CFTC Staff Letter 12-19: Interpretation of Bona Fide Hedging in Regulation 4.5

U.S. COMMODITY FUTURES TRADING COMMISSION
Three Lafayette Centre
1155 21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5977
Facsimile: (202) 418-5407 gbarnett@cftc.gov
Division of Swap Dealer and
Intermediary Oversight
Gary Barnett
Director
CFTC Letter No. 12-19
Interpretation
October 12, 2012
Division of Swap Dealer and Intermediary Oversight Re: Interpretation of Bona Fide Hedging in Commission Regulation 4.5: Restatement of Terms Incorporated by Reference Ladies and Gentlemen:
This letter is in response to requests from multiple parties received by the Division of Swap Dealer and Intermediary Oversight (“Division”) of the Commodity Futures Trading Commission (“Commission”) requesting clarification regarding the bona fide hedging exclusion from the threshold calculation of Commission Regulation 4.5. On February 24, 2012, the Commission adopted amendments to Commission Regulation
4.5 in the release “Commodity Pool Operators and Commodity Trading Advisors: Compliance
Obligations.”1
The Commission amended Regulation 4.5 to include, among other things, a commodity interest trading threshold above which the operator of a registered investment company would be included within the definition of commodity pool operator (“CPO”). 2

Specifically, these commodity interest trading thresholds were established as an aggregate initial margin of 5 percent of the liquidation value of the pool’s portfolio, or a notional exposure of 100 percent of the liquidation value of the pool’s portfolio. The release excluded from the calculation of these thresholds any positions that would qualify as “bona fide hedging” within the “meaning and intent” of Commission Regulations 1.3(z)(1) and 151.5, regulations defining “bona fide hedging” for the separate purpose of exclusion from position limits for futures and swaps. Following the adoption of amended 4.5, the position limits rule that promulgated Commission Regulation 151.5, and amended Commission Regulation 1.3(z)(1), was vacated by a court of law. See International Swaps & Derivatives Ass’n v. CFTC, _ F. Supp. 2d. _, 2012 WL 4466311 (D.D.C. Sept. 28, 2012) (“ISDA”). However, the context indicates, that, in promulgating amended Regulation 4.5, the Commission intended to incorporate the substance of amended Regulation 1.3(z)(1) and new Regulation 151.5 as an exception to the trading threshold

1
77 FR 11252 (Feb. 24, 2012); correction 77 FR 17328 (March 26, 2012).
2
17 CFR 4.5(c)(2)(iii)(A) and 17 CFR 4.5(c)(2)(iii)(B).

test in Commission Regulation 4.5(c)(2)(iii), independently of whether amended Regulation 1.3(z)(1) and Regulation 151.5 remain effective in connection with position limits. This intent of the Commission is not inconsistent with the judgment in ISDA, because the appropriate standard for bona fide hedging in the context of the definition of a CPO was not before the court in that case and the court’s decision did not purport to address the issue. 3

Accordingly, the Division interprets Commission Regulations 4.5(c)(2)(iii)(A) and (B) as continuing to incorporate the substance of amended Commission Regulation 1.3(z)(1) and Commission Regulation 151.5, for purposes of that provision. The Division further states that, in any event, the Division will not recommend that the Commission commence an enforcement action against any person based on any application of the trading threshold test of Commission Regulation 4.5(c)(2)(iii) that excludes transactions falling within the substance of amended Commission Regulations 1.3(z)(1) and 151.5. 4

By this guidance, the Division restates those terms that were incorporated by reference in the adopting release for Commission Regulation 4.5, which are as follows 5 :
Commission Regulation 1.3(z)(1)
(z) Bona fide hedging transactions and positions for excluded commodities. (1) General definition. Bona fide hedging transactions and positions shall mean any agreement, contract or transaction in an excluded commodity on a designated contract market or swap execution facility that is a trading facility, where such transactions or positions normally represent a substitute for transactions to be made or positions to be taken at a later time in a physical marketing channel, and where they are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, and where they arise from:
(i) The potential change in the value of assets which a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising, (ii) The potential change in the value of liabilities which a person owns or anticipates incurring, or (iii) The potential change in the value of services which a person provides, purchases, or anticipates providing or purchasing.

3 The provisions of Commission Regulation 151.5 defined “bona fide hedging” only with respect to certain “Referenced Contracts.” These contracts, to be included for purposes of defining bona fide hedging in Commission Regulation 151.5, were enumerated in Commission Regulation 151.2; the terms of which the Commission implicitly also adopted by reference. Commission Regulation 151.2 was also subject to vacatur. Accordingly, the terms of vacated Commission Regulation 151.2 will, as will the terms of Commission Regulation 151.5, be restated infra in separate sections. 4 See generally 17 C.F.R. § 140.99. 5 The sections below are restatements of Commission Regulations 1.3(z)(1), 151.5, and 151.2 as they existed prior to vacatur, and as incorporated by reference by the Commission in Commission Regulation 4.5.

(iv) Notwithstanding the foregoing, no transactions or positions shall 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 and, for transactions or positions on contract markets subject to trading and position limits in effect pursuant to section 4a of the Act, unless the provisions of paragraphs (z)(2) and (3) of this section have been satisfied. Commission Regulation 151.5 Bona fide hedging and other exemptions for Referenced Contracts. (a) Bona fide hedging transactions or positions. (1) Any person that complies with the requirements of this section may exceed the position limits set forth in § 151.4 to the extent that a transaction or position in a Referenced Contract:
(i) Represents a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel; (ii) Is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise; and (iii) Arises from the potential change in the value of one or several— (A) Assets that a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising; (B) Liabilities that a person owns or anticipates incurring; or (C) Services that a person provides, purchases, or anticipates providing or purchasing; or (iv) Reduces risks attendant to a position resulting from a swap that— (A) Was executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction pursuant to paragraph (a)(1)(i) through (iii) of this section; or (B) Meets the requirements of paragraphs (a)(1)(i) through (iii) of this section. (v) Notwithstanding the foregoing, no transactions or positions shall be classified as bona fide hedging for purposes of § 151.4 unless such transactions or positions are established and liquidated in an orderly manner in accordance with sound commercial practices and the provisions of paragraph (a)(2) of this section regarding enumerated hedging transactions and positions or paragraphs (a)(3) or (4) of this section regarding pass-through swaps of this section have been satisfied.

(2) Enumerated hedging transactions and positions. Bona fide hedging transactions and positions for the purposes of this paragraph mean any of the following specific transactions and positions:
(i) Sales of Referenced Contracts that do not exceed in quantity:
(A) Ownership or fixed-price purchase of the contract's underlying cash commodity by the same person; and (B) Unsold anticipated production of the same commodity, which may not exceed one year of production for an agricultural commodity, by the same person provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (ii) Purchases of Referenced Contracts that do not exceed in quantity:
(A) The fixed-price sale of the contract's underlying cash commodity by the same person; (B) The quantity equivalent of fixed-price sales of the cash products and by-products of such commodity by the same person; and (C) Unfilled anticipated requirements of the same cash commodity, which may not exceed one year for agricultural Referenced Contracts, for processing, manufacturing, or use by the same person, provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (iii) Offsetting sales and purchases in Referenced Contracts that do not exceed in quantity that amount of the same cash commodity that has been bought and sold by the same person at unfixed prices basis different delivery months, provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (iv) Purchases or sales by an agent who does not own or has not contracted to sell or purchase the offsetting cash commodity at a fixed price, provided that the agent is responsible for the merchandising of the cash positions that is being offset in Referenced Contracts and the agent has a contractual arrangement with the person who owns the commodity or holds the cash market commitment being offset. (v) Anticipated merchandising hedges. Offsetting sales and purchases in Referenced Contracts that do not exceed in quantity the amount of the same cash commodity that is anticipated to be merchandised, provided that:

(A) The quantity of offsetting sales and purchases is not larger than the current or anticipated unfilled storage capacity owned or leased by the same person during the period of anticipated merchandising activity, which may not exceed one year; (B) The offsetting sales and purchases in Referenced Contracts are in different contract months, which settle in not more than one year; and (C) No such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (vi) Anticipated royalty hedges. Sales or purchases in Referenced Contracts offset by the anticipated change in value of royalty rights that are owned by the same person provided that:
(A) The royalty rights arise out of the production, manufacturing, processing, use, or transportation of the commodity underlying the Referenced Contract, which may not exceed one year for agricultural Referenced Contracts; and (B) No such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (vii) Service hedges. Sales or purchases in Referenced Contracts offset by the anticipated change in value of receipts or payments due or expected to be due under an executed contract for services held by the same person provided that:
(A) The contract for services arises out of the production, manufacturing, processing, use, or transportation of the commodity underlying the Referenced Contract, which may not exceed one year for agricultural Referenced Contracts; (B) The fluctuations in the value of the position in Referenced Contracts are substantially related to the fluctuations in value of receipts or payments due or expected to be due under a contract for services; and (C) No such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (viii) Cross-commodity hedges. Sales or purchases in Referenced Contracts described in paragraphs (a)(2)(i) through (vii) of this section may also be offset other than by the same quantity of the same cash commodity, provided that:
(A) The fluctuations in value of the position in Referenced Contracts are substantially related to the fluctuations in value of the actual or anticipated cash position; and

(B) No such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts. (3) Pass-through swaps. Bona fide hedging transactions and positions for the purposes of this paragraph include the purchase or sales of Referenced Contracts that reduce the risks attendant to a position resulting from a swap that was executed opposite a counterparty for whom the swap transaction would qualify as a bona fide hedging transaction pursuant to paragraph (a)(2) of this section (“pass-through swaps”), provided that no such position is maintained in any physical-delivery Referenced Contract during the last five days of trading of the Core Referenced Futures Contract in an agricultural or metal commodity or during the spot month for other physical-delivery contracts unless such pass-through swap position continues to offset the cash market commodity price risk of the bona fide hedging counterparty. (4) Pass-through swap offsets. For swaps executed opposite a counterparty for whom the swap transaction would qualify as a bona fide hedging transaction pursuant to paragraph (a)(2) of this section (pass-through swaps), such pass-through swaps shall also be classified as a bona fide hedging transaction for the counterparty for whom the swap would not otherwise qualify as a bona fide hedging transaction pursuant to paragraph (a)(2) of this section (“non-hedging counterparty”), provided that the non-hedging counterparty purchases or sells Referenced Contracts that reduce the risks attendant to such pass-through swaps. Provided further, that the pass-through swap shall constitute a bona fide hedging transaction only to the extent the non￾hedging counterparty purchases or sells Referenced Contracts that reduce the risks attendant to the pass-through swap. (5) Any person engaging in other risk-reducing practices commonly used in the market which they believe may not be specifically enumerated in § 151.5(a)(2) may request relief from Commission staff under § 140.99 of this chapter or the Commission under section 4a(a)(7) of the Act concerning the applicability of the bona fide hedging transaction exemption. (b) Aggregation of accounts. Entities required to aggregate accounts or positions under §
151.7 shall be considered the same person for the purpose of determining whether a person or
persons are eligible for a bona fide hedge exemption under § 151.5(a).
(c) Information on cash market commodity activities. Any person with a position that exceeds the position limits set forth in § 151.4 pursuant to paragraphs (a)(2)(i)(A), (a)(2)(ii)(A), (a)(2)(ii)(B), (a)(2)(iii), or (a)(2)(iv) of this section shall submit to the Commission a 404 filing, in the form and manner provided for in § 151.10. (1) The 404 filing shall contain the following information with respect to such position for each business day the same person exceeds the limits set forth in § 151.4, up to and through the day the person's position first falls below the position limits:

(i) The date of the bona fide hedging position, an indication of under which enumerated hedge exemption or exemptions the position qualifies for bona fide hedging, the corresponding Core Referenced Futures Contract, the cash market commodity hedged, and the units in which the cash market commodity is measured; (ii) The entire quantity of stocks owned of the cash market commodity that is being hedged; (iii) The entire quantity of fixed-price purchase commitments of the cash market commodity that is being hedged; (iv) The sum of the entire quantity of stocks owned of the cash market commodity and the entire quantity of fixed-price purchase commitments of the cash market commodity that is being hedged; (v) The entire quantity of fixed-price sale commitments of the cash commodity that is being hedged; (vi) The quantity of long and short Referenced Contracts, measured on a futures￾equivalent basis to the applicable Core Referenced Futures Contract, in the nearby contract month that are being used to hedge the long and short cash market positions; (viii) The total number of long and short Referenced Contracts, measured on a futures equivalent basis to the applicable Core Referenced Futures Contract, that are being used to hedge the long and short cash market positions; and (viii) Cross-commodity hedging information as required under paragraph (g) of this
section.
(2) Notice filing. Persons seeking an exemption under this paragraph shall file a notice with the Commission, which shall be effective upon the date of the submission of the notice. (d) Information on anticipated cash market commodity activities —(1) Initial statement. Any person who intends to exceed the position limits set forth in § 151.4 pursuant to paragraph (a)(2)(i)(B), (a)(2)(ii)(C), (a)(2)(v), (a)(2)(vi), or (a)(2)(vii) of this section in order to hedge anticipated production, requirements, merchandising, royalties, or services connected to a commodity underlying a Referenced Contract, shall submit to the Commission a 404A filing in the form and manner provided in § 151.10. The 404A filing shall contain the following information with respect to such activities, by Referenced Contract:
(i) A description of the type of anticipated cash market activity to be hedged; how the purchases or sales of Referenced Contracts are consistent with the provisions of (a)(1) of this
section; and the units in which the cash commodity is measured;

(ii) The time period for which the person claims the anticipatory hedge exemption is required, which may not exceed one year for agricultural commodities or one year for anticipated merchandising activity; (iii) The actual use, production, processing, merchandising (bought and sold), royalties and service payments and receipts of that cash market commodity during each of the three complete fiscal years preceding the current fiscal year; (iv) The anticipated use production, or commercial or merchandising requirements (purchases and sales), anticipated royalties, or service contract receipts or payments of that cash market commodity which are applicable to the anticipated activity to be hedged for the period specified in (d)(1)(ii) of this section; (v) The unsold anticipated production or unfilled anticipated commercial or merchandising requirements of that cash market commodity which are applicable to the anticipated activity to be hedged for the period specified in (d)(1)(ii) of this section; (vi) The maximum number of Referenced Contracts long and short (on an all-months￾combined basis) that are expected to be used for each anticipatory hedging activity for the period specified in (d)(1)(ii) of this section on a futures equivalent basis; (vii) If the hedge exemption sought is for anticipated merchandising pursuant to (a)(2)(v) of this section, a description of the storage capacity related to the anticipated merchandising transactions, including:
(A) The anticipated total storage capacity, the anticipated merchandising quantity, and purchase and sales commitments for the period specified in (d)(1)(ii) of this section; (B) Current inventory; and (C) The total storage capacity and quantity of commodity moved through the storage capacity for each of the three complete fiscal years preceding the current fiscal year; and (viii) Cross-commodity hedging information as required under paragraph (g) of this
section.
(2) Notice filing. Persons seeking an exemption under this paragraph shall file a notice with the Commission. Such a notice shall be filed at least ten days in advance of a date the person expects to exceed the position limits established under this part, and shall be effective after that ten day period unless otherwise notified by the Commission. (3) Supplemental reports for 404A filings. Whenever a person intends to exceed the amounts determined by the Commission to constitute a bona fide hedge for anticipated activity in the most recent statement or filing, such person shall file with the Commission a statement that

updates the information provided in the person's most recent filing at least ten days in advance of the date that person wishes to exceed those amounts. (e) Review of notice filings. (1) The Commission may require persons submitting notice filings provided for under paragraphs (c)(2) and (d)(2) of this section to submit such other information, before or after the effective date of a notice, which is necessary to enable the Commission to make a determination whether the transactions or positions under the notice filing fall within the scope of bona fide hedging transactions or positions described under paragraph (a) of this section. (2) The transactions and positions described in the notice filing shall not be considered, in
part or in whole, as bona fide hedging transactions or positions if such person is so notified by
the Commission.
(f) Additional information from swap counterparties to bona fide hedging transactions. All persons that maintain positions in excess of the limits set forth in § 151.4 in reliance upon the exemptions set forth in paragraphs (a)(3) and (4) of this section shall submit to the Commission a 404S filing, in the form and manner provided for in § 151.10. Such 404S filing shall contain the following information with respect to such position for each business day that the same person exceeds the limits set forth in § 151.4, up to and through the day the person's position first falls below the position limit that was exceeded:
(1) By Referenced Contract;
(2) By commodity reference price and units of measurement used for the swaps that would qualify as a bona fide hedging transaction or position gross long and gross short positions; and (3) Cross-commodity hedging information as required under paragraph (g) of this section. (g) Conversion methodology for cross-commodity hedges. In addition to the information required under this section, persons who avail themselves of cross-commodity hedges pursuant to (a)(2)(viii) of this section shall submit to the Commission a form 404, 404A, or 404S filing, as appropriate. The first time such a form is filed where a cross-commodity hedge is claimed, it should contain a description of the conversion methodology. That description should explain the conversion from the actual commodity used in the person's normal course of business to the Referenced Contract that is being used for hedging, including an explanation of the methodology used for determining the ratio of conversion between the actual or anticipated cash positions and the person's positions in the Referenced Contract. (h) Recordkeeping. Persons who avail themselves of bona fide hedge exemptions shall keep and maintain complete books and records concerning all of their related cash, futures, and swap positions and transactions and make such books and records, along with a list of pass￾through swap counterparties for pass-through swap exemptions under (a)(3) of this section, available to the Commission upon request.

(i) Additional requirements for pass-through swap counterparties. A party seeking to rely upon § 151.5(a)(3) to exceed the position limits of § 151.4 with respect to such a swap may only do so if its counterparty provides a written representation ( e.g., in the form of a field or other representation contained in a mutually executed trade confirmation) that, as to such counterparty, the swap qualifies in good faith as a bona fide hedging transaction under paragraph (a)(3) of this
section at the time the swap was executed. That written representation shall be retained by the
parties to the swap for a period of at least two years following the expiration of the swap and furnished to the Commission upon request. Any person that represents to another person that the swap qualifies as a pass-through swap under paragraph (a)(3) of this section shall keep and make available to the Commission upon request all relevant books and records supporting such a representation for a period of at least two years following the expiration of the swap. (j) Financial distress exemption. Upon specific request made to the Commission, the Commission may exempt a person or related persons under financial distress circumstances for a time certain from any of the requirements of this part. Financial distress circumstances are situations involving the potential default or bankruptcy of a customer of the requesting person or persons, affiliate of the requesting person or persons, or potential acquisition target of the requesting person or persons. Such exemptions shall be granted by Commission order. Commission Regulation 151.2 Core Referenced Futures Contracts. (a) Agricultural commodities. Core Referenced Futures Contracts in agricultural commodities include the following futures contracts and options thereon:
(1) Core Referenced Futures Contracts in legacy agricultural commodities:
(i) Chicago Board of Trade Corn (C);
(ii) Chicago Board of Trade Oats (O);
(iii) Chicago Board of Trade Soybeans (S);
(iv) Chicago Board of Trade Soybean Meal (SM); (v) Chicago Board of Trade Soybean Oil (BO); (vi) Chicago Board of Trade Wheat (W); (vii) ICE Futures U.S. Cotton No. 2 (CT); (viii) Kansas City Board of Trade Hard Winter Wheat (KW); and (ix) Minneapolis Grain Exchange Hard Red Spring Wheat (MWE). (2) Core Referenced Futures Contracts in non-legacy agricultural commodities:
(i) Chicago Mercantile Exchange Class III Milk (DA); (ii) Chicago Mercantile Exchange Feeder Cattle (FC); (iii) Chicago Mercantile Exchange Lean Hog (LH); (iv) Chicago Mercantile Exchange Live Cattle (LC); (v) Chicago Board of Trade Rough Rice (RR); (vi) ICE Futures U.S. Cocoa (CC); (vii) ICE Futures U.S. Coffee C (KC);

(viii) ICE Futures U.S. FCOJ-A(OJ);
(ix) ICE Futures U.S. Sugar No. 11 (SB); and
(x) ICE Futures U.S. Sugar No. 16 (SF).
(b) Metal commodities. Core Referenced Futures Contracts in metal commodities include the following futures contracts and options thereon:
(1) Commodity Exchange, Inc. Copper (HG);
(2) Commodity Exchange, Inc. Gold (GC);
(3) Commodity Exchange, Inc. Silver (SI);
(4) New York Mercantile Exchange Palladium (PA); and (5) New York Mercantile Exchange Platinum (PL). (c) Energy commodities. The Core Referenced Futures Contracts in energy commodities include the following futures contracts and options thereon:
(1) New York Mercantile Exchange Henry Hub Natural Gas (NG); (2) New York Mercantile Exchange Light Sweet Crude Oil (CL); (3) New York Mercantile Exchange New York Harbor Gasoline Blendstock (RB); and (4) New York Mercantile Exchange New York Harbor Heating Oil (HO). Therefore, despite the vacatur of Commission Regulation 151.5 and the amendments to Commission Regulation 1.3(z)(1), the Division reaffirms that the provisions of Commission Regulation 4.5 permit any operator of a registered investment company to exclude from the trading thresholds calculation any transaction that satisfies the definition of “bona fide hedging” as those definitions appear as restated above. This letter, and the positions taken herein, represent the view of this Division only, and do not necessarily represent the position or view of the Commission or of any other office or division of the Commission. The interpretation issued by this letter does not excuse any registrant from compliance with any other applicable requirements contained in the Act or in the Commission’s regulations issued thereunder. Should you have any questions, please do not hesitate to contact Amanda Olear, Special Counsel, at 202-418-5283 or Michael Ehrstein, Attorney Advisor, at 202-418-5957. Very truly yours, Gary Barnett