Key Topics & Takeaways
- Fine Tuning:Chair Massad said the proposals “involve fine-tuning our rules” to make sure “they work as intended” and “do not impose undue burdens or unintended consequences, particularly for the nonfinancial commercial businesses” who use the markets to hedge risk.
- Residual Interest Deadline: This proposal eliminates the December 31, 2018 termination date for the phased-in compliance schedule for FCMS and provides assurance that the Residual Interest Deadline would only be revised through a separate Commission rulemaking.
- Rule 1.35 Amendments: This proposal would: 1) provide that all records required under this regulation must be searchable; 2) exclude identification requirements of communications leading to the execution of a transaction in a commodity interest and related cash or forward transactions; 3) exclude unregistered DCM or SEF members from the requirements to retain text messages; and 4) exclude CTAs from the requirement to record and maintain oral communications.
- Embedded Volumetric Optionality: This proposal would modify the “seven-part” test of swap definition to: 1) to clarify that the interpretation applies to embedded volumetric optionality in the form of both puts and calls; and 2) modify the seventh element to clarify that the EVO “must be primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.”
Tim Massad, Chairman of the Commodity Futures Trading Commission (CFTC), said in hisopening statement that the three items the Commission considered “all involve fine-tuning our rules” to make sure “they work as intended” and “do not impose undue burdens or unintended consequences, particularly for the nonfinancial commercial businesses” who use the markets to hedge risk.
Massad said the proposal on the residual interest deadline would amend Regulation 1.22 to ensure that customer funds deposited at futures commission merchants (FCMs) remain safe by prohibiting an FCM from using one customer’s funds for the benefit of another customer. Massad explained that Reg 1.22 was amended last year to require a FCM to maintain its own capital, known as “residual interest,” in customer aggregated accounts to make up any deficiencies in margin amounts. Last year’s amendments, he added, also: 1) required FCMs to deposit this residual interest by 6:00 pm EST on the settlement date, starting November 14, 2014; 2) directed CFTC staff to conduct a study on practicability of the deadline 3) said the Commission would decide, within nine months of the study, whether to move up the deadline to 9:00 am; and 4) stated that if the Commission failed to act, the deadline would automatically move to 9:00 am on December 31, 2018.
The current amendment, he said, would eliminate the provision to automatically move the deadline, while keeping the November 14, 2014 deadline as well as the staff study.
On records of commodity interest and related cash and forward transactions, Massad explained that the proposal would amend Rule 1.35, which requires various market participants to keep written and oral records of transactions. He noted that after the Commission implemented amendments to this rule in 2012, CFTC staff “determined that the costs of complying with certain aspects of the rule for some market participants might exceed the potential benefits” and granted no-action relief. This no-action relief, he continued, stated that: 1) members of designated contract markets (DCMs) and swap execution facilities (SEFs) that are not registered with the Commission do not have to keep text messages or store their other records in a manner that is identifiable and searchable by transaction; and 2) commodity trading advisors (CTAs) do not have to record oral communications regarding their swap transactions. Massad said that record keeping costs must be balanced with their benefits because they will “ultimately be reflected in the transactions costs incurred by all customers.”
On forwards contracts with embedded volumetric optionality (EVO), Massad said the proposed interpretation would alleviate ambiguity in the seventh factor of the original interpretation and allow contracts with volumetric optionality “that truly are intended to address uncertainty with respect to the parties’ future production capacity or delivery needs, and not for speculative purposes or as a means to obtain one-way price protection, to fall within the exclusion” of the CFTC’s jurisdiction. He also noted that because the proposed interpretation pertains to the definition of a swap, the CFTC is coordinating with the Securities and Exchange Commission (SEC) on this proposal.
Commissioner Mark Wetjen, in his statement, said the new swaps rules under Dodd-Frank “should not place additional costs and compliance burdens on firms operation in the real economy unless necessary to achieve the purpose of the post-crisis reforms.”
On volumetric optionality, Wetjen said he is “confident Congress did not intend to pull contracts that historically have been treated as forwards” into the new regulatory regime “solely because of optionality in the amount of the physical commodity delivered under the contract.” He said that ambiguities and uncertainties in the seven factor test “increased transaction costs for commercial firms and limited their access to an effective risk-management tool.” Wetjen explained that the proposed amendments would: 1) clarify that meeting the seventh prong should be determined “by looking to the intent of the parties at the outset of contract initiation;” and 2) delete language referring to physical or regulatory factors being “outside of the control of the parties.”
On residual interest, Wetjen said that the “resulting certainty” from the proposed amendments “outweighs the potential value of incentivizing FCMs to improve their margin-collection practices to comply with a future, time-of-settlement deadline.”
On Rule 1.35, Wetjen stated that the “proposal tries to balance certain commission regulatory prerogatives… against considerations related to accessibility to the derivatives markets more generally, and certain trading venues more specifically.”
Commissioner Sharon Bowen, in her statement, said that the CFTC needs “to get the little things right to get the big things right, and I feel we have gotten these small changes right.”
She noted that the amendments to Rule 1.35 are in response to requests from a number of parties, including: 1) non-registrants that requested clarity on the meaning of “searchable and identifiable” in the context of pre-execution records; 2) non-registrants that sought relief from the obligation to collect text messages and 3) CTAs that asked for relief from the oral-recordkeeping requirement.
On residual interest, Bowen said she looks forward to hearing from the public “about whether it makes sense” to remove the December 2018 end-point.
On EVO, Bowen said she is “sympathetic” to concerns of lack of clarity and agrees the CFTC “should try to make our guidance on this point clearer,” but expressed concern that the current proposal “as written goes too far and will cause too many options to be incorrectly regarded as forwards.” She added that “the trade option exemption provides a much clearer and cleaner approach to address the issues raised regarding volumetric optionality” and hoped the Commission “can consider revising our trade option regulations soon.”
Commissioner Christopher Giancarlo provided his statements during the staff presentations of each proposal.
Staff Presentation – Proposed Rule on Residual Interest Deadline for FCMs – Approved Unanimously
Thomas Smith, Deputy Director of Margin and Segregation in the Division of Swap Dealer and Intermediary Oversight, explained that Reg 1.22 states that FCMs may not use the funds of one customer to margin the position of another person and that each FCM is required to compute the total aggregate amount that customer accounts are under-margined at the end of each business day. The FCM, he continued, would have to fund this under-margined amount with its own residual interest at the time of settlement on the next business day. He noted the phased-in compliance period will begin on November 14, 2014 with a residual interest deadline of 6:00 pm the next business day and that CFTC staff is required to publish a report for public comment by May 16, 2016 assessing the “practicability” of moving the deadline up to the time of clearing house settlement or another point in time.
Smith then noted that initial regulation states that if the Commission takes no action, this deadline will automatically move to the time of settlement on December 31, 2018. He then said that CFTC staff, in the proposal, recommends that this automatic termination date be eliminated.
Wetjen asked what types of impediments exist that prevent market participants from making more timely settlement payments, adding that time zone differences may be one example.
Smith replied that staff has heard from the agriculture community and small customers that they have difficulty moving funds because they use real-time financing for their margins and “do not want to maintain sufficient amounts of excess margin funds with FCMs.” He added that non-U.S.-based customers may face issues when trying to meet margin calls of U.S.-based FCMs.
Wetjen then added that in light of continued innovations in the payment system, customers prefunding their FCM accounts “doesn’t seem necessary” as issues of getting timely margin and collateral payments could be solved.
Commissioner Giancarlo supported the proposal, saying that without revision the current rules may drive small and medium agriculture producers out of the market due to the increased costs of pre-funding their accounts. He noted that in conversations with these parties, they highlighted that more of their money would be at risk in the event of an FCM failure. He also mentioned that there is bipartisan legislation in both the House and Senate which seek to address issues of margin for end-users, H.R. 634 and S. 888.
Giancarlo then raised a separate issue that also has an automatic adjustment: the de minimis exception to the swap dealer definition. He said the CFTC should revise the definition so that the de minimis level does not automatically adjust from $8 billion to $3 billion without a rulemaking process with public comment.
Massad then asked if the staff study would address technological developments and look at what FCMs may potentially be able to do with these advances. Smith said the study would consider technology developments.
The Commission voted unanimously to approve a Proposed Rule on the Residual Interest Deadline for Futures Commission Merchants.
Staff Presentation – Proposed Amendments to Rules Regarding Records of Commodity Interest and Related Cash or Forward Transactions – Approved by Vote of 3-1
Katherine Driscoll, Associate Director of the Division of Swap Dealer and Intermediary Oversight, explained that Rule 1.35 requires, with some exceptions, that FCMs must keep records relating to the business of dealing in commodity interest and related cash or forward transactions, including oral and written communications that lead to the execution of a transaction and that these records must be kept in a manner that is “identifiable and searchable” by transaction.
She explained that the first part of the proposal would clarify and amend the “form and manner” requirement of “identifiable and searchable by transaction” to specify that all records kept pursuant to the rule must be searchable, including “both the records of a transaction and the records of the communications that lead to a transaction.” The proposal, she said, would also change the language of the rule to allow the exception that “pre-trade communication would not have to be kept in this form and manner that allows for the identification of a transaction” but that pre-transaction communications would still have to be searchable.
The second part of the proposal, she stated, would: 1) codify Commission Letter 14-72, which granted no action relief to unregistered members of FCMs and SEFs from the written recordkeeping requirement for text messages; and 2) codify Commission Letter 14-60 to exclude CTAs from the requirement to record oral communications.
Giancarlo commented that Rule 1.35 “has proven simply unworkable” and noted that market participants “voiced their inability to tie all communications leading to the execution of a transaction to a particular transaction or transactions” and “pointed out that it was simply not feasible technologically to keep pre-trade text messages in a form and manner identifiable and searchable by transaction.”
Giancarlo said that the revisions to Rule 1.35 “go a long way towards addressing the rule’s difficulties,” but “unfortunately, they do not go far enough.” He added that “many of the problems stem from imprecise construction and definition in the legal drafting” and that the term “searchable” is not defined. He concluded that “the underlying rule and the lack of sufficient relief provided” in the proposal will “result in senseless cost increases” which may “curtail the use of sound risk management tools.”
Massad added that the proposal “obviously is a way to receive public comment” and that it is “not actually adding new compliance costs.”
The Commission voted 3 to 1, with Giancarlo voting “no”, to approve the Proposed Amendments to Rules Regarding Records of Commodity Interest and Related Cash or Forward Transaction.
Staff Presentation – Forward Contracts with Embedded Volumetric Optionality – Approved Unanimously
Elise Pallais, Office of General Counsel, explained that the final proposal would amended a 2012 interpretation that defined the term “swap” with respect to the forward contracts that provide for variation of the delivery amount, known as EVO.
The proposal, she noted, would: 1) modify the fourth and fifth prongs of the initial interpretation to clarify that it applies to EVO in put and call options; and 2) modify the seventh element to clarify that the EVO “must be primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.”
Bowen asked Pallais to explain the difference between an exemption and an exclusion from the Commission’s jurisdiction.
Pallais replied that forward contracts that provide for some optionality in the delivery amount are still forward contracts, but that “to the degree that the contract does not fit within the interpretation, they could be considered options within the Commission’s jurisdiction.”
Giancarlo stated that EVOs are “widely used in everyday business and do not pose a threat to the stability of financial markets” so thus should not be regulated the same way as financial derivatives. He added that regulation of these transactions 1) will “have the effect of increasing companies’ costs of doing business;” 2) will force some businesses “to curtail market activity and thereby consolidate risk in the marketplace rather than transfer and disperse it;” and 3) will ultimately raise costs for consumers.
Giancarlo concluded that the proposed interpretation of the seventh prong “provides a good start to providing some sensible relief” and that “although a change to the underlying product definition would be strongly preferred,” the proposal “hopefully will provide relief through a revision to the CFTC’s interpretation of the rules.”
The Commission voted unanimously to approve the Proposed Interpretation for Forward Contracts with Embedded Volumetric Optionality.
For more information on this meeting, please click here.
- Residual Interest Deadline
- Commodity Interest and Related Cash or Forward Transactions
- Forward Contracts with Embedded Volumetric Optionality
Federal Register Release:
Federal Register: Residual Interest Deadline for Futures Commission Merchants
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