The Commodity Exchange Act, 15 U.S.C.§ 6a(a), authorizes the Commodities Futures Trading Commission to “proclaim and fix such limits on the amounts of trading which may be done or on positions that may be held” of commodities in which “excessive speculation” has caused “sudden or unreasonable fluctuations or unwarranted changes in the price” of the commodity. Once those limits are established, § 6a(b) makes it unlawful to “directly or indirectly to hold or control a net long or a net short position in any commodity for future delivery… in excess of any position limit fixed by the Commission for or with respect to such commodity.” “Bona fide hedging transactions or positions,” however, are exempt from this rule [§ 6a(c)].
For corn, oats, wheat, soybeans, soybean oil, soybean meal, and cotton, the CFTC specifies the maximum position that one person can hold in a single month or in all months. The size of positions is denominated in contract units or contracts, which are relatively large quantities of a commodity by mass.
Position limits are supposed to be determined by formula for each commodity class. The determinative factor in this formula is the previous calendar year’s average combined futures and delta-adjusted option month-end open interest. If that number is less than 25,000 contract units, the position limit is set at 10% of it. If the previous year’s average month-end interest is greater than 25,000 contract units, the position limit is 2,500 plus 2.5% of however much the average month-end interest is greater than 25,000. If the previous year’s average month-end open interest was 10,000 contract units, for example, then the formula would set a position limit of 1,000. If the previous year’s average month-end open interest was 200,000 contract units, the formula would set 2,500 for the first 25,000 contract units and 4,375 for the rest (2.5% of 175,000), for a combined 2,500 + 4,375 = 6,875 contract units.
A spot month is the month in which a futures contract matures and becomes deliverable. Because physical delivery is required in that month, excessive positions and disorderly trading practices can be particularly disruptive. In consequence, position limits are stricter in the spot month. The Commission’s Acceptable Practices Principle 5 provides that the position limits specified for the spot month should be determined according to an analysis of deliverable supplies and the history of spot month liquidations. Cash-settled markets should have spot-month position limits at a level no greater than necessary to minimize potential manipulation. These guidelines are codified in a formula, which sets the spot-month position limit at 25% of the estimated deliverable supply at the futures delivery point. If the deliverable supply for an entire crop year of corn futures is 12 million bushels, for example, then 25% of this amount is 3 million bushels. Each corn futures contract, meanwhile, represents 5,000 bushels. Dividing 3 million by 5,000 gives the spot month position limit of 600 contract units.
Single-month and all-month limits have been in place since December 2005, notwithstanding that agricultural futures contracts have seen significant growth since that time. Spot month limits, in the meantime, have not increased since 1999. The exchange markets are therefore operating under position limits that are significantly stricter than they would if current data were properly used in the formulas.
For commodities other than those specified in the table, CFTC authorizes the exchanges to set their own position limits. On these commodities, the exchanges can impose, in lieu of position limits, “position accountability” requirements,[1] which allow the exchanges to ask high-volume traders for information related to the hedging and strategic nature of a heavy position. This information facilitates detection of attempts at market manipulation.
Hedging Exemptions
One function of futures markets is to allow commodity holders that are averse to the risk of price movements in their held commodity to transfer that risk to firms or individuals who are tolerant of such risk. This transfer of risk occurs through a “hedge,” in which as-yet-unproduced commodity units are sold at current market prices. The buyer of a hedge—often referred to as a speculator—bears the pricing risk, basically betting that the commodity will increase in price.
Because they transfer risk to the most efficient holders, hedges constitute value-adding transactions. The CFTC therefore exempts “bona fide hedgings” from position limits. “Bona fide hedgings” are defined in 17 C.F.R. 1.3(z)(1) as those transactions or positions that “normally represent a substitute for transactions to be made or positions to be taken at a later time in a physical marketing channel” that are “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise.” As provided in 17 C.F.R. 1.3(z)(1), “no transactions or position will be classified as bona fide hedging...unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices.” In other words, a hedge must 1) reduce risk and 2) involve a change in the hedger’s assets or liabilities. In the event that an exemption is given, the exempted firm cannot take a limitless position; it just faces a higher position limit. Some exchanges disable or restrict hedging exemptions in the last few days of a delivery month.
17 C.F.R. 1.45 allows the CFTC to grant exemptions for spreads, straddles, arbitrage positions, and other positions consistent with the function of futures markets. The CFTC periodically reviews how exchanges grant exemptions. 17 CFR 19 requires that firms that violate a position limit file a report with the CFTC documenting the violation.
Definition of a Person
Responsibility for futures-market manipulation is often distributed across multiple firms or entities working in collusion. If these colluding entities were treated as multiple persons for the purposes of position limits, it would defeat the purposes of the Commodity Exchange Act. Commodity Exchange Act § 6a therefore provides that any persons or entities working jointly or pursuant to an agreement in holding a regulated commodity will be considered a single “person” for the purposes of position limits.
In terms of joint ownership, two (or more) holders of commodity interests are treated as a single person for compliance with position limits if one holder has a 10 percent or greater financial interest in the other. The size of a person’s interest is not determined proportionally by the person’s fractional stake in the holder – the person is treated as owning the whole of the holder’s position. For example, if firm B has a position of 600 contract units in corn, and person A has a 50% ownership stake in firm B, person A is treated as having a position of 600 contract units, rather than 300 contract units. Similarly, two or more separately-owned firms acting pursuant to an express or implied agreement are treated as a single person for the purposes of position limits.
The CFTC treats a pool of traders as a single trader. Limited partners and pool participants that have no knowledge of or control over the positions of the pool are exempt from this aggregation rule, as are commodity pool operators or commodity trading advisors with commonly-owned but independently-controlled positions.
[1] See 56 Fed. Reg. 51687 (Oct. 15, 1991) (Notice of proposed exchange rule changes; request for comments).