CFTC Proposed Interpretation: Forward Contracts with Volumetric Optionality

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Gavel.png FINAL RULE: This page refers to the proposed rulemaking on Volumetric Optionality. For a summary of the final rule, click here.
Dodd-Frank Timeline, Swap Product Definitions
Proposed Interpretation Comment Deadline Final Interpretation
November 20, 2014 December 22, 2014 TBA

On November 3, 2014, the CFTC proposed an interpretation and clarification of the CFTC/SEC Joint Final Rule on Swap Product Definitions, July 2012 that would clarify whether certain swaps with "volumetric optionality" should be considered swaps.[1] The proposal entered the Federal Register on November 20, 2014, and the deadline for public comment is December 22, 2014. Comments may be filed HERE.

Background

Title VII of the Dodd-Frank Act gives the SEC jurisdiction over "security-based" swaps, and jurisdiction to the CFTC on all other swaps, except for a category known as "mixed swaps" which may have both security-based and non-security-based components. For mixed swaps, the two agencies will have joint oversight responsibilities. Dodd-Frank required that the two agencies, in consultation with the Federal Reserve, further define the terms. A joint final rule on entity definitions, including "swap dealer," "major swap participant" and "eligible contract participant" was released in 2012. Under the rule, forward contracts for non-financial commodities were ruled as "not swaps," in a manner consistent with the CFTC’s historical interpretation of the existing forward exclusion with respect to futures contracts.

The joint final rule, however, did not address the issue of certain forward contracts with "volumetric optionality" - forward contracts that provide for variations in delivery amount would be considered a forward contract rather than a swap. In past guidance, so-called "price optionality" have been ruled as forwards, but certain contracts such as energy contracts, some forwards are priced with volumetric optionality, and the persons who trade is such forwards believe these contracts should be treated in similar fashion.


The Proposed Interpretation

The CFTC's proposed interpretation has set forth seven elements that clarify when such a contract would be considered a forward, and thus excluded from certain swap rules under the Dodd-Frank Act:[2]

  1. The embedded optionality does not undermine the overall nature of the agreement, contract, or transaction as a forward contract;
  2. The predominant feature of the agreement, contract, or transaction is actual delivery;
  3. The embedded optionality cannotbe severed and marketed separately from the overall agreement, contract, or transaction in which it is embedded;
  4. The seller of a nonfinancialcommodity underlying the agreement, contract, or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction to deliver the underlying nonfinancial commodity if the embedded volumetric optionality is exercised;
  5. The buyer of a nonfinancial commodity underlying the agreement, contract or transaction with embedded volumetric optionality intends, at the time it enters into the agreement, contract, or transaction, to take delivery of the underlying nonfinancial commodity if the embedded volumetric optionality is exercised;
  6. Both parties are commercial parties; and
  7. The embedded volumetric optionality is 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.

The proposal clarifies the fourth and fifth elements to include both puts and calls. Also, with regard to the seventh element, commenters from the initial interpretation stressed that many commercial parties are often unable to accurately predict exact delivery needs or production capacity, but would like to utilize forward contracts to mitigate risk. The seventh element ensures that any embedded volumetric optionality must primarily be intended as a means of assuring a supply source or providing delivery flexibility.

For more information on the CFTC's final rule on product definitions, including a summary table, click HERE

Related Documents: Fact Sheet, Federal Register Entry

References

  1. CFTC to Hold an Open Commission Meeting on November 3rd. CFTC. Retrieved on November 21, 2014.
  2. Forward Contracts with Embedded Volumetric Optionality. CFTC. Retrieved on November 21, 2014.

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