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CFTC Proposes New Position Limit Rules: Addresses Absolute Limits of 28 Core Futures Products, Aggregation, and Bona Fide Hedging

News Developments    Between Bridges   
Published Date: November 05, 2013

Today the CFTC proposed new rules related to derivatives speculative position limits, addressing (1) absolute levels regarding 28 so-called "core referenced futures contracts" involving various agricultural commodities, energy products and metals, (2) aggregation of related accounts, and (3) what constitutes bona fide hedging positions. The proposed rules are meant to replace final rules adopted by the CFTC on October 18, 2011, that were vacated by a US District Court during September 2012.

Each proposed limit applies to the aggregate of a trader's futures and options, and economically equivalent swaps, across all trading venues (and OTC), to the extent that the derivative products are under the jurisdiction of the CFTC. They do not apply to financial instruments under the jurisdiction of the SEC, such as exchange-traded funds. Different limits will apply to spot month and non-spot month positions. Ultimately the Commission will expand the list of core referenced futures contracts in physical commodities.

Spot month limits generally are proposed to be set at 25% of estimated deliverable supply, and be applied separately to physical delivery and cash-settled referenced contracts.  However a trader only transacting in cash-settled contracts will be eligible for an exemption to trade up to five times the cash-settled spot month limit.

Non-spot month limits generally are proposed to be set as a function of open interest using a  10/2.5 formula – 10% of a contract's first 25,000 of open interest plus 2.5% of the remainder. There will be single-month and all-months-combined limits.

There will be exemptions from the speculative position limits solely for bona fide hedging positions as defined under existing law, augmented by a few proposed new exemptions. Under existing law, derivatives trading constitutes bona fide hedging when it:

  1. represents a substitute for physical transactions made or to be made;
  2. is economically appropriate to the reduction of risks of a commercial enterprise; and
  3. arises from the potential change in value of current or future assets, liabilities or services of the commercial enterprise

A transaction can also be a bona fide hedge if it is reduces the risk of a swap entered opposite a counterparty who is transacting itself a bona fide hedge.

In general, all bona fide hedge positions must be to offset price risks "incidental to commercial cash operations" and must be acquired and liquidated in "an orderly manner in accordance with sound commercial practices."

The proposed rules also address aggregation requirements for affiliated entities but permit exemptions, among other circumstances, where ownership

  1. is not greater than 50% in an affiliate whose trading is independently controlled;
  2. is greater than 50% in a non-consolidated entity whose trading is independently controlled and where the entity's positions either are bona-fide hedges or do not exceed 20% of any position limit; and
  3. results from broker dealer activities as a dealer.

In proposing the new rules, the Commission claims that it is mandatory under Dodd Frank for it to impose position limits, but notes that the US District Court, in striking down the CFTC's September 2011 position limit rules, held that it is ambiguous whether the statute permits the imposition of such rules without a prior finding of necessity. The Commission endeavors to use its "experience and expertise" to resolve this ambiguity.

Although the Commission claims it is not obligated under Dodd Frank to make a prior determination of necessity, it says positions limits are necessary as a "prophylactic measure because excessively large speculative positions may cause sudden or unreasonable price fluctuations even if not accompanied by manipulative conduct." The CFTC provides two examples – the Hunt brothers induced silver price spike from 1979-1980 and extreme price volatility in the 2006 natural gas markets – as circumstances where the existence of position limits would have likely prevented dramatic price fluctuations caused by very large positions.

Chairman Gensler referenced this litigation in his opening remarks:

"With a strong proposal ready for the Commission's consideration today, we determined that the best path forward to expedite position limits implementation was to pursue the new rule and dismiss the appeal of the court's ruling, subject to the Commission's approval of this proposal. Today's proposed rule is consistent with [C]ongressional intent."

Commissioner Wetjen likewise argued that adoption of the position limits is a mandatory obligation of the CFTC, consistent with Congressional intent:

"I find it implausible that Congress would add many sections of new statutory text to simply affirm authority that the [C]ommission already has. Such a conclusion does not seem to comport with the obligatory language used in the statutory amendments, and it does not comport with my understanding of the statute's intent as informed by my experience working as a Senate aide during consideration of these provisions."

Commissioner O'Malia, however, dissented from the new position limits rules proposals for three reasons. He claims the proposals fail to:

  1. use "current, forward-looking data and other empirical evidence as a justification for position limits;
  2. provide "enough flexibility for commercial end-users to engage in necessary hedging activities;" and
  3. institute "a useful process for end-users to seek hedging exemptions."

According to Commissioner O'Malia:

"I am troubled that the proposal uses only two examples from the past—one of them as far back as the 1970s—to cobble together a weak, after-the-fact justification that position limits would have prevented market disruption. This is glaringly insufficient. Instead, the Commission should have taken the time to analyze the new data, especially from the swaps market, that has been collected under the Dodd-Frank Act."

Unrelated, but while expressing his approval for the new proposed rules, Commissioner Chilton announced he would be leaving the CFTC soon.

Comments will be due on the new proposed rules by 60 days after their publication in the Federal Register.

For more information, see:
 

General Background:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/pl_150_factsheet.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/pl_150_qa.pdf
Proposed Aggregation Rules:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister110513.pdf
 
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of November 5, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.


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