In this 3rd post in our CFTC series we look at the impact of the Final Rule on exchange-imposed Position Limits across US exchanges. In the 2nd post we looked specifically at the changes to Federal position limits, and in post #1 we shared a handy timeline of what to expect and when.
With the publication of the Final Rule in the Federal Register, the CFTC has set a clear path forward outlining Federal limits for trading in 25 various derivative contracts.
But what of the role of exchanges and the existing limits already set by exchanges directly? Exchange-based limits exist across numerous contracts but does the Final Rule set out how the exchange-set limit regime works alongside the new Federal regime?
Spoiler alert - yes, it does.
Firstly, what are exchange-set limits? And how do they differ from Federal limits?
Currently, the CFTC imposes Federal position limits on nine agricultural commodity linked derivatives, soon increasing to 25 from Jan 2022 - click here for a timeline of the CFTC’s changes. But exchanges also impose their own “exchange-set” hard position limits and / or accountability limits on most futures contracts, including on these 25 contracts now in scope for the Federal limits regime.
The Final Rule doesn’t really change this, but what it does set out to do is enhance the roles played by exchanges in setting limits and granting exemptions to these limits, where permissible.
Chicago Mercantile Exchange building
But which limit is the right one? And which limit takes precedence?
As is currently the case anyway, the Final Rule prohibits exchanges from setting limits that are more lenient than any set at the Federal level. Any exchange-set limits for these 25 contracts subject to Federal position limits must be less than or equal to the Federal limits. However, exchanges are free to set tighter, more stringent limits than dictated at the Federal level.
In addition, the Final Rule grants increased flexibility to exchanges in setting both position limits and position accountability levels for those contracts where no Federal limit exists - for example, for physical commodity derivatives. In general, the regulations require exchanges to set spot month position limit levels at no more than 25% of deliverable supply. However, the Final Rule allows for the exchanges to submit other approaches for review by the CFTC - both for spot month limits and for limits and accountability levels outside of the spot month - provided the approach results in position limit levels that are “necessary and appropriate to reduce the potential threat of market manipulation or price distortion of the contract's or the underlying commodity's price or index”.
But what of exemptions? A rule isn’t a rule without exemptions
The Final Rule provides clarity to market participants and exchanges where exemptions to both the exchange-set and Federal limits may be permitted. Given the overall purpose of the Final Rule is arguably to set limits on positions held for speculative purposes, it comes as no surprise that permitted exemptions to the Final Rule relate exclusively to holders of bona fide hedge positions. The new rules change the bona fide hedge exemption by, among other things, expanding the list of permissible bona fide hedges. But, market participants, including asset managers, will no longer be allowed to treat a futures position as a bona fide hedge simply because it was entered into for “risk management purposes.” A bona fide hedge position now needs to explicitly "be connected to the production, sale, or use of a physical cash-market commodity."
Could this lead to more scrutiny from the CFTC and exchanges on any relatively large positions held by asset managers or hedge funds, which can’t be clearly linked to applicable business in the underlying cash-market commodity?
A push for greater collaboration between the CFTC and exchanges?
With the focus for this blog being exclusively on exchanges and exchange-set limits, the final area of relevance is on the topic of collaboration. Through the Final Rule, the CFTC pushes for “greater collaboration between the Commission and the exchanges” with the CFTC believing that “cooperation between the Commission and the exchanges on position limits should not only be continued but enhanced”. The CFTC clearly recognises the role exchanges play in the market and realises they are “particularly well-positioned” to share key data and insight with the Commission with regard to deliverable supply estimates and even to provide limit recommendations. But perhaps even more importantly for market participants, such as asset managers - the CFTC will also be looking to exchanges to “help administer the program for recognizing bona fide hedges”.
The Final Rule provides exchanges with a compliance date of January 1, 2022 for purposes of establishing exchange-set position limits and provisions associated with exemptions to such limits. If you’d like to hear us discuss this and the other proposed changes in more detail ahead of these new rules becoming active, register to attend our Webinar on Position Limits on Wednesday 3rd March.