Alert August 21, 2012

CFTC Grants Temporary No-Action Relief to Persons Eligible for the Trade Option Exemption

The CFTC issued a no-action letter granting temporary relief to persons eligible for the “trade option exemption” from certain CFTC regulations. The relief relates to final regulations on commodity options issued by the CFTC in April 2012. Because commodity options were governed by a regime that predated the Dodd-Frank Act, the final regulations included a final rule that generally subjects commodity options to the Dodd-Frank regime by permitting market participants to trade commodity options subject to the same rules applicable to other types of swaps. However, the final regulations also included an interim final rule that provides for a trade option exemption from several of the general swaps rules for certain physical delivery commodity options, subject to certain conditions.

A “trade option” is a commodity option transaction used by a commercial entity solely for purposes relating to its business involving the commodity. For example, a producer of a particular commodity might enter into a trade option to hedge against a decline in the price of that commodity. Trade options were largely unregulated prior to Dodd-Frank, but were included in Dodd-Frank’s definition of “swap” and therefore are subject to applicable CFTC regulations.  The interim final rule, however, would shield trade options from many of those regulations.  As stated in the release for the final regulations, “Trade options would not contribute to, or be a factor in, the determination of whether a market participant is [a swap dealer or major swap participant]; trade options would be exempt from the rules on mandatory clearing; and trade options would be exempt from the rules related to real-time reporting of swap transactions. However, trade options would still be considered for large trader reporting and position limits regulations, and swap dealers and major swap participants would need to count trade options for purposes of their capital and margin requirements. Finally, trade options would still be subject to antifraud and anti-manipulation rules.

Under the interim final rule, the relief discussed above would be granted if the “offeror,” or the seller of the commodity option, is either an eligible contract participant or a producer, processor, or commercial user of, or a merchant handling, the commodity which is the subject of the commodity option transaction, and is entering into the transaction solely for purposes related to its business as such. Furthermore, the offeror must have a reasonable basis for believing that the “offeree,” or the buyer of the commodity option, is a producer, processor, or commercial user of, or a merchant handling, the commodity which is the subject of the commodity option transaction, and entering into the transaction solely for purposes related to its business as such. Finally, both parties must intend that the commodity option be physically settled. Persons seeking to avail themselves of this relief must meet certain recordkeeping and reporting requirements.

Because the trade option exemption was crafted largely in response to comments on the proposed commodity option rule, the CFTC classified it as an “interim final rule,” rather than a final rule, and solicited public comment. It asked a number of questions in the rule release, requesting feedback on such matters as whether the interim final rule provides “an appropriate regulatory framework for trade options,” inquiring as to the trade option exemption’s likely market impact, asking whether the specific requirements of the exemption were appropriate, and so on.

A footnote in the rule release noted that the product definition rules, which had not yet been released, “will address the determination of whether a commodity option or a transaction with optionality is subject to the swap definition in the first instance. If a commodity option or a transaction with optionality is excluded from the scope of the swap definition…the final rule and/or interim final rule adopted herein are not applicable.”  However, when the product definition rules were ultimately published, they did not definitively settle the matter. Rather, although the product definition rules stated that certain “forwards with embedded volumetric optionality” (that is, forwards that are settled by physical delivery and in which customer demand for the underlying commodity may be variable) would be excluded from the swap definition, it also requested public comment about its interpretation, indicating the potential for further rulemaking or interpretive guidance on the subject.

In light of this uncertainty, the CFTC decided to issue no-action relief regarding the conditions of the trade option exemption to reduce the compliance burden on those intending to avail themselves of the trade option exemption while the CFTC reviews, together, comments on both the trade option exemption and on forwards with embedded volumetric optionality.

Although the no-action relief requires those utilizing the trade option exemption to comply with the position limits rules and antifraud and anti-manipulation rules as specified in the interim final rule, it does not require them to comply with the interim final rule’s various recordkeeping and reporting requirements, nor does it require swap dealers and major swap participants utilizing the exemption to comply with capital and margin requirements pertaining to swaps subject to the exemption. Only those parties eligible to use the trade option exemption may benefit from the relief.

The no-action relief expires on the earlier of (1) December 31, 2012 or (2) the effective date of any final rule, interpretation, or order taken by the CFTC regarding the trade option exemption interim final rule.