Many swap end users assumed they would be exempt from CFTC position limits because most of their transactions would qualify as bona fide hedges. Based on the most recent CFTC proposals, however, they were wrong.
On December 12, 2013, the CFTC entered in the federal register two separate but interrelated drafts of rules governing swaps transaction position limits: Position Limits for Derivatives and Aggregation of Positions.
Until these near-final rules were proposed, many swap end users assumed that, because their primary commodities business was physical and not financial derivatives trading and marketing, they would have minimal accountability to actively monitor CFTC-mandated position limits on swaps. As a result, they decided to make a minimal investment to automate compliance. It was assumed by many end users that most transactions would qualify for a bona fide hedge and as such would be excluded from position limit exposure, as they are in futures markets. By many, fulfilling compliance was assumed to be a blanket filing to absolve companies from rigorous monitoring requirements.
While it is true that many, if not most, end-user transactions will qualify as a bona fide hedge or “certain other types of transactions” exemption, upon examination of the latest proposed position limit and aggregation rules, it is evident there are many requirements that will encourage the end user to strengthen controls to minimize exposure to this regulatory compliance risk.
As is currently proposed, there are 10 areas that may impact the end user, falling into three categories:
1. Position limits are on 28 core referenced futures contracts. All market participants – even end users – will be required to evaluate which related transactions may or may not apply toward limits.
2. Some transactions are no longer exempt. Hedges against unfilled storage capacity, contemplated hedges or transactions entered during good faith negotiations for an asset, and some commodity spread transactions that many label as basis contracts in transaction and risk management systems, will count against limits.
3. The CFTC Title VII trade option exemption does not apply to position limits. Trade options, which include many types of physical contracts with embedded optionality, will still need to be notated and disaggregated for position exposure measurement.
4. There will be multiple aggregate views of position limits. Spot month, which is defined as the nearest contract month for core referenced futures contracts, and both aggregate and single-month forward exposure should be monitored. Netting will be allowed in the aggregated, but disallowed in the single-month limit.
5. Physical and financial limits should be calculated separately and available to calculate in aggregate.
6. Affiliate positions will be required to be aggregated. If an entity has control over the trading of the affiliate, or has 10% or greater of ownership or equity interest, they must be aggregated. However, they can be treated separately if there is a law preventing information sharing (e.g., regulated and unregulated affiliates in electricity and other certain jurisdictions or separation agreements).
7. Affiliate positions always must be aggregated, unless positions of the entity do not exceed 20% of the position limits, which will need to be monitored.
8. Affiliate accounting treatment can affect aggregation requirements. A single filing to allow companies to monitor affiliates independently if they are ring-fenced based on certain legal and accounting qualifications.
Recordkeeping and Reporting
9. Exemption claims require transaction-specific recordkeeping responsibilities. Companies may be called on by the CFTC to demonstrate that the exempt transactions were thoroughly reviewed, notated and monitored. On a related note, new data-keeping and retention rules require a certain rigor of electronic recordkeeping and a short and prescriptive data response time. For end users, it is five business days.
10. The following reports will need to be proactively filed:
- Form 204 –monthly – bona fide hedge report
- Form 504 – daily – conditional spot month report (when over limit)
- Form 604 – daily – pass-through bona fide hedge exemption for spot month
- Form 604 – monthly – pass-through bona fide hedge exemption for forward months
- Form 704 – annually and 10 days prior to entering transaction – anticipatory hedging
Do these relate to your company’s swaps and futures activities?
Traditionally, the CFTC monitored position limits on futures in a similar manner to what they’ve proposed for swaps. Oversight was typically dependent on the clearinghouse and futures commission merchant monitoring and calling on the market participant to file correctly. Now some swaps will be cleared and some will not be cleared; some swaps will be standard and some will be non-standard; and all swaps may not necessarily be executed on the same platform. As a result, it is the responsibility of the market participant – including the end user – to monitor and report accordingly.
Despite CFTC rules still being shaped, the soon-to-be-finalized and emerging industry standards are yet to be tested by regulators. The risk of pleading ignorance to responsibility of position limit monitoring is high. The CFTC has socialized a stance that the act of monitoring position limits should not be new to market participants that transact in futures, as it has been around for many years.
Good business practice in risk control dictates that at a minimum, attention to process change, documented oversight, accurate monitoring with enhancements to current transaction management and risk systems, and comprehensive data retention and reporting will need to be formalized – particularly if there is potential to have aggregate exposure across affiliates and equity held entities.