete CFTC Rule 1.47, which currently permits a person to file an application seeking approval for a non-enumerated position to be recognized as a bona fide hedging position; Notes that, notwithstanding the deletion of Rule 1.47, a person engaged in risk-reducing practices that are not enumerated in the revised definition of bona fide hedging may use two different avenues to apply to the Commission for relief from federal position limits: (i) the person may request an interpretative letter from Commission staff pursuant to section concerning the applicability of the bona fide hedging position exemption, or (ii) the person may seek exemptive relief from the CFTC under CEA section 4a(a)(7) (the CFTC s general position limits exemptive authority, added by the Dodd-Frank amendments to the CEA); Requests comment as to whether the CFTC should adopt, as an alternative, an administrative procedure that would allow the Commission to add additional enumerated bona fide hedges without requiring notice-and-comment rulemaking; and -8-

9 Does not include a hedge exemption for unfilled storage capacity although such an exemption was included in the Original Position Limit Rules which would have permitted a person to establish as a bona fide hedge offsetting sales and purchases of commodity derivative contracts that did not exceed in quantity the amount of the same cash commodity that was anticipated to be merchandized, and was limited to the current or anticipated amount of unfilled storage capacity that the person owned or leased. 2. General Requirements for All Bona Fide Hedging Positions Under the Proposal, there are two general requirements for any legitimate hedging position: (i) the purpose of the position must be to offset price risks incidental to commercial cash operations (the incidental test ); and (ii) the position must be established and liquidated in an orderly manner in accordance with sound commercial practices (the orderly trading requirement ). The Proposal notes that the CFTC intends the proposed incidental test to be a requirement that the risks offset by a commodity derivative contract hedging position must arise from commercial cash-market activities. In addition, the Proposal notes that the proposed orderly trading requirement is intended to impose on bona fide hedgers a duty of ordinary care when entering, maintaining, and exiting the market in the ordinary course of business and to avoid, as practicable, the potential for significant market impact in establishing, maintaining, or liquidating a position in excess of position limits. 3. Requirements and Guidance for Hedges in an Excluded Commodity The Proposal would require hedges in an excluded (i.e., non-physical) commodity to meet both the incidental test and the orderly trading requirement and would require the position to be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise (the economically appropriate test). In addition, the hedge would have to be either (i) specifically enumerated in paragraphs (3) (5) of the definition of bona fide hedging position (each discussed below) or (ii) recognized as a bona fide hedging position by a DCM or swap execution facility ( SEF ) consistent with the guidance on risk-management exemptions in proposed appendix A to Part 150 (which incorporates concepts taken from a 1987 CFTC risk-management-exemptions interpretative statement). 4. Requirements for Hedges in a Physical Commodity Under the Proposal, all hedges of a physical commodity would be required to meet the incidental test and the orderly trading requirement. The Proposal clarifies that the new proposed definition of bona fide hedging positions would apply to (i) futures and option contracts on physical commodities listed by DCMs, (ii) swaps that are economically equivalent to futures contracts, and (iii) direct-access linked FBOT futures contracts that are economically equivalent to futures contracts listed by DCMs. a. General Definition Seeking to codify the statutory definition of bona fide hedging for a physical commodity, the Proposal would define as bona fide hedges in a physical commodity those positions that (i) represent a substitute for positions taken or to be taken at a later time in the physical marketing channel (i.e., the temporary -9-

10 substitute test); (ii) are economically appropriate to the reduction of risks (i.e., the economically appropriate test); and (iii) arise from the potential change in value of assets, liabilities, or services (i.e., the change in value requirement), provided the position is enumerated in paragraphs (3) (5) of the proposed definition (each discussed below). b. Pass-Through Swaps and Offsets The proposed bona fide hedging position definition would separately recognize as bona fide hedging a transaction in a commodity derivative contract that reduces the risk of a position resulting from a swap executed opposite a counterparty for which the position at the time of the transaction would qualify as a bona fide hedging position (i.e., the offset of a pass-through swap ). However, the Proposal would not recognize as a bona fide hedge the offset of such swaps with physical-delivery contracts during the lesser of the last five days of trading or the time period for the spot month in such physical-delivery commodity derivative contract (the five-day rule ). In the Proposal, the CFTC requests comment on whether the fiveday rule should be waived for pass-through swaps and offsets where a position of the bona fide counterparty in the physical-delivery futures contract would have been recognized as a bona fide hedging position. c. Trade Options The Proposal includes conforming changes to confirm that the position limits still apply to trade options if no bona fide hedging exemption is applicable. In the Proposal, the CFTC also is requesting comment as to whether it should use its exemptive authority under CEA section 4a(a)(7) to adopt a presumption that a person buying a commodity option that qualifies for the trade-option exemption is a pass-through swap counterparty. Based on that presumption, the seller/offeror of the trade option would therefore be permitted to rely on the pass-through swap exemption for the purpose of classifying its own offset of the trade option as a bona fide hedging position. In addition, the Proposal asks whether it would be appropriate to exclude trade options from the definition of Referenced Contracts, or to include trade options as one of the enumerated exemptions, and, thus, to exempt trade options from the proposed position limits. d. Enumerated Exemptions Paragraph (3) The Proposal would include exemptions for the following four enumerated categories of bona fide hedging positions: 10 Hedges of inventory and cash commodity purchase contracts. Short derivatives positions in commodity derivative contracts that do not exceed the same person s (i) ownership of or (ii) fixed-price purchase contracts to acquire the cash commodity underlying the contact. -10-

11 Hedges of cash commodity sales contracts. Long positions in commodity derivative contracts that do not exceed the same person s (i) fixed-price contracts to sell the cash commodity underlying the contract and (ii) fixed-price contracts to sell the cash products and by-products of such commodity. Hedges of unfilled anticipated requirements. The following positions in a physical-delivery commodity derivative contract, provided that during the lesser of the last five days of trading or the time period for the spot month (as determined under the proposed definition of spot month ) in such physical-delivery contract they do not exceed the person s unfilled anticipated requirements of the same cash commodity for that month and for the next succeeding month: A long position in a commodity derivative contract that does not exceed the same person s unfilled anticipated requirements of the same cash commodity (note that for agricultural commodities, unfilled anticipated requirements would be limited to looking 12 months ahead), for processing, manufacturing, or use; and A long position in a commodity derivative contract that does not exceed the unfilled anticipated requirements of the same cash commodity for resale by a utility that is required or encouraged to hedge by its public utility commission in anticipation of its customers use. 11 Hedges by agents. Long or short positions in commodity derivative contracts by an agent that 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 offset in commodity derivative contracts and that the agent has a contractual arrangement with the person who owns the commodity or holds the cash-market commitment being offset. e. Enumerated Exemptions Paragraph (4) The Proposal would also include exemptions for the following four enumerated categories of bona fide hedging positions, each subject to the five-day rule: Hedges of unsold anticipated production. Short positions in commodity derivative contracts that do not exceed in quantity unsold anticipated production of the same commodity, and that do not exceed 12 months of production for an agricultural commodity, by the same person. In the Proposal, the Commission notes that it is considering relaxing the five-day rule to permit a person to hold, through the close of the spot month, a position in a physical-delivery commodity derivative contract, other than in an agricultural commodity, that does not exceed in quantity the reasonably anticipated unsold forward production that would be available for delivery under the terms of a physical-delivery commodity derivative contract. Hedges of offsetting unfixed-price cash commodity sales and purchases. Positions in commodity derivative contracts (short and long) that do not exceed the amount of the same cash commodity that has been bought and sold by the same person at unfixed prices: Basis different delivery months in the same commodity derivative contract; or -11-

12 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. 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. This proposed exemption differs from the analogous exemption in the Original Position Limit Rules because it applies only to: (i) short positions (ii) arising from production (iii) in the context of mineral extraction. Hedges of services. 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, and which may not exceed one year for agricultural commodities. This proposed exemption would largely track the analogous exemption for offsets of risks in connection with service contracts that had appeared in the Original Position Limit Rules. f. Enumerated Exemptions Paragraph (5) Cross-commodity hedges. The Proposal would also provide that positions in derivatives to offset passthrough swaps, and positions in the derivatives described in the enumerated exemptions in proposed paragraphs (3) and (4) of the bona fide hedging positions definition (discussed above), may also be used to offset the risks arising from a commodity other than the same cash commodity underlying a commodity derivative contract provided that the fluctuations in value of the position in the commodity derivative contract, or of 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. Nevertheless, the Proposal would not permit a bona fide hedge exemption when such position is maintained in any physical-delivery commodity derivative contract during the lesser of either (i) the last five days of trading or (ii) the time period for the spot month in such physical-delivery contract. The Proposal would include guidance on the language substantially related that would establish a nonexclusive safe harbor for cross-commodity hedges. Under the proposed safe harbor, the CFTC would assess (i) whether the target commodity has a reasonable commercial relationship to the commodity underlying the commodity derivative contract (i.e., a qualitative factor), and (ii) whether the target commodity is being offset by a derivatives position that provides a reasonable quantitative correlation (i.e., a quantitative factor). The Proposal includes an explanation of the statistical factors relevant to determining whether the Commission will presume that an appropriately correlated quantitative relationship exists as between two commodities. -12-

13 g. Examples of Bona Fide Hedging Positions As in the Original Position Limit Rules, the Proposal would include an appendix to the rules now providing 14 examples describing examples of bona fide hedging positions for physical commodities Reporting Requirements for Claiming a Bona Fide Hedge Exemption (Part 19) a. Generally The Position Limit 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 rewriting Part 19 of the CFTC s rules. Under the Original Position Limit Rules, the reporting requirements for exemptions from position limits were in vacated Part 151. Exemptions from position limits would require the submission of series 04 reports some revised and some new 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 (under the Original Position Limit Rules, the analogous form was required to be submitted daily); 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 -13-

14 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 ten days in 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 ten 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. c. Notes on Manner of Reporting Source commodities / physical inventory. The Proposal notes for purposes of reporting cash-market positions under current Part 19, the Commission historically has allowed a reporting trader to exclude certain products or byproducts in determining its cash positions for bona fide hedging (i.e., source commodities ) if it is the regular business practice of the reporting trader to do so. Under the Proposal, a source commodity itself can only be excluded from a calculation of a cash position 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. 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. 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. E. MISCELLANEOUS REGULATORY AMENDMENTS The Proposal includes several miscellaneous regulatory amendments. For example, the Proposal will confirm the ongoing application of the non-position limit provisions of the CEA and the Commission s regulations; i.e., nothing in Part 150 could be applied so as to affect the applicability of any other provision promulgated under the CEA or the Commission regulations including (but not limited to) the non-position limit rules addressing manipulation, attempted manipulation, corners, squeezes, fraudulent or deceptive -14-

15 conduct, or prohibited transactions. In addition, like the Original Position Limit Rules, the Proposal includes a severability clause, which would provide that should any provision(s) of Part 150 be declared invalid, including the application thereof to any person or circumstance, all remaining provisions of Part 150 would not be affected to the extent that such remaining provisions, or the application thereof, could be given effect without the invalid provisions. F. RULES FOR DCMS AND SEFS The Original Position Limit Rules would have required DCMs and SEFs to adopt position limits for Referenced Contracts, and would have established acceptable practices for establishing position limits and position accountability for certain non-referenced contracts and excluded commodities. The Proposal similarly includes guidance to DCMs and SEFs that are trading facilities and sets forth requirements and acceptable practices for setting position limits for the 28 Referenced Contracts, as well as position limits or accountability rules in all other listed contracts, including those on excluded commodities. The Proposal would also implement uniform requirements for DCMs and SEFs relating to hedging exemptions across all types of contracts, including those that are subject to federal limits, and would require DCMs and SEFs to have aggregation policies that mirror the federal aggregation provisions. The Proposal also clarifies that (i) a DCM or SEF would continue to be permitted to enforce position limits that are more stringent than the federal limits, and that (ii) federal spot-month position limits do not to apply to physicaldelivery contracts after delivery obligations are established. G. POSITION VISIBILITY LEVELS The Original Position Limit Rules required market participants to report when their positions in energy and metal Referenced Contracts in all months or in any single month exceed certain thresholds that were lower than the non-spot-month position limits. The new Position Limit Proposal does not include the position visibility provisions. THE CFTC S LEGAL ANALYSIS A. BACKGROUND The Original Position Limit Rules, which were proposed and adopted in 2011, in part responded to Dodd- Frank amendments to the CFTC s position limits rulemaking authority under CEA section 4a. 13 The lawsuit challenging the Original Position Limit Rules included several different alleged grounds for vacating the rules, including that the CFTC had misread its statutory grant of authority. 14 The Court vacated the Original Position Limit Rules and remanded them to the CFTC for it to reevaluate the scope of its authority in light of the Court s decision. 15 The CFTC was actively appealing that decision for over a year, until October 28, when the CFTC announced that it would move to voluntarily dismiss its appeal upon issuing the new Position Limit Proposal. -15-

16 B. STATUTORY INTERPRETATION 1. Summary In the face of a possible renewed challenge to the Commission s rulemaking, and attempting to follow the Court s directive, the CFTC argues in the Proposal that, with the benefit of its experience and expertise, section 4a of the CEA is best construed, when viewed as a whole, as a mandate requiring the Commission to adopt position limits for derivatives on physical commodities and that the CFTC is not first required to find that position limits are necessary to diminish, eliminate, or prevent sudden or unreasonable fluctuations or unwarranted changes in the price of a commodity due to excessive speculation. Notwithstanding that conclusion, the CFTC also included, as an alternative justification, a proposed finding that the new position limits are necessary to accomplish these statutory goals. 2. The Question of Required Findings a. Position Limits as Mandatory In the Proposal, the CFTC used its experience and expertise to resolve the ambiguity over whether the necessity-finding requirement was incorporated into the Dodd-Frank amendments to the CFTC s position limit authority. The CFTC reviewed the legislative history preceding Dodd-Frank s enactment, as well as the structure of the Dodd-Frank position limits amendments that were enacted, to support its conclusion that Congress had already concluded that excessive speculation imposed an undue burden on the economy and that position limits were necessary. The CFTC argued that various congressional members and committees, in drafting Dodd-Frank, had so strengthened the position limits provisions so as to remove all doubt over whether imposing position limits would be mandatory. From this, the CFTC concluded that the Dodd-Frank position limits amendments require the CFTC to impose position limits, even in the absence of the CFTC making a general or particularized necessity finding. In briefly addressing another concern that the Court had with the Original Position Limit Rules, the CFTC concluded that, because it is reasonable to interpret CEA section 4a(a) to mandate the imposition of limits, the words as appropriate refer only to the level of limits that may be imposed. That is, the Commission s view is that it must set limits (pursuant to its conclusion that the Dodd-Frank amendments to the CEA s position limit provisions constitute a mandate to impose limits) and is only restricted by the statute in that the limits must be set at appropriate levels. b. Necessity Finding The CFTC offered, alternatively, as a separate and independent basis for the Proposal, a preliminary finding that position limits are necessary to achieve the purpose of CEA section 4a(a)(1). 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 rules in the Position Limit Proposal 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. The CFTC -16-

17 addressed limits on cash-settled contracts and on contracts outside of the spot month by arguing that an extraordinarily large position in such contracts may cause an unwarranted price fluctuation, but it conceded that concerns about corners and squeezes and other forms of manipulation are reduced because the potential for [manipulation] is reduced beyond the context of physical-delivery, spot-month contracts. The Commission specifically invited comment on all aspects of its proposed necessity finding. * * * Copyright Sullivan & Cromwell LLP

18 ENDNOTES Please see our memorandum to clients entitled and Aggregation Rules: CFTC Proposes New Rules to Impose Position Limits on Derivatives on 28 Physical Commodities, Voluntarily Dismisses Appeal of District Court Decision Vacating Original Position Limit Rules, and Proposes Aggregation Standards Applicable to Position Limits for Derivatives, dated November 5, 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 Class III Milk, Chicago Mercantile Exchange Feeder Cattle, Chicago Mercantile Exchange Lean Hog, 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. Under the Proposal, the CFTC explains that, for the purpose of position limits, the term spot month does not refer to a month of time. Instead, the proposed spot month definition would clarify that the spot month is generally the trading period (not an actual month) immediately preceding the delivery period for a physical-delivery futures contract or the settlement-price determination date for a cash-settled futures contract. Under the Proposal, a trader may hold positions up to the spot-month limit in the physical-delivery contracts, as well as positions up to the applicable spot-month limit in cash-settled contracts (i.e., cash-settled futures and swaps), but a trader in the spot month may not net across physical-delivery and cash-settled contracts. Also, see our discussion of the proposed conditional spot-month limit, below. Under the Proposal, traders will be permitted to net all positions in Referenced Contracts (regardless of whether such referenced contracts are for physical delivery or are cash settled) when calculating their positions under the proposed single-month or all-months-combined position limits. The Proposal provides certain guidance in defining this term, noting that the term estimated deliverable supply means 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. The Proposal also notes: Typically, deliverable supply reflects the quantity of the commodity that potentially could be made available for sale on a spot basis at current prices at the contract s delivery points. For a physical-delivery commodity contract, this estimate might represent product which is in storage at the delivery point(s) specified in the futures contract or can be moved economically into or through such points consistent with the delivery procedures set forth in the contract and which is available for sale on a spot basis within the marketing channels that normally are tributary to the delivery point(s). Pub. L. No , 124 Stat (2010). In contrast, in setting the initial all-months-combined and any-single-month limits, the Proposal does not use the data currently reported under part 20, explaining that, instead, the CFTC is proposing to set initial levels based on open interest in futures, options on futures, and significant price discovery swaps. According to the Proposal, by using that approach for setting initial levels, the proposed initial levels represent lower bounds for the initial levels the CFTC may establish in final rules. As of the Proposal, the CFTC noted that part 20 data had been less reliable and thus was not used for purposes of setting proposed initial position limit levels. -18-