A summary: the CFTC position limits compliance deadline of January 2022

The Commodities Future Trade Commission (CFTC) recently finalized regulations on speculative position limits, amended the definition of a “bona fide hedging transaction or position,” and expanded position limit exemptions (Final Rules).^[1]  The new speculative position limits, which are generally higher than previous limits, became effective on March 15, 2021, with a full compliance date for the 16 non-legacy core referenced futures contracts set for January 1, 2022.  Additionally, the amended definition of “bona fide hedging transaction or position” simplifies the analysis on whether a position qualifies as a bona fide hedge allowing bona fide hedgers to exceed position limits without triggering a penalty.  Lastly, the Final Rules expanded exemptions for positions in relation to the federal spot month position limits. Companies are encouraged to review these changes to ensure compliance with the Final Rules.  

Background

Spot month position limits are the maximum number of contracts that a trader can own during the month in which a futures contract becomes deliverable. Non-spot month position limits are the maximum the number of contracts a trader can own for any month.

The CFTC generally uses both of these position limits to address four concerns: (1) prevent harms on the market caused by excessive speculation; (2) deter and prevent market manipulation, squeezes and corners; (3) ensure sufficient market liquidity for bona fide hedgers; and (4) ensure that price discovery is not disrupted.^[2] As the CFTC determines that updated position limits could better serve these aims, the CFTC may update position limits.

In 1999, the CFTC set spot month position limits only for legacy agricultural commodities. Legacy agricultural commodities represent 9 of the most liquid contracts, and their liquidity tends to leave them vulnerable to manipulation and excessive speculation.^[3] So to prevent market manipulation, the CFTC set the maximum number of spot month positions at or below 25 percent of their deliverable supply.

In that same year, the CFTC determined the federal position limit levels for non-spot months should be 10 percent of open interest for the first 25,000 contracts of open interest with a marginal increase of 2.5 percent of open interest thereafter. This action too helped address the CFTC’s four aims, and the formula became known as the 10/2.5 percent formula. This formula was based on open interest data at the time and the size of large traders’ positions.

Despite increases in maximum open interest and supply, the CFTC had not updated the 10/2.5 percent  formula or commodity exchanges’ estimates to reflect these changing market dynamics. New rules meant to implement aspects of the 2010 Dodd-Frank Act did arrive in 2011, but in 2012, a district court order vacated the 2011 Final Rules. Specifically, the district court found that the CFTC had not shown that the proposed position limits were “necessary” or “appropriate” to diminish, eliminate or prevent manipulation and excessive speculation. Nevertheless, after nearly five years without updated guidance, on January 14, 2021, the CFTC published its Final Rules for federal position limits along with findings that these position limits were necessary and appropriate.

New rules

Position limits

The Final Rules affect the nine legacy agricultural contracts discussed above, and they also set spot month position limits on sixteen other types of commodities contracts.

While the federal spot month position limits maintained the original regulation’s 10/2.5 percent  formula, the CFTC updated the exchange estimates for the 9 legacy agricultural contracts. Additionally, the non-spot month position limits now allow up to 10 percent  of open interest for the first 50,000 contracts of open interest, instead of the previous rules first 25,000 contracts. For example, the maximum number of contracts for CBOT Corn for non-spot months has increased from 33,000 total positions to 57,800 total positions —almost double the previous federal limit. This degree of increase is present in most of the new spot month limits imposed by the 2020 Final Rules allowing traders to hold more contract positions for many of these very liquid commodities.

However, not all of the legacy agricultural contracts enjoy now feature greater spot month and non-spot month position limits. For instance, CBOT Oats is the sole legacy agricultural contract spot level remaining the same as the previous federal spot position limit, and BOT KC HRW Wheat and MGEX HRS Wheat maintained their 1999 position limit levels.

The CFTC also introduced spot month position limits for sixteen new non-legacy core referenced contracts. Previously, the only limit on set spot month position limit levels for these contracts were limits created by the exchanges themselves. In other words, the position limits were created by the platforms on which they traded. For example, until the introduction of these regulations, there were no federal spot limits for ICE Cocoa, ICE Coffee C, and COMEX Silver. However, outside the spot-month, the newly limited non-legacy core referenced futures contracts are only subject to their exchange’s set all-month position limits. The CFTC’s decision to set position limits for these sixteen new non-legacy core referenced contracts might signal a policy shift by the CFTC to exercise greater control over commodities even if the CFTC sets position limits that exceed exchange limits.

Indeed, some of these newly imposed limits are much greater than even the existing exchange limits. In theory, this could mean that exchanges can raise their own position limits, but this possibility does not mean exchanges will respond accordingly. For example, previously the only spot limit for ICE Cocoa was the exchange’s own limit of 1,000 contract positions within the spot month. However, the recent regulation creates a new federal spot month position limit of 4,900 contract positions. The only instance where the federal levels matched existing limit levels of the exchanges were with most metal contracts with the exception of spot month position limits on COMEX Silver positions which exceeded the exchange limits. However, since the new regulation had first been published, some exchanges, such as the NYMEX, have since increased their own spot month limits to match the new higher federal limits, but ICE has yet to alter their spot month position limits.

Bona fide hedging position

The Final Rules also set updated standards for finding that a contract position is exempt from positions limits because it qualifies as a “bona fide hedging position.”  Under the current definition of a “bona fide hedging position,” to qualify for the exemption, a position must (1) represent a substitute for a transaction to be made or positions to be taken at a later time in a physical marketing channel (temporary substitute test), (2) be economically appropriate to reduce risks in the conduct and management of a commercial enterprise (economically appropriate), and (3) arises from the potential change in value of actual or anticipatory assets, liabilities, or services. The CFTC also included enumerated hedges set forth in Appendix A in the Final Rules that are self-effectuating as “bona fide hedging positions.” Non-enumerated bona fide hedges must receive approval from the CFTC after an application process.

The Final Rules do not include the “incidental test” nor the “orderly trading requirement” that was previously included in section 1.3 of the original 1999 regulation. Neither of these tests were included in the Dodd-Frank Act, and the CFTC viewed both to be redundant and created uncertainty in the definition of a bona fide hedge. Eliminating these requirements may streamline deciding whether new trading practices and strategies qualify under the exemption for exchanges and market participants, thereby, perhaps, leading to a greater volume of trading.

Other exemptions

Additionally, the CFTC implemented or expanded several exemptions to the newly imposed position limits. One such expanded exemption is an effect of the enlargement of the definition of a “spread transaction” and allowing most spread exemption requests to be self-effectuating. Another exemption added is the “Financial Distress Exemption” where the CFTC may, on a case-by-case basis and only on request, allow a market participant to hold a position above the federal limit when that holder is under financial distress. Finally, to ensure that the regulation does not have an effect on positions acquired in a pre-enactment swap, the CFTC enacted an exemption for such positions acquired in good faith.

Conclusion

With the recently enacted higher federal spot limits and an expansion of exemptions, commodities traders may look to adjust their internal trading controls to ensure compliance both with the new limits and to see if they might now qualify for the revised exemptions.