Enter to open, tab to navigate, enter to select
CFTC Clarifies Most Commodity Options Are Swaps Subject to Dodd-Frank
Practical Law Legal Update 3-544-1025 (Approx. 6 pages)
CFTC Clarifies Most Commodity Options Are Swaps Subject to Dodd-Frank
by Practical Law Finance
| Published on 28 Feb 2014 • USA (National/Federal) |
The CFTC released FAQs clarifying that commodity options are generally regulated as swaps under Title VII of the Dodd-Frank Act, but that physical commodity options embedded in forward contracts and trade options may fall outside the scope of Dodd-Frank swaps regulation.
On September 30, 2013, the CFTC released FAQs on commodity options, clarifying that commodity options will generally be regulated as swaps under the Title VII of the Dodd-Frank Act. On February 28, 2014, the CFTC issued revised FAQs clarifying some of the language from the original release relating to Form TO (see Data Reporting for Trade Options). The releases also clarified that certain types of physical commodity options may fall outside the scope of Title VII swaps regulation. The guidance exempts three types of physical commodity options from full Dodd-Frank swaps regulatory treatment, including:
- Commodity options that are embedded in forward contracts (embedded options) provided that:
- the option does not undermine the overall nature of the contract as a forward (it may, however, affect the forward price);
- the predominant feature of the option contract is that it contemplates actual delivery (that is, it is intended to be physically settled); and
- the option cannot be severed and marketed separately from the overall forward contract in which it is embedded.
- Embedded volumetric options, which are a specific type of option that can be used to hedge physical supply risk and are often used in energy commodities, provided that:
- the three requirements (listed above) for embedded commodity options are met;
- the seller intends to deliver the commodity if the option is exercised;
- the buyer intends to take delivery if the option is exercised;
- both parties are commercial entities; and
- the decision to exercise or to refrain from exercising the volumetric option is based primarily on physical factors or regulatory requirements that are outside the control of the parties.
- Trade options, which must involve a physical commodity, provided that the trade option:
- is offered by either an eligible contract participant (ECP) or a commercial participant, which includes producers, processors and commercial end users;
- is offered to a commercial participant; and
- is intended to be physically settled.
Embedded options and embedded volumetric options in forward contracts are generally excluded from regulations applicable to swaps. Trade options, while exempt from most rules applicable to swaps, are subject to CFTC Regulations 32.3(b)-(d), which require, among other things, compliance with the following regulations, to the extent that these sections would apply to any other swap:
- Large-trader reporting requirements (see Practice Note, US Derivatives Regulation: CFTC Swap Data Reporting and Recordkeeping Rules: Large-trader Position Data Reporting for Physical Commodity Swaps).
- Speculative commodity position limits (see Practice Note, The Dodd-Frank Act: Commodity Position Limits).
- Duties of swap dealers (SDs) and major swap participants (MSPs) included in subpart J of CFTC Regulations Part 23, which includes regulations that address monitoring position limits, diligent supervision, business continuity and disaster recovery, conflicts of interest policies and procedures and general information regarding the availability of records for disclosure and inspection.
- Recordkeeping for trade options if the counterparty is an SD or MSP (see Practice Note, US Derivatives Regulation: CFTC Swap Data Reporting and Recordkeeping Rules).
- CFTC recordkeeping requirements explicitly contained in 17 CFR 45.2, which require, among other things, the retention of full, complete and systematic records on each transaction as well as compliance with general recordkeeping requirements, which govern, among other things, the maintenance of records and their availability.
- Capital and margin requirements applicable to SDs and MSPs.
- Prohibitions on manipulation, fraud, abusive practices applicable to swaps specifically, as well as the antifraud and enforcement provisions of the CEA (see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives: Non-security-based Swap Antifraud Rules).
For more information on the mechanics and other basics of commodity options, see Practice Notes, Derivatives: Overview (US): Options and Derivatives: Commercial Uses.
Data Reporting for Trade Options
Trade options are subject to either swap data reporting, as described in CFTC Regulations Part 45 (SDR reporting), or the filing a CFTC Form TO, depending on the entity type and entity type of its counterparty. Section 32.3(b)(1) of the CFTC Regulations generally requires entities to report trade options in the same manner as other swaps under Part 45, if, during the 12 months preceding the trade option, the entity has been obligated to report under Part 45.
All trade options not otherwise reported under Part 45 must be reported by both parties on the annual Form TO.
However, under subsequent no-action guidance,the CFTC has exempted non-SDs and non-MSPs from reporting trade options under Part 45, if they:
- Report otherwise unreported trade options on Form TO. Functionally, only trade options to which both counterparties are neither SDs or MSPs will be otherwise unreported, and therefore required to be included on the Form TO of the non-SD or non-MSP.
- Notify the CFTC's Division of Market Oversight (DMO) through e-mail at the address [email protected] within 30 days of reaching an aggregate notional value of trade options of $1 billion.
This will result in a reporting structure that requires:
- SDs and MSPs to report trade options, along with other swaps, in a accordance with Part 45 requirements.
- Non-SDs and non-MSPs that enter into trade options with SDs and MSPs obtain and transmit an LEI number to the SD or MSP counterparty for inclusion in the SD's or MSP's Part 45 reporting. These trade options need not be reported in the non-SD or no-MSP's Form TO. For information on LEIs and their temporary replacements, CICIs and GMEIs, see Practice Note, US Derivatives Regulation: Practical Guide to Over-the-Counter (OTC) Swap Data Reporting: CFTC Reporting Compliance: Creation Data Reporting Under Part 45.
- Non-SDs and non-MSPs that enter into trade options with other non-SDs or non-MSPs to report all such trade options on their annual Form TOs by March 1 of the year following the year in which the trade option was entered into.
- Non-SDs and non-MSPs to notify the DMO within 30 days of entering into trade options with an aggregate notional value above $1 billion via e-mail at the address [email protected].
For details on swap data reporting under Part 45 (SDR reporting), see Practice Notes, US Derivatives Regulation: Practical Guide to Over-the-Counter (OTC) Swap Data Reporting and US Derivatives Regulation: CFTC Swap Data Reporting and Recordkeeping Rules: Final "SDR" Data Reporting Rules.