Concurring Statement of Commissioner Bowen Regarding Proposed Rulemaking on Trade Options

April 30, 2015

Today, we are approving a proposed rule that would implement changes to the Commission’s Trade Option exemption to reduce the burden on commercial entities seeking to hedge risks associated with their physical businesses. I support these changes. However, based upon comments the Commission has received and meetings that I have had with members of the public, I believe the Commission should consider additional clarifications to better ensure legal certainty for the manufacturing, energy and agricultural industries’ ability to address their commercial risks.

In the manufacturing, agriculture and energy sectors, a wide variety of physically-delivered instruments are used to secure companies’ commercial needs for a physical commodity. These instruments, although they call for physical delivery, often contain some element of optionality that can lead to questions about their appropriate regulatory treatment. These contracts, particularly in the energy sector, are all commonly referred to as physical contracts, and they, according to what I have been told, often receive similar treatment from both a business operations and an accounting standpoint within the entities that use them.

Further, these physical contracts are often handled and accounted for separately from other derivatives, such as futures contracts or cash-settled swaps, according to market participants. Treating some portion of these physical contracts as swaps simply because they may contain some characteristics of commodity options can lead to significant costs and difficulties. For instance, companies may have to reconfigure their business systems to parse transactions where there was, before Dodd Frank, no need to undertake such a reconfiguration.

Many commenters and people I have met have expressed particular concerns regarding how instruments having elements of both forward contracts and some volumetric optionality should be regulated. In a separate release, the Commission plans to finalize guidance on how forward contracts with embedded volumetric optionality relate to the forward contract exclusion from the swap definition. While that release will help address the circumstances under which volumetric optionality embedded in a forward contract do not cause the forward contract to be a “swap”, my understanding is that additional relief may still be helpful to commercial market participants seeking to hedge their physical needs with instruments that contain a forward contract with volumetric optionality.

Market participants have also expressed concerns about the appropriate treatment of “peaking supply contracts” which are often used by companies to manage the risks attendant to their need for physical commodities that may be used to generate electricity, run an operating plant, or manufacture or supply other goods and services.

For both types of instruments, I think, the Commission could benefit from getting comments on potential avenues for addressing concerns that have been raised about their appropriate treatment.

Instruments Containing a Forward Contract with Volumetric Variability

As noted in the proposal, the trade option exemption is intended to permit parties to hedge or otherwise enter into commodity option transactions for commercial purposes without being subject to the general Dodd-Frank swaps regime. The exemption continues the long Commission policy of exempting them from requirements of the Commodity Exchange Act that would otherwise apply to commodity options. It provides an exemption for contracts meeting the requirements of the trade option exemption from regulation as swaps to the extent they would otherwise be subject to regulation by virtue of being a “commodity option”.

Both forward contracts and trade options play an important role in managing the physical commodity risks attendant to commercial operations. According to industry participants, there can be difficulty in separating out, for regulatory purposes, the “option” component of an instrument containing both a forward contract and an element that might be considered a commodity option. My understanding is that these overall instruments are typically used to address a commercial entity’s physical requirements for a particular commodity as part of its ongoing commercial operation and that the commodity option component is often used to manage uncertainty in the commercial supply and demand factors that affect a commercial entities’ need for a particular physical commodity. Additionally, these instruments are often highly customized and the various components not always easy to separate and classify, according to industry participants.

Given these concerns, I think it would be helpful to get comment upon whether the Commission should consider a new § 32.3(f) as part of the trade option exemption being proposed today. Such an exemption would exempt qualifying trade options from the swap reporting and recordkeeping requirements that would otherwise apply to them as trade options so long as they: 1) are not severable nor separately marketable from the forward contract component of overall instrument, (2) are related to and entered into concurrently with the forward contract component of overall instrument, and (3) for which the physical commodity underlying the trade option component is the same as that underlying the forward contract component of the overall instrument.

The text of such additional exemption would read as follows:

“§ 32.3(f) Instruments Containing a Forward Contract with Volumetric Variability.  In the case of an instrument containing a forward contract with volumetric variability that meets the definition of a trade option (as defined by paragraph (a)), the component of such  instrument that is a trade option shall be subject to only the requirements of paragraph (d) provided:

1) the volumetric variability is not severable nor separately marketable from the forward contract component,


2) the volumetric variability is related to and entered into concurrently with the forward contract component, and


3) the physical commodity underlying the volumetric variability is the same as that underlying the forward contract component.”

Supply Contracts for a Specified Portion of an Entity’s Physical Need for a Commodity (e.g., peaking supply contracts)

As noted above, concerns have also been raised about the appropriate treatment of peaking supply contracts which are often used by companies to manage the risks attendant to their need for physical commodities that may be used to generate electricity, run an operating plant, or manufacture or supply other goods and services.

Market participants have raised concerns about whether or not these contracts could be considered commodity options. In instances where these contracts represent a reservation of a portion of supplier’s capacity to provide a particular commodity and not a transaction for the commodity itself, it seems possible these contracts may not be commodity options. One test that has been proposed to determine whether or not such contracts are commodity options is whether:

1. The subject of the agreement, contract or transaction is a binding, sole-source, obligation of a supplier of a physical commodity to stand ready to meet a specified portion of a commercial consumer’s physical need for a commodity through providing for the physical delivery of that commodity to the specified commercial consumer or its designee in connection with the physical obligation,


2. The payment provided by the commercial consumer to the commercial supplier for such agreement, contract or transaction is in the nature of a reservation charge to provide the service of standing ready to meet the physical needs of the commercial consumer,


3. Payment for any commodity delivered under such agreement, contract or transaction is at the market price for that commodity at the time of delivery (i.e., the agreement, contract, or transaction is not used to hedge price risk), and


4. The agreement, contract or transaction is necessary to meet the commercial consumer’s projected physical needs or is required by regulation.

I think the Commission would benefit from receiving comments on this proposed test and peaking supply contracts more generally as it appears to be one of the significant outstanding issues regarding instruments that may or may not be trade options.

Together, these two additional items may help address outstanding concerns that have been expressed by commercial market participants, and I think the Commission would benefit by getting comment upon them.

Last Updated: April 30, 2015