“Speculative” position limits are caps imposed on each trader’s positions in a given futures contract during the end of trading for a given delivery month (i.e., the “spot month”). These limits are generally intended to prevent excessive speculation and the potential for manipulation, as well as unnatural price fluctuations. In November 2020, the Commodity Futures Trading Commission (CFTC) voted to finalize regulations to expand the types of products subject to such limits from certain agricultural futures contracts (as had previously been the case) to also include certain energy and metals futures contracts.1
In the same rulemaking, and after proposing to do so several times, the CFTC also expanded position limits to cover swaps that are “economically equivalent” to the futures and options on futures that are themselves subject to the CFTC’s position limits. However, the CFTC decided to delay the compliance date for economically equivalent swaps until January 1, 2023 because “exchanges cannot view market participants’ positions in swap positions across the various places they trade, including on competitor exchanges.”2
What are “economically equivalent” swaps?
CFTC regulations define an “economically equivalent swap” as “with respect to a particular referenced contract [i.e., a futures or option on futures contract that is subject to federal position limits], any swap that has identical material contractual specifications, terms, and conditions to such referenced contract.”3 The CFTC explained that “material” specifications, terms, and conditions are limited to those provisions that drive the economic value of a swap, including with respect to pricing and risk, and that examples of “material” provisions include the underlying commodity, including commodity reference price and grade differentials; maturity or termination dates; settlement type (i.e., cash-settled versus physically-settled); and, as applicable for physically delivered swaps, delivery specifications, including commodity quality standards and delivery locations.4 The CFTC further stated several times in the adopting release that its definition of “economically equivalent swaps” was intentionally narrow.5
Therefore, market participants could interpret the rule to mean that a swap is only “economically equivalent” to a given referenced contract if it has terms that are identical to the material terms included in that specific referenced contract. Furthermore, given that the CFTC identified settlement type as one of the material terms of a referenced contract, many market participants have taken the position that swaps are only subject to position limits if they are settled in the same manner as the futures contract referenced (e.g., as the Commodity Reference Price) in the swap confirmation.
This would indeed be a small subset of swaps that are subject to position limits. For example, in the context of natural gas swaps, a swap referencing NYMEX’s NG contract would not be subject to position limits because the swap would (presumably) be cash-settled and the NG contract is physically settled. However, a swap referencing ICE Futures U.S.’s H contract could be subject to position limits (assuming all other material terms were identical) because both contracts are cash-settled.
The CFTC has given little public guidance on this issue or the application of position limits to swaps generally, resulting in a growing belief that the scope of swaps subject to position limits is indeed very narrow. However, the CFTC’s Division of Market Oversight (DMO) recently created uncertainty by indicating in a non-public communication6 that a swap may be economically equivalent if it mirrors any referenced contract (not merely the contract actually referenced in the swap), including cash-settled look-alike contracts. As a result, market participants with swaps that reference physically settled futures contracts may be required to count those swaps toward their position limits if there is any cash-settled referenced contract that settles against the price of the physically settled future.7
The due diligence safe harbor
In the adopting release, the CFTC did recognize that determining which swaps are “economically equivalent” may be difficult and provided a mechanism to mitigate concerns that market participants may face enforcement risk due to that uncertainty. Specifically, the CFTC stated that it will not pursue any enforcement action against a market participant for violating federal position limits for swaps as long as, with respect to such swaps, the market participant “(i) performed the necessary due diligence and is able to provide sufficient evidence, if requested, to support its reasonable, good-faith determination that the swap is or is not an economically equivalent swap and (ii) comes into compliance with the applicable federal position limits within a commercially reasonable time, as determined by the Commission in consultation with the market participant, and if applicable, any relevant exchange.”8
Thus, market participants with swaps that reference futures subject to federal position limits may mitigate risks that they would be found to violate position limits if they conduct an analysis of their swaps and come to a reasonable, good-faith determination that, based on the specific facts at hand, the swaps are not economically equivalent. This analysis should be documented and retained by such market participants in the event that the CFTC or a futures exchange requests such information for review.
- See Position Limits for Derivatives, 86 Fed. Reg. 3236 (Jan. 14, 2021).
- Id. at 3247.
- 17 C.F.R. 150.1.
- Position Limits for Derivatives, 86 Fed. Reg. at 3291.
- See, e.g., id. at 3302 n.493 (“the Commission adopted an ‘economically equivalent swap’ definition that is narrower than the class of futures contracts and option on futures contracts that would be included as referenced contracts.”).
- In a joint letter to the CFTC, dated December 16, 2022, the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) described this informal communication, which was sent by DMO to the FIA.
- Such swaps would be aggregated with (and netted against) the cash-settled futures, though, not the physically settled futures.
- Position Limits for Derivatives, 86 Fed. Reg. at 3295.
Client Alert 2023-036