"This may be the one case where the exception to the rule is more important than the rule itself." — CFTC Chairman Heath Tarbert, Jan. 30, 2020
The chairman's words foreshadowed the dramatic change in approach embedded in the CFTC's latest proposal to implement speculative position limits across 25 "core referenced futures contracts." This new approach would minimize the impact on farmers and other end-users by providing greater certainty and increased regulatory flexibility for hedging activities. Tarbert's words suggest that he recognizes that making hedging more costly and burdensome for commercial end-users would harm the very markets that the rule is meant to protect.
- MORE ON FIA — Read a special report on the position limits rulemaking
The overall purpose of the rule is to set numerical limits on the number of positions held for speculative purposes. If and when the proposal is finalized, it will extend Federal speculative position limits for the first time to include energy and metals contracts and the range of agricultural futures contracts covered by these limits will increase from nine to sixteen. Equally important, the limits will apply not only to the 25 core referenced futures contracts but also to cash-settled futures linked to those contracts as well as certain OTC swaps.
If Tarbert succeeds in moving this proposal across the finish line, it will bring about the largest change to the position limit regime in at least a generation. At the same time, the proposal includes many provisions designed to limit the impact on market participants that use derivatives for hedging purposes. So while the scope of the rule is very broad, it appears targeted to address several of the more controversial restrictions that doomed the prior iterations.
From a commercial end-user perspective, the key provisions include:
- The list of enumerated bona fide hedges would be expanded to include many of those requested by the industry in comments on prior iterations of this proposal. For example, the list now includes the long-sought exemption for anticipatory merchandising hedges.
- The proposal would eliminate the 80% correlation requirement for cross hedges included in past proposals, instead relying on a demonstration of a "reasonable commercial relationship." The 80% requirement cast uncertainty over many cross-commodity hedging strategies because of the prospect of a future change in characterization from hedging to speculation. It moreover reflected an arbitrary determination about what price risks may be hedged, ignoring a commercial assessment of prudent risk management.
- Self-effectuating exemptions would also be available for spreads, pass-through swaps, natural gas spot and others as approved by exchanges.
- The Form 204 report, which requires market participants to report related positions in cash markets, would be eliminated.
- Risk management exemptions would be eliminated. Although this is a rare instance where the proposal removes rather than expands a set of exemptions, it reflects the conclusion that bona fide hedges must always "be connected to the production, sale, or use of a physical cash-market commodity." The proposal suggests, however, the need for risk management exemptions may be mitigated by other provisions of the proposed rule, including: an expected increase in overall limits, the elimination of limits outside the spot month, and the availability of hedge exemptions for pass-through swaps activities.
Overall, the proposed rules respond favorably to comments submitted by end-users over the past decade. One notable feature of the proposed regime is a reliance on the exchanges to not only approve additional non-enumerated hedges, but also to develop the processes and data requirements for approving and annually renewing all hedge exemptions.
The following initial thoughts highlight how end-users may look at the proposal and the potential effects on trading activities and end-user obligations:
- The proposed approach should provide increased certainty around hedging activities, particularly in the area of anticipatory hedging. That said, it will fall to the exchanges to establish the underlying requirements necessary to obtain and retain exemptions for current and anticipatory risks. This raises questions in at least three areas:
- Will hedgers be required to identify discrete anticipatory hedges?
- Will processors be allowed modest mismatches in anticipatory hedge positions reflecting economic dislocations in cash or must positions be perfectly matched as expressed in prior Commission rule proposals?
- What data will be required to be captured and maintained to support trading against anticipated purchases or sales over a rolling 12-month period.
- The proposed elimination of Form 204 and changes to Form 304 should relieve hedgers of reporting burdens and reduce a significant compliance risk exposure. The relief, however, does not extend to ongoing obligations to maintain records of cash transaction data in a manner and format that can be made available to the CFTC promptly upon request for purposes of responding to surveillance and/or enforcement inquiries.
- The much-needed flexibility in the definition of bona fide hedging and elimination of complex reporting obligations should ease the compliance burden on end-users in some respects, but before anyone heaves a sigh of relief, they should note the ongoing evolution of the CFTC's approach to enforcement. As recent speeches and enforcement actions have shown, the CFTC is rigorously pursuing violations of its rules that relate to trading behavior. These include the creation of a task force dedicated to detecting and prosecuting "spoofing" and the aggressive pursuit of wash trading, manipulation and other forms of market abuse. In fact, this emphasis on enforcement is echoed in sections of the proposal that indicate a focus on active oversight of trading behaviors in lieu of relying on reports. In short, end-users will need to maintain investments in effective compliance controls to limit potential scrutiny of trading activities.
The 90-day comment period ends April 29 and the chairman has signaled an intent to move forward quickly and approve final rules this year. That said, the Commission's vote to approve publishing the proposed rules split three to two along traditional political fault lines. The lack of consensus seems likely to attract Congressional interest, particularly since the House and Senate Agriculture Committees are preparing to consider CFTC reauthorization legislation prior to the 2020 elections. That process will give committee members on both sides of the aisle an opportunity to opine on the proposal/wade back into the debate about position limits.
It may be that appeasing the longstanding concerns of end-users and farm constituencies will be enough to overcome any potential partisan disagreement and maintain momentum for the long-stalled rules. Time will tell.
Tom Erickson is an attorney and former Commissioner at the Commodity Futures Trading Commission. He is the founder of Erickson Law & Consulting, PLLC, a commodities and financial markets practice drawing from career experiences in global political, legal and senior corporate environments. Tom previously served as vice president for commodity markets compliance and senior derivatives counsel at Cargill, Inc. and as vice president and general counsel for Bunge Product Lines. The author may be reached at email@example.com.
- Market Structure