CFTC’s re-proposed position limits rule

12 February 2020 Reed Smith Client Alerts

Inicio Perspectivas CFTC’s re-proposed position limits rule

On January 30, 2020, the Commodity Futures Trading Commission (CFTC) proposed to amend its regulations concerning speculative position limits for derivatives (the Proposed Rule). The Proposed Rule is the CFTC's latest attempt in finalizing decade-long rulemaking to modify the position limits framework established under Part 150 of the CFTC's regulations. The CFTC first revisited position limits in 2011 during the implementation of the Dodd-Frank Act of 2010. However, the latest incarnation of the Proposed Rule marks a significant change in direction and regulatory philosophy. The Proposed Rule was drafted with a view to preserving the U.S. markets' price discovery market function for commodities and includes new and/or amended federal spot month limits. The Proposed Rule follows the EU's implementation of comparable rules on position limits for derivatives. We will publish a more detailed analysis that will include a comparison of the Proposed Rule to the EU's position limits regime and guidance on steps to take to prepare for compliance with the new rule.

The Proposed Rule covers four main areas: (1) the contracts subject to position limits; (2) the trading limits that would apply to these contracts; (3) the exemptions that would be available to qualified traders; and (4) the processes for complying with or seeking exemptions from position limits. We briefly discuss these provisions below.

Contracts. Under the Proposed Rule, position limits will apply to: (i) 25 physically settled "core referenced futures contracts" (CRFCs); (ii) their linked cash-settled futures and options on futures; and (iii) "economically equivalent swaps." Part 150 of the CFTC's regulations already establishes federal position limits for nine agricultural commodity futures contracts. The Proposed Rule will reestablish speculative position limits for these "legacy" agricultural contracts and implement additional speculative position limits on seven agricultural, five metals, and four energy physically settled CRFCs. The Proposed Rule also defines "economically equivalent swaps" as those with an "identical material" contractual specification. Inclusion of the linked cash-settled futures contracts and the economically equivalent swaps will dramatically expand the universe of contracts that market participants will be required to monitor on a global basis on the exchanges and OTC markets (with respect to economically equivalent swaps) to ensure compliance.
Position Limits - Spot Month and Netting. Under the Proposed Rule, for the nine legacy agricultural contracts, the position limits will apply to spot and non-spot months, while for the 16 new CRFCs, the limits will apply only to spot months. Nonetheless, participants will be required to comply with the exchange-implemented speculative position limits for non-spot months for other contracts. The CFTC sets spot month limits at or below the 25 percent of commodity deliverable supply. Because position limits apply separately to physically and financially settled contracts, netting is also only possible among physically or financially settled contract categories, but not between these two categories.
Exemptions. The Proposed Rule reiterates that the proposed position limits are speculative position limits, meaning that these restrictions are not intended to limit trading that would qualify as "hedging," although the Proposed Rule presumes that all trading is speculative and therefore position limits will apply unless a trader can demonstrate that an exemption applies. The Proposed Rule recognizes the following: (i) bona fide hedging transactions (which include both enumerated and non-enumerated hedges); (ii) spread positions; (iii) certain financial distress positions; (iv) certain natural gas positions; and (v) the transition period for pre-enactment swaps. The Proposed Rule expands the list of enumerated hedges, or examples of legitimate hedging practices, to include anticipatory merchandizing, hedges by agents, hedges of services, and offsets of commodity trade options, with the focus on how risk is measured and whether a transaction meets the "temporary substitute test." On the other hand, the Proposed Rule eliminates the "risk management" exemption unless a transaction qualifies as a pass-through swap or as a swap offset. Market participants will need to closely review the position limits and available exemptions and be mindful of the fact that under the new rule, both exchange-traded and OTC swap transactions are equally impacted.
Processes. The Proposed Rule also changes some of the processes applicable to the administration of position limits. Under the Proposed Rule: (i) market participants will no longer be required to submit the Form 204 report (the exchange will provide the report to the CFTC on an aggregated basis); and (ii) unless an exemption is self-effectuating (as is the case with enumerated hedges), market participants will need to continue submitting exemption requests to the exchanges (e.g., for non-enumerated bona fide hedges), and unless the CFTC objects within 10 business days, the exemption will become effective.

Given the broad scope and the novel compliance mechanisms of the Proposed Rule, many intended and unintended consequences will need to be considered. The following are just some key issues that market participants would have to consider (assuming that the final rule follows the Proposed Rule):

Aggregation. The CFTC's 2016 rule on the aggregation of position limits remains unchanged and, after the final rule goes into effect, will apply to contracts subject to the limits under this rule. Accordingly, potential aggregation will apply to a much broader number of transactions, across a number of markets (for economically equivalent swaps) and with respect to various affiliates.
Contract Review. Inclusion of cash-settled CRFCs and the economically equivalent swaps will require a thorough review of market participants' portfolios. For example, forwards with volumetric optionality will not be captured by the rule, while certain commodity (trade) options on the CRFC may be captured, even though both contract types can be virtually indistinguishable at first glance. In addition, depending on the contract, hedging must be done on a gross or net basis.
Jurisdictional Reach. Inclusion of economically equivalent swaps in the Proposed Rule dramatically broadens the scope of the position limits rule, and it affects the OTC markets, which are international. Many market participants will need to review the impact of aggregation in the cross-border context if the economically equivalent swaps are traded outside of the United States. Additionally, companies with operations in the EU and the UK will need to conduct a gap analysis to identify contracts that may be subject to position limits under the U.S. and EU position limits regimes.
The Risk Management Exception. Swap dealers will need to closely review their practices and make sure that the pass-through exemption for swaps will be available. There could be a significant gap risk in matching swaps and hedges (e.g., the front and the tail risk). Likewise, swap end-users would be required to make to swap dealers certain representations as to the use of their swaps, which will increase documentation burden and potential risk of liability for a misrepresentation.
Self-Effectuating Exemptions. Market participants will need to establish practices, policies, and procedures to ensure that the enumerated and the non-enumerated bona fide hedging exemptions are treated differently and that transactions expected to qualify for any such exemptions meet the definition of a "bona fide hedge."
Compliance. The Proposed Rule will impose more extensive compliance burdens on market participants as they will be responsible for collecting data and documenting position limits practices. Companies with cross-border operations will face a different set of challenges as they adopt compliance with the Proposed Rule. The Proposed Rule will also require the exchanges to undertake new duties, including submission of monthly reports to the CFTC.
Other Compliance. In addition to heightened compliance obligations under the Proposed Rule, market participants must continue to monitor their trading for market abuse (e.g., spoofing or wash trades) and meet all applicable reporting requirements (e.g., large trader reporting). Practical issues may arise if a market participant chooses to disaggregate its trading operations while still having to monitor the traders for market abuse purposes on a global basis.

The 90-day comment period for the Proposed Rule commenced on January 30, 2020 (the date of the CFTC's open meeting adopting the Proposed Rule, and not the date of publication in the Federal Register) and comments are due on April 29, 2020. The CFTC aims to finalize this rulemaking before the November 2020 presidential elections and, accordingly, it is expected that compliance timelines will be compressed.

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