December 16, 2010
Good afternoon Mr. Chairman, Commissioners. Today staff is recommending the Commission approve a notice of proposed rulemaking to establish position limits for certain derivatives.
The proposed regulations would establish a process for setting position limits for certain derivatives executed pursuant to the rules of designated contract markets (that is, DCMs) and, simultaneously, physical commodity swaps that are economically equivalent to such DCM contracts. The proposed regulations would establish initial position limits through a Commission order. The proposal includes exemptions for bona fide hedging transactions and for positions that are established in good faith prior to the effective date of specific limits that could be adopted pursuant to final regulations. Staff also recommends new account aggregation standards, visibility regulations that are similar to current reporting obligations for large bona fide hedgers, and new regulations establishing requirements and standards for position limits and accountability rules that are implemented by registered entities.
The Dodd-Frank Act amended section 4a(a)(1) of the Commodity Exchange Act and authorized the Commission to extend position limits beyond futures and option contracts to swaps that are economically equivalent to DCM futures and option contracts with Federal position limits. Most importantly, the Act requires the Commission to apply position limits on an aggregate basis to economically equivalent derivatives across different trading facilities and manners of execution.
A primary mission of the CFTC is to foster fair, open and efficient functioning of the commodity derivatives markets. Congress has declared that sudden or unreasonable price fluctuations attributable to “excessive speculation” creates an “undue and unnecessary burden” on interstate commerce and directed that the Commission shall establish limits on the amounts of positions which may be held as it finds necessary to “diminish, eliminate, or prevent” such burden. As the plain reading of the statutory text indicates, the prevention of sudden or unreasonable changes in price attributable to large speculative positions, even without manipulative intent, is a congressionally-endorsed regulatory objective of the Commission.
The Commission is not required to find that an undue burden on interstate commerce resulting from excessive speculation exists or is likely to occur in the future in order to impose position limits. Nor is the Commission required to make an affirmative finding that position limits are necessary to prevent sudden or unreasonable fluctuations or unwarranted changes in prices or otherwise necessary for market protection. Rather, the Commission may impose position limits prophylactically, based on its reasonable judgment that such limits are necessary for the purpose of “diminishing, eliminating, or preventing” such burdens.
The proposal enumerates 28 core physical delivery DCM futures contracts that would be subject to the proposed position limit framework. The 28 specific exempt and agricultural commodities covered by the proposed regulations include gold, silver, copper, crude oil, natural gas, corn, soybeans and wheat.
The enumerated contracts were selected either because such contracts have high levels of open interest and significant notional value or because they otherwise may provide a reference price for a significant number of cash market transactions. “Referenced contracts” are defined as derivatives (1) that are directly or indirectly linked to the price of an enumerated contract, or (2) that are based on the price of the same commodity for delivery at the same location(s) as that of an enumerated contract, or another delivery location with substantially the same supply and demand fundamentals as the delivery location of an enumerated contract.
Staff recommends establishing limits in two phases. In the first phase staff recommends the Commission establish spot-month position limits at the levels currently imposed by DCMs. This first phase would include related provisions, such as proposed regulations pertaining to bona fide hedging and account aggregation standards. During the second phase, staff recommends the Commission establish single-month and all-months-combined position limits and to revise spot-month position limits based on then current estimates of deliverable supply levels.
Phased implementation or adoption of final regulations is possible because DCMs currently set spot-month position limits based on their own estimates of deliverable supply. These spot month limits can, therefore, be implemented by the Commission relatively expeditiously.
For the second phase, staff recommends the Commission determine the numerical non-spot-month position limits for exempt and agricultural commodity derivatives by applying open interest formulas. Because the Commission will not be able to gather swap positional data for some time, staff recommends the Commission determine the levels of such limits when the Commission receives data regarding the levels of open interest in the swap markets to which these limits will apply.
The proposed spot-month position limit formula seeks to minimize the potential for corners and squeezes by facilitating the orderly liquidation of positions as the market approaches the end of trading and by restricting the swap positions which may be used to influence the price of referenced contracts that are executed on DCMs.
In the second phase of implementation, these spot-month limits would be based on 25 percent of estimated deliverable supply as determined by the Commission, which could choose to adopt exchange-provided estimates or, for example, in the case of inconsistent estimates from exchanges, issue its own estimates.
The proposed regulations would apply spot-month position limits separately for physically-delivered contracts and all cash-settled contracts, including cash-settled futures and swaps. A trader may therefore have up to the spot-month position limit in both the physically-delivered and cash-settled contracts.
With respect to cash-settled contracts, proposed regulations incorporate a conditional-spot-month limit that permits traders without a hedge exemption to acquire position levels that are five times the spot-month limit if such positions are exclusively in cash-settled contracts and the trader holds a physical commodity position that is no more than 25 percent of the estimated deliverable supply.
In contrast to spot-month position limits which are set as a function of deliverable supply, the class and aggregate single-month and all-months-combined position limits, as proposed, would be tied to a specific percentage of overall open interest for a particular referenced contract in the aggregate or on a per class basis. Under the proposed regulations, there are two classes of contracts in connection with non-spot-month limits. One class is comprised of all futures and option contracts executed pursuant to the rules of a DCM. The second class is comprised of all swaps.
Class and aggregate speculative position limits based on a percentage of open interest help prevent any single speculative trader from acquiring excessive market power. Class limits ensure that market power is not concentrated in any one submarket. The formula proposed ensures that no single speculator can constitute more than 10 percent of a market, as measured by open interest, below 25,000 contracts of open interest, and 2.5 percent thereafter.
The new statutory definition of a bona fide hedge generally follows the existing definition in Commission regulations, except: (1) the directive requires all bona fide hedging transactions and positions to represent a substitute for a physical market transaction; and (2) the directive provides an explicit exemption for a trader to reduce the risks of swap positions, provided the counterparty to the swap transaction would have qualified for a bona fide hedging transaction exemption or the risk reducing positions offset a swap that qualifies as a bona fide hedging transaction.
The proposed definition of bona fide hedging conforms to the statutory directive.
Staff recommends regulations that would set position visibility, or reporting, levels and establish reporting requirements for all traders exceeding those levels. The reporting regulations aim to make the derivatives portfolios of the largest traders in referenced contracts visible to the Commission.
Staff also recommends proposed regulations for account aggregation standards. Under the proposed standards, the Federal position limits in referenced contracts would apply to all positions in accounts in which any trader, directly or indirectly, has an ownership or equity interest of 10 percent or greater or, by power of attorney or otherwise, controls trading.
Staff recommends a limited exemption from aggregation provisions for positions in pools, a limited exemption for the positions of futures commission merchants in certain discretionary accounts, and a limited exemption for entities to disaggregate the positions of an independently controlled and managed trader that is not a financial entity. In all three cases, the exemption would only become effective upon the Commission’s approval of an application under the proposed regulations.
I would be happy to answer any questions.
Last Updated: January 18, 2011