Full transcripts include:
*Opening statement of Chairman "The Genz" Gary Gensler
*Opening statement of "Huggy Bear" Bart Chilton
*Opening statement of Jill Sommers
*Opening statement of Scott O'Malia
*Statement in support of position limits by Chairman Gensler
*Statement in opposition to position limits by O'Malia
*FINAL REGULATIONS ON POSITION LIMITS FOR FUTURES AND SWAPS
*Full PDF file of the FINAL REGULATIONS ON POSITION LIMITS FOR FUTURES AND SWAPS can be found at the CFTC's site: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/pl_factsheet_final.pdf
Chairman Gary GenslerOctober 18, 2011
Good morning. This meeting will come to order. This is a public meeting of the Commodity Futures Trading Commission (CFTC) to consider proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). I’d like to welcome members of the public, market participants and members of the media, as well as those listening to the meeting on the phone or watching the webcast.
I would like to thank Commissioners Dunn, Sommers, Chilton and O’Malia for their significant contributions to the rule-writing process. I also want to thank the CFTC’s hardworking staff – they are working day, night and weekends to complete these rules.
During today’s meeting, the first final rule that we will consider relates to position limits. A position limits regime in the commodity futures and swaps markets is a critical component of comprehensive regulatory reform of the derivatives markets.
The second final rule that we will consider today relates to core principles for derivative clearing organizations.
Lastly, we will consider staff recommendations providing further exemptive relief – consistent with the CFTC’s July 14th Exemptive Order – from certain provisions of Dodd-Frank’s Title VII requirements.
Importance of Reform
Today is our 20th meeting to implement Dodd-Frank rules. As we continue our work to complete the rulemaking process under Dodd-Frank, it is critical to remember why we are here in the first place. Though it has been three years since the financial crisis, we cannot forget the weaknesses that it exposed in both our financial system and our financial regulatory system.
We cannot forget the millions of Americans who had no connection to derivatives or other exotic financial contracts but still lost their jobs due to a poorly regulated industry. We cannot forget the millions more who lost their homes or whose homes are now worth less than their mortgages, in part because of how the financial system – including the unregulated swaps market – brought the economy to the edge of the cliff. The package of reforms included in the Dodd-Frank Act will help address the contributing factors to the 2008 crisis to protect those Americans. They are concrete measures that will bring transparency, openness and competition to the swaps markets while lowering the risk they pose to the American public.
There are those who might like to roll the Dodd-Frank Act’s reforms back and put us back in the same regulatory environment that preceded the crisis three years ago. But that regulatory system failed to protect the American public. We must not forget about the 8 million lost jobs – the majority of which were lost by people who have never used derivatives. We must not forget what the nation went through three years ago – and what the nation continues to recover from now.
Some have raised cost considerations about our rulemakings. We are going through those comments and they have been very helpful. But the greatest cost is having a public that is not protected from the risks of the swaps market and that does not get the benefits of transparent markets. That is why it is so essential that we finish implementing the Dodd-Frank reforms.
Before we hear from the staff on the rulemakings that we will consider today, I will recognize my fellow Commissioners for their opening statements.
“Huggy Bear and Position Limits”
Statement of Commissioner Bart Chilton Before the CFTC Public MeetingOctober 18, 2011
This will date me. I don’t know how many of you remember the television series Starsky and Hutch. Huggy Bear was the informant, the narc, who provided tips to the detectives. What Huggy Bear said to Starsky and Hutch was, “I’ll lay it out so you can play it out.”
Well, that’s sort of like what Congress does when it passes a law—it lays it out. As regulators, we take the law, and we play it out. Our role is to put meat on the bones of the law and do what Congress told us to do. It is a serious responsibility. Congress mandated these position limits and, finally and belatedly, we are putting them in place. I also want to note that we have been very careful to stay within the four corners of the law as Congress has laid it out. I’m convinced we are on solid legal footing with this rule.
This is an uncommon rule and there is no way it will please everyone. Not all of it pleases me. For example, I still want to ensure that appropriate anticipatory hedging is allowed for certain bona fide hedgers. While I'd have an even tougher rule in many respects if I were the only author, this is nonetheless a very strong, needed and imperative rule to ensure more efficient and effective markets devoid of fraud, abuse and importantly, manipulation. This rule balances the needs of consumers and market participants alike.
Here are the key take-aways: first, the rule sets federally enforced limits, for the first time ever, on the amount of concentration anyone may control in energies and metals. It mirrors similar limits that we’ve had in some agricultural markets for decades. In these other markets, we have seen cases where one trader holds 30, 35 and even 40-plus percent of a market. That can be, and I believe has been at times, manipulative. This rule will put a stop to that.
Second—and one of the most important aspects of this rule for me—the “Wild, Wild West” of exempting traders from any concentration levels whatsoever ends now. Exemptions to limits will from here on out be approved by the Agency, not the exchanges, and under strict guidelines. A bona fide hedge will truly be a bona fide hedge. Traders will have to continually prove their business need to this agency to receive an exemption, and—significantly—if we see that there is a deviation from a bona fide hedging strategy, we can immediately close that down.
Third, this rule will bring all derivatives within the Commission’s jurisdiction—futures and swaps—the formerly dark OTC markets—under the same position limits. This brings needed transparency and accountability to markets that were part and parcel to the economic meltdown in 2008.
While I would have preferred tighter limits for certain contracts—particularly precious metals—simply establishing a position limit regime is critically important. Initially, the limit levels will be identical. The Commission will, however, be required to periodically reassess those levels to ensure more appropriate recalibration as necessary.
So Congress laid this out in July 2010. We’ve been playing it out since then. I’m hopeful that we’ll finally pass the rule today. I thank the Chairman. I thank the staff, and I thank my colleagues. Most importantly, I thank all of those individuals who have taken the time to give us their views about what we should do as we “Play It Out.” Thank you.
Commissioner Jill E. SommersTuesday, October 18, 2011
Good morning. Thank you Mr. Chairman and thank you to the teams that have worked so hard on the final rules before us today and on the amendments to the Commission’s July 14, 2011 Order relating to the Effective Date for Swap Regulation. The current Order expires on December 31, 2011, and I am glad we are addressing the necessary amendments to that Order now instead of waiting until the last minute to provide certainty to market participants.
Today we will first be voting on final rules for DCO’s. In my opinion, these rules are needlessly prescriptive and go beyond what is required by the statute. Our registered DCOs have a fantastic track record of protecting their own financial safety and soundness and have proven themselves, even during the financial crisis, to be excellent at managing margin and risk. We should allow them to continue to do so without imposing unnecessary and inflexible rules, regulations, and restrictions upon them.
It appears that these rules, and many others we have proposed and finalized, are largely colored by the perception that swaps are inherently riskier than futures and options and as a result require a more prescriptive regulatory oversight regime.
To that I say, futures and options are, and always have, been risky. Swaps that are exchange traded and cleared will likely have a similar risk profile as exchange traded futures and options. We should not be creating a separate regulatory regime for economically equivalent products. I believe this approach will not stand the test of time and will have to be re-thought as the market evolves.
The fact that we are allowing letters of credit to be used as initial margin for futures and not for swaps is an example of this thinking – and is a distinction that is not legally or factually justifiable. We should treat them the same way unless there is a compelling reason not to. This is especially the case given the fact that today, there are end-users that voluntarily clear swaps using letters of credit as initial margin. Once we ban that practice, voluntary clearing will become more expensive for these end-users, and therefore less attractive to them. If we want to encourage clearing, which I think was one of our goals, we should not be taking steps to make clearing less attractive to those that are not required to do it.
It has been nearly two years since the Commission issued its January 2010 proposal to impose position limits on a small group of energy contracts. Since then, Commission staff and the Commission have spent an enormous amount of time on the issue of imposing speculative limits.
For me, this vote today on position limits today is no doubt the single most significant vote I have taken since becoming a Commissioner. It is not because imposing position limits will fundamentally change the way the U.S. markets operate, but because I believe this agency is setting itself up for an enormous failure.
As I have said in the past, position limits can be an important tool for regulators. I have been clear that I am not philosophically opposed to limits. After all, this agency has set limits in certain markets for many years. However, I have had concerns all along about the particular application of the limits in this rule, compounded by the unnecessary narrowing of the bona-fide hedging exemptions, beyond what was required by the Dodd-Frank Act.
Over the last four years, many have argued for position limits with such fervor and zeal, believing them to be a panacea for everything. Just this past week, the Commission has been bombarded by a letter-writing campaign suggesting that the five of us have the power to end world hunger by imposing position limits on agricultural commodities.
This latest campaign exemplifies my ongoing concern and may result in damaging the credibility of this agency. I do not believe position limits will control prices or market volatility, and I fear that this Commission will be blamed when this final rule does not lower food and energy costs. I am disappointed at this unfortunate circumstance because, while the Commission’s mission is to protect market users and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open, competitive, and financially sound markets, nowhere in our mission is the responsibility or mandate to control prices.
When analyzing the potential impact this final rule will have on market participants, I am most concerned about the effect on bona fide hedgers – that is, the producers, processers, manufacturers, handlers and users of physical commodities. This rule will make hedging more difficult, more costly, and less efficient, all of which, ironically, can result in increased costs for consumers.
Currently, the Commission sets and administers position limits and exemptions for nine agricultural commodities. Pursuant to this final rule, the Commission will set and administer position limits and exemptions for 28 reference contracts. Along with the 19 new reference contracts comes the new responsibility to administer bona-fide hedging exemptions for the transactions of massive, global corporate conglomerates that on a daily basis produce, process, handle, store, transport, and use physical commodities in their extremely complex logistical operations. Their hedging strategies are no doubt equally complex.
At the very time the Commission is taking on this new responsibility, the Commission is eliminating a valuable source of flexibility that has been a part of regulation 1.3(z) for decades – that is, the ability to recognize non-enumerated hedge transactions and positions. This final rule abandons important and long-standing Commission precedent without justification or reasoned explanation, by merely stating “the Commission has . . . expanded the list of enumerated hedges.” The Commission also seems to be saying that we no longer need the flexibility to allow for non-enumerated hedge transactions and positions because one can seek interpretative guidance pursuant to Commission Regulation 140.99 on whether a transaction or class of transactions qualifies as a bona-fide hedge, or can petition the Commission to amend the list of enumerated transactions.
These processes are cold comfort. There is no way to tell how long interpretative guidance will take. Moreover, if a market participant petitions the Commission to amend the list of enumerated transactions, if the Commission chooses to do so, it must formally propose the amendment pursuant to APA notice and comment. As we know all too well, that is a time consuming process fraught with delay and uncertainty. In the end, neither of these processes is flexible or useful to the needs of hedgers in a complex global marketplace.
When the Commission first recognized the need to allow for non-enumerated hedges in 1977, the Commission stated “The purpose of the proposed provision was to provide flexibility in application of the general definition and to avoid an extensive specialized listing of enumerated bona fide hedging transactions and positions. . . .” Today the global marketplace is much more complex than it was in 1977, as are complex hedging strategies. I am not comfortable with notion that a list of eight bona-fide hedging transactions in this rule is sufficiently extensive and specialized to cover the complex needs of today’s bona-fide hedgers. Repealing the ability to recognize non-enumerated hedge transactions and positions is a mistake and the statute does not require it.
For decades, the Act has allowed the Commission to define bona-fide hedging transactions and positions “to permit producers, purchasers, sellers, middlemen, and users of a commodity or a product derived therefrom to hedge their legitimate anticipated business needs….” This provision is Section 4a(c)(1). In addition, Section 4a(c)(2) clearly recognizes the need for anticipatory hedging by using the word “anticipates” in three places. Nonetheless, without defining what constitutes “merchandising” the Commission has limited “Anticipated Merchandising Hedging” to transactions not larger than “current or anticipated unfilled storage capacity.” It appears then that merchandising does not include the varying activities of “producers, purchasers, sellers, middlemen, and users of a commodity” as contemplated by Section 4a(c)(1), but merely consists of storing a commodity. This limited approach is needlessly at odds with the statute and with the legitimate needs of hedgers.
I have always believed that there was a right way and a wrong way for us to move forward on position limits. Unfortunately I believe we have chosen to go way beyond what is in the statute and have created a very complicated regulation that has the potential to irreparably harm these markets.
Thank you again to both of the teams who are presenting today and have worked tirelessly…for many, many months on these very important rules.
“Does the Commission Always Know Best?”
Opening Statement by Commissioner Scott D. O’Malia: Open Meeting on Position Limits for Futures and Swaps; Derivatives Clearing Organizations; Effective Date for Swap RegulationOctober 18, 2011
Today, the Commission is voting on final rulemakings on position limits and the operation of derivatives clearing organizations (“DCOs”). Further, the Commission is voting on a proposed order that would extend needed exemptive relief to market participants during the pendency of Commission rulemaking. Before we begin, I would like to join my colleagues in thanking the three teams responsible for the final rulemakings and the proposed order. Their hard work has resulted in comprehensive documents totaling nearly 800 pages. Their perseverance over the one-and-a-half-year rulemaking process has been truly inspiring.
The position limits rulemaking will form the foundation for Commission surveillance of the physical commodity markets, whereas the DCO rulemaking will form the foundation for Commission oversight of the financial integrity of market transactions. That is why I am particularly disappointed with both rulemakings. Both rulemakings rely on one fundamentally flawed assumption – namely, that the Commission, in nearly all circumstances, knows best and can substitute its judgment for that of exchanges and DCOs, despite the complexities of the futures - and now swaps - markets. As I will further explain, such assumption leads to regulations with substantial costs and little corresponding benefits. Such assumption is also difficult to justify from an evidentiary and statutory perspective.
First, both rulemakings will have a substantial economic impact on market participants, who for legitimate commercial reasons, use futures and swaps markets for hedging purposes. Both rulemakings have been confirmed by the Office of Management and Budget (“OMB”) to be “major rules” under the Congressional Review Act. This means that OMB has determined that each rule will have an annual effect on the economy of more than $100 million. This determination is unsurprising given that the position limits rulemaking alone will force commercial hedgers to invest multiple millions of dollars in developing compliance systems to justify and account for their legitimate hedging strategies.
Despite the above, neither the position limits rulemaking nor the DCO rulemaking fully describes its costs, even qualitatively, in its cost-benefit analysis. Further, neither rulemaking attempts meaningful quantification of its costs. Thus, both rulemakings deprive the public of transparency into their impact, in direct contradiction of two Executive Orders.1 Finally, both rulemakings again render themselves vulnerable to legal challenge.2
The two quotes that best capture my views on cost-benefit analyses come from President Barack Obama himself. They are:
“Wise regulatory decisions depend on public participation and on careful analysis of the likely consequences of regulation. Such decisions are informed and improved by allowing interested members of the public to have a meaningful opportunity to participate in rulemaking. To the extent permitted by law, such decisions should be made only after consideration of their costs and benefits (both quantitative and qualitative).” 3
“I have continued to underscore the importance of reducing regulatory burdens and regulatory uncertainty, particularly as our economy continues to recover.” 4
Obviously, it is a challenge to balance the regulatory objectives of the Dodd-Frank Act with economic growth, but as President Obama has urged in these two quotes, the Commission has an obligation to not lose sight of the impact our rulemakings will have on our economy. By not providing meaningful quantification – especially when we can easily do so – our cost-benefit analyses are inadequate by President Obama’s own standards.
Second, in addition to failing to detail costs, the two final rulemakings fail to articulate a convincing rationale for eliminating our current regime of principles-based regulation and substituting in its stead a prescriptive “government-knows-best” regime. After all, our current regime has served the Commission well both prior to and during the 2008 financial crisis. Specifically, the two final rulemakings fail to root their prescriptive requirements in fact-based evidence. As a result, both rulemakings contain multiple provisions that appear arbitrary. Consequently, the two final rulemakings again render themselves vulnerable to legal challenge.5 Whereas Congress may have mandated that the Commission promulgate certain rulemakings under the Dodd-Frank Act, the Commission retains the discretion to determine the best manner to meet such mandate.
I believe that both of the abovementioned points highlight themes that will be replicated in forthcoming rulemakings. Therefore, it is important to emphasize the deficiencies with these themes now. I recently celebrated my second anniversary serving as a Commissioner at the Commodity Futures Trading Commission. Like my colleagues, I take this responsibility very seriously and am honored to serve. I recognize there are passionate views on both sides, especially with regard to position limits, but our role is to make decisions on policy in a dispassionate manner that is rooted in facts. I hope that we continue to examine the facts and ask tough questions as to the implications of each and every rulemaking.
I have several concerns with both the position limits rulemaking and the DCO rulemaking. I have articulated my concerns in comprehensive separate dissents, which will be available on the Commission website after our vote and which will be published in the Federal Register. I will briefly describe herein my concerns with each rulemaking in turn.
Position Limits – CFTC Checks A Box
Today’s rule represents the Commission’s desire to “check the box” as to position limits. Unfortunately, in its exuberance and attempt to justify doing so, the Commission has overreached in interpreting its statutory mandate to set position limits. While I do not disagree that the Commission has been directed to impose position limits, as appropriate, the Commission cannot provide a legally sound, comprehensible rationale based on empirical evidence for the final rule we will likely pass today.
For commercial hedgers this rule puts them on the defense immediately and will keep them scrambling to (i) justify, and perhaps to alter, their hedging strategies and (ii) comply with the extraordinarily complex aggregation and hedging limitations.
If the commercial entities who use futures and swaps markets for hedging commercial risk feel like we are waging war on them, I don’t blame them. According to the Commission’s cost-benefit analysis, legitimate hedgers will pay close to 1/3 of the total annual $100 million cost of this proposal for reporting alone. These are the market participants to which Congress extended specific protection, yet this rulemaking will increase the cost of hedging and managing risk.
Now there are some market players that will probably find the new regulatory regime challenging, but full of gaps. I don’t believe this will diminish their ability to find exposure in commodity markets, but it may change the way they access these markets. I have no doubt that index investors and other passive long investors will continue to be able to secure their commodity exposure through new regulatory loopholes, including possibly expanding their investments in physical stocks, which are assets outside the Commission’s regulatory authority. This result is not what Congress intended.
DCO Core Principles
The DCO final rulemaking6 is among the most important Dodd-Frank rulemakings that the Commission has undertaken. I have been a strong proponent of clearing ever since the Enron crisis, when I witnessed the effectiveness of ClearPort in ameliorating counterparty credit fears and restoring liquidity to the energy merchant markets. I am certain that clearing will similarly benefit the swaps market,7 particularly by significantly expanding execution on electronic platforms and by ensuring that swaps counterparties – and not the hardworking American taxpayer – post collateral to support their exposures.
The main goal of this final rulemaking is to ensure that clearing contributes to the integrity of the United States financial system. I fully support this goal. However, I disagree with the prescriptive approach of this final rulemaking, because it leaves DCOs with insufficient discretion to take legitimate actions to manage the risks that they confront. Moreover, such an approach may result in substantial costs to the futures and swaps market, which are not detailed or explored. If the costs of this final rulemaking discourage market participants from prudently hedging their risks or from clearing on a voluntary basis, then such rulemaking may undermine the Dodd-Frank Act, which seeks to move risk from our financial and commercial entities into a regulated framework.
Two provisions in particular best highlight my concerns.
$50 Million Capital Requirement
This final rulemaking prohibits a DCO from requiring more than $50 million in capital from any entity seeking to become a swaps clearing member. This number makes a great headline. Unfortunately, it appears to lack an evidentiary basis. Moreover, whereas the $50 million threshold may prevent a DCO from engaging in anticompetitive behavior, it may also prohibit a DCO from taking a range of legitimate, risk-reducing actions (e.g., increasing capital requirements in proportion to risk). This final rulemaking provides little to no insight on the manner in which the Commission intends to distinguish between the former and the latter. Finally, this final rulemaking may impose costs on DCOs, which are likely to be passed on to commercial and financial end-users. Such costs may include: (i) the costs that a DCO would incur to ensure access to entities that have no ability to clear any significant volume of transactions in certain asset classes, for themselves or for customers; (ii) increased margin requirements; and (iii) increased guaranty fund contributions. Given the magnitude of such potential costs, it is at least likely that they would deter market participants from hedging or voluntarily clearing. The cost-benefit analysis of the final rulemaking, however, neither qualitatively nor quantitatively explores such costs.
Let me be plain. I am against anticompetitive behavior. However, an entity with $50 million in capitalization may not be an appropriate clearing member for every DCO. Rather than setting forth a prescriptive requirement that may scourge both the guilty and the innocent alike, the Commission should have provided principles-based guidance to DCOs on the other components of fair and open access, such as the standard for less restrictive participation requirements.8 By taking such an approach, the Commission would have been in greater accord with international regulators (one of which explicitly cautioned against the $50 million threshold),9 current international standards,10 and proposed revisions of such standards.11
Minimum Liquidation Time
This final rulemaking requires a DCO to calculate margin using different minimum liquidation times for different products. Specifically, a DCO must calculate margin for (i) futures based on a one-day minimum liquidation time, (ii) agricultural, energy, and metals swaps based on a one-day minimum liquidation time, and (iii) all other swaps based on a five-day minimum liquidation time.12
As a preliminary matter, such minimum liquidation times appear to lack an evidentiary basis. More importantly, when these requirements are juxtaposed against our proposal interpreting core principle 9 for designated contract markets (“DCMs”),13 it becomes clear that these requirements have the potential to severely disrupt already established futures markets. In the proposal, which is entitled Core Principles and Other Requirements for Designated Contract Markets, the Commission proposed, in a departure from previous interpretations of DCM core principle 9, to prohibit a DCM from listing any contract for trading unless an average of 85 percent or greater of the total volume of such contract is traded on the centralized market, as calculated over a twelve (12) month period.14 If the Commission finalizes such proposal, then DCMs may need to delist hundreds of futures contracts.15 Financial contracts may be affected, along with contracts in agricultural commodities, energy commodities, and metals.
According to the proposal, DCMs may convert delisted futures contracts to swap contracts.16 However, if the futures contracts reference financial commodities, then this final rulemaking would require that a DCO margin such swap contracts using a minimum liquidation time of five days instead of one day for futures. If nothing substantive about the contracts change other than their characterization (i.e., futures to swaps), then how can the Commission justify such a substantial increase in minimum liquidation time and margin? An increase of this magnitude may well result in a chilling of activity in the affected contracts. Such chilling would be an example of the type of market disruption that the Commodity Exchange Act (“CEA”) was intended to avoid.
I believe this has severe implications for competition. As commenters to the DCM proposal noted, market participants generally execute new futures contracts outside the DCM centralized market until the contracts attract sufficient liquidity. Attracting such liquidity may take years.17 Let us assume that an established DCM already lists a commercially viable futures contract on a financial commodity that meets the 85 percent threshold. Even without the DCM proposal and this final rulemaking, a DCM seeking to compete by listing a futures contract with the same terms and conditions already faces an uphill battle. Now with the DCM proposal, the competitor DCM would have to also face the constant threat of being required to convert the futures contract into a swap contract. With this final rulemaking, the competitor DCM (or a competitor swap execution facility (SEF)) faces the additional threat that, by virtue of such conversion, the contract would be margined using a five-day minimum liquidation time. It is difficult to imagine a DCM (or a competitor SEF) willing to compete given the twin Swords of Damocles that it would need to confront. By dissuading such competition, this final rulemaking and the DCM proposal undermine the “responsible innovation and fair competition among boards of trade” that the CEA was intended to promote.18
What should the Commission have done to avoid market disruption and a curtailment in competition? Again, the Commission should have retained a principles-based regime, and should have permitted each DCO to determine the appropriate minimum liquidation time for its products. Determining appropriate margin requirements involves quantitative and qualitative expertise. Such expertise resides in the DCOs and not in the Commission. In its cost-benefit analysis, the final rulemaking admits as much.19 Returning to a principles-based regime would have also better aligned with current international standards on CCP regulation,20 as well as the revisions to such standards.21
Amendment to the Effective Date Order
As Yogi Berra famously proclaimed: “It is déjà vu all over again.” Yogi perfectly encapsulates my feelings today.
I support the proposal, as I did last time, because it is important for the Commission to provide market participants and the public with the form of relief the exemptive order is contemplating, but I would have preferred that this rule, like its predecessor, not select an arbitrary end date.
Mr. Chairman, I again renew my call for a comprehensive rulemaking schedule and implementation plan, that provides greater insight on reporting requirements to swap data repositories as well as separate rulemaking on real-time and block rules. The Commission must also provide some certainty on the clearing and trading mandate including clarification of “made available for trading” and guidance on swap clearing.
Thank you, Mr. Chairman.
Statements of Support by Chairman Gary GenslerPosition Limits
I support the final rulemaking to establish position limits for physical commodity derivatives. The CFTC does not set or regulate prices. Rather, the Commission is charged with a significant responsibility to ensure the fair, open and efficient functioning of derivatives markets. Our duty is to protect both market participants and the American public from fraud, manipulation and other abuses.
Position limits have served since the Commodity Exchange Act passed in 1936 as a tool to curb or prevent excessive speculation that may burden interstate commerce.
When the CFTC set position limits in the past, the agency sought to ensure that the markets were made up of a broad group of market participants with no one speculator having an outsize position. At the core of our obligations is promoting market integrity, which the agency has historically interpreted to include ensuring that markets do not become too concentrated.
Position limits help to protect the markets both in times of clear skies and when there is a storm on the horizon. In 1981, the Commission said that “the capacity of any contract market to absorb the establishment and liquidation of large speculative positions in an orderly manner is related to the relative size of such positions, i.e., the capacity of the market is not unlimited.”
In the Dodd-Frank Act, Congress mandated that the CFTC set aggregate position limits for certain physical commodity derivatives. The Dodd-Frank Act broadened the CFTC’s position limits authority to include aggregate position limits on certain swaps and certain linked contracts traded on foreign boards of trade in addition to U.S. futures and options on futures. Congress also narrowed the exemptions traditionally available from position limits by modifying the definition of bona fide hedge transaction, which particularly would affect swap dealers.
Today’s final rule implements these important new provisions. The final rule fulfills the Congressional mandate that we set aggregate position limits that, for the first time, apply to both futures and economically equivalent swaps, as well as linked contracts on foreign boards of trade. The final rule establishes federal position limits in 28 referenced commodities in agricultural, energy and metals markets.
Per Congress’s direction, the rule implements one position limits regime for the spot month and another for single-month and all-months combined limits. It implements spot-month limits, which are currently set in agriculture, energy and metals markets, sooner than the single-month or all-months-combined limits. Spot-month limits are set for futures contracts that can by physically settled as well as those swaps and futures that can only be cash-settled. We are seeking additional comment as part of an interim final rule on these spot month limits with regard to cash-settled contracts.
Single-month and all-months-combined limits, which currently are only set for certain agricultural contracts, will be re-established in the energy and metals markets and be extended to certain swaps. These limits will be set using a formula that is consistent with that which the CFTC has used to set position limits for decades. The limits will be set by a Commission order based upon data on the total size of the swaps and futures market collected through the position reporting rule the Commission finalized in July. It is only with the passage and implementation of the Dodd-Frank Act that the Commission now has broad authority to collect data in the swaps market.
The final rule also implements Congress’s direction to narrow exemptions while also ensuring that bona fide hedge exemptions are available for producers and merchants.
The final position limits rulemaking builds on more than two years of significant public input. The Commission benefited from more than 15,100 comments received in response to the January 2011proposal. We first held three public meetings on this issue in the summer of 2009 and got a great deal of input from market participants and the broader public. We also benefited from the more than 8,200 comments we received in response to the January 2010 proposed rulemaking to re-establish position limits in the energy markets. We further benefited from input received from the public after a March 2010 meeting on the metals markets.
Clearinghouse Core Principles
I support the final rulemaking on core principles for derivatives clearing organizations (DCOs). Centralized clearing has been a feature of the U.S. futures markets since the late-19th century. Clearinghouses have functioned both in clear skies and during stormy times – through the Great Depression, numerous bank failures, two world wars, and the 2008 financial crisis – to lower risk to the economy. Importantly, centralized clearing protects banks and their customers from the risk of either party failing.
When customers don’t clear their transactions, they take on their dealer’s credit risk. We have seen over many decades, however, that banks do fail. Centralized clearing protects all market participants by requiring daily mark to market valuations and requiring collateral to be posted by both parties so that both the swap dealer and its customers are protected if either fails. It lowers the interconnectedness between financial entities that helped spread risk throughout the economy when banks began to fail in 2008.
Today’s rulemaking will establish certain regulatory requirements for DCOs to implement important core principles that were revised by the Dodd-Frank Act. We recognize the need for very robust risk management standards, particularly as more swaps are moved into central clearinghouses. We have incorporated the newest draft Committee on Payment and Settlement Systems (CPSS)-International Organization of Securities Commissions (IOSCO) standards for central counterparties into our final rules.
First, the financial resources and risk management requirements will strengthen financial integrity and enhance legal certainty for clearinghouses. We’re adopting a requirement that DCOs collect initial margin on a gross basis for its clearing member’s customer accounts For interest rates and financial index swaps, such as credit default swaps, we are maintaining, as proposed, a minimum margin for a five-day liquidation period. This is consistent with current market practice, and many commenters recommended this as a minimum. For the clearing of physical commodity swaps, such as on energy, metals and agricultural products, we are requiring margin that is risk-based but consistent with current market practice – a minimum of one day.
Maintaining a minimum five day liquidation period for interest rates and credit default swaps is appropriate not only as it is consistent with current market practice, but also as these markets are the most systemically relevant for the interconnected financial system. History shows that, in 2008, it took five days after the failure of Lehman Brothers for the clearinghouse to transfer Lehman’s interest rate swaps positions to other clearing members. These financial resource requirements, and particularly the margin requirements, are critical for safety and soundness as more swaps are moved into central clearing.
Second, the rulemaking implements the Dodd-Frank Act’s requirement for open access to DCOs. The participant eligibility requirements promote fair and open access to clearing. Importantly, the rule addresses how a futures commission merchant can become a member of a DCO. The rule promotes more inclusiveness while allowing DCO to scale a member’s participation and risk based upon its capital. This improves competition that will benefit end-users of swaps, while protecting DCOs’ ability manage risk.
Third, the reporting requirements will ensure that the Commission has the information it needs to monitor DCO compliance with the Commodity Exchange Act and Commission regulations.
Fourth, the rules formalize the DCO application procedures to bring about greater uniformity and transparency in the application process and facilitate greater efficiency and consistency in processing applications.
These reforms will both lower risk in the financial system and strengthen the market by making many of the processes more efficient and consistent.
Proposed Amendment to Dodd-Frank Rulemaking Effective Dates
I support the proposed amendment to the July 14th Exemptive Order regarding the effective dates of certain Dodd-Frank Act provisions.
The July 14th order provided relief until December 31, 2011, or when the definitional rulemakings become effective, whichever is sooner, from certain provisions that would otherwise apply to swaps or swap dealers on July 16. This includes provisions that do not directly rely on a rule to be promulgated, but do refer to terms that must be further defined by the CFTC and SEC, such as “swap” and “swap dealer.”
Commission staff is working very closely with Securities and Exchange Commission (SEC) staff on rules relating to entity and product definitions. Staff is making great progress, and we anticipate taking up the further definition of entities in the near term and product definitions shortly thereafter.
As these definitional rulemakings have yet to be finalized or become effective, today’s proposed amendment would provide relief through July 16, 2012, or when the definitional rulemakings become effective – whichever is sooner.
The order also provided relief through no later than December 31, 2011, from certain CEA requirements that may apply as the result of the repeal, effective on July 16, 2011, of CEA sections 2(d), 2(e), 2(g), 2(h) and 5d. The proposed amendment also extends this relief to July 16, 2012, or until a date the Commission may otherwise determine with respect to a particular requirement under the CEA.
In addition, today’s proposed amendment also tailors the July 14th relief in light of the Commission’s actions finalizing the agricultural swap rules.
Statement of Dissent, Position Limits for Futures and Swaps
Commissioner Scott D. O’MaliaOctober 18, 2011
I respectfully dissent from the action taken today by the Commission to issue final rules relating to position limits for futures and swaps. While I have a number of serious concerns with this final rule, my principal disagreement is with the Commission’s restrictive interpretation of the statutory mandate under Section 4a of the Commodity Exchange Act (“CEA” or “Act”) to establish position limits without making a determination that such limits are necessary and effective in relation to the identifiable burdens of excessive speculation on interstate commerce.
While I agree that the Commission has been directed to establish position limits applicable to futures, options, and swaps that are economically equivalent to such futures and options (for exempt and agricultural commodities as defined by the Act), I disagree that our mandate provides for so little discretion in the manner of its execution. Throughout the preamble, the Commission uses, “Congress did not give the Commission a choice”1 as a rationale in adopting burdensome and unmanageable rules of questionable effectiveness. This statement, in all of its iterations in this rule, is nothing more than hyperbole used tactfully to support a politically-driven overstatement as to the threat of “excessive speculation” in our commodity markets. In aggrandizing a market condition that it has never defined through quantitative or qualitative criteria in order to justify draconian rules, the Commission not only fails to comply with Congressional intent, but misses an opportunity to determine and define the type and extent of speculation that is likely to cause sudden, unreasonable and/or unwarranted commodity price movements so that it can respond with rules that are reasonable and appropriate.
In relevant part, section 4a(a)(1) of the Act states: “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery . . . or swaps . . . causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.” Section 4a(a)(1) further defines the Commission’s duties with regard to preventing such price fluctuations through position limits, clearly stating: “For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits . . . as the Commission finds are necessary to diminish, eliminate, or prevent such burden.” Congress could not be more clear in its directive to the Commission to utilize not only its expertise, but the public rulemaking process, each and every time it determines to establish position limits to ensure that such limits are essential and suitable to combat the actual or potential threats to commodity prices due to excessive speculation.
An Ambiguously Worded Mandate Does Not Relieve the Commission of Its Duties Under the Act
Historically, the Commission has taken a much more disciplined and fact-based approach in considering the question of positions limits; a process that is lacking from the current proposal. The general authority for the Commission to establish “limits on the amounts of trading which may be done or positions which may be held . . . as the Commission finds are necessary to diminish, eliminate, or prevent” the “undue burdens” associated with excessive speculation found in section 4a of the Act has remained unchanged since its original enactment in 1936 and through subsequent amendments, including the Dodd-Frank Act.2 Over thirty years ago, on December 2, 1980, the Commission, pursuant in part to its authority under section 4a (1) of the Act, issued a proposal to implement rules requiring exchanges to impose position limits on contracts that were not currently subject to Commission imposed limits.3
In support of its proposal, the Commission relied on a June 1977 report on speculative limits prepared by the Office of the Chief Economist (the “Staff Report”). The Staff Report addressed three major policy questions: (1) whether there should be limits and for what groups of commodities; (2) what guidelines are appropriate in setting the level of limits; and (3) whether the Commission or the exchange should set the limits.4, 5 In considering these questions, the Staff Report noted, “Although the Commission is authorized to establish speculative limits, it is not required to do so.”6 In its Interpretation of the above language in section 4a, the Staff Report at the outset provided the legal context for its study as follows:
[T]he Commission need not establish speculative limits if it does not find that excessive speculation exists in the trading of a particular commodity. Furthermore, apparently, the Commission does not have to establish limits if it finds that such limits will not effectively curb excessive speculation.7
While not directly linked to the statutory language of section 4a or an interpretation of such language, the Staff Report utilized its findings to formulate a policy for the Commission to move forward, which, based on comments to the Commission’s January 2011 proposal,8 is clearly embodied in the purpose and spirit of the Act:
Perhaps the most important feature brought out in the study is that, prior to the adoption of speculative position limits for any commodity in which limits are not now imposed by CFTC, the Commission should carefully consider the need for and effectiveness of such limits for that commodity and the resources necessary to enforce such limits.9
In its final rule, published in the Federal Register on October 16, 1981—almost exactly thirty years ago today—the Commission chose to base its determination on Congressional findings embodied in section 4a(1) of the Act that excessive speculation is harmful to the market, and a finding that speculative limits are an effective prophylactic measure. The Commission did not do so because it found that more specific determinations regarding the necessity and effectiveness of position limits were not required. Rather, the Commission was fashioning a rule “to assure that the exchanges would have an opportunity to employ their knowledge of their individual contract markets to propose the position limits they believe most appropriate.”10 Moreover, none of the commenters opposing the adoption of limits for all markets demonstrated to the Commission that its findings as to the prophylactic nature of the proposal before them were unsubstantiated.11 Therefore, the Commission did not eschew a requirement to demonstrate whether position limits were necessary and would be effective—it delegated these determinations to the exchanges.
Today, the Commission reaffirms its proposed interpretation of amended section 4a that in setting position limits pursuant to directives in sections 4a(a)(2)(A), 4a(a)(3) and 4a(a)(5), it need not first determine that position limits are necessary before imposing them or that it may set limits only after conducting a complete study of the swaps market.12 Relying on the various directives following “shall,” the Commission has bluntly stated that “Congress did not give the Commission a choice.”13 This interpretation ignores the plain language in the statute that the “shalls” in sections 4a(a)(2)(A), 4a(a)(3) and 4a(a)(5) are connected to the modifying phrase, “as appropriate.” Although the Commission correctly construes the “as appropriate” language in the context of the provisions as a whole to direct the Commission to exercise its discretion in determining the extent of the limits that Congress “required” it to impose, the Commission ignores the fact that in the context of the Act, such discretion is broad enough to permit the Commission to not impose limits if they are not appropriate. Though a permissible interpretation, the Commission’s narrow view of its authority permeates the final rules today and provides a convenient rationale for many otherwise unsustainable conclusions, especially with regard to the cost-benefit analysis of the rule.
Section 4a(a)(2)(A), in relevant part, states that the Commission “shall by rule, regulation, or order establish limits on the amount of positions, as appropriate” that may be held by any person in physical commodity futures and options contracts traded on a designated contract market (DCM). In section 4a(a)(5), Congress directed that the Commission “shall establish limits on the amount of positions, including aggregate position limits, as appropriate” that may be held by any person with respect to swaps. Section 4a(a)(3) qualifies the Commission’s authority by directing it so set such limits “required” by section 4a(a)(2), “as appropriate . . . [and] to the maximum extent practicable, in its discretion” (1) to diminish, eliminate, or prevent excessive speculation as described under this section (section 4a of the Act), (2) to deter and prevent market manipulation, squeezes, and corners, (3) to ensure sufficient market liquidity for bona fide hedgers, and (4) to ensure that the price discovery function of the underlying market is not disrupted.14
Congress, in repeatedly qualifying its mandates with the phrase “as appropriate” and by specifically referring back to the Commission’s authority to set position limits as proscribed in section 4a(a)(1), clearly did not relieve the Commission of any requirement to exercise its expertise and set position limits only to the extent that it can provide factual support that such limits will diminish, eliminate or prevent excessive speculation.15 Instead, by directing the Commission to establish limits “as appropriate,”16 Congress intended to provide the Commission with the discretion necessary to establish a position limit regime in a manner that will not only protect the markets from undue burdens due to excessive speculation and manipulation, but that will also provide for market liquidity and price discovery in a level playing field while preventing regulatory arbitrage.17
I agree with commenters who argued that the Commission is directed under its new authority to set position limits “as appropriate,” or in other words meaning that whatever limits the Commission sets are supported by empirical evidence demonstrating that those would diminish, eliminate, or prevent excessive speculation.18 In the absence of such evidence, I also agree with commenters that we are unable, at this time, to fulfill the mandate and assure Congress and market participants that any such limits we do establish will comply with the statutory objectives of section 4a(a)(3). And, to be clear, without empirical data, we cannot assure Congress that the limits we set will not adversely affect the liquidity and price discovery functions of affected markets. The Commission will have significant additional data about the over-the-counter (OTC) swaps markets in the next year, and at a minimum, I believe it would be appropriate for the Commission to defer any decisions about the nature and extent of position limits for months outside of the spot-month, including any determinations as to appropriate formulas, until such time as we have had a meaningful opportunity to review and assess the new data and its relevance to any determinations regarding excessive speculation. At a future date, when the Commission applies the second phase of the position limits regime and sets the non-spot-month limits (single and all-months combined limits), I will work to ensure that the position formulas and applicable limits are validated by Commission data to be both appropriate and effective so that those limits truly “diminish, eliminate, or prevent excessive speculation.”
An Absence of Justification
Today the Commission voted to move forward on a rule that (1) establishes hard federal position limits and position limit formulas for 28 physical commodity futures and options contracts and physical commodity swaps that are economically equivalent to such contracts in the spot-month, for single months, and for all-months combined; (2) establishes aggregate position limits that apply across different trading venues to contracts based on the same underlying commodity; (3) implements a new, more limited statutory definition of bona fide hedging transactions; (4) revises account aggregation standards; (5) establishes federal position visibility reporting requirements; and (6) establishes standards for position limits and position accountability rules for registered entities. The Commission voted on this multifaceted rule package without the benefit of performing an objective factual analysis based on the necessary data to determine whether these particular limits and limit formulas will effectively prevent or deter excessive speculation. The Commission did not even provide for public comment a determination as to what criteria it utilized to determine whether or not excessive speculation is present or will potentially threaten prices in any of the commodity markets affected by the new position limits.
Moreover, while it engaged in a public rulemaking, the Commission’s Notice of Proposed Rulemaking,19 in its complexity and lack of empirical data and legal rationale for several new mandates and changes to existing policies—in spite of the fact that we largely rely on our historical experiences in setting such limits—tainted the entire process. By failing to put forward data evidencing that commodity prices are threatened by the negative influence of a defined level of speculation that we can define as “excessive speculation,” and that today’s measures are appropriate (i.e. necessary and effective) in light of such findings, I believe that we have failed under the Administrative Procedure Act to provide a meaningful and informed opportunity for public comment.20
Substantive comment letters, of which there were approximately 100,21 devoted at times substantial text to expressions of confusion and requests for clarification of vague descriptions and processes. In more than one instance, preamble text did not reflect proposed rule text and vice versa.22 Indeed, the entire rulemaking process has been plagued by internal and public debates as to what the Commission’s motives are and to what extent they are based on empirical evidence, in policy, or are simply without reason.
Implementing An Appropriate Program for Position Management
This rule, like several proposed before it, fails to make a compelling argument that the proposed position limits, which only target large concentrated positions,23 will dampen price distortions or curb excessive speculation—especially when those position limits are identified by the overall participation of speculators as an increased percentage of the market. What the rule argues is that there is a Congressional mandate to set position limits, and therefore, there is no duty on the Commission to determine that excessive speculation exists (and is causing price distortions), or to “prove that position limits are an effective regulatory tool.”24 This argument is incredibly convenient given that the proposed position limits are modeled on the agricultural commodities position limits, and despite those federal position limits, contracts such as wheat, corn, soybeans, and cotton contracts were not spared record-setting price increases in 2007 and 2008. Indeed, the cotton No. 2 futures contract has hit sixteen “record-setting” prices since December 1, 2010. The most recent high was set on March 4, 2011 when the March 2011 future traded at a price of $215.15.
To be clear, I am not opposed to position or other trading limits in all circumstances. I remain convinced that position limits, whether enforced at the exchange level or by the Commission, are effective only to the extent that they mitigate potential congestion during delivery periods and trigger reporting obligations that provide regulators with the complete picture of an entity’s trading. I therefore believe that accountability levels and visibility levels provide a more refined regulatory tool to identify, deter, and respond in advance to threats of manipulation and other non-legitimate price movements and distortions. I would have supported a rule that would impose position limits in the spot-month for physical commodities, i.e. the referenced contracts,25 and would establish an accountability level. The Commission’s ability to monitor such accountability levels would rely on a technology based, real-time surveillance program that the Commission must be committed to deploying if it is to take its market oversight mission seriously.
And to be absolutely clear, “speculation” in the world of commodities is a technical term ascribed to any trading that does not qualify as “bona fide hedging.” Congress has not outlawed speculation, even when that speculation reaches some unspecified tipping point where it becomes “excessive.” What Congress has stated, for over seventy years until the passage of the Dodd-Frank Act, is that excessive speculation that causes sudden or unreasonable fluctuations or unwarranted changes in the price of a commodity is a burden on interstate commerce, and the Commission has authority to utilize its expertise to establish limits on trading or positions that will be effective in diminishing, eliminating, or preventing such burden.26 The Commission, however, is not, and has never been, without other tools to detect and deter those who engage in abusive practices.27 What the Dodd-Frank Act did do is direct the Commission to exercise its authority at a time when there is simply a lack of empirical data to support doing so, in a universe of legal uncertainty. However, the Dodd-Frank Act did not leave us without a choice, as contended by today’s rule. Rather, against the current backdrop of market uncertainty, and Congress’s longstanding deference to the expertise of the Commission, the most reasonable interpretation of Dodd-Frank’s mandate is that while we must take action and establish position limits, we must only do so to the extent they are appropriate.
Today I write to not only reiterate my concerns with regard to the effectiveness of position limits generally, but to highlight some of the regulatory provisions that I believe pose the greatest fundamental problems and/or challenges to the implementation of the rule passed today. In addition to disagreeing with the Commission’s interpretation of its statutory mandate, I believe the Commission has so severely restricted the permitted activities allowed under the bona fide hedging rules that the pursuit by industry of legitimate and appropriate risk management is now made unduly onerous. These limitations, including a veritable ban on anticipatory hedging for merchandisers, are inconsistent with the statutory directive and the very purpose of the markets to, among other things, provide for a means for managing and assuming price risks. I also believe that the rules put into place overly broad aggregation standards, fail to substantiate claims that they adequately protect against international regulatory arbitrage, and do not include an adequate cost-benefit analysis.
Bona Fide Hedging: Guilty Until Proven Innocent
The Commission’s regulatory definition of bona fide hedging transactions in §151.5 of the rules, as directed by new section 4a(c)(1) of the Act, generally restricts bona fide hedge exemptions from the application of federally-set position limits to those transactions or positions which represent a substitute for an actual cash market transaction taken or to be taken later, or those trading as the counterparty to an entity that it engaged in such transaction. This definition is narrower than current Commission regulation 1.3(z)(1), which allows for an exemption for transactions or positions that normally represent a substitute for a physical market transaction.
When combined with the remaining provisions of §151.5, which provide for a closed universe of enumerated hedges and ultimately re-characterize longstanding acceptable bona fide hedging practices as speculative, it is evident that the Commission has used its authority to further narrow the availability of bona fide hedging transactions in a manner that will negatively impact the cash commodity markets and the physical commodity marketplace by eliminating certain legitimate derivatives risk management strategies, most notably anticipatory hedging. Among other things, I believe the Commission should have defined bona fide hedging transactions and positions more broadly so that they encompass long-standing risk management practices and should have preserved a process by which bona fide hedgers could expeditiously seek exemptions for non-enumerated hedging transactions.
In this instance, Congress was particularly clear in its mandate under section 4a(c)(2) that the Commission must limit the definition of bona fide hedging transactions/positions to those that represent actual substitutes for cash market transactions, but Congress did not so limit the Commission in any other manner with regard to the new regulatory provisions addressing anticipatory hedging and the availability of non-enumerated hedges.28 Moreover, inasmuch as the bona fide hedging definition is restrictive, section 4a(a)(7) provides the Commission broad exemptive authority which it could have utilized in any number of ways to accommodate a broader set of legitimate trading strategies that might not fit the confines of section 4a(c)(1). In addition, given the complex, multi-faceted nature of hedging for commodity-related risks, the Commission could have, as suggested by one commenter, engaged in a separate and distinct informal rulemaking process to develop a workable, commercially practicable definition of bona fide hedging.29 Given the commercial interests at stake, this would have been a welcome approach. Instead, the Commission chose form over function so that it could “check the box” on its mandate.
In order to qualify as a bona fide hedging transaction or position, a transaction must meet both the requirements under §151.5(a)(1) and qualify as one of eight specific and enumerated hedging transactions described in §151(a)(2). While the list of enumerated hedging transactions is an improvement from the proposed rules, and responds to several comments, especially with regard to the addition of an Appendix B to the final rule describing examples of bona fide hedging transactions, it remains inflexible. In response to commenters, the Commission has failed to articulate any rationale for discontinuing the policy and practice of granting requests for non-enumerated hedging exemptions. Rather, the Commission has directed market participants to general provisions of the Act by which anyone can seek interpretive guidance or petition the Commission to “amend the current list of enumerated hedges or the conditions therein,”30 which is the long way of saying that the Commission would have to engage in another rulemaking.31 Neither of these alternatives provides for an expeditious determination, nor do they provide for a predictable or certain outcome. In its refusal to accommodate traders seeking legitimate bona fide hedging exemptions in compliance with the Act with an expeditious and straightforward process, the Commission is being short-sighted in light of the dynamic (and in the case of the OTC markets, uncertain) nature of the commodity markets and with respect to the appropriate use of Commission resources.
One particularly glaring example of the Commission’s decision to pursue form over function is found in the enumerated exemption for anticipated merchandising found at §151.5(2)(v). The new statutory provision in section 4a(c)(d)(A)(ii) is included to assuage unsubstantiated concerns about unintended consequences such as creating a potential loophole for clearly speculative activity.32 The Commission has so narrowly defined the anticipated merchandising that only the most elementary operations will be able to utilize it.
For example, in order to qualify an anticipatory merchandising transaction as a bona fide hedge, a hedger must (i) own or lease storage capacity and demonstrate that the hedge is no greater than the amount of current or anticipated unfilled storage capacity owned or leased by the same person during the period of anticipated merchandising activity, which may not exceed one year, (ii) execute the hedge in the form of a calendar spread that meets the “appropriateness” test found in §151.5(a)(1), and (iii) exit the position prior to the last five days of trading if the Core Referenced Futures Contract is for agricultural or metal contracts or the spot month for other physical-delivery commodities. In addition, (iv) an anticipatory merchandiser must meet specific filing requirements under §151.5(d), which among other things, (v) requires that the person who intends on exceeding position limits complete the filing at least ten days prior to the date of expected overage.
Putting the burdens associated with the §151.5(d) filings aside, the anticipatory merchandising exemption and its limitations on capacity, the requirement to “own or lease” such capacity, and one-year limitation for agricultural commodities does not comport with the economic realities of commercial operations. In recent testimony, Todd Thul, Risk Manager for Cargill AgHorizons, commented on its understanding of this provision. He said that by limiting the exemption to unfilled storage capacities through calendar spread positions for one year, the CFTC will reduce the industry’s ability to continue offering the same suite of marketing tools to farmers that they are accustomed to using.33 Mr. Thul offered a more reasonable and appropriate limitation on anticipatory hedging based on annual throughput actually handled on a historic basis by the company in question. It is unclear from today’s rule as to whether the Commission considered such an alternative, but according to Mr. Thul, by going forward with the exemption as-is, we will “severely limit the ability of grain handlers to participate in the market and impede the ability to offer competitive bids to farmers, manage risk, provide liquidity and move agriculture products from origin to destination.”34, 35 Limiting commercial participation, Mr. Thul points out, increases volatility—and that is clearly not what Congress intended. I agree. I cannot help but think that the Commission is waging war on commercial hedging by employing a “government knows best” mandate to direct companies to employ only those hedging strategies that we give our blessing to and can conceive of at this point in time. Imagine the absurdity that we could prevent a company such as a cotton merchandiser from hedging forward a portion of his expected cotton purchase. Or, if they meet the complicated prerequisites, the commercial firm must get approval from the Commission before deploying a legitimate commercial strategy that exchanges have allowed for years.
In another attack on commercial hedging the Commission has developed a flawed aggregation rule that singles out owned-non financial firms for unique and unfair treatment under the rule. These commercial firms, which, among others, could be energy producers or merchandisers, are not provided the same protections under the independent controller rules as financial entities such as hedge funds or index funds. I believe that the aggregation provisions of the final rule would have benefited from a more thorough consideration of additional options and possible re-proposal of at least two provisions: the general aggregation provision found in §151.7(b) and the proposed aggregation for exemption found in §151.7(f) of the proposed rule,36 now commonly referred to at the Commission as the owned non-financial exemption or “ONF.”
Under §151.7(b), absent the applicability of a specific exemption found elsewhere in §151.7, a direct or indirect ownership interest of ten percent or greater by any entity in another entity triggers a 100% aggregation of the “owned” entity’s positions with that of the owner. While commenters agreed that an ownership interest of ten percent or greater has been the historical basis for requiring aggregation of positions under Commission regulation §150.5(b), absent applicable exemptions, historically, aggregation has not been required in the absence of indicia of control over the “owned” entity’s trading activities, consistent with the independent account controller exemption (the “IAC”) under Commission regulation §150.3(a)(4). While the final rule preserves the IAC exemption, it only does so in response to overwhelming comments arguing against its proposed elimination, which was without any legal rationale.37 And, to be clear, the IAC is only available to “eligible entities” defined in §151.1, namely financial entities, and only with respect to client positions.
The practical effect of this requirement is that non-eligible entities, such as holding companies who do not meet any of the other limited specified exemptions will be forced to aggregate on a 100% basis the positions of any operating company in which it holds a ten percent or greater equity interest in order to determine compliance with position limits. While the Commission concedes that the holding company could conceivably enter into bona fide hedging transactions relating to the operating company’s cash market activities, provided that the operating company itself has not entered into such hedges,38 this is an inadequate, operationally-impracticable solution to the problem of imparting ownership absent control. Moreover, by requiring 100% aggregation based on a ten percent ownership interest, the Commission has determined that it would prefer to risk double-counting of positions over a rational disaggregation provision based on a concept of ownership that does not clearly attach to actual control of trading of the positions in question.
Exemptions like those found in §§151.7(g) and (i) that provide for disaggregation when ownership above the ten percent threshold is specifically associated with the underwriting of securities or where aggregation across commonly-owned affiliates would require information sharing that would result in a violation of federal law, are useful and no doubt appreciated. However, the Commission has failed to apply a consistent standard supporting the principles of ownership and control across all entities in this rulemaking.
Tiered Aggregation – A Viable and Fair Solution
Also, the Commission did not address in the final rules a proposal put forth by Barclays Capital for the Commission to clarify that when aggregation is triggered, and no exemption is available, only an entity’s pro rata share of the position that is actually controlled by it, or in which it has an ownership interest will be aggregated. This proposal included a suggestion that the Commission consider positions in tiers of ownership, attributing a percentage of the positions to each tier. While Barclays acknowledged that the monitoring would still be imperfect, the measures would be more accurate than an attribution of a full 100% ownership and would decrease the percentage of duplicative counting of positions.39
I believe that a tiered approach to aggregation should have been considered in these rules, and not be entirely removed from consideration as we move forward with these final rules. Barclays (and perhaps others) has made a compelling case and staff has not persuaded me that there is any legal rationale for not further exploring this option. While I understand that it may be more administratively burdensome for the Commission to monitor tiered aggregation, I would presume that we could engage in a cost-benefit analysis to more fully explore such burdens in light of the potential costs to industry associated with the implementation of 100% aggregation.
Owned Non-Financial – No Justification
The best example of the Commission’s imbalanced treatment of market participants is manifest in the aggregation rules applied to owned non-financial firms. The Commission has shifted its aggregation proposal from the draft proposal to this final version. The final rule does not ultimately adopt the proposed owned-non-financial entity exemption which was proposed in lieu of the IAC to allow disaggregation primarily in the case of a conglomerate or holding company that “merely has a passive ownership interest in one or more non-financial companies.”40 The rationale was that, in such cases, operating companies would likely have complete trading and management independence and operate at such a distance that is would simply be inappropriate to aggregate positions.41 While several commenters argued that the ONF was too narrow and discriminated against financial entities without a proper basis, the Commission provided no substantive rationale for its decision to fully drop the ONF exemption from consideration. Instead, the Commission relied upon its determination to retain the IAC exemption and add the additional exemptions under §§151.7(g) and (i) described above to find that it “may not be appropriate, at this time, to expand further the scope of disaggregation exemptions to owned-non financial entities.”
In failing to articulate a basis for its decision to drop outright from consideration the ONF exemption, the Commission places itself in the same improvident position it was in when it proposed eliminating the IAC exemption, and now has given no reasoned explanation for discriminating against non-financial entities. This is especially disconcerting since at least one commenter has pointed out that baseless decision-making of this kind creates a risk that a court will strike down our action as arbitrary and capricious.42
Since I first learned of the Commission’s change of course, I have requested that the Commission re-propose the ONF exemption in a manner that establishes an appropriate legal basis and provides for additional public comment pursuant to the Administrative Procedure Act. The Commission has outright refused to entertain my request to even include in the preamble of the final rules a commitment to further consider a version of the ONF exemption that would be more appropriate in terms of its breadth. The Commission’s decision puts the rule at risk of being overturned by the courts and exemplifies the pains at which this rule has been drafted to put form over function.
The Great Unknown: International Regulatory Arbitrage
In addressing concerns relating to the opportunities for regulatory arbitrage that may arise as a result of the Commission imposing these position limits, the Commission points out that is has worked to achieve the goal of avoiding such regulatory arbitrage through participation in the International Organization of Securities Commissions (“IOSCO”) and summarily rejects commenters who believe it is a foregone conclusion that the existence of international differences in position limit policies will result in such arbitrage in reliance on prior experience. While I don’t disagree that the Commission’s work within IOSCO is beneficial in that it increases the likelihood that we will reach international consensus with regard to the use of position limits, the Commission ought to be more forthcoming as to principles as a whole.
In particular, while the IOSCO Final Report on Principles for the Regulation and Supervision of Commodity Derivatives Markets43 does, for the first time, call on market authorities to make use of intervention powers, including the power to set ex-ante position limits, this is only one of many such recommendations that international market authorities are not required to implement. The IOSCO Report includes the power to set position limits, including less restrictive measures under the more general term “position management.” Position Management encompasses the retention of various discretionary powers to respond to identified large concentrations. It would have been preferable for the Commission to have explored some of these other discretionary powers as options in this rulemaking, thereby putting us in the right place to put our findings into more of a practice.
As to the Commission’s stance that today’s rules will not, by their very passage, drive trading abroad, I am concerned that the Commission’s prior experience in determining the competitive effects of regulatory policies is inadequate. Today’s rules by far represent the most expansive exercise of the Commission’s authority both with regard to the setting of position limits and with regard to its jurisdiction in the OTC markets. The Commission’s past studies regarding the effects of having a different regulatory regime than our international counterparts, conducted in 1994 and 1999, cannot possibly provide even a baseline comparison. Since 2000, the volume of actively traded futures and option contracts on U.S. exchanges alone has increased almost tenfold. Electronic trading now represents 83% of that volume, and it is not too difficult to imagine how easy it would be to take that volume global.
I recognize that we cannot dictate how our fellow market authorities choose to structure their rules and that in any action we take, we must do so with the knowledge that as with any rules, we risk triggering a regulatory race to the bottom. However, I believe that we ought not to deliver to Congress, or the public, an unsubstantiated sense of security in these rules.
Cost-Benefit Analysis: Hedgers Bear the Brunt of an Undue and Unknown Burden
With every final rule, the Commission has attempted to conduct a more rigorous cost-benefit analysis. There is most certainly an uncertainty as to what the Commission must do in order to justify proposals aimed at regulating the heretofore unregulated. These analyses demonstrate that the Commission is taking great pains to provide quantifiable justifications for its actions, but only when reasonably feasible. The baseline for reasonability was especially low in this case because, in spite of the availability of enough data to determine that this rule will have an annual effect on the economy of more than $100 million, and the citation of at least fifty-two empirical studies in the official comment record debating all sides of the excessive speculation debate, the Commission is not convinced that it must “determine that excessive speculation exists or prove that position limits are an effective regulatory tool.”44 I suppose this also means that the Commission did not have to consider the costs of alternative means by which it could have complied with the statutory mandates. It is utterly astounding that the Commission has designed a rule to combat the unknown threat of “excessive speculation” that will likely cost market participants $100 million dollars annually and yet, “[T]he Commission need not prove that such limits will in fact prevent such burdens.”45 A flip remark such as this undermines the entire rule, and invites legal challenge.
I respect that the Commission has been forthcoming in that the overall costs of this final rule will be widespread throughout the markets and that swap dealers and traditional hedgers alike will be forced to change their trading strategies in order to comply with the position limits. However, I am unimpressed by the Commission’s glib rationale for not fully quantifying them. The Commission does not believe it is reasonably feasible to quantify or even estimate the costs from changes in trading strategies because doing so would necessitate having access to and an understanding of entities’ business models, operating models, hedging strategies, and evaluations of potential alternative hedging or business strategies that would be adopted in light of such position limits.46 The Commission believed it impractical to develop a generic or representative calculation of the economic consequences of a firm altering its trading strategies.47 It seems that the numerous swap dealers and commercial entities who provided comments as to what kind of choices they would be forced to make if they were to find themselves faced with hard position limits, the loss of exchange-granted bona fide hedge exemptions for risk management and anticipatory hedging, and forced aggregation of trading accounts over which they may not even have current access to trading strategies or position information, more likely than not thought they were being pretty clear as to the economic costs.
In choosing to make hardline judgments with regard to setting position limits, limiting bona fide hedging, and picking clear winners and losers with regard to account aggregation, the Commission was perhaps attempting to limit the universe of trading strategies. Indeed, as one runs through the examples in the preamble and the new Appendix B to the final rules, one cannot help but conclude that how you choose to get your exposure will affect the application of position limits. And the Commission will help you make that choice even if you aren’t asking for it.
I have numerous lingering questions and concerns with the cost-benefit analysis, but I will focus on the impact of these rules on the costs of claiming a bona fide hedge exemption.
In addition to incorporating the new, narrower statutory definition of bona fide hedging for futures contracts into the final rules, the Commission also extended the definition of bona fide hedging transactions to swaps and established a reporting and recordkeeping regime for bona fide hedging exemptions. In the section of the cost-benefit analysis dedicated to a discussion of the bona fide hedging exemptions, the Commission “estimates that there may be significant costs (or foregone benefits)” and that firms “may need to adjust their trading and hedging strategies” (emphasis added)48 Based on the comments of record and public contention over these rules, that may be the understatement of the year. To be clear, however, there is no quantification or even qualification of this potentially tectonic shift in how commercial firms and liquidity providers conduct their business because the Commission is unable to estimate these kinds of costs, and the commenters did not provide any quantitative data for them to work with.49 I think this part of the cost-benefit analysis may be susceptible to legal challenge.
The Commission does attempt a strong comeback in estimating the costs of bona fide hedging-related reporting requirements. The Commission estimates that these requirements, even after all of the commenter-friendly changes to the final rule, will affect approximately 200 entities annually and result in a total burden of approximately $29.8 million. These costs, it argues, are necessary in that they provide the benefit of ensuring that the Commission has access to information to determine whether positions in excess of a position limit relate to bona fide hedging or speculative activity.50 This $29.8 million represents almost thirty percent of the overall estimated costs at this time, and it only covers reporting for entities seeking to hedge their legitimate commercial risk. I find it difficult to believe that the Commission cannot come up with a more cost-effective and less burdensome alternative, especially in light of the current reporting regimes and development of universal entity, commodity, and transaction identifiers. I was not presented with any other options. I will, however, continue to encourage the rulemaking teams to communicate with one another in regard to progress in these areas and ensure that the Commission’s new Office of Data and Technology is tasked with the permanent objective of exploring better, less burdensome, and more cost-efficient ways of ensuring that the Commission receives the data it needs.
We Have Done What Congress Asked—But, What Have We Actually Done?
The consequence is that in its final iteration, the position limits rule represents the Commission’s desire to “check the box” as to position limits. Unfortunately, in its exuberance and attempt to justify doing so, the Commission has overreached in interpreting its statutory mandate to set position limits. While I do not disagree that the Commission has been directed to impose position limits, as appropriate, this rule fails to provide a legally sound, comprehensible rationale based on empirical evidence. I cannot support passing our responsibilities on to the judicial system to pick apart this rule in a multitude of legal challenges, especially when our action could negatively affect the liquidity and price discovery function of our markets, or cause them to shift to foreign markets. I also have serious reservations regarding the excessive regulatory burden imposed on commercial firms seeking completely legitimate and historically provided relief under the bone fide hedge exemption. These firms will spend excessive amounts to remain within the strict limitations set by this rule. Congress clearly conceived of a much more workable and flexible solution that this Commission has ignored.
In its comment letter of March 25, 2011, the Futures Industry Association (FIA) stated, “The price discovery and risk-shifting functions of the U.S. derivatives markets are too important to U.S. and international commerce to be the subject of a position limits experiment based on unsupported claims about price volatility caused by excessive speculative positions.”51 Their summation of our proposal as an experiment is apt. Today’s final rule is based on a hypothesis that historical practice and approach, which has not been proven effective in recognized markets, will be appropriate for this new integrated futures and swaps market that is facing uncertainty from all directions largely due to the other rules we are in the process of promulgating. I do not believe the Commission has done its research and assessed the impacts of testing this hypothesis, and that is why I cannot support the rule. As the Commission begins to analyze the results of its experiment, it remains my sincerest hope that our miscalculations ultimately do not lead to more harm than good. I will take no comfort if being proven correct means that the agency has failed in its mission.