Number: 3-92
Date: August 2004

SPECULATIVE LIMITS, HEDGING, AND AGGREGATION IN
COMMODITY FUTURES AND OPTIONS

To protect futures markets from excessive speculation that can cause unreasonable or unwarranted price fluctuations, the Commodity Exchange Act (CEA) authorizes the CFTC (Commission) to impose limits on the size of speculative positions in futures markets. Furthermore, exchanges are required by CFTC rule 150.5 to adopt speculative limit rules for certain other contracts not subject to CFTC speculative limits.

There are three basic elements to the regulatory framework for speculative position limits. They are:

This Backgrounder covers the current rules and policies for speculative position limits, hedging, and aggregation as they apply to commodity futures and options. Attached is a guide to the speculative limit levels that apply to major markets.

Speculative Position Limits

The CEA, §4a(a), specifically holds that excessive speculation in a commodity traded for future delivery may cause "sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity." That section provides that, for the purpose of diminishing, eliminating, or preventing such problems, the Commission may fix limits on the amount of speculative trading that may be done or speculative positions that may be held in contracts for future delivery.

All agricultural and natural resource and many financial futures and option contracts are subject to speculative position limits. For several markets (corn, oats, wheat, soybeans, soybean oil, soybean meal, and cotton), the limits are determined by the Commission and set out in Federal regulations. For all other markets, the limits are determined by the exchanges according to standards established by the Commission. Violations of exchange-set limits are subject to exchange disciplinary action, and the Commission may institute enforcement action against violations of exchange speculative limit rules that have been approved by the Commission.

The Commission does not require that exchanges set position-limit levels for markets that have Federal speculative limits or for markets in major foreign currencies. For all other markets, acceptable speculative-limit levels typically combine futures and options on a delta-adjusted basis, as well as set absolute levels for gross option positions. For new markets, exchanges are required to set the initial position-limit levels for non-spot months at a minimum of 1,000 contracts for tangible commodities and 5,000 contracts for financial and energy markets. For existing markets, reasonable single-month and all-months-combined limits are generally no larger than 10 percent of the open interest up to a level of 25,000 contracts, with a marginal increase of 2.5 percent after that.

Speculative limits in physical-delivery markets are generally set at a lower level during the spot month (the month when the futures contract matures and becomes deliverable). Lower limits in the spot month are important because that is when physical delivery may be required and when the contract may be more vulnerable to price fluctuation caused by abnormally large positions or disorderly trading practices.

The Commission requires that spot-month levels for physical-delivery markets be based upon an analysis of deliverable supplies and the history of spot-month liquidations. Specifically the spot-month limits for physical-delivery markets must be no more than 25 percent of the deliverable supply. For cash-settled markets, spot-month position limits should be no greater than necessary to minimize the potential for manipulation or distortion of the contract’s or the underlying commodity’s price.

After 12 months of trading, exchanges are permitted to replace position limits with "accountability" rules for qualifying contracts on financial instruments, intangible commodities, or certain tangible commodities. In order to qualify for accountability rules, these markets must meet requirements with respect to average month-end open interest and average daily volume and have a highly liquid cash market. If a market has accountability rules, a trader—whether speculating or hedging—is not subject to a specific limit. Once a trader reaches a preset accountability level, however, he must provide information about his positions upon request by the exchange. Depending upon the size of the market and type of commodity, any trader over the accountability level must also consent to stop increasing his position if so ordered by the exchange. (The specific requirements that exchanges must meet in order to adopt accountability rules are set out in Commission Rule 150.5(e).)

Exemptions

The Commission and exchanges grant exemptions to their position limits for bona fide hedging (as defined in Commission Rule 1.3(z)). A hedge is a futures or option transaction or position that normally represents a substitute for transactions to be made or positions to be taken at a later time in a physical marketing channel. Hedges must be economically appropriate to the reduction of risk for a commercial enterprise and must arise from a change in the value of hedger's (current or anticipated) assets or liabilities.

A short hedge, for example, includes sales for future delivery (short futures positions) that do not exceed the amount of the commodity that the seller owns, has agreed to purchase (for a fixed price), or anticipates producing during the next 12 months. A long hedge includes long futures positions that do not exceed the hedger's fixed-price sales or 12 months' unfilled anticipated requirements for processing or manufacturing.

There are a number of technical provisions relating to eligibility for hedge exemptions, including the treatment of cross hedging and applications to the Commission for case-by-case exemptions in special circumstances. There is also the important requirement, that: "… 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. …" [Commission Rule 1.3(z), emphasis added].

Exchanges may also grant exemptions for spreads, straddles, or arbitrage, or other exemptions that are consistent with the purposes of position-limit rules. The Commission requires that exchanges establish a program for traders to apply for these exemptions and be granted a specific exemption level higher than the applicable speculative limit rather than simply be granted a limitless hedge exemption. Exchanges sometimes disallow or place severe restrictions on exemptions during the last several days of trading in a delivery month. The Commission periodically reviews how each exchange grants exemptions, how it monitors compliance with its limits, and what types of regulatory action (warnings, fines, trading suspensions, etc.) the exchange takes once a violation of a position limit or exemption is detected.

In the several markets with Federal limits, hedgers must file a report with the Commission if their futures/option positions exceed the speculative position limits (see Commission Rules Part 19). That report must be filed monthly or in response to a request by the Commission. It shows the trader’s positions in the cash market and is used to check whether the trader has sufficient cash position to justify futures/option positions in excess of the speculative position limits.

Aggregation Requirements

In order to achieve the intended effect of the speculative position limits, the Commission and the exchanges treat multiple positions that are subject to common ownership or control as if they were a single trader. Accounts are considered to be under common ownership if there is a 10 percent or greater financial interest. The rules are applied in a manner calculated to aggregate related accounts. For example, each participant with a 10 percent or greater interest in a partnership account must aggregate the entire position of the partnership—not just their fractional share—together with whatever positions they may hold separately from the partnership. Likewise, a pool comprised of many traders is allowed only to hold positions as if it were a single trader. The Commission also treats accounts that are not otherwise related, but are acting pursuant to an express or implied agreement, as a single aggregated position for purposes of applying the limits.

There are narrow exceptions to the aggregation rules for limited partners and pool participants that have no knowledge of, or control over, the positions of the pool. Also exempted are commodity pool operators or commodity trading advisors with commonly-owned but independently-controlled market positions. Entities claiming this exemption are required, upon call by the Commission, to provide information supporting their claim that the account controllers for these positions are acting completely independently of each other (see table below).

GUIDE TO SPECULATIVE POSITION LIMITS (See Note 1)

For Major Futures/Option Markets (in contracts)

NOTE 1: This table is only a general guide to speculative position limits and includes futures/option markets that had a combined open interest of approximately 10,000 contracts or greater recently. The limits are subject to change. They are generally based upon "futures equivalent" positions, i.e., futures plus delta-adjusted options. There may be separate limits on gross option positions. The "spot month" is defined in many different ways, but generally refers to the nearest futures month beginning on a date near the first business day of the month in which the futures expires or on a date near the first day that delivery notices can be tendered. Some spot-month limits apply to both hedge and speculative positions. For the current rules and interpretations, see Commission Rules Part 150 and consult the appropriate exchange.

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