Following on from our previous blogposts on the upcoming changes to CFTC Position Limits rules, in this instalment we examine the changes set out in the Final Rule (as required by Dodd-Frank) relating to economically equivalent swaps.
A lot of time... but a lot of work
For those trading OTC derivatives, the key date to be mindful of is 1st of January 2023. This is the compliance date for Federal position limits on economically equivalent swaps. 2023 may seem a long way off but it isn’t and there is good reason the date has been staggered versus other changes enacted by the Final Rule - there is clearly a large body of work needed from a legal, operational and compliance perspective to be ready to include OTC derivatives in calculations for Position Limits, in addition to exchange-traded contracts.
What is an “economically equivalent swap”?
An economically equivalent swap is defined as having the identical material contractual specifications, terms and conditions as the referenced future contract. The material contractual specifications include: the underlying commodity, the underlying commodity reference price and grade differentials, maturity and terminations dates and settlement type, as these provisions drive the economic value of a swap.
The CFTC’s definition of an ‘economically equivalent swap’ is identical to the European definition of OTC ‘economically equivalent’ contracts to commodity derivatives, with minor differences, such as the measurement of identical material terms, but still making the US definition comparable.
As a result, market participants will be required to include these swaps or net them against other referenced contracts of the same commodity in order to determine the correct aggregated position for the purposes of federal position limits.
Differences concerning (i) lot size or notional amount, (ii) delivery dates diverging by less than one calendar day on physically-settled swaps (and two calendar days for natural gas), (iii) post-trade risk management arrangement, (iv) business day or holidays conventions and (v) choice of law can be disregarded, as they are not relevant for determining the economic equivalence of a swap. This narrows down the definition substantially.
Rules vs. intentions
Pursuant to the rules, market participants will have the discretion to decide themselves whether their financial position in swaps falls under the aforementioned scope of economically equivalent swaps. The Final Rule does state that if a market participant pursues a swap transaction in a manner to avoid the definition of an economically equivalent swap and hence the applicable position limits, this evasive activity would actually bring the swap transaction within the scope of federal position limits. In short, the CFTC can impose at its own discretion federal position limits on OTC transactions if it considers that position limits are being deliberately evaded in the structure pursued by a market participant.
There is much to be done across the industry. For instance, exchanges cannot currently view market participants’ positions in swap positions across the various places they trade and they do not have existing compliance and monitoring resources for economically-equivalent swaps. These concerns will be reflected by other industry participants, including investors, traders and market makers across US exchanges. Undeterred, the CFTC is pushing ahead with the proposed changes and wants compliance from January 1st 2023. The work starts now.
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.