CFTC Proposed Rule on Energy Markets Position Limits and Hedge Exemptions

CFTC Proposed Rule on Energy Markets Position Limits and Hedge Exemptions CFTC Adopts Proposed Rule During Public Meeting to Impose Speculative Position Limits on Energy Commodities and to Limit Hedge Exemptions for Swap Dealers SUMMARY On January 14, 2010, the Commodity Futures Trading Commission ( CFTC ) held a Public Meeting on whether or not to adopt the publication of a Proposed Rule to allow the CFTC to directly impose speculative position limits for futures and option contracts in energy commodities and to establish a uniform process for the CFTC to grant swap dealers limited risk management exemptions for swap transactions, instead of a bona fide hedging transaction exemption (the Proposed Rule ). The speculative position limits in the Proposed Rule would apply to the Henry Hub natural gas contract; the light sweet crude oil contracts (West Texas Intermediate or WTI), the New York Harbor No. 2 heating oil, and the New York Harbor gasoline blend stock. These four energy commodities currently trade on the New York Mercantile Exchange (NYMEX) and the IntercontinentalExchange (ICE). By a vote of 4-1, the CFTC voted to adopt the Proposed Rule, which will be published in the Federal Register for a 90-day comment period. The Proposed Rule seeks comments on whether the CFTC should adopt the position limits and should limit the hedge exemption for swap dealers, and poses an additional 18 questions on related issues. BACKGROUND The Proposed Rule builds on steps taken by the CFTC during the past year to address volatile energy prices and concerns over excess speculation in commodity markets. In March 2009, the CFTC issued a Concept Release soliciting comment on whether to eliminate the bona fide hedge exemption for swap dealers and replace it with a limited risk management exemption (the Concept Release ). 1 In July and New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com

August 2009, the CFTC held a series of hearings on the issue of whether the CFTC should itself impose direct speculative position limits on energy commodities and other commodities for the purpose of preventing excessive speculation. At the hearings, the CFTC also sought comments on whether it should eliminate hedge exemptions for swap dealers with respect to their positions in futures contracts that offset their exposure to their noncommercial counterparties. 2 The Concept Release and hearings took place in the midst of pending congressional actions on these issues. The volatility of energy prices, along with the dramatic run-up in prices during the spring and summer of 2008, led to increasing demands from members of Congress for the CFTC to address the effect of excessive speculation on energy prices. Members of Congress have introduced legislation that would impose position limits, limit hedge exemptions to commercial market participants, impose additional regulations on over-the-counter transactions and establish additional reporting requirements for all market participants. In June 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454) that would require the CFTC to set aggregate position limits that may be held by any person for each month across all markets subject to the jurisdiction of the CFTC; give the CFTC exclusive authority to grant position limit exemptions for energy commodities; and limit hedge exemptions to bona fide hedgers who are commercial participants engaged in physical transactions. In December 2009, the U.S. House of Representatives passed H.R. 4173, the Wall Street Reform and Consumer Protection Act of 2009. Title III of H.R. 4173, the Derivatives Transparency and Accountability Act (H.R. 4713), was based on the legislative proposals to regulate comprehensively the over-the-counter ( OTC ) derivatives industry introduced by the Treasury Department and passed by the House Agriculture Committee and the House Financial Services Committee earlier in the year. 3 Under H.R. 4713, the CFTC and the Securities and Exchange Commission (the SEC ) will be given extensive new authority to regulate the OTC derivative markets, products and market participants. The CFTC will be given authority over swaps, swap dealers and major swap participants, who would be subject to clearing and execution requirements, capital and margin, and business conduct rules. The Senate is expected to address financial reform during the 2010 legislative session, and both the Senate Banking Committee and the Senate Agriculture Committees are currently drafting OTC derivatives legislation. While Section 4a of the Commodity Exchange Act authorizes the CFTC to impose position limits in order to address excessive speculation, the CFTC has delegated authority over position limits on energy commodities to the relevant exchanges. The CFTC has never directly regulated position limits on energy commodities, nor does the CFTC have the authority to impose position limits on OTC energy commodities. Notably, H.R. 4713 did not provide the CFTC authority to regulate OTC markets, an issue of great concern to several of the Commissioners at the Public Meeting. -2-

PUBLIC MEETING During the Public Meeting, CFTC staff discussed the CFTC s legislative authority to directly impose position limits on energy commodities and the framework of the Proposed Rule. The Commissioners gave prepared statements and questioned the CFTC staff extensively on a variety of topics. While speculative position limits and hedge exemptions were discussed at great length, the Commissioners also touched on a variety of other issues, including: the impact of position limits on the OTC derivative and foreign markets; the impact of index investors on the futures markets; enforcement of the Proposed Rules; and the imposition of position limits on metal commodities. The Commissioners and CFTC staff testifying at the Public Meeting noted that the proposed position limits are intended to reduce the market concentration of large market participants to ensure they do not disrupt the price discovery or liquidity of the markets. Position Limits Commissioner Dunn noted his previously stated concern with the implications of the CFTC setting hard position limits on regulated markets, without similar limits in place in OTC markets or in foreign markets. While the intent of the Proposed Rule would be beneficial, its application could be highly disruptive, and would diminish transparency into the markets, as market participants could move towards these unregulated markets that do not have position limits. Commissioners Dunn and Somers also focused on the failure of position accountability levels imposed by the exchanges to limit the ability of market participants, such as Amaranth and US Natural Gas Fund, to obtain excessively large positions across regulated and unregulated markets. Along the same line of questioning, Commissioner O Malia queried why position limits in energy markets would reduce market volatility, even as similar position limits in agricultural markets had failed to prevent extreme volatility in these markets. Hedge Exemptions for Swap Dealers Noting the lack of authority to set position limits for OTC contracts, the CFTC staff agreed that market participants could work around the new position limits through the OTC swap markets and that the CFTC would have limited ability to monitor the positions of OTC swap customers. It was also noted that swap dealers would not impose aggregate limits on their customers, so the CFTC could only see the OTC position of a swap counterparty if and when the swap dealer applied for a risk management exemption. Additional Issues The CFTC voted in favor of publication by a 4 to 1 margin, with Commissioner Somers dissenting. Both Commissioner Dunn and Commissioner O Malia explicitly noted that while they were voting in favor of publishing the Proposed Rule in the Federal Register to solicit comments from market participants, their vote should in no way be construed as support for any final rule based on the Proposed Rule. Commissioner Dunn noted that he was very interested in reviewing comments from market participants, -3-

which addressed the concerns that he raised over the migration of market participants to less regulated markets. PROPOSED RULE Under the Proposed Rule, the CFTC would directly impose speculative position limits for futures and option contracts in four energy commodities traded on NYMEX and ICE: the Henry Hub natural gas contract, the light sweet crude oil contracts (West Texas Intermediate or WTI), the New York Harbor No. 2 heating oil, and the New York Harbor gasoline blendstock. The Proposed Rule would also establish a uniform process for the CFTC to grant swap dealers limited risk management exemptions for certain swap transactions, instead of the bona fide hedging transaction exemption that they currently obtain through the exchanges. Position Limits on Energy Contracts Using the precedent that the CFTC has long applied for position limits for agricultural commodities, the Proposed Rule would take position limit setting authority away from the exchanges for these four contracts and create aggregate CFTC imposed and overseen position limits based on open interest for all-months-combined, single-month, and spot month. The all-months-combined position limit would be 10 percent of the first 25,000 contracts of open interest and 2.5 percent of open interest beyond 25,000 contracts. The single month position limit would be 2/3 of the all-months-combined position limit and the spot-month position limit for the physical delivery market would be 25 percent of the estimated deliverable supply. For example, under the Proposed Rule, the all-months-combined limit for light sweet crude oil would be 98,200 contracts; 8,900 contracts for New York Harbor gasoline blendstock; 13,100 contracts for New York Harbor heating oil; and 117,300 for Henry Hub natural gas contracts. These position limits would be calculated on an annual basis, based on the open interest for the prior year aggregated across all regulated markets (NYMEX, Clearport, and ICE). The Proposed Rule would create separate limits for small reporting markets. In these markets, the allmonths-combined position limit would be 30 percent of the total open interest of that market and the single-month position limit would be 2/3 of the total open interest of the market, up to 20% of the open interest. Finally, the Proposed Rule would create a de minimis all-months-combined position limit for new reporting markets, which would be the greater of 5,000 contracts or one percent of all open interest. The Proposed Rule would create spot month position limits for cash-settled contracts and physicallysettled contracts as described in the Proposed Rule. The Proposed Rule states that the spot-month for the major energy contracts generally is three days in duration. Under the Proposed Rule, the spot month position limit for physically-delivered contracts would be 1/4 of the estimated deliverable supply. The spot month position limit for cash-settled contracts based on the prices of physically-delivered futures contracts -4-

would also be 1/4 of the estimated deliverable supply. The CFTC would determine the estimated deliverable supply on an annual basis, based on reports from the reporting market listing the physicallydelivered contracts. However, the spot month position limit for cash-settled contracts would be five times the limit for the physical counterpart of the cash-settled contract for market participants who do not hold the physically-settled contract for that spot month. If the market participant does hold the physicallysettled contract for that spot month, the market participant would have to comply with the same position limit as for physically-settled contracts. This is the same rule imposed by NYMEX and ICE on the cashsettled Henry Hub natural gas contracts, beginning in February 2010. The CFTC would determine the estimated deliverable supply on an annual basis, based on reports from the reporting market listing the physically-delivered contracts. Finally, the CFTC will aggregate the positions for accounts in which any person has an ownership or equity of 10% or more or controls the trading for the position; or for positions that are held by two or more people with an agreement to treat the position as being held by a single person. However, the CFTC will not aggregate positions in pools in which a trader is a limited partner or owns less than 25% of the pool, unless the trader controls the trading by that pool. While this will clarify that a person who owns less than 25% in a fund will not have to aggregate its position with the positions in the fund, those funds, including newly seeded funds, cannot rely on individual account controller relief and will have to aggregate their position. Hedge Exemptions Under the Proposed Rule, the CFTC would provide market participants with two types of exemptions from these hard position limits: bona fide hedging exemptions, which currently apply to position limits for agricultural commodities to traders with physical hedging needs, and the new limited risk management exemption for swap dealers. Traders who are hedging commercial risk, such as airlines purchasing futures contracts to hedge their cost of jet fuel, would qualify for a bona fide hedging exemption from the proposed speculative position limits to the extent of their demonstrated commodity needs. The exchanges will continue to provide bona fide hedge exemptions to traders for commercial hedging, subject to the authority of the CFTC. Swap dealers, who must offset their positions held for counterparties, would apply for the new limited risk management exemption for their positions held outside the spot month. The limited risk management exemption for swap dealers would now be administered by the CFTC and will allow the swap dealer to hold two times the applicable proposed position limit. Swap dealers would be permitted to apply for hedge exemptions for their commercial hedging needs, in addition to any risk management exemptions granted by the CFTC. However, it appears that the Proposed Rule will limit the speculative activity of swap dealers who received risk management exemptions. Swap dealers will be required to aggregate their positions held -5-

for risk management transactions with their net speculative positions to comply with the new position limits. In addition, the Proposed Rule states that swap dealers holding large positions pursuant to the proposed swap dealer exemption would be unable to also take on positions as speculators. Thus, any swap dealer who received a risk management exemption would be precluded from any speculative transactions, even if such transactions were within the speculative position limits. The swap dealer cannot carry speculative and risk management positions if the combination of those positions exceed the applicable proposed position limit (not the 2X limited risk management level). While not addressed during the Public Meeting, this provision could significantly impact the business of swap dealers who engage in speculative activity, in addition to their risk management transactions. Under the Proposed Rule, the CFTC would implement a new application process for the risk management exemption. The swap dealer would be required to file an application for an exemption directly with the CFTC and update their application annually. The swap dealer would be required to make monthly reports to the CFTC of their actual risk management needs and must maintain records that will demonstrate their net risk management needs. Finally, the CFTC would publicly disclose the names of swap dealers that have filed for an exemption after a six-month delay. Additional Comments As with the Concept Release, the Proposed Release seeks comments on a variety of issues related to the Proposed Rule and seeks public comments on 18 additional questions on related topics. 4 While the Proposed Release did not specifically address how the CFTC should regulate passive long-only market participants, the Proposed Release did seek comment on how the CFTC could identify such market participants and whether the CFTC should impose additional limitations on them. OUTLOOK As noted during the Public Meeting, the proposed position limits on energy contracts would be in addition to, and not a substitute for, the existing speculative position limit and accountability requirements of the exchanges. Regardless, the direct imposition and enforcement of position limits on energy commodities by the CFTC would represent a significant change in the regulation of trading in such markets. However, the promulgation of a Final Rule in the form of the Proposed Rule faces significant challenges, as made clear by the dissent of Commissioner Somers and the statements at the Public Meeting by Commissioner Dunn and Commissioner O Malia. All three remain deeply concerned with the unintended consequences of the Proposed Rule, should the CFTC move forward with position limits on regulated markets without a corresponding requirement for OTC markets or on foreign markets. With position limits on regulated markets, these Commissioners fear that market participants will shift their activity to unregulated markets, limiting transparency and weakening the regulatory authority of the CFTC. * * * -6-

1 2 3 4 For additional information on the Concept Release, see our Memorandum, Bona Fide Hedge Exemptions for Commodity Swap Dealers, dated March 24, 2009. For additional information on CFTC regulatory initiatives, see our Memorandum, CFTC Hearings on Energy Markets, dated August 11, 2009. For additional information on H.R. 4713, see our Memorandum, U.S. House of Representatives Passes Comprehensive OTC Derivatives Legislation, dated December 14, 2009. See Attachment for list of questions posed. Copyright Sullivan & Cromwell LLP 2010-7-

ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., 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 Jennifer Rish (+1-212-558-3715; rishj@sullcrom.com) or Alison Alifano (+1-212- 558-4896; alifanoa@sullcrom.com) in our New York office. CONTACTS New York David J. Gilberg +1-212-558-4680 gilbergd@sullcrom.com Kenneth M. Raisler +1-212-558-4675 raislerk@sullcrom.com -8- NY12525:453637.4

SPECIFIC QUESTIONS FROM THE PROPOSED RELEASE 1. Are Federal speculative position limits for energy contracts traded on reporting markets necessary to diminish, eliminate, or prevent the burdens on interstate commerce that may result from position concentrations in such contracts? 2. Are there methods other than Federal speculative position limits that should be utilized to diminish, eliminate, or prevent such burdens? 3. How should the Commission evaluate the potential effect of Federal speculative position limits on the liquidity, market efficiency and price discovery capabilities of referenced energy contracts in determining whether to establish position limits for such contracts? 4. Under the class approach to grouping contracts as discussed herein, how should contracts that do not cash settle to the price of a single contract, but settle to the average price of a sub-group of contracts within a class be treated during the spot month for the purposes of enforcing the proposed speculative position limits? 5. Under proposed regulation 151.2(b)(1)(i), the Commission would establish an all-monthscombined aggregate position limit equal to 10% of the average combined futures and option contract open interest aggregated across all reporting markets for the most recent calendar year up to 25,000 contracts, with a marginal increase of 2.5% of open interest thereafter. As an alternative to this approach to an all-months-combined aggregate position limit, the Commission requests comment on whether an additional increment with a marginal increase larger than 2.5% would be adequate to prevent excessive speculation in the referenced energy contracts. An additional increment would permit traders to hold larger positions relative to total open positions in the referenced energy contracts, in comparison to the proposed formula. For example, the Commission could fix the all-months-combined aggregate position limit at 10% of the prior year s average open interest up to 25,000 contracts, with a marginal increase of 5% up to 300,000 contracts and a marginal increase of 2.5% thereafter. Assuming the prior year s average open interest equaled 300,000 contracts, an all-months-combined aggregate position limit would be fixed at 9,400 contracts under the proposed rule and 16,300 contracts under the alternative. 6. Should customary position sizes held by speculative traders be a factor in moderating the limit levels proposed by the Commission? In this connection, the Commission notes that current regulation 150.5(c) states contract markets may adjust their speculative limit levels based on position sizes customarily held by speculative traders on the contract

market, which shall not be extraordinarily large relative to total open positions in the contract 7. Reporting markets that list referenced energy contracts, as defined by the proposed regulations, would continue to be responsible for maintaining their own position limits (so long as they are not higher than the limits fixed by the Commission) or position accountability rules. The Commission seeks comment on whether it should issue acceptable practices that adopt formal guidelines and procedures for implementing position accountability rules. 8. Proposed regulation 151.3(a)(2) would establish a swap dealer risk management exemption whereby swap dealers would be granted a position limit exemption for positions that are held to offset risks associated with customer initiated swap agreements that are linked to a referenced energy contract but that do not qualify as bona fide hedge positions. The swap dealer risk management exemption would be capped at twice the size of any otherwise applicable all-months-combined or single non-spot-month position limit. The Commission seeks comment on any alternatives to this proposed approach. The Commission seeks particular comment on the feasibility of a look-through exemption for swap dealers such that dealers would receive exemptions for positions offsetting risks resulting from swap agreements opposite counterparties who would have been entitled to a hedge exemption if they had hedged their exposure directly in the futures markets. How viable is such an approach given the Commission s lack of regulatory authority over the OTC swap markets? 9. Proposed regulation 20.02 would require swap dealers to file with the Commission certain information in connection with their risk management exemptions to ensure that the Commission can adequately assess their need for an exemption. The Commission invites comment on whether these requirements are sufficient. In the alternative, should the Commission limit these filing requirements, and instead rely upon its regulation 18.05 special call authority to assess the merit of swap dealer risk management exemption requests? 10. The Commission s proposed part 151 regulations for referenced energy contracts would set forth a comprehensive regime of position limit, exemption and aggregation requirements that would operate separately from the current position limit, exemption and aggregation requirements for agricultural contracts set forth in part 150 of the Commission s regulations. While proposed part 151 borrows many features of part 150, there are notable distinctions between the two, including their methods of position limit calculation and treatment of positions held by swap dealers. The Commission seeks -2-

comment on what, if any, of the distinctive features of the position limit framework proposed herein, such as aggregate position limits and the swap dealer limited risk management exemption, should be applied to the agricultural commodities listed in part 150 of the Commission s regulations. 11. The Commission is considering establishing speculative position limits for contracts based on other physical commodities with finite supply such as precious metal and soft agricultural commodity contracts. The Commission invites comment on which aspects of the current speculative position limit framework for the agricultural commodity contracts and the framework proposed herein for the major energy commodity contracts (such as proposed position limits based on a percentage of open interest and the proposed exemptions from the speculative position limits) are most relevant to contracts based on other physical commodities with finite supply such as precious metal and soft agricultural commodity contracts. 12. As discussed previously, the Commission has followed a policy since 2008 of conditioning FBOT no-action relief on the requirement that FBOTs with contracts that link to CFTC-regulated contracts have position limits that are comparable to the position limits applicable to CFTC-regulated contracts. If the Commission adopts the proposed rulemaking, should it continue, or modify in any way, this policy to address FBOT contracts that would be linked to any referenced energy contract as defined by the proposed regulations? 13. The Commission notes that Congress is currently considering legislation that would revise the Commission s section 4a(a) position limit authority to extend beyond positions in reporting market contracts to reach positions in OTC derivative instruments and FBOT contracts. Under some of these revisions, the Commission would be authorized to set limits for positions held in OTC derivative instruments and FBOT contracts. 14. Under proposed regulation 151.2, the Commission would set spot-month and all-monthscombined position limits annually. The Commission seeks comment on how it should take this pending legislation into account in proposing Federal speculative position limits. a. Should spot-month position limits be set on a more frequent basis given the potential for disruptions in deliverable supplies for referenced energy contracts? b. Should the Commission establish, by using a rolling-average of open interest instead of a simple average for example, all-months-combined position limits on a more frequent basis? If so, what reasons would support such action? -3-

15. Concerns have been raised about the impact of large, passive, and unleveraged longonly positions on the futures markets. Instead of using the futures markets for risk transference, traders that own such positions treat commodity futures contracts as distinct assets that can be held for an appreciable duration. This notice of rulemaking does not propose regulations that would categorize such positions for the purpose of applying different regulatory standards. Rather, the owners of such positions are treated as other investors that would be subject to the proposed speculative position limits. a. Should the Commission propose regulations to limit the positions of passive long traders? b. If so, what criteria should the Commission employ to identify and define such traders and positions? c. Assuming that passive long traders can properly be identified and defined, how and to what extent should the Commission limit their participation in the futures markets? d. If passive long positions should be limited in the aggregate, would it be feasible for the Commission to apportion market space amongst various traders that wish to establish passive long positions? e. What unintended consequences are likely to result from the Commission s implementation of passive long position limits? 16. The proposed definition of referenced energy contract, diversified commodity index, and contracts of the same class are intended to be simple definitions that readily identify the affected contracts through an objective and administerial process without relying on the Commission s exercise of discretion. a. Is the proposed definition of contracts of the same class for spot and non-spot months sufficiently inclusive? b. Is it appropriate to define contracts of the same class during spot months to only include contracts that expire on the same day? c. Should diversified commodity indexes be defined with greater particularity? 17. Under the proposed regulations, a swap dealer seeking a risk management exemption would apply directly to the Commission for the exemption. Should such exemptions be processed by the reporting markets as would be the case with bona fide hedge exemptions under the proposed regulations? -4-

18. In implementing initial spot-month speculative position limits, if the notice of proposed rulemaking is finalized, should the Commission: a. Issue special calls for information to the reporting markets to assess the size of a contract s deliverable supply; b. Use the levels that are currently used by the exchanges; or c. Undertake an independent calculation of deliverable supply without substantial reliance on exchange estimates? NY12525:453735.1-5-