Regulators took steps toward clarifying the treatment of forward contracts that lock in a price of a good but allow some flexibility in the volume that is purchased, in an effort to assuage concerns that corporates could face significant new reporting requirements.
The Commodity Future Trading Commission (CFTC) voted unanimously November 3 to adopt a proposal to tweak rules on how to treat forward contracts with embedded volumetric optionality. The contracts enable companies to lock in the price for a good at some point in the future, typically some form of energy or another commodity, while giving them flexibility on the amount to be purchased.
Recognizing that such options ultimately make the forward contracts derivatives but are also common features of contracts involving physical deliveries, the CFTC drafted its product definition rules in 2012 to exclude the contracts from the definition of a swap as long as they met a seven-prong test. The exclusion meant that market participants engaged in the contracts wouldn’t face reporting requirements and other derivative rules.
“The CFTC has always recognized these kinds of contracts weren’t used to speculate on price but as tools for managing a business,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial. “However, the seventh factor in the test raised some questions and concerns that a wide swathe of supply contracts could be pulled into the swap definition.”
That factor said use of a forward contract’s volumetric optionality was mostly based on factors outside the control of the counterparties and influencing demand for or supply of the commodity. The proposal, which will be released for comment shortly, eliminates the clause describing the factors as “outside the control of the parties,” a change aimed at reducing concerns that such a stipulation could result in many such forward contracts falling under the swap definition.
For example, a company experiencing limited demand for a product may shut down part of its factory’s production capacity, prompting it to reduce the energy it purchases. But whether that reduction was outside the company’s control or a choice it made is ambiguous. Such uncertainty raised concerns about the rule’s impact on thousands of common supply contracts, often generated in a company’s procurement department and far away from the treasury department dealing with new derivative regulations.
“Now companies would need to figure out whether to report transactions to a swap data repository (SDR), a particular burden for contracts whose features may not be stored electronically in a format that can be reported to an SDR,” Mr. Zubrod said
Mr. Zubrod said that dealers would handle the U.S. derivative reporting requirements for corporate clients, but a corporate can have supply contracts with a variety of commodity providers that are not registered as swap dealers under Dodd-Frank Act regulation. In addition, companies employing treasury centers typically have inter-affiliate swaps. To make use of regulatory no-action relief to avoid reporting those inter-affiliate swaps, he said, the company would have to report all of its overseas affiliate trades to an SDR under U.S. law.
Mr. Zubrod said few corporates he’s familiar with have sought so far to tackle the concern about the treatment of forward contracts with volumetric optionality, perhaps because they assumed regulators would ultimately address it.
“This proposed rule-making signals that, indeed, the CFTC sees this as a problem and is eager to take some action,” Mr. Zubrod said. “The action is narrow but likely helpful to remove any dark clouds that could have caused anxiety about a pretty significant burden for companies.”