In another move that reduces derivative-related burdens for commercial end-users, regulators recently amended the Dodd-Frank Act’s trade option exemption to eliminate reporting and recordkeeping requirements for companies using commodity trade options to hedge business risk.
The options are primarily used in the agricultural, energy and manufacturing sectors where the intent is to deliver the underlying commodity, unlike with financial options. Physical delivery is so crucial a feature that a company failing to deliver a commodity according to the contractual time and amount commonly reimburses its counterparty for any related losses–for example, if an energy company’s customer must purchase energy from an alternative, more costly source.
Recognizing that commercial end-users’ derivative activities provide minimal systemic risk, federal regulators have reduced or eliminated numerous requirements that apply to swap dealers (SD) and major swap participants (MSP), such as clearing and margin requirements.
“Today, the CFTC (Commodity Futures Trading Commission) has taken another important step to address the concerns of commercial end-users who rely on the derivatives markets to hedge risk—and who, we should always remember, did not cause the financial crisis,” said CFTC Chairman Timothy Massad in a statement.
The CFTC’s decision March 16 eliminates end-users’ obligation to report trade options to a swap data repository as well as on Form TO, which itself was a streamlined form designed to reduce the burden on end-users while still providing some information to regulators. The amendment also ends the swap-related recordkeeping requirements for these end-users in connection with their trade option activities, although a legal entity identifier will still be necessary when transacting in trade options with an SD or MSP.
Matt Hoffman, director, global regulatory solutions at Chatham Financial, noted that as with financial derivatives, the values of trade options rise and fall with the values of the underlying assets, in this case commodities. However, while the physical delivery of the underlying asset sets trade options apart from financial derivatives, which were the focus of Dodd-Frank, the initial Dodd-Frank definition of “swap” included commodity options, without any exemption for trade options.
Following requests from commenters, the CFTC adopted an interim final rule that reduced Dodd-Frank compliance for qualifying commodity trade options. It has also issued a series of no-action letters with the aim of reducing end-users’ regulatory requirements for trade options that apply to other types of derivatives.
In 2013, through one of these no-action letters, the CFTC sought a middle ground between full compliance and none at all, reducing end-users’ recordkeeping obligations and allowing them to file Form TO, which simplifies and reduces end-users’ reporting obligations to an annual filing, rather than trade by trade. Last week, the CFTC approved a final rule further amending the trade option exemption by eliminating the Form TO filing requirement and related end-user recordkeeping obligations save for the requirement to obtain a legal entity identifier and share it with their swap dealer and major swap participant counterparties.
“With this final rule, the reduced burden has been eliminated altogether,” Mr. Hoffman said. He added while Form TO is “fairly streamlined” and straightforward to complete, a recent discussion with a client in the energy industry revealed where eliminating it will save resources.
“In this case, where our client’s business is distributed across a fairly wide geography and encompasses a number of different types of products, there was a fair amount of coordination required behind the scenes to finish this otherwise fairly simple form,” Mr. Hoffman said.
Another compliance element stemming from the 2013 no-action letter required organizations to notify the CFTC if their trade-option activity exceeding $1 billion in a calendar year.
“That introduced a monitoring element and a set of processes to identify whether a company crosses that threshold, and now companies no longer have to worry about managing that,” Mr. Hoffman said.