Welcome to Futures Industry
Kenneth Raisler and David Gilberg
Published 8/25/2008

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In the past few months, substantial concerns have been raised in Congress regarding a number of issues related to rising prices in the energy and agriculture markets, including the possible role of speculators and commodity index investors in the rise of energy and agriculture prices, off­exchange energy and agriculture trading, and trading on non­U.S. exchanges. These concerns have led to the introduction of more than twenty separate bills addressing these issues.

In the last several weeks, the focus has narrowed to a bill introduced by Representative Collin Peterson (D­Minn.) entitled "Commodity Markets Transparency and Accountability Act of 2008", and a bill introduced by Senate Majority Leader Harry Reid (D­Nev.) entitled "Stop Excessive Energy Speculation Act of 2008". The Peterson bill was voted upon but not passed by the House on July 30, while the Reid bill is still pending in the Senate. Congress is expected to take up both bills again in September.

The Peterson bill and the Reid bill are substantially similar in most respects, with some distinctions between them, and would substantially affect the operation and functioning of the agriculture and energy trading markets in the United States. The legislation, if enacted, includes measures that potentially could impose combined position limits on futures contracts, options and over­the­counter transactions, substantially limit the availability of hedge exemptions, impose additional requirements on foreign boards of trade offering direct access from the U.S., and impose recordkeep­ing and reporting requirements on participants in the over­the­counter markets.

Principal Provisions of the Proposed Legislation

The principal provisions of the Peterson bill and the Reid bill and the material differences between them are the following: Covered Commodities. The Peterson bill defines "energy commodity" to mean coal, crude oil, gasoline, diesel fuel, jet fuel, heating oil, propane, electricity, natural gas, and any other substance that is used as a source of energy as the Commodity Futures Trading Commission deems appropriate. The Reid bill defines "energy commodity" to mean a petroleum product and natural gas. Both bills also apply, in certain circumstances, to "agricultural commodities" as that term has been defined in the Commodity Exchange Act.

Position Limits. The Peterson bill requires the CFTC to set position limits with respect to agricultural and energy commodities traded on designated contract markets, derivative transaction execution facilities, and electronic trading facilities in "significant price discovery contracts" (those that are used as a significant basis of pricing in the over­the­counter and physical markets). Currently, except for agricultural products, this responsibility rests with the exchanges, which have largely moved away from position limits. The position limits must be set at levels designed to, among other things, limit excessive speculation and deter manipulation. The CFTC would be permitted to grant exemptions from the position limits for "bona fide hedging" transactions. However, both bills narrow the scope of recognized hedging activities.

The Peterson bill limits "bona fide hedging" transactions to those that are directly related to positions or exposures in the physi­cal commodity markets and to OTC deriva­tives that are entered into with persons engaged in hedging under this definition. The Reid bill defines "legitimate hedge trading" as transactions by commercial producers and purchasers of actual physical petroleum and energy commodities for future delivery and the direct counterparties to such trades and requires the CFTC to impose speculative posi­tion limits on trading that does not qualify as "legitimate hedge trading."

The effect of the Peterson bill and the Reid bill would be to substantially restrict the availability of hedge exemptions and, specifically, to preclude the granting of hedge exemptions to swap dealers unless a dealer can demonstrate that a particular futures position is hedging a swap with a counterparty that is itself engaged in hedging. This effectively imposes position limits on swaps, narrows the business available to dealers and eliminates many traditional forms of hedging.

Speculative Limits and Transparency of Offshore Trading. The Peterson bill and the Reid bill require that a foreign board of trade providing direct electronic access to its markets to U.S. persons trading in contracts priced against a contract traded on a U.S. exchange make public daily trading informa­tion comparable to that published by the U.S. exchange on which the related contract is traded. The Peterson bill also requires these FBOTs to adopt position limits for contracts in agricultural and energy commodities, to have the authority to require market participants to liquidate or reduce positions if necessary to protect against manipulation, and to notify the CFTC regarding position limits and accountability provisions, position reductions, or any other area of interest to the CFTC. The Reid bill similarly requires the FBOT to adopt position limits or position accountability provisions, but only for contracts in energy commodities, and to notify the CFTC of any change regarding position limits or position accountability provisions. The Peterson bill does not distinguish between "legitimate" and "nonlegitimate" hedge trading but requires that the FBOT provides information regarding large trader positions and aggregate trader positions, whereas the Reid bill requires that the FBOT provides information to the CFTC regarding the extent of legitimate and nonle­gitimate hedge trading.

Over-­the-­Counter Authority. The Peterson bill requires the CFTC to conduct a study to determine the need for and appropriateness of position limits on OTC positions for contracts for physical­based commodities to prevent market disruption, excessive speculation or manipulation (although, as noted, the provisions with respect to position limits on exchange­traded contracts effectively would impose limits on OTC positions in any event). The Peterson bill also instructs the CFTC to determine whether fungible OTC agricultural and energy transactions have the potential to disrupt market liquidity and price discovery functions, cause severe market disturbance, or prevent prices from reflecting supply and demand; and if the CFTC so finds, the Peterson bill authorizes the CFTC to impose and enforce position limits for specu­lators trading these fungible OTC agreements.

The Reid bill provides for speculative limits across all markets, including futures, electronic and OTC based on an aggregate futures equivalent exposure. The Reid bill goes well beyond the Peterson bill to authorize the CFTC to declare a major market disturbance and, in the event of such disturbance, to require the liquidation of any OTC transaction or to impose limits on OTC positions acquired in good faith before the date of the disturbance. This potential for the CFTC to require the unwinding of bilateral agreements is an unprecedented involvement in the OTC arena. The Peterson bill requires routine reporting of fungible OTC agricultural and energy transactions, and the Reid bill similarly imposes recordkeeping requirements with respect to large OTC transactions.

Other Provisions. Each of the Peterson bill and the Reid bill calls for detailed reporting from index traders and swap dealers in agricul­ture and energy trading markets, studies of international regulation of energy futures markets, an increase in staffing and resources available to the CFTC, and CFTC review of its prior actions. The Peterson bill requires the CFTC to disaggregate and publish agriculture and energy market trading information, whereas the Reid bill requires the CFTC to disaggregate and publish only energy market trading information.

Kenneth Raisler is the head of the commodities, futures and derivatives group at the law firm of Sullivan & Cromwell LLP. David Gilberg is a partner at the same firm. Both advise a wide range of clients on trading and regulatory matters relating to securities and derivatives. The information con­tained in this article should not be construed as legal advice. Copyright © Sullivan & Cromwell LLP 2008. Reprinted by permission.
 
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