Summary
On January 14, 2010, the Commodity Futures Trading Commission ("CFTC") approved for publication in the Federal Register proposed rule amendments that would establish position limits for futures and options contracts in four major energy commodities (light sweet crude oil (West Texas Intermediate or WTI), New York Harbor gasoline blendstock, New York Harbor No. 2 heating oil, and Henry Hub natural gas) (the "Proposed Rules"). 75 Fed. Reg. 4144 (January 26, 2010). Comments must be received on or before April 26, 2010.
The Proposed Rules would apply to positions in energy futures and options contracts listed for trading on CFTC-regulated exchanges, which are currently the New York Mercantile Exchange ("NYMEX"), and with regard to natural gas, the IntercontinentalExchange ("ICE"). The CFTC is also proposing to apply specific aggregation criteria to positions in the referenced energy futures and options contracts, which are stricter than the CFTC's general aggregation policy.
The Proposed Rules are contained in a lengthy, detailed and complex document and raise a host of questions and issues. This memorandum provides a general overview of the principal features of the Proposed Rules, but is not intended to be comprehensive.
Proposed Position Limit Framework
The CFTC is proposing to establish position limits in the energy futures and options markets that are similar in some respects though quite different than existing CFTC-set position limits in the domestic agricultural contracts listed in Rule 150.2, i.e., corn, oats, soybeans, wheat, and cotton. Currently, positions in these energy contracts are not subject to CFTC or to exchange-set limits, except for positions in spot month contracts which are subject to exchange-set limits. These energy contracts are also subject to exchange position accountability rules which require a trader holding or controlling a certain number of open contracts to report the nature of its positions, trading strategy and hedging needs to the exchange upon request and provide as well that the exchange may order such a trader to reduce or not add to its positions.
Under the Proposed Rules, the CFTC would set position limits in these contracts for all months combined ("AMC"), any single month and the spot month, as it does for the agricultural contracts listed in Rule 150.2. However, the proposal would go further than the current limits applicable to those agricultural contracts by establishing aggregated position limits across physically-settled and cash-settled contracts, across reporting markets (i.e., across different exchanges such as NYMEX and ICE) in the case of positions outside of the spot month, and special criteria for aggregating positions across accounts on the basis of ownership. These limits would be reset by the CFTC on an annual basis.
The Proposed Rules would base limits for positions in spot month contracts on the estimated deliverable supply of the underlying commodity and for positions in non-spot month contracts (and AMC position limits) on the basis of open interest in the relevant futures and options contracts. The AMC position limit would be 10% of the first 25,000 contracts of open interest and 2.5% of open interest thereafter. The single month position limit would be set at two-thirds of the AMC position limit. The spot month limit in physically-delivered contracts would be 25% of the estimated deliverable supply. The spot month limit in cash-settled contracts would be 5 times the level fixed for the cash-settled contract's physically-settled counterpart if the trader holds no positions in the physically-settled contract in the spot month; otherwise the cash-settled contract would be subject to the same limit applicable to its physically-settled counterpart.
The Proposed Rules would permit netting of offsetting positions in different classes of the same contract and across different reporting markets or exchanges, subject to various conditions.
Aggregation Policy
The CFTC is proposing to modify its general aggregation policy with respect to position limits in the referenced energy futures and options contracts in a number of respects and apply specific aggregation criteria for the purpose of calculating compliance with the proposed energy position limits. Given that the CFTC has applied its general aggregation policy with respect to CFTC-set position limits in the domestic agricultural contracts listed in Rule 150.2 and that the futures exchanges have generally applied the same aggregation policy with respect to exchange-set position limits in other futures contracts for many years, this aspect of the Proposed Rules is highly significant. First, the CFTC is proposing to make the independent account controller exemption in Rule 150.3 unavailable for positions in the referenced energy futures and options contracts. The independent account controller exemption permits eligible entities using multi-advisor structures to disaggregate nonspot month positions if such positions are controlled by traders who trade independently on their behalf. In this regard, there is also an ambiguous reference to the ability of advisory affiliates of a futures commission merchant ("FCM") to disaggregate independently controlled positions in the referenced energy futures and options contracts from the FCM's proprietary positions in such contracts pursuant to Rule 150.4. 75 Fed. Reg. 4144 at 4161. Second, the CFTC is proposing to require that any trader with an ownership or equity interest of 25% or more in a commodity pool or similar collective investment vehicle must aggregate all positions in the referenced energy futures and options contracts held by the pool or similar vehicle with positions in such contracts held or controlled by the trader. Under current CFTC rules, subject to a few exceptions, a trader who is an investor in a commodity pool or similar vehicle is generally not required to aggregate the pool's positions on the basis of such an ownership interest, if the trader does not control the entity's trading.
In applying the proposed energy position limits, it would therefore be necessary to aggregate positions which would not ordinarily be aggregated pursuant to these new criteria. The rationale articulated for these provisions is that the CFTC's current aggregation policy "may be incompatible with the [proposed energy position limits] and used to circumvent its requirements" and "may not be appropriate" given that the proposed limit levels are at "the outer bounds of the largest positions held by market participants." Id. at 4161.
Exemptions from the Proposed Position Limit Framework
The Proposed Rules include two types of exemptions: (i) a bona fide hedging exemption for traders with inventory or anticipated purchase or sale transactions in the underlying physical commodity; and (ii) a new limited risk management exemption for swap dealers taking positions to offset exposure arising from swap transactions for positions outside of the spot month. The Proposed Rules do not include an exemption for positions held or controlled by passive, unleveraged long-only index traders or for any other types of positions such as arbitrage transactions.
An entity requesting a bona fide hedge exemption to hedge commercial risks would submit an application to the relevant exchange substantiating its need for the exemption, and the CFTC would audit the process. An entity obtaining a hedge exemption would be subject to routine reporting requirements to support and substantiate the exemption.
A swap dealer seeking a risk management exemption would submit an application to the CFTC. A swap dealer obtaining such an exemption would be required to update the application annually, provide monthly reports of its actual risk management needs and maintain records that demonstrate its net risk management needs. The CFTC would publicly disclose the names of swap dealers that have filed for an exemption after a six month lag period. In addition, any such risk management exemption granted by the CFTC would be capped at no more than two times an otherwise applicable position limit (i.e., an AMC or single month limit).
In another departure from current practice by the CFTC as well as the exchanges, it appears that the Proposed Rules would impose significant constraints on the ability of entities who are engaged in a variety of trading activities in connection with different parts of their business (e.g., an integrated oil company entering into both hedging and view of the market positions) to obtain exemptions from the position limits. Thus, an entity seeking to hold hedging positions in excess of an applicable position limit could not generally also hold speculative positions. Also, if bona fide hedging positions outside the spot month exceed twice an otherwise applicable AMC or single month position limit, then such an entity would not be permitted to hold positions as a swap dealer. Similarly, an entity seeking to hold swap risk management positions in excess of an applicable position limit could not simultaneously hold speculative positions. In effect, it appears that such an entity must conduct all of its trading activities within the applicable limits because it would not be able to obtain a hedging exemption from the relevant exchange or a swap dealer risk management exemption from the CFTC to permit it to exceed an applicable limit. The stated purpose of these so-called "crowding out" provisions is to address concerns about the ability of a single firm to hold large, concentrated positions in the energy futures and options markets. The CFTC may also be taking the view that, because the framework is intended to establish high position levels that are at the "outer bounds" of the largest positions held by market participants, such restrictions would not be unreasonable or unduly burdensome.
Commissioners' Concerns and Request for Comments
Although the CFTC voted to adopt the Proposed Rules by a vote of 4-1, three of the five Commissioners expressed serious reservations about the Proposed Rules as drafted. Commissioner Sommers, who voted against publication of the Proposed Rules for public comment, as well as Commissioners Dunn and O'Malia, who voted in favor of publication, expressed concerns that imposing these limits could drive trading activity overseas or to the over-the-counter ("OTC") markets, which are generally not subject to CFTC oversight and result in less transparency. There is legislation pending in Congress (H.R. 4173, 111th Cong. (2009)) which would provide the CFTC with oversight of the OTC markets, but the CFTC may hesitate to adopt these limits without the authority to set corresponding position limits applicable to OTC transactions and absent similar undertakings by foreign regulators.
The CFTC is specifically requesting comments on a number of issues, including, but not limited to, the following: whether federal position limits for the energy futures and options markets are necessary to address concerns regarding position concentration; what alternative methods are available; the appropriate level of position limits; the feasibility of alternative approaches to the proposed swap dealer risk management exemption; whether the proposed position limit framework for energy commodities, including aggregation requirements, should be applied to the domestic agricultural commodities listed in Rule 150.2; the extension of speculative position limits to contracts based on other physical commodities with finite supplies, such as precious metals and soft agricultural commodities; how the CFTC should take the pending legislation into account in proposing federal speculative position limits; and the treatment of positions held or controlled by passive, unleveraged long-only index traders.
Conclusion
If adopted as proposed, the Proposed Rules may restrict the ability of market participants to utilize the energy futures and options markets for legitimate economic purposes. The result may be that market participants will move their trading activities elsewhere, with an adverse impact on the functioning of the U.S. futures markets as a price discovery and hedging mechanism. If market participants incur additional costs and expenses as a result, the consequences could be harmful to the national economy as a whole, including in the form of increased prices to consumers.
We will continue to monitor and report on developments in this area.
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