Starting in March, both multinational companies and asset managers that trade US futures and certain other derivatives will face new, but long-awaited, position limit rules. The US Commodity Futures Trading Commission (CFTC or "Commission") recently amended its rules ("Final Rule") limiting speculative positions that market participants may take in certain commodities contracts. While the US position limit regime is intended to limit speculation on commodities, the Final Rule covers derivatives commonly used by companies to manage agricultural, energy and other commodity risks. The Final Rule expands the scope of the US position limit regime to include not only specified futures but also swaps that are economically equivalent to those futures.
Although the Final Rule comes into force on 15 March 2021, the Commission adopted a phased-in compliance timeline to provide market participants with sufficient time to prepare for the rulemaking's most-novel elements. Funds, asset managers and corporate end users that trade the Referenced Futures Contracts (as defined below) should undertake a holistic review of their current hedging practices to ensure compliance with the Final Rule. In particular, while the Final Rule expands the menu of exemptions from the CFTC position limit regime, previously granted "risk management" exemptions will be eliminated, and end users will need to evaluate whether other available exemptions will apply.
This alert is not intended to be a comprehensive summary of the Final Rule. Instead, it is a high-level overview of certain features of the legislation. Readers are encouraged to reach out to a member of Baker McKenzie's Derivatives Team to understand the applicability of the Final Rule to their organizations.
Ten years on from receiving its initial mandate to do so, the CFTC has arrived at a version of the Final Rule that limits speculative hedging on key commodities contracts. The Final Rule — in expanding the commodities contracts that are subject to federal position limits from nine to 25, clearly setting out position limits and available exemptions, and streamlining the process for accessing those exemptions — will give certainty and predictability to market participants. However, the expansion of the position limits regime to the swaps market is a significant change and will inevitably introduce its own uncertainties.
The Final Rule comes into effect on 15 March 2021, and a phased-in approach to compliance will commence immediately for Original Covered Contracts, with compliance for other requirements effective on the dates mentioned above. This more gradual approach is essential to allow market participants the time to resolve technological and other challenges for compliance through the development of robust systems to monitor trading in the Referenced Futures Contracts.
Funds, asset managers and corporate end users alike should review their hedging practices to identify the extent of their exposure to Referenced Futures Contracts. Although market participants may be familiar with the position limits applicable to the futures market, the introduction of such limits to the swaps market will require the development of policies and systems to identify which swaps would be deemed economically equivalent based on the facts and circumstances.
To help market participants with compliance, the CFTC will publish a workbook (updated from time to time) that provides a list of Referenced Futures Contracts (along with a non-exhaustive list of linked referenced contracts) subject to the federal position limits.
To help your organization plan and respond to the regulatory developments in the Final Rule, contact a member of the Baker McKenzie Derivatives Team.
In more detail
The Final Rule establishes limits on "speculative trading" in certain commodities contracts, amending the US Commodity Exchange Act to (at last) implement elements of the Dodd–Frank Wall Street Reform and Consumer Protection Act after a decade of attempts at regulatory and policy guidance. The US position limit regime operates on two levels: (1) "federal" position limits on a limited universe of futures; and (2) a broader range of exchange-set position limits and accountability thresholds. The position "limits" refer to the maximum positions, net long or net short, that a market participant may maintain in a particular futures contract. In general, position limits cannot be exceeded absent an exemption, and market participants are responsible for monitoring their trading activities to ensure compliance.
Prior to the Final Rule, federal positions limits covered nine agricultural "legacy" core referenced futures contracts ("Original Covered Contracts"), while other exchange-traded futures and options on futures contracts are subject to exchange-set limits and/or position accountability. The Final Rule expands the scope of covered contracts to include 16 new agricultural, metals and energy core reference futures contracts ("New Covered Contracts"). In addition to the Original Covered Contracts and the New Covered Contracts, the Final Rule also includes: (i) any futures contract and option thereon that is directly or indirectly linked to the price of a core referenced futures contract or the same commodity underlying the applicable contract and (ii) any "economically equivalent swaps," which are swaps with materially identical terms to those of referenced futures contracts (collectively, "Referenced Futures Contracts"). The Referenced Futures Contracts were determined based on the importance of the core referenced futures contracts to the markets of the underlying commodities' cash markets, including requirements for the physical delivery of the commodity, and the importance of the core Referenced Futures Contracts to the US national economy.
The Final Rule
The CFTC adopted a phased-in compliance timeline to allow market participants sufficient time to update and further develop technological and risk systems to address these new position limits. Although the Final Rule is effective as of 15 March 2021, compliance deadlines for certain elements of the rules are staggered as follows:
|Changes under the Final Rule
||15 March 2021
||1 January 2022|
||1 January 2023|
In the Final Rule, the Commission deals with speculative position limits relating to Referenced Futures Contracts through regulation of four key areas: (A) setting out the Referenced Futures Contracts that are subject to position limits; (B) the trading limits applicable to the Referenced Futures Contracts; (C) exemptions available to market participants under certain circumstances; and (D) the process for seeking exemption from the Final Rule. We address each of these four areas in turn.
Referenced Futures Contracts
Speculative position limits for the Original Covered Contracts have been in place for decades and include physically settled futures on agricultural commodities. The Final Rule establishes position limits on 16 additional New Covered Contracts but excludes certain contracts that would otherwise be caught by the Final Rule, including basis contracts, commodity index contracts, contracts based on prices over the course of a month, and swap guarantees, among others.
Spot month vs. non-spot month limits
The Final Rule sets out spot month position limits that apply to all Referenced Futures Contracts, including both Original Covered Contracts and New Covered Contracts and their associated Referenced Futures Contracts. Spot month limits are set at or below 25% of the deliverable supply of each underlying commodity as estimated by the CFTC. On the other hand, federal position limits outside of the spot month (i.e., "non-spot month" position limits) apply only to the Original Covered Contracts and their associated Referenced Futures Contracts, with New Covered Contracts and associated Referenced Futures Contracts subject only to exchange-set limits outside of the spot month.
The differences between spot month and non-spot month also apply to contract netting. For spot month positions, the federal position limits apply separately, net long or short, to cash-settled and physically settled contracts in the same commodity. In contrast, for non-spot month positions, cash and physically settled contracts in the same commodity are netted together to determine a single net long/short position.
The Final Rule sets out various exemptions, reflecting the principle that the limits should apply only to "speculative" positions and not to trading that qualifies as "hedging" under the Final Rule. However, the Commission's default position is that all trading is speculative — and the position limits therefore apply — unless the trader can demonstrate the applicability of an exemption from the Final Rule. The Final Rule expands the scope of permitted enumerated bona fide hedges that are intended to cover additional hedging practices common in the futures market.
The exemptions set out in the Final Rule include: (1) "bona fide" hedging transactions; (2) transactions that qualify as "spread transactions"; (3) a financial distress exemption for entities that take over the positions of another party in financial distress that results in exceeding the federal position limits; and (4) a conditional spot month limit exemption for certain Referenced Futures Contracts for which the underlying commodity is natural gas. The Final Rule both expands an existing list of enumerated bona fide hedges to cover certain hedging practices, and also amends the definition of general bona fide hedging, which includes: (i) the "temporary substitute test"; (ii) the "economically appropriate test"; and (iii) a "change in value requirement." As noted in more detail below, the enumerated bona fide hedge exemptions are self-executing (i.e., participants do not need CFTC approval before relying on the exemption).
Although the expansion of the permissible exemptions under the Final Rule was widely lauded, the elimination of the risk management exemption will directly affect participants that currently rely on the exemption. In light of the potential industry impact, the CFTC has granted an extended compliance deadline for this particular change until 1 January 2023.
Once the exchanges begin to comply with the Final Rule (required by 1 January 2022), market participants with positions that comply with the Final Rule's bona fide hedging definition and within the enumerated categories of bona fide hedges will automatically qualify for exemption; such market participants will not need to file Form 204/304 with the CFTC on a monthly basis, as was previously the case. The market participant would still be required to apply to the applicable exchange with respect to position limits imposed by the exchange. Exemptions for all other positions that qualify as bona fide hedges but are not covered by the Final Rule must be granted by the CFTC. Applications for specifically granted exemptions may be submitted either directly to the Commission or indirectly via the relevant exchange under a newly established streamlined procedure.
1. For example, see the December 2020 workbook produced by the CFTC's Division of Market Oversight at https://www.cftc.gov/media/5481/StaffWorkbookDec2020/download