The Commodity Futures Trading Commission (CFTC) has adopted final rules that would heighten its oversight of certain lightly regulated contracts in exempt commercial markets (ECM) that perform significant price discovery for commodities in interstate commerce. The agency also issued an advance notice of proposed rulemaking (ANOPR) that seeks comments on whether a proposed limited risk management exemption should be extended to physical commodities other than agricultural, such as energy and metals.
The final ECM rules, which were adopted earlier this month and published in the Federal Register last Monday, are due to take effect on April 22.
The CFTC Reauthorization Act of 2008 required the CFTC to issue rules that bolster the oversight of ECMs, thus establishing a level playing field between regulated trading exchanges like the New York Mercantile Exchange (Nymex) and ECMs (see NGI, May 19, 2008). ECMs are lesser-regulated electronic trading platforms that permit institutional participants to trade exempt over-the-counter (OTC) commodities such as energy swaps. Atlanta-based IntercontinentalExchange (ICE), a global exchange that trades natural gas, electricity, crude oil and other commodities, is essentially unregulated as an ECM, according to the CFTC.
The CFTC, in its final rules, said it will use four criteria to determine whether an ECM contract performs significant price discovery: price linkage, arbitrage, material price reference and material liquidity. Price linkage is defined as "the extent to which [an] agreement, contract or transaction uses or otherwise relies on a daily or final settlement price...of a contract or contracts listed for trading on or subject to the rules of a designated contract market [Nymex] or a derivatives transaction execution facility, or a significant price discovery contract traded on an electronic trading facility, to value a position, transfer or convert a position, cash or financially settle a position, or close out a position," the CFTC notice said.
"The Commission is committed to the prompt and thorough processing of SPDC [significant price discovery contract] determinations and agrees...that absent special circumstances, its order generally should issue within 60 days of the closing of the comment period," the agency said.
The CFTC's final rule would give an ECM exchange that has been determined to have an SPDC a 90-day grace period to make necessary changes to its trading system to ensure compliance with the core principles. Further, it said that 30 days should be sufficient for clearing firms to meet the reporting requirements and avoid market disruptions.
The agency said it interpreted the reauthorization act to give it authority over all SPDCs, whether cleared or uncleared.
The rule also requires ECM exchanges to adopt position limits and position accountability for speculators, where necessary and appropriate. "ECMs are obliged to monitor trading in their markets and to discourage manipulative activity in the spot month as well as in back months; the purpose of accountability levels is to provide the ECM with additional information and authority to address positions that threaten to create disorderly trading or market abuses," the CFTC said.
"For smaller positions that exceed the accountability level, the ECM may find that placing such positions on a 'close watch' is appropriate. For larger positions, depending on the potential threat to the market, it may be appropriate for the ECM to request that the trader not further increase (or even reduce) a position. Market liquidity also should be considered when monitoring traders with positions above the accountability level; an ECM may find it appropriate to more aggressively limit positions in markets that are relatively illiquid." ECMs can conduct inquiries into breaches of position accountability levels.
With respect to position accountability levels, the CFTC has given ECMs specific guidance -- 10% of open interest -- but designated contract markets (DCM), such as Nymex, are free to determine their own methodologies. However, the CFTC clarified that the "10% of open interest" standard for determining position accountability would only apply to "unique" SPDCs -- for example, ECM contracts that are determined to be SPDCs based on material price reference grounds, rather than on the basis of economic equivalence with another contract through a price linkage or arbitrage relationship.
The CFTC said the "acceptable practices" for nonunique, economically equivalent SPDCs allow an ECM to adopt the same accountability levels of the DCM for the underlying contract.
ICE expressed concern that requiring an ECM to adopt a DCM's position limits for its economically equivalent SPDCs could have anticompetitive implications for trading on an ECM. "The Commission does not believe this is a likely consequences of its acceptable practice," the agency countered.
In adopting the new rules, the CFTC said that "ECMs have evolved [over the years] such that some no longer are simple trading platforms with low trading volumes relative to DCMs. Also over time, these facilities began to offer 'look-alike' contracts that are linked to the settlement prices of their exchange-traded counterparts.
"This evolution, particularly the linkage of ECM contract settlement prices to DCM futures contract settlement prices, began to raise questions about whether ECM trading activity could impact trading on DCMs and whether the CFTC had adequate authority to address the impact and protect markets from manipulation and abuse."
In response, the CFTC conducted a study of the relationship between the natural gas contracts that trade on Nymex and ICE. It also issued a series of special calls for information related to ICE's cleared natural gas swap contracts that are cash-settled based on the settlement price of the Nymex physical delivery natural gas contract.
The report called on Congress to amend the Commodity Exchange Act to grant the CFTC additional authority over ECM contracts serving significant price discovery and that certain certain self-regulatory responsibilities be assigned to ECMs offering such contracts.
In other CFTC matters, the agency is seeking comments on an ANOPR that would review whether to eliminate the bona fide hedge exemption for swap dealers, which applies only to certain agricultural commodities, and replace it with a conditional limited risk management exemption that could extend to energy and metal commodities.
Receiving a limited risk management exemption would be conditioned on an obligation to report to the CFTC and applicable self-regulatory organizations when certain noncommercial swap clients reach a certain position level and/or a certification that none of a swap dealer's noncommercial swap clients exceed specified position limits in related exchange-regulated commodities.
If industry favors a limited risk management exemption, the CFTC has asked for comments on "what form the new limited risk management exemptive rules should take and how they might be implemented most effectively." Comments on the ANOPR, which was published in the Federal Register last Tuesday, are due at the CFTC on or before May 26.
"The existing bona fide hedge exemptions granted by the commission extend only to those agricultural commodities subject to federal speculative position limits. Should the reinterpretation of bona fide hedging and any new limited risk management exemption extend to other physical commodities, such as energy and metals, which are subject to exchange position limits or position accountability rules?" the CFTC also asked.
The CFTC last summer issued a special call for information from swap dealers and index traders regarding their over-the-counter market activities. This was followed up by a September 2008 report that directed agency staff to develop the ANOPR on potentially replacing the bona fide hedge exemption (see NGI, Sept. 15, 2008). The CFTC first granted this exemption from the speculative position limit rules in 1991.
As noted in the September 2008 report, "eliminating the existing bona fide hedge exemption for swap dealers and replacing it with a limited risk management exemption that would essentially look through the swap dealer to its counterparty traders...has the potential to bring greater transparency and accountability to the marketplace and to guard against possible manipulation," the CFTC said.
"While more information is needed to fully evaluate this recommendation, requiring swap dealers to monitor and restrict the position sizes of their counterparty traders, subject to CFTC reporting and audits, as a condition of obtaining and maintaining such an exemption, is a practicable way of ensuring that noncommercial counterparties are not purposefully evading the oversight and limits of the CFTC and exchanges, and that manipulation is not occurring outside of regulatory view."
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