position limits: calculations, overlapping jurisdiction, eu developments and more

#EnergyTrading

ACI’s 9th National Forum on Energy Trading Compliance & Regulatory Enforcement

James C. Allison

Manager, Corporate Studies and Initiatives

ConocoPhillips

Position Limits: Calculation, Aggregation, Overlapping Jurisdiction, EU Developments and More

Kara L. Dutta

Assistant General Counsel

IntercontinentalExchange

Bruce B. Fekrat

Executive Director and Associate General Counsel

CME Group

June 5th – 6th, 2014

Julian E. Hammar

Of Counsel

Morrison Foerster

Tweeting about this conference?

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Top Priority 1st Speaker

Recent Developments: Upcoming CFTC Roundtable June 19, and re-opened comment periods

Julian

What is in scope? Account aggregation and position aggregation (and definition of included contracts)

Bruce

Hedge exemptions: Enumerated exemptions, rules and processes. Julian

Keeping track of positions on multiple exchanges or facilities Jim

Interaction with Exchange limits. Effect of new rules on how exchanges set limits; loss of flexibility.

Kara

Impact on the market from treating physical delivery contracts and financially settled contract differently

Bruce

Additional information is included in the slide packet.

Agenda

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Recent Developments • Acting CFTC Chairman Mark Wetjen directed CFTC staff to hold a

public roundtable on June 19, 2014 to consider certain issues related to hedging physical commodity derivatives and aggregation.

• CFTC re-opened the comment periods for the position limits and aggregation proposals for a 3-week period starting June 12, 2014 and ending July 3, 2014.

• CFTC specifically asks market participants to comment on: • Hedges of a physical commodity by a commercial enterprise,

including gross hedging, cross-commodity hedging, anticipatory hedging and the process for obtaining a non-enumerated exemption;

• The setting of spot month limits in physical-delivery and cash-settled contracts and a conditional spot-month limit exemption;

• The setting of non-spot limits for wheat contracts; and • Aggregation exemption for certain ownership interests greater

than 50% in an owned entity and aggregation based on substantially identical trading strategies.

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Julian


Bruce




Kara


Bruce


Agenda

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What is in scope? Comparison of contracts covered by CFTC limits

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Current part 150 limits • Covers nine

specific agricultural DCM commodity contracts (“legacy contracts”)

Proposed part 150 limits • Covers 28 DCM

contracts, including legacy contracts

• Limits to be imposed over all other physical commodities at a later time

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Definition of “referenced contract”

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Included

• Same reference price as underlying core referenced futures contract (“CRFC”)

• Same location and same commodity as CRFC

• Contract “partially settled” to CRFC or same location/commodity, including intercommodity spread contracts

• Contract at a fixed differential to CRFC or same location/commodity

Excluded

• Basis contracts with both legs in either same or substantially the same commodity as CRFC (“substantially the same” commodities are defined specifically in Appendix B – not defined generally and therefore a challenge for exchange-set limits)

• Commodity index contracts with two or more commodities that are not the same nor substantially the same (and not a basis nor a spread contract)

Note: CFTC has published a “CFTC Staff Workbook of Commodity Derivative Contracts” for referenced contracts

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Whose positions are aggregated? View of proposal from 30,000 feet

1. Major departure from current aggregation rules » But no identification of problems in current rules

2. True, CFTC is “walking back” from the even more extreme aggregation rules vacated in ISDA/SIFMA vs. CFTC » CFTC started walking back by re-proposing aggregation

rules in 2012, even before the court decision

3. BUT: CFTC’s new re-proposed aggregation rules of 2013 do not walk back nearly far enough » Significant, negative impacts on traders, and on DCMs

and SEFs that must implement these new rules

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What would the new proposed rules do?

1. Impose an owned entity aggregation requirement

» Must aggregate positions of entities in which a person holds an ownership interest of 10% or more

» Some exemptions, but insufficient

2. Adopt SITS rule

» Must aggregate positions in accounts or pools with “substantially identical trading strategies” (SITS)

3. Require DCMs/SEFs to adopt conforming rules

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Owned-entity aggregation standard’s flaws

1. Prescribes enterprise-level aggregation, not entity-level • Thereby penalizes complex corporate ownership structures

2. CFTC staff view: Owned entity aggregation has always been required for ownership interest of 10% or more

• Inconsistent with text of Commodity Exchange Act

• CFTC has never said that

3. CFTC staff view: Ownership over 50% indicative of control • Indicative of corporate control, maybe; not of control over trading

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What is the SITS rule?

1. Must aggregate all positions held or controlled in more than one account or pool following “substantially identical trading strategies”

2. Aggregation required under SITS rule even if positions would otherwise be exempt from aggregation

3. No guidance as to meaning of “substantially identical”

4. Absurd results: Retail investor must aggregate positions of $1B single-commodity index fund if he/she--

• Invests $10,000 in 2 such funds using same index

• Invests $10,000 in fund-of-funds that invests it in 2 such funds using same index – even if investor doesn’t know

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Limits on spot-month positions have teeth

•Set at low levels • narrow estimated deliverable supply concept (long term

contracts excluded) and outdated numbers

•Aggregation of accounts will matter

•Restrictions on bona fide hedging most impactful during spot-month

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Julian


Bruce




Kara


Bruce


Agenda

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Hedging Exemptions: Key Issues • Orderly trading requirement: negligence/ordinary duty of

care standard (not just disruptive trading).

• Economically appropriate test: requires commercial enterprise to take into account all inventory or products that the commercial enterprise owns or controls.

• How a commercial enterprise is interpreted is critical.

• May require assessment of hedging activity at corporate group level, as opposed to individual affiliates or other business units, even where aggregation not required.

• No exemption for anticipated merchandizing activity for unfilled storage capacity permitted under vacated rule.

• This may affect the ability to hedge the value of assets (e.g. storage capacity) that are not currently operating.

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Hedging Exemptions (cont’d)

• New exemption for utilities hedging unfilled anticipated requirements of customers where required or encouraged by public utility commission.

• Cross-commodity hedges to qualify for safe harbor treatment must meet qualitative and a new quantitative standard (correlation of 0.8 for 36 mos.) (rebuttable presumption). • Preamble states that natural gas generally is not a cross-

commodity hedge for power. • Relief for non-enumerated hedge exemptions must be

obtained through an exemptive order from CFTC or a letter from CFTC staff requested under reg. 140.99. • Prior staff process under reg. 1.47 had timeframes for

decision, which are eliminated under the proposal. • Concern that staff will not be able to respond to requests in

a commercial reasonable time.

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Julian


Bruce




Kara


Bruce


Agenda

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Tracking across facilities

• Federal limits will apply to the aggregated entity’s aggregated position • Including all exchanges or other facilities and OTC • To the extent the instruments are “referenced contracts”

• Therefore, you must track • All sub-entities that are aggregated • All transactions in referenced contracts • In real time

• What if you have offsetting positions on different facilities? • The proposed rule contemplated an exemption for this. • Unclear how it would work in practice • The exchanges need additional guidance from the CFTC on implementation processes

• Hypothetical for discussion: • Assume my positions are for trading, not hedging • Strategy is buy low/sell high • By happenstance, all my “buys” are on exchange A, and all my “sells” on exchange B • My net position is very nearly flat, but the position on each of Exchange A and Exchange B is a

multiple of the exchange limit. 16

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Julian


Bruce




Kara


Bruce


Agenda

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Exchange Limits and Federal Limits

• If there are CFTC set limits, then DCMs and SEFs that are trading facilities must set limits no higher than the CFTC limits • Same aggregation standards and definition of bona fide hedging as the CFTC • Netting: Under CFTC federal limits, Referenced Contracts net outside of the spot month. For exchange limits, market participants must apply for an exemption. – Inter-market spread exemption: positions across exchanges or OTC – Intra-market spread exemption: e.g., calendar spread

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• The process for applying to the exchange for exemptions should largely stay the same.

• The ability of the exchange to grant exemptions will be modified. Currently, exchanges have flexibility when granting hedge exemptions. Under the Federal Limits, the burden of proof shifts to the CFTC.

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Julian


Bruce




Kara


Bruce


Agenda

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Treating physical delivery contracts and financially settled contract differently

•Different regulatory treatment in the spot-month as to: • So-called “five day rule” restriction • Cross-commodity and unfilled production hedge

exemptions • Swap pass through hedge exemption • “Spread” exemption

•Five-times conditional limit

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Development outside the U.S.

• Europe • The topic of Position Limits is included in MiFID II

• On May 22, ESMA released a Consultation document and a Discussion document on MiFID II (see following slides)

• Comments due August 1, 2014.

• Consultation Paper

• Discussion Paper

• Canada • Little notable progress

• Federal/Provincial coordination seems to be improving 22

http://www.esma.europa.eu/consultation/Consultation-Paper-MiFID-IIMiFIR

http://www.esma.europa.eu/consultation/Discussion-Paper-MiFID-IIMiFIR

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ESMA Draft Hedging Exclusion • 11. The standard developed for the purpose of EMIR states that a derivative contract is objectively

measurable as reducing risks directly relating to the commercial activity when, by itself or in combination with other derivative contracts it meets one of the following criteria: • it covers the risks arising from the potential change in the value of assets, services, inputs, products,

commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business;

• it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in point (1), resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk;

• it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS) adopted in accordance with Article 3 of Regulation (EC) No 1606/2002 of the European Parliament and of the Council.

• 12. ESMA believes that the interpretation and consequent application of risk-reducing activity should be consistent (recognising that EMIR addressed this question only in relation to OTC trades) as far as possible with the RTS produced under EMIR.

• Q491: Do you agree with ESMA’s proposal to link the definition of a risk-reducing trade under MiFID II to the definition applicable under EMIR? If you do not agree, what alternative definition do you believe is appropriate?

From ESMA discussion paper 2014-548 at page 408 23

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ESMA Draft re Physical Settlement • 1. Contracts must be physically settled if:

• i. the party to the contract entitled to receive the underlying commodity has an unrestricted and unconditional right to physical delivery;

• ii. there is no option for either party to replace physical delivery with cash settlement;

• iii. the obligations under the contract cannot be cancelled out against obligations from other contracts between the parties concerned.

• 2. The existence of force majeure provisions do not prevent a contract from being characterised as “must be physically settled” for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.

• 3. The existence of other bona fide clauses rendering it impossible to perform the contract on a physical settlement basis do not prevent a contract from being characterised as “must be physically settled” for the purposes of further specifying wholesale energy products under Section C 6 and C 6 energy derivative contracts.

• 4. Contracts that are physically settled have a broad range of delivery methods including the following: • i. physical delivery of the relevant goods themselves;

• ii. delivery of a document giving rights of an ownership nature to the relevant goods or the relevant quantity of the goods concerned (such as a bill of lading or a warehouse warrant); or

• iii. another method of bringing about the transfer of rights of an ownership nature in relation to the relevant quantity of goods without physically delivering them (including notification, scheduling or nomination to the operator of an energy supply network) that entitles the recipient to the relevant quantity of the goods.

From ESMA consultation paper 2014-549 at page 282

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Additional Information

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Overview

• Definition of Bona Fide Hedging

• Orderly Trading Requirement

• General Requirements

• Enumerated Hedging Positions

• Pass-Through Swaps

• Cross-Commodity Hedges

• Non-Enumerated Hedges

• Reports and Records

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Definition of Bona Fide Hedging

• To qualify as a bona fide hedge under the position limits rule, transaction must:

• Meet orderly trading requirement;

• 3 general requirements traditionally associated with hedging; and

• Qualify as a:

• specified, enumerated hedge,

• pass-through swap, or

• cross-commodity hedge.

• No non-enumerated exemption as part of definition (as in existing definition).

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Orderly Trading Requirement

• Negligence Standard/Ordinary duty of care – must be

aware of potential impact on market.

• Applies in addition to CFTC’s disruptive trading

practice authority.

• Unclear who at the CFTC determines when trading is

negligent.

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General Requirements

3 general requirements:

(1) Temporary substitute test (physical commodities): represent a substitute for transactions or positions made or to be taken at a later time in a physical marketing channel.

(2) Economically appropriate test: requires commercial enterprise to take into account all inventory or products that the commercial enterprise owns or controls.

• How a commercial enterprise is interpreted is critical

• May require assessment of hedging activity at corporate group level, as opposed to individual affiliates or other units, even where no aggregation required.

(3) Change in value requirement (physical commodities): must be to offset risks incidental to cash operations.

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Enumerated Hedging Positions • Enumerated hedges:

• Inventory and cash commodity purchase contracts

• Cash commodity sales contracts

• Unfilled anticipated requirements

• Utility hedging unfilled anticipated requirements of customers where required or encouraged to by public utility commission – New exemption not included in vacated rule

• Hedges by agents

• “Other” enumerated hedges: • Unsold anticipated production

• Offsetting unfixed-price cash commodity sales and purchases

• Anticipated royalties

• Services

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Enumerated Hedging (cont’d)

• No exemption for anticipated merchandizing activity for unfilled storage capacity permitted under vacated rule.

• This may affect the ability to hedge the value of assets (e.g. storage capacity) that are not currently operating.

• Entities required to aggregate positions under the aggregation proposed rule shall be considered the same person for purposes of determining whether they are eligible for a hedging exemption.

• CFTC expressly declined to recognize as bona fide hedges 6 out of 10 specific types of hedges that the Working Group of Commercial Energy Firms had petitioned the CFTC to recognize under the vacated rules.

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Pass-Through Swaps • “Pass-through swaps” are swaps executed opposite a

counterparty for whom the transaction would qualify as a

bona fide hedge.

• Benefit of the hedge may be “passed through” to the

non-hedging counterparty if it enters into a Referenced

Contract that reduces the risk of (e.g. offsets) the pass-

through swap.

• Non-hedging party would be able to exclude the pass-

through swap and the offsetting swap from its position

limit calculation.

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Pass-Through Swaps (cont’d)

• Requires written representation from counterparty that

the swap is a bona fide hedging position.

• Subject to the “5-day rule” for physical delivery

contracts:

• Not recognized as a bona fide hedge during the lesser

of the last 5 days of trading or the time period of the

swap month in the physical delivery contract.

• Vacated rule did not subject pass-through swaps to the

5-day rule.

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Cross-Commodity Hedges

• Cross-commodity hedging transactions are eligible for

the bona fide hedging exemption if:

• Fluctuations in value of the derivative are

“substantially related” to the fluctuations in value of

the actual or anticipated cash position or pass-

through swap and

• Meet the 5-day rule for physical delivery derivatives.

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Cross-Commodity Hedges (cont’d)

• Substantially related test: non-exclusive safe harbor

• Target commodity must have reasonable

commercial relationship to underlying commodity

and

• Target commodity must be offset by a position that

provides a quantitative correlation of at least 0.80

for 36 months

• Not required under existing or vacated rules

• Rebuttable presumption if does not meet

quantitative test

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Cross-Commodity Hedges (cont’d)

• Facts and circumstances for cross-commodity hedges

outside of the safe harbor determined on a case-by-case

basis upon application.

• Natural gas generally is not a cross-commodity hedge

for power per the Preamble.

• However, the Preamble clarifies that an electric

generator that owns or leases a natural gas generator

may qualify for an unfilled anticipated requirements

hedging exemption to meet a fixed-price power

commitment in the form of an electricity sale.

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Non-enumerated hedges

• Relief for non-enumerated hedging positions must be obtained:

• Interpretative Letter from CFTC staff requested pursuant to CFTC Reg. 140.99 or

• Exemptive relief from CFTC under section 4a(a)(7) of the Commodity Exchange Act.

• Prior staff process under CFTC reg. 1.47 (which included timeframes for decision: 30 days to respond to a new request and 10 days for supplemental filings) would be eliminated.

• Concern that CFTC or its staff will not be able to respond to requests in a commercially reasonable time.

• Not clear what standards will be used for evaluating requests, which may further exacerbate timeliness issue.

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Reports and Records • Reports:

• Form 204: required for any person seeking a bona fide hedging exemption (submitted monthly)

• Form 304: applies to merchants and dealers of cotton (submitted weekly)

• Form 504: required to claim conditional spot-month limit exemption (submitted daily during the spot month)

• Form 604: required to claim pass-through swap exemption (submitted daily during the spot month)

• Form 704: required to claim anticipatory hedging exemptions (must describe anticipated activity at last 10 days in advance of entering into positions that exceed the relevant position limit)

• Records: persons claiming a hedge exemption must maintain complete books and records concerning related cash, forward, futures, options and swaps.

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• The CFTC has proposed to eliminate the spread and arbitrage exemptions.

• The CFTC will decide whether they believe a trade or strategy is hedging or speculative:

• For example, staff currently believes that anticipatory hedging is speculative.

• For example, the Southwest Hedge would be considered speculative under the re-proposed Federal rule.