The Commodity Futures Trading Commission has approved, by a 5-0 vote, a final rule regulating commodity options as "swaps" under The Dodd–Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), and an interim final rule (IFR)1 establishing a "trade option exemption" that exempts certain physical option transactions from most, but not all, regulations related to swaps.
Under Section 4c(b) of the Commodity Exchange Act (CEA), the CFTC has plenary authority to regulate commodity option transactions. Commodity options are illegal unless and until the CFTC specifically authorizes them. The Commodity Options Final Rule (1) repeals and replaces prior CFTC regulations regarding commodity options; (2) authorizes market participants to engage in commodity options; and (3) subjects commodity options to the same rules applicable to all other swaps. The CFTC retained certain pre-Dodd-Frank Act antifraud provisions to ensure that it has the regulatory tools to police the commodity options market.2
Section 721 of the Dodd-Frank Act defines the term "swap" to include "a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more...commodities." Certain options transactions, like options on futures contracts, are not swaps under the statutory definition of "swap" in the Dodd-Frank Act. However, options on physical commodities are included in the statutory definition of "swap."
While, as required by the Dodd-Frank Act, the CFTC has proposed a regulatory definition of the term "swap" (the "Swap Definitional Rule"),3 it has not yet issued a final rule. According to the CFTC, the final Swap Definitional Rule will contain guidance to assist market participants in determining whether a physical transaction that contains optionality is a swap. Importantly, if a transaction is not a swap under the final Swap Definitional Rule then it will not be subject to the Commodity Options Final Rule and IFR. In other words, the Commodity Options Final Rule and IFR will apply only to transactions that are swaps under the final Swap Definitional Rule.
Comments on the Commodity Options Rule
The CFTC addressed many of the core comments submitted by market participants. The principal change that the CFTC adopted, in response to comments, was to rescind its prior proposal to withdraw the trade option exemption and to effectively restore that exemption through the IFR (with modifications to reflect its authority over swaps). In further response to concerns about impacts on commercial end users, the CFTC underscored the discussion of physical forward transactions in its February 2011 Swap Definitional Rule. The CFTC stated that it plans to address volumetric options and related issues in the final Swap Definitional Rule, not in the Commodity Options Final Rule.
Additionally, the CFTC discussed the comments it received regarding transactions regulated by the Federal Energy Regulatory Commission, but it did not make any policy decision regarding these transactions in the Commodity Options Final Rule.
Trade option exemption
The Commodity Options Final Rule contains an IFR that establishes a new "trade option exemption" for certain physical delivery commodity options. Since 1976, CTFC regulations have included a trade option exemption that exempted options offered to commercial end users from the CFTC’s prohibition against off-exchange commodity option transactions. The proposed rule would have removed the trade option exemption without implementing a replacement.
As discussed above, the Commodity Options Final Rule permits commodity options to be transacted pursuant to all rules applicable to swaps. Under the general rules applicable to all swaps, market participants that do not qualify as "Eligible Contract Participants" (ECPs)4 can only enter into swaps executed on a Designated Contract Market (DCM). Commenters noted that many non-ECPs enter into commodity options transactions and thus the rule would have prohibited those participants from transacting in OTC physical options unless granted exemptive relief. To address these concerns, the new trade option exemption exempts qualifying trade options from many, but not all, of the rules that apply to swaps. To qualify for the new trade option exemption, a transaction must meet the following three requirements:
must be either (1) an ECP or (2) a commercial end user.6
must be a commercial end user.
The commodity option, if exercised, must be intended to be physically settled. If exercised, the transaction must either be a "spot" or "forward" transaction.
These requirements are similar to the CFTC’s prior trade option exemption. The offeror must "reasonably believe" that the offeree meets the requirements for being an offeree under the regulation. In determining whether the option, if exercised, is a "forward," the CFTC pointed out, as instructive, the discussion of "forwards" in the proposed Swap Definitional Rule and "such other guidance" that may be adopted in the final Swap Definitional Rule.
The IFR applies only to an option that, if exercised, is intended for physical delivery and that is purchased by a commercial end user of the underlying commodity. Conversely, commodity option transactions that include embedded optionality that affect volume but do not allow for zero physical delivery should be addressed under the forward contract exclusion in the final Swap Definitional Rule.
The Commodity Options Final Rule retains the CFTC’s general exemptive authority to exempt certain transactions if "it would not be contrary to the public interest."
Regulations applicable to exempt trade options
Although the trade option exemption provides a general exemption from the rules otherwise applicable to swaps, such as mandatory clearing and exchange trading, the IFR subjects exempted trade options to certain enumerated rules otherwise applicable to swaps. Under the IFR, all trade options are subject to the recordkeeping requirements of 17 C.F.R § 45.2; reporting, pursuant to part 45 of the CFTC’s regulations or through an annual report to the CFTC, described below; position limits under part 151; and all antifraud, anti-manipulation and other enforcement provisions of the CEA. Depending on the status of the counterparties, trade options will also be subject to large trader reporting requirements under part 20 of the CFTC’s regulations and the capital, margin, recordkeeping, reporting and risk management obligations applicable to Swap Dealers and Major Swap Participants (SDs and MSPs, respectively).
Reporting exempt trade options
In relation to reporting trade options, market participants that must comply with the swap reporting rules for other swaps (besides trade options) will be required to report trade options just like the other swaps it reports. If neither counterparty is required to report a trade option under part 45, then both counterparties must submit an annual filing to the CFTC, described further below.
If the trade option involves one counterparty that was, during the prior 12 months, required to become a "reporting counterparty" under the reporting rules applicable to non-trade options swap trading activity, then that counterparty must report the exempt trade option pursuant to the reporting obligations contained in part 45 of the CFTC’s regulations. If only one counterparty previously had to comply with part 45, then that counterparty is the reporting counterparty. If both counterparties had to previously report, then the determination of which counterparty will report is determined pursuant to the normal hierarchy in the swap reporting rules.8
If neither party is required to report under this rule, then both counterparties must make an
annual notice filing to the CFTC on "Form TO" by March 1 following the year the market participant entered into an unreported trade option. Filers must provide the following information in Form TO:
name and contact information
the categories of commodities (metals, energy, agriculture or other) of the options the entity entered into in the prior year and
for each commodity, an approximate value of the underlying physical commodity that the entity delivered or received during the prior year (i.e., those transactions that actually resulted in delivery, not those positions that were unexercised or still open)
The CFTC is requesting comments on all aspects of the trade option exemption IFR and the annual notice requirement in Form TO. Specifically, the CFTC requests comments on the costs and benefits of the annual notice filing and its relation to the goal of ensuring CFTC visibility of trade option positions.
Comments are due June 26, 2012. As noted above, the CFTC considered comments relating to the proposed Swap Definitional Rule in finalizing the Commodity Options Final Rule. Accordingly, market participants may want to comment on the IFR, especially with respect to its relation to the final Swap Definitional Rule. The CFTC also discussed a number of alternatives to the IFR as they relate to smaller entities. Participants may also want to comment on those alternatives.
Effective date and compliance date
The effective date for the Commodity Options Final Rule and IFR is June 26, 2012. However, market participants will not have to comply with the Commodity Options Final Rule and the IFR until 60 days after the CFTC publishes in the Federal Register the final Swap Definitional Rule. The first Form TO will be due by March 1, 2014 for transactions entered into between January 1, 2013 and December 31, 2013. There is no Form TO filing requirement for transactions entered into between January 1, 2012 and December 31, 2012.
For more information about the Final Rule and the comment process, please contact:
Mary Anne Mason
A copy of the final rule, approved on April 18, is available here.
1 An IFR is rule that has the full force and effect of law and becomes effective on the date specified in the Federal Register release. An IFR allows interested parties to submit comments during the comment period and the agency will consider those comments in determining whether to revise the final rule.
2 17 C.F.R. § 32.4; 77 Fed. Reg. at 25,325. The scienter standard under the antifraud provision of the final rule remains "intentionally or with reckless disregard." 77 Fed. Reg. at 25,325 n.30. (citing In re Osler, CFTC Docket No. 00-5, 2001 WL 138975 (Feb. 15, 2001)).
3 76 Fed. Reg. 29,818 (May 23, 2011).
4 The definition of the ECP was recently revised in the CFTC’s issuance of final rules relating to the terms "Swap Dealer" and "Major Swap Participant." In general, a corporate entity that has at least $10 million in total assets qualifies as an ECP.
5 An offeror is also known as a grantor or seller of a commodity option.
6 A commercial end user is "a producer, processor, or commercial user of, or a merchant handling the commodity that is the subject of the commodity option transaction, or the products or by-products thereof, and such offeror is offering or entering into the commodity option transaction solely for purposes related to its business as such." 17 C.F.R. § 32.2(a)(1)(i).
7 An offeree is also known as a grantee or a buyer of a commodity option.
8 An SD will be the reporting counterparty for transactions where only one party is an SD. An MSP will be the reporting counterparty for transactions where only one party is an MSP (and the other counterparty is not an SD). If one counterparty is not an SD/MSP, but is a "Financial Entity," then the Financial Entity will be the reporting counterparty (if the other counterparty is not an SD or MSP). If both counterparties are of the same level (i.e., both SDs, MSPs, non-SDs/MSPs), then the parties must agree which counterparty is the reporting counterparty. The one exception to this rule is that if both counterparties are non-SDs/MSPs and only one counterparty is a "U.S. person," then the "U.S. person" counterparty is the reporting counterparty. See 17 C.F.R. § 45.8.