UNITED STATES OF AMERICA

 COMMODITY FUTURES TRADING COMMISSION

 ROUNDTABLE ON POSITION LIMITS

 Washington, D.C.

 Thursday, June 19, 2014
 2

 1 PARTICIPANTS:

 2 Panel I: Hedges of a Physical Commodity: Gross

 Hedging, Cross-Community Hedging, Anticipatory

 3 Hedging

 4

 5 TIM BARRY, ICE

 6 LAEL CAMPBELL, Edison Electric Institute

 7 MATTHEW JANSEN, ADM, CMC

 8 THOMAS LaSALA, CME

 9 JOSEPH NICOSIA, Louis Dreyfus

 10 RON OPPENHEIMER, Vitol, CEWG

 11 JOHN PARSONS, MIT

 12 DAVID PEARLMAN, COPE

 13 EDWARD PROSSER, Gavilon, NGFA

 14 KRISTIN REBERTUS, CHS Hedging, NCFC

 15 MIKE RICKS, Cargill

 16 Panel II: Process for Non-Enumerated Exemption:

 17 TIM BARRY, ICE

 18 LAEL CAMPBELL, Edison Electric Institute

 19 MATTHEW JANSEN, ADM, CMC

 20 THOMAS LaSALA, CME

 21 JOSEPH NICOSIA, Louis Dreyfus

 22 RON OPPENHEIMER, Vitol, CEWG
 3

 1 PARTICIPANTS (CONT'D):

 2 JOHN PARSONS, MIT

 3 DAVID PEARLMAN, COPE

 4 EDWARD PROSSER, Gavilon, NGFA

 5 KRISTIN REBERTUS, CHS Hedging, NCFC

 6 MIKE RICKS, Cargill

 7 Panel III: Spot-Month Limits and Conditional

 Exemption:

 8

 9 LAYNE CARLSON, MGEX

 10 SEAN COTA, Commodity Markets Oversight Coalition

 11 TERRY DUFFY, CME

 12 EDWARD GALLAGHER, DFA, NCFC

 13 BENJAMIN JACKSON,

 14 JERRY JESKE, Mercuria

 15 EDWARD PROSSER, Gavilon, NGFA

 16 SARAH TOMALTY, BG Group, Natural Gas Supply

 Association

 17

 Panel IV: Aggregation of Positions:

 18

 19 CHARLES CERRIA Hess, CMC

 20 THOMAS LaSALA, CME

 21 WILLIAM McCOY, Morgan Stanley, FIA

 22 MATTHEW NEVINS, SIFMA AMG
 4

 1 PARTICIPANTS (CONT'D):

 2 JOHN PARSONS, MIT

 3 KENNETH RAISLER, Sullivan & Cromwell, PEGCC

 4 MICHAEL SWEENEY, American Gas Association, CEWG

 5 KURT WINDELER, ICE

 6 Other Participants:

 7 TIMOTHY MASSAD

 8 SHARON BOWEN

 9 SCOTT O'MALIA

 10 MARK WETJEN

 11 CHRIS GIANCARLO

 12 KEN DANGER

 13 VINCENT McGONAGLE

 14 RIVA ADRIANCE

 15

 16 * * * * *

 17

 18

 19

 20

 21

 22
 5

 1 P R O C E E D I N G S

 2 (9:32 a.m.)

 3 MR. McGONAGLE: Good morning, everyone.

 4 Welcome to the Staff Roundtable, hosted by the

 5 Division of Market Oversight, to discuss position

 6 limits. At this time I'd like to turn it over to

 7 the Chairman.

 8 CHAIRMAN MASSAD: Good morning. I just

 9 want to welcome everybody. I'll turn it back over

 10 to Vince, in terms of how the meeting will work.

 11 As you know this is a Staff Roundtable, this is

 12 not a Commission Meeting.

 13 However, it's quite an auspicious

 14 occasion, in that we now have a Commission that is

 15 back to full strength of all five members. And

 16 moreover all five members are in one room, which

 17 has not happened for more than a year, so I know

 18 we are all delighted to be here, I certainly am.

 19 As a new Chairman I know my fellow new

 20 Commissioners, Commissioner Giancarlo, and

 21 Commissioner Bowen, are very happy. It took us a

 22 little longer to get here than we'd all hoped, but
 6

 1 now we are back to full strength.

 2 We look forward to today's Roundtable.

 3 We are not going to really make any substantive

 4 comments, so that we can get right into the

 5 questions of the staff, and I look forward to

 6 meeting as many of you as I can. And I know my

 7 fellow Commissioners feel the same way. So, back

 8 to you, Vince. Thank you.

 9 MR. McGONAGLE: Thank you, Chairman.

 10 And welcome Commissioners. My introduction, so

 11 I'm Vincent McGonagle, Director of the Division of

 12 Market Oversight. Thank you all for coming here

 13 today. We have a number of substantive Panel

 14 discussions, concerning comments that we've

 15 received both to the position limits and the

 16 Aggregation proposed Rule Makings.

 17 This is a Staff Roundtable, and it's not

 18 a meeting being conducted under the Sunshine Act,

 19 as the Chairman referenced. The Commissioners

 20 may, of course, ask questions and also request

 21 clarifications on points discussed here today.

 22 However, when present, Commissioners do not plan
 7

 1 to engage in the joint conduct or disposition of

 2 official Agency business, and will not deliberate

 3 between or among themselves on the topics or

 4 issues discussed in today's Roundtable.

 5 Staff have provided questions to the

 6 panelists in anticipation of today's meeting.

 7 We've also posted those questions onto the CFTC

 8 website. Yesterday evening we made some revisions

 9 to the questions for Panel 3, so I'll just draw

 10 you attention to the fact that the questions on

 11 the website have been changed.

 12 The comment period for both the position

 13 limits and the aggregation proposed rule makings

 14 have been reopened. The current reopened comment

 15 period will continue to July 3. In addition, a

 16 video -- a video no less -- of this Roundtable

 17 will be posted and available shortly.

 18 We welcome comments from the public

 19 during the reopened public comment period for both

 20 position limits and the aggregation proposal.

 21 Comments on the discussion today can be submitted

 22 to the Commission during the reopened comment
 8

 1 period.

 2 Joining me today; on my right, Riva

 3 Spear Adriance; and on my left, Ken Danger, from

 4 the Division of Market Oversight. Any views of

 5 the staff here represent our own views and do not

 6 necessarily represent those of the Division or the

 7 Commission. I'll note that our job here today is

 8 to listen. We are very close now to getting

 9 started.

 10 We have four sessions. I welcome the

 11 first Panel to the table. Logistically, I'll ask

 12 that when you speak, please press the button to

 13 talk, briefly introduce yourself, and the

 14 organization you represent. In addition, please

 15 turn off your microphone after you speak, as only

 16 a limited number may be on at one time. Please

 17 also keep cell phones away from the microphone,

 18 and we ask that for comments and questions if the

 19 panelists can place their name card on its end, so

 20 we'll know to recognize you. I'll appreciate

 21 that.

 22 So if we can start just with a brief
 9

 1 introduction of the panelists, and I'll start with

 2 Ron, over here on my left.

 3 MR. OPPENHEIMER: Good morning. I'm Ron

 4 Oppenheimer, I'm General Counsel of Vitol Inc. but

 5 I'm here on behalf of Commercial Energy Working

 6 Group.

 7 MR. PARSONS: Good morning. I'm John

 8 Parsons, I teach Corporate Finance at MIT Sloan

 9 School.

 10 MR. PROSSER: Good morning. I'm Ed

 11 Prosser. I am the VP of Agriculture Trading for

 12 Gavilon, and I'm here to represent Gavilon and the

 13 National Grain and Feed Association.

 14 MS. ROBERTUS: Good morning. I'm Kris

 15 Robertus, I represent CHS Inc., and I'm the

 16 Director of Enterprise Risk Management.

 17 MR. RICKS: Good morning. I'm Michael

 18 Ricks, with Cargill.

 19 MR. JANSEN: Good morning. I'm Matt

 20 Jansen. I'm Chief Risk officer of ADM. I also

 21 serve as the President of our Global Oilseeds

 22 Business. And I'm also here representing
 10

 1 Commodity Markets Council as Vice Chairman.

 2 MR. CAMPBELL: Good morning. I'm Lael

 3 Campbell, Director of Regulatory Affairs for

 4 Exelon Constellation, a fully integrated energy

 5 company; I'm here on behalf of the Edison Electric

 6 Institute, which is the association for all of the

 7 investor owned utilities in the United States, and

 8 EEI Members are responsible for serving

 9 electricity to more than 70 percent of the U.S.

 10 Population.

 11 MR. PEARLMAN: Good morning. My name is

 12 David Pearlman. I'm from the law firm of

 13 Bracewell & Giuliani. We represent the Coalition

 14 of Physical Energy Companies, as well as a number

 15 of other similarly-situated physical companies.

 16 Our clients are the hedgers, as well as other

 17 people here represent hedgers, but we are hedgers

 18 in a physical energy space.

 19 MR. NICOSIA: Good morning. I'm Joe

 20 Nicosia. I'm Global Platform Head, and Senior

 21 Vice President with Louis Dreyfus Commodities.

 22 MR. BARRY: Good morning. I'm Tim Barry
 11

 1 with ICE Futures U.S.

 2 MR. LaSALA: Good morning. I am Tom

 3 LaSala. I am the Chief Regulatory Officer for the

 4 CME Group.

 5 MR. McGONAGLE: Great. Thank you. So

 6 during this first Panel, we are going to focus on

 7 hedges for physical commodities, gross hedging,

 8 cross commodity hedging and anticipatory hedging.

 9 We have a number of questions that we had set

 10 forth in the document, but before we start, sort

 11 of digging though, into those, on a one-by-one

 12 basis, I'd like to turn it over to Ron, to give us

 13 sort of an overview perspective from the

 14 commenters on bona fide hedging. Ron?

 15 MR. OPPENHEIMER: Thank you very much,

 16 Vincent. And thanks to the Commission for holding

 17 this Roundtable. In particular I want to thank

 18 Chairman Massad and Commissioner Bowen and

 19 Commissioner Giancarlo for making time. I know

 20 you're probably drinking from the fire hose right

 21 now, and so we really appreciate your making time

 22 for us.
 12

 1 This is a very important rulemaking to

 2 us. The Commercial Energy Working Group is

 3 comprised of firms from all aspects of the energy

 4 business, oil, gas and power, upstream, midstream

 5 and downstream, integrated companies, and

 6 independent companies. And as substantial users

 7 of the markets, we support the Commission's

 8 mandate that pricing be established by forces of

 9 supply and demand, and not by extraneous outside

 10 forces.

 11 We understand, and I think part of the

 12 reason why we are still having debates on some of

 13 these issues, is the Commission's concern for some

 14 loopholes that could undermine the ability to

 15 limit speculative trading and that would allow

 16 speculative trading under the name of hedging.

 17 Our concern is on the other side of

 18 that, and that is that legitimate hedging

 19 activities might be sacrificed in order to prevent

 20 any abuse that might occur in the marketplace. We

 21 think it's very important to keep focused on the

 22 public policy drivers behind speculative position
 13

 1 limit rules.

 2 The speculative position limit rules

 3 have always existed for one particular purpose,

 4 and that's to prevent the harm that could be

 5 caused by excessive speculation. And Dodd-Frank

 6 really didn't change that. Dodd-Frank had

 7 speculative position limit provisions in it mainly

 8 to accomplish two goals. First of all, to include

 9 swaps within the speculative position limit

 10 regime. And secondly, to address concerns that

 11 had arisen with respect to what I'll call investor

 12 money, principally on the long side, and what

 13 effect that might have on pricing.

 14 The Dodd-Frank Provisions really weren't

 15 addressed at perceived abuses with respect to

 16 commercial hedging. In fact, really the opposite;

 17 in Dodd-Frank Congress gave the Commission

 18 exemptive authority, so that any legitimate end

 19 user hedging activity that wasn't foreseen at the

 20 time could be exempted by the Commission, as it

 21 saw fit. And the public interest also supports

 22 commercial hedging, because at the end of the day
 14

 1 effective hedging programs reduce the ultimate

 2 price of energy commodities, and all commodities

 3 to consumers.

 4 We are very committed to working with

 5 the Commission to address all of these issues we

 6 have for the last, unfortunately, several years I

 7 will say; we are interested in closing the

 8 loopholes, we are interested in preserving the

 9 markets for legitimate commercial end-user

 10 hedging. And personally, I would like to say, we

 11 are committed to try to put this behind us and

 12 focus on other things.

 13 The Working Group has written extensive

 14 comments, and I know that you've got them --

 15 you've probably read them, if not, I know that you

 16 will read in the near future, and I'm not going to

 17 address everything in the comment letter but, as

 18 Vince said, I'd like to sort of lay out some of

 19 the landscape of the different issues that we see

 20 out there. And it may seem like a long list, but

 21 it's really not, I think we are in striking

 22 distance with some good, constructive dialogue to
 15

 1 closing the gaps on some of these issues.

 2 Two of them are new in the proposed rule

 3 that didn't exist in some of the other speculative

 4 position limit rules that we've seen in the past.

 5 The first one is the construct of what's called

 6 the economically appropriate test. It's always

 7 been the case that the Statute and the Regs said

 8 that a hedge had to be economically appropriate to

 9 the reduction of risks in the conduct and

 10 management of a commercial enterprise in order to

 11 be bona fide.

 12 But in the proposal, for the first time,

 13 the Commission has written that the measurement of

 14 that, is that it has to reduce the risk to the

 15 entire enterprise. In other words, that risk has

 16 to be managed on a global affiliated entity basis,

 17 and that's not how risk is managed in the energy

 18 space. Different companies do it differently.

 19 Some do it on the enterprise basis, some do it on

 20 a corporate or division-wide basis, some do it by

 21 trading desk or trader, and some do it on a

 22 strategy level. And many do it on a combination
 16

 1 of all of those things. The Rule wouldn't permit

 2 that.

 3 We think that's a problem and we think

 4 that needs to be addressed so that companies can

 5 manage their risks in the prudent ways they see

 6 appropriate to do it. In the cross commodity --

 7 cross commodity hedging space there's a new

 8 quantitative test that never existed before.

 9 Essentially there's a Safe Harbor for cross

 10 commodity correlations that exceed a particular

 11 mathematical number.

 12 That formula, and we've put some

 13 examples in our comment letter, would exclude from

 14 bona fide hedge treatment, things that we commonly

 15 use as cross hedging, the most obvious being

 16 natural gas to hedge power prices, but in the oil

 17 space blend stocks which become gasoline, or

 18 become RBOB, which is the deliverable greater

 19 under the NYMEX Contract, some of the blend stocks

 20 also would not qualify for cross commodity

 21 treatment, and we think that's a problem.

 22 Some of the older issues that have been
 17

 1 out there but, you know, remain a problem, are the

 2 so-called Five-Day Rule. So-called Five-Day Rule

 3 by itself, in its simplest form is not that big a

 4 problem, it suggests that you can't hold a

 5 commodity for certain types of hedges into the

 6 last few days of trading in the contract, if you

 7 don't have the ability to make or take delivery of

 8 that commodity. It works in some cases, in others

 9 it doesn't.

 10 When the Commission first passed that

 11 Rule in 1977, the only commodities it had

 12 speculative position limits for were agricultural

 13 commodities, and it specifically said, at sometime

 14 in the future when we consider other commodities,

 15 we will consider changing the Five-Day Rule.

 16 That's particularly appropriate at this point in

 17 time. Very simply deliverable supply is the

 18 baseline for which the Commission will establish

 19 spot-month position limits, the CME has submitted

 20 updated data for what constitutes deliverable

 21 supply in energy contracts.

 22 We would recommend that the Commission
 18

 1 adopt those numbers of deliverable supply for the

 2 purpose of setting spot-month limits. The single

 3 and all-month limits for the RBOB and the heating

 4 oil futures contracts, quite simply are too low.

 5 The Commission's data, it's in Table 11 of the

 6 Proposed Rule, supports the fact that they are too

 7 low, it identifies between 7 and 11 companies

 8 whose positions would have exceeded the limits if

 9 they were in place as they are proposed to be set,

 10 and taking those companies out of the market would

 11 draw substantial liquidity away from the markets

 12 particularly in the out months where liquidity is

 13 limited to begin with.

 14 Trade options and volumetric options are

 15 really physical delivery contracts, and not

 16 hedging instruments or speculative instruments and

 17 should be removed from the speculative position

 18 limit rules, and we would support a process

 19 whereby the Commission could look at

 20 non-enumerated hedges on an expedited basis.

 21 The biggest issue to us is of course

 22 merchandizing and anticipatory merchandising
 19

 1 hedging. The Working Group has put a number of

 2 examples in its comment letters, many of them were

 3 the subject of a petition filed with respect to

 4 the now Vacated Rule. I'm not going to go into

 5 detail of any of them right now, but would be

 6 delighted to either as part of this discussion or

 7 later, to explain exactly why they are

 8 risk-reducing and not speculative positions.

 9 It's a little surprising that the

 10 subject has become as controversial as it has.

 11 The starting point for considering whether or not

 12 merchandising hedges and anticipatory

 13 merchandising hedges should be permitted is really

 14 the statute, and it's very clear that the statute

 15 provides for those types of hedging activity.

 16 There's no distinction in the statute between that

 17 kind of activity and anticipatory hedging by

 18 producers and processors, and there's no -- we

 19 think the problem may stem from a fundamental

 20 misunderstanding of the merchandising function.

 21 Merchandizes move commodities from one

 22 location to another where prices dictate they
 20

 1 should go, where supplies in lesser supply in one

 2 region and greater demand in the region, prices

 3 dictated that it should move. And the

 4 merchandisers connect the producer to the

 5 consumer, merchandisers actually own the

 6 commodity. They store the commodity, they blend

 7 the commodity, and they deliver them to users so

 8 that the users can demand them on an as-needed

 9 basis, freeing up their own credit and their

 10 capital for other uses.

 11 Merchandisers buy commodities in regions

 12 where users can't, or decide not to go and have

 13 commercial relationships. Merchandisers allow

 14 producers and users to outsource all the logistics

 15 and risks of arranging transportation and

 16 scheduling, managing customs, inspections and all

 17 the other operations that go along with the

 18 physical energy business. Merchandisers have as

 19 much invested in their business as producers and

 20 processors, it's their credit and capital that

 21 support the purchases, sales and the inventory

 22 they carry.
 21

 1 They own and they charter vessels and

 2 barges, they own or lease, storage and pipeline

 3 capacity, and transmission. They invest in

 4 technology systems and personnel that make it all

 5 work. In short, merchandising should never be

 6 confused with paper trading. We don't see the

 7 logic in permitting anticipatory hedging for

 8 producers and processors while prohibiting it for

 9 merchandisers.

 10 Just as a very quick example, a

 11 merchandiser who buys product at a floating price

 12 with the intention of moving it somewhere else,

 13 and selling it at a floating price, needs to lock

 14 in the differential between those two prices in

 15 order to justify making the purchase in the first

 16 place, and engaging in the merchandising activity

 17 that brings the commodity to the consumer where

 18 the consumer needs it.

 19 It's really no different than the

 20 producer who has oil in the ground that he has not

 21 yet produced, and has not yet sold. He has an

 22 unfixed price risk which he wants to hedge with an
 22

 1 anticipatory unsold production hedge. It's the

 2 same thing as the processor who hasn't yet filled

 3 his requirements. If the merchant has brought --

 4 I'm sorry -- has sold before he has bought, he has

 5 the same risk that the processor has when he is

 6 trying to hedge his unfilled anticipated

 7 requirements.

 8 Just in closing, I want to say that the

 9 concern about speculation slipping through a door

 10 open for hedging, has some serious criteria that

 11 will limit those possibilities that are already in

 12 place, and I know you know of all of them, so I'll

 13 go very quickly. But some of them go to the

 14 staff's questions. The ordinary course documents

 15 maintained by a physical energy company will go a

 16 long way toward defeating any possibility that the

 17 hedging exemption is abused.

 18 The company's hedging strategy is in its

 19 documents, and whether it's conducted in an

 20 affiliate- wide basis or something else, that's

 21 also contained in the records. Whether they've

 22 made a binding bidder offer and how they've hedged
 23

 1 it, that's in their records. What financial

 2 commitments they've made to an anticipated

 3 transaction, such as establishing one leg of a

 4 two-legged transaction, that's in their records.

 5 And all of the transaction records that support a

 6 bona fide hedge exemption are required to be kept

 7 under CFTC Rules, and made available for

 8 inspection and responsive to special calls.

 9 DCM oversight will remain in place. In

 10 my opinion it's the most effective tool to ensure

 11 against abuse, and I think Tom will probably cover

 12 that more as we go forward. Positions that are in

 13 excess of spec limits pursuant to hedge

 14 exemptions, have to be reported on a Form 204 and

 15 explained. And that's done under the penalty of

 16 perjury, and so I think that goes a long way to

 17 ensuring that there won't be false statements

 18 about hedging activity.

 19 Then finally there's anti-disruptive

 20 trading practice requirements, there are orderly

 21 trading requirements and there are

 22 anti-manipulation rules. So if anybody took a
 24

 1 position in claiming a hedge exemption, and did

 2 anything that disrupted the markets there's ample

 3 opportunity to challenge that activity.

 4 In closing I just want to say thank you

 5 again. We are very grateful for all the time that

 6 the Commission and the Staff has given us over the

 7 years as we've debated position limits. We are

 8 very hopeful that we can continue to do that, and

 9 we are hopeful we can be a resource to the

 10 Commission as we move forward. Thanks, Vince, and

 11 I'm happy to move to questions.

 12 MR. McGONAGLE: Thanks, Ron. I think

 13 that's a very good overview of the session for

 14 this morning. I want to go into some detail with

 15 respect to the application of these particular

 16 hedges. Thinking about some of the themes that we

 17 articulated in the questions, which are focusing

 18 first on what the statute discusses on the

 19 economic appropriate test, which is the reduction

 20 of risk in the conduct and management of a

 21 commercial enterprise.

 22 How are these risks then, separately
 25

 1 being managed, separate from a request for a bona

 2 fide hedge exemption? How does the firm manage

 3 its own risk profile? And how is the request for

 4 the exemption consistent with that profile? And

 5 what assistance can you give us, the staff, on

 6 evaluating the difference between what is being

 7 put forth as a bona fide hedge exemption request,

 8 versus speculation. And then, you know, how do we

 9 document them. I know Ron has touched on a number

 10 of these in particular examples.

 11 Looking at gross hedging then, for

 12 example, I know in our -- the Notice of Proposed

 13 Rulemaking, we were focused on -- you know, if you

 14 drill down to identify specific risks, we've put

 15 forth that the staff would be in agreement that so

 16 long as -- you didn't need to require that there

 17 be netting, but that if you had, you know,

 18 multiple identified specific risks, if you hedged

 19 each of those, that might be sufficient for an

 20 exemption. The question I think that we see is,

 21 is there a selective use of a specific identified

 22 risk for a hedge exemption that, effectively,
 26

 1 doesn't result in the netting of risk at the

 2 entity level?

 3 And so how do we differentiate with

 4 respect to gross hedging a bona fide exemption

 5 versus speculation? And I think the same analysis

 6 might apply to the difference of the operating

 7 units. So I put that out to the Panel, if you

 8 want to talk in a little more detail about how we

 9 can evaluate gross hedging in way that would

 10 recognize a bona fide hedge exemption.

 11 MR. PEARLMAN: I'm going to answer that

 12 question but I want to make a statement first --

 13 this is Dave Pearlman -- that I agree with really,

 14 everything Ron said, but I would ask that the

 15 Commission think about, in the context of this

 16 issue, potentially taking a step back, because I

 17 don't want the conversation to start out with the

 18 concept that the only way to deal with issues of

 19 position limits, and dealing with the concern

 20 about excessive speculation, is to create a regime

 21 of enumerated hedges, and complex record keeping,

 22 and difficult reporting arrangements.
 27

 1 Because the thing I want to say, I

 2 agree, again, with what Ron said, but stepping

 3 back from that, my clients are a group of physical

 4 energy companies that are historically users of

 5 the exchanges and they are familiar with the

 6 manner in which exchange position limits work, and

 7 they have over- the-counter swaps, historically.

 8 And in doing so they manage their risk -- and I'll

 9 get to your question in a minute -- but in doing

 10 so they understand what they need to do if they

 11 need a hedge exemption, which is to come to the

 12 Exchange because they are not in the enumerated

 13 hedge world, and basically explain what their

 14 risks are, show their physical business, and then

 15 through the exchanges well- equipped staff who are

 16 expert in this, there is a manner in which the, a

 17 hedge exemption can be provided to an entity that

 18 needs one. And I'm sure that Tom can talk about

 19 that in more detail.

 20 But for my clients, we are switching

 21 from that regime, which is one in which they can

 22 talk about their business. Talk about what their
 28

 1 risks are. Provide sufficient information to get

 2 a hedge exemption which caps their position, to

 3 one in which every time they do a trade they have

 4 to figure out which enumerated hedge it is, the

 5 trader has to know that, it needs to be

 6 identified, it needs to go into the records.

 7 If they are dealing with a swap dealer

 8 they are going need to make binding reps that this

 9 can be a pass- through hedge, and do a number of

 10 very complicated, and actually confusing,

 11 activities to completely change the regime they're

 12 living within. The other thing they are going to

 13 have to do, is track swaps in this regard. And,

 14 again, one thing we'd like you to think about is

 15 that swaps that are OTC swaps, and as Ron said,

 16 trade options. These are not price discovery

 17 vehicles, we understand the need in a price

 18 discovery world to be concerned about excessive

 19 speculation, but we ask you to think about whether

 20 there's a price discovery impact of excessive

 21 speculation, in non- transparent OTC swaps; and

 22 certainly, in physical delivery trade options.
 29

 1 So we would like you, for our segment of

 2 the market, which is hedgers-- who have

 3 historically been on exchanges and have been able

 4 to have non-enumerated relationships where we

 5 would get hedge exemptions, as well as engage in

 6 over-the-counter swaps--to maybe think about ways

 7 to make this less burdensome, because this is the

 8 most burdensome element of Dodd-Frank to

 9 non-registrants. And to turn around and implement

 10 this at organizations that are not well resourced

 11 to make this an entire effort. When we were about

 12 to do it last time it was incredibly burdensome.

 13 So with that I'll answer your question,

 14 I'll be happy to talk more about this threshold

 15 issue.

 16 MR. McGONAGLE: What do we want to see?

 17 Is there any reaction on the Panel, agreement or

 18 comment on those remarks?

 19 MR. PEARLMAN: I guess we are the Lone

 20 Ranger on this. But I do think, frankly, if you

 21 were to reach out to market participants who are

 22 not at a sophisticated level of doing significant
 30

 1 amounts of merchandising, trading, that sort of

 2 thing, that we are more, I would call them garden

 3 variety hedgers. You'll find that what I'm

 4 telling you is very much a concern that they have.

 5 And again you have, I think, a little more of a

 6 higher level of sophistication around this table,

 7 and frankly if you were to think about the numbers

 8 that this Rule affects of just individual

 9 organizations, probably the bulk of those

 10 organizations are in the category that I'm

 11 describing and we can talk about it offline, or we

 12 can bring those people to meet with you if you

 13 like then -- though the folks who do larger and

 14 more sophisticated business.

 15 So let me come back to your question and

 16 I think it follows along what Ron was saying.

 17 When companies such as the companies that I

 18 represent do their hedging, and think about how

 19 they are hedging their risks. They start out with

 20 a structure where, typically from a management

 21 perspective they have no interest in, and frankly,

 22 they are prohibited from speculating. So the
 31

 1 organization has a structure in which speculation

 2 is not permissible.

 3 That is typically the case; there may be

 4 some very minor speculative activity that could be

 5 permitted to engage in price discovery or some

 6 sort of non-business line activity, it's really

 7 not the purpose of it, but the purpose of touching

 8 these markets is to hedge, so you start out by

 9 looking at the basic mission that the individuals

 10 touching these markets have, which is to hedge.

 11 There is also oftentimes, if you have

 12 loan documents or project finance arrangements

 13 around these types of businesses, the lenders will

 14 have covenants, required covenants, that there

 15 will be no hedging -- I mean no speculation,

 16 pardon me, and there will be likely a mandate for

 17 some level of hedging. And that's what we see in

 18 our business. So we have documentation that at

 19 the threshold, before you go into the market, you

 20 are precluded from speculating, or if there's some

 21 kind of tiny tranche you can, or your lender

 22 precludes you from speculating, requires you to
 32

 1 hedge.

 2 And as Ron said, then what follows from

 3 that, is an effort to execute the mandate that's

 4 been provided by management, and in doing so, this

 5 whole idea of gross or net, or whatever, across

 6 the enterprise, is really not contemplated in the

 7 kind of quantitative techniques that you're

 8 talking about, or how to actually capture this for

 9 you to then come back with what I assume you're

 10 talking about, is the enumerated hedge of some

 11 sort.

 12 It's really a business-related process

 13 that is endeavoring to accomplish the hedging

 14 mission of the business, and you'll see an entire

 15 sort of dialogue between management and the

 16 business to identify how they are hedging, to

 17 accomplish hedging, to report that they've

 18 implemented a hedge plan, to have periodic reports

 19 on how the hedges are performing, all that sort of

 20 thing. And I think if you were to look, to

 21 understand gross, net, whatever, because that's

 22 not the way that it's thought of.
 33

 1 Whether there was hedging taking place,

 2 you would find a significant documentary basis for

 3 it, and frankly I think people would have

 4 personnel action taken against them if they want

 5 to speculate in this business segment, because

 6 frankly that's a great way to lose money, and

 7 these people are not in that business, and their

 8 investors don't want them speculating.

 9 So the bottom line of what I'm saying

 10 is, that the way you are looking at it, is not the

 11 way these businesses look at it. If there's

 12 something you'd like them to do to demonstrate

 13 that they are hedging in some technique that would

 14 be satisfactory to you, to demonstrate that, that

 15 could be done, but it's a back fit on everything

 16 that's done today. And frankly the whole

 17 enumerated hedging process is a back fit on what

 18 people do today. It is not the way that firms

 19 think about their activities when they hedge.

 20 MR. McGONAGLE: Thanks, David. Joe?

 21 MR. NICOSIA: Thank you. In response to

 22 your question, I'm going to go a little bit around
 34

 1 it, but get to it. When we look at gross or net

 2 hedging, the ability to take it in totally on a

 3 global basis, or an entire universe is almost

 4 impossible. I think it's important for the

 5 Commission to understand and recognize that we

 6 have many risks that we manage and hedge within

 7 our own businesses. And these risks are more than

 8 just flat price or absolute price risk.

 9 These risks that we have, if you take a

 10 narrow and a restrictive view of the

 11 interpretation of hedging, it can be very

 12 detrimental to our business. Some of these risks

 13 will include time risk, we have location risk,

 14 quality risk, quantity risk, credit risk,

 15 execution risk, counterparty risk, governmental or

 16 sovereign risk, just to name a few of these

 17 things. And we need the marketplaces in order to

 18 hedge these in very different ways. Probably the

 19 most important thing is that you need to recognize

 20 that price risk is not just absolute, but it's

 21 also relative price risk. It seems that that has

 22 been lost somewhere along the way.
 35

 1 When we say relative price risk, we are

 2 talking about the ability to have ownership, and

 3 then have an off- setting, what is known as a

 4 hedge, against it. The most common form of this

 5 is to use futures, and what is known as basis

 6 trading. But basis trading in and of itself is a

 7 risk, is a shift of risk from absolute to

 8 relative. It is one that requires usually the use

 9 of the futures market, and then also requires us

 10 to be able to use future futures spreads and the

 11 cash market.

 12 Along this line, and taking care of this

 13 risk one of the most important things is

 14 convergence. The need for convergence in the

 15 marketplace, and convergence takes place, not just

 16 by a user or a producer, but more importantly also

 17 the inclusion of the merchandiser. It is their

 18 inclusion in these markets that allows and calls

 19 for the convergence within the futures market. In

 20 order to have that, the hedger, the merchandiser

 21 has to be able to be allowed to use the

 22 marketplace, and have access to it.
 36

 1 Without it, risk premiums are going to

 2 rise throughout our business, and when the risk

 3 premium rises, it's going to move throughout the

 4 supply chain, and that will raise the cost of

 5 doing business. And the end result of that is

 6 that the producers will receive less for their

 7 product. Consumers are going to pay more for

 8 their product, because someone has to absorb that

 9 risk cost that's going to take place.

 10 Bid/offer spreads are going to widen,

 11 liquidity is going to dry up, and ultimately, less

 12 business is going to be done here. So when we

 13 look at that there's really three main issues that

 14 we need to really address here. One is the

 15 inclusion of merchandising into the exemption. It

 16 is not understandable how that could be removed.

 17 The merchant accepts far more risks than anyone

 18 else in the value chain. He has to absorb all of

 19 those risks that I mentioned before.

 20 The second area is anticipatory. The

 21 anticipatory hedging needs, there is almost

 22 nothing that takes place in this business that
 37

 1 doesn't have some form of anticipation in it.

 2 Whether it is -- whether you will make a sale,

 3 whether your quality will be right, whether the

 4 quantity will arrive on time, what time the boat

 5 arrives, what are your export commitments,

 6 whatever the case may be. Not to mention simple

 7 things such as weather.

 8 And the third thing is your treatment of

 9 fixed and unfixed sales with your inability to

 10 recognize unfixed sales as that which you need,

 11 that the merchandiser has, for treatment in the

 12 hedging. Now, to return to the question about a

 13 universal versus gross, versus net; because we

 14 have so many different needs to be hedged, not

 15 just absolute flat price risk, you will find that

 16 different entities, whether they be assets,

 17 whether they be countries, whether they be

 18 products, whether they be cross products, have

 19 different means and times for those risks that

 20 they need to hedge. The fact that you may be long

 21 soya beans universally, does you no good if you

 22 have a crushing plant in area that has had a
 38

 1 drought or is short in supply. You will not be

 2 able to move those beans from South America on a

 3 timely basis into your plant in Indiana.

 4 And conversely, the same thing that can

 5 take place of whether you were working on shipping

 6 lines, transportation, logistics, whatever it is.

 7 So no matter what you do, even if you try to look

 8 at it on a global basis you will have to manage

 9 your risk on an entity, but more importantly, on a

 10 need basis, because those needs will arrive from

 11 both geographical different needs, from the

 12 ability to have to deal with supply, from the

 13 ability you have to deal with execution, and

 14 therefore it's universally impossible to do it on

 15 a gross scale -- I mean totally universal basis.

 16 MR. McGONAGLE: Thanks, Joe. Lael?

 17 MR. CAMPBELL: Yeah. I want to comment

 18 on this gross versus net issue, because it's very

 19 important to the electricity industry, which, it's

 20 very regional in nature, electricity prices can

 21 vary, depending on the unique attributes of

 22 different parts of the country, supply, load, fuel
 39

 1 type requirements can all make electricity prices

 2 very different, dependent on the region you are

 3 in.

 4 Most risks in the electricity industry

 5 is not managed on an entity level, certainly not

 6 managed on an enterprise level, it's managed on a

 7 regional level. We have traders that are

 8 responsible for a portfolio of positions, either

 9 customer demand, which we call "load" in the

 10 electricity industry, or generation, and they are

 11 responsible for managing the risk in their

 12 particular region.

 13 You know, we could be -- have less, much

 14 less generation than we do customers to serve in

 15 Texas, where prices are trading around $150, and

 16 we could have much more generation in the

 17 Northeast than we do have customer served, so we

 18 are long generation Northeast where the cost is

 19 around $60. Those positions are not natural

 20 offsets to each other. They need to be managed

 21 independently, and forcing us to net these types

 22 of positions is going to cause problems.
 40

 1 Even within the same region, I could

 2 have a gas generator, still in the ground, and

 3 managing the risk of that generator, I have fuel

 4 requirements that I have to manage. I may also

 5 have gas storage facility in that same region, but

 6 I may need to manage that gas storage facility,

 7 separately from that generator, even it's in the

 8 same region; because I don't necessarily have the

 9 transmission to get the gas out of the storage to

 10 that particular generator.

 11 So it's very important, and I want to

 12 echo what David said, what Ron said at the outset,

 13 and what Joe just said, you know, accepted risk

 14 management practices of the industry that have

 15 been around for a long time, need to be

 16 maintained. There is a lot of distrust in the

 17 rules, and as Ron pointed out in the outset, there

 18 is no evidence of anyone abusing the bona fide

 19 hedge rules to engage in speculative activities.

 20 And in an attempt to catch a theoretical

 21 bad actor, you are potentially impacting real,

 22 legitimate hedgers that have serious risks to
 41

 1 manage in their day-to- day business operations.

 2 And one of the points I want to make is that in a

 3 -- Joe talked about this too, and so did David--

 4 is that there are built-in controls within each of

 5 our companies. These are important risks for us to

 6 manage. We have an army of people that are,

 7 everyday, assessing our physical risk exposures,

 8 and our hedges against those exposures.

 9 If the hedge gets out of whack, it's out

 10 of correlation that's costing us money, and we are

 11 going to have to do something about it to adjust

 12 the hedge, or put on a hedge if something is not

 13 hedged enough. We have the infrastructure in

 14 place. We are managing value at risk, VAR, every

 15 single day, and adjusting our hedges accordingly.

 16 So, again, I think the Commission should

 17 be very differential to those that are out in the

 18 industry every day managing these risks, they have

 19 a lot of experience doing it. They have a lot of

 20 infrastructure in place to make sure they are

 21 doing it right, and I would hope that at the end

 22 of the day we could have a rule that's deferential
 42

 1 to those practices.

 2 MR. McGONAGLE: Thanks, Lael. We'll go

 3 to Matt, and then Tom, and then I want to move to

 4 cross-commodity hedging.

 5 MR. JANSEN: Okay. Thank you. And

 6 first of all, I agree with everything that's been

 7 said from the Panel, so far, this morning. When I

 8 think about ADM, for an example, as a hedger and a

 9 merchandiser of crops, we have over 400 locations

 10 just in the U.S. and many of those are locations

 11 that are deliverable, in one form or another. And

 12 so we are, as an example, a place where

 13 convergence actually happens.

 14 And I think one of the potential

 15 consequences that we are facing right now, as Joe

 16 pointed out, is a potential lack, or a moving away

 17 from convergence, that I don't think is anything

 18 that this Committee or the industry supports. And

 19 so, you know, as we are buying -- and

 20 merchandising--you know, the U.S. crops in these

 21 400 locations, and even more, this ability to --

 22 we manage on as-need basis, the risk, at the
 43

 1 location. And then we also aggregate that up from

 2 an enterprise standpoint, so there is a component

 3 of netting, but it's on an as-need basis. And I

 4 believe it's extremely important to be able to

 5 maintain that flexibility in order to allow us to

 6 do that.

 7 MR. McGONAGLE: Tom, before we go to

 8 you, Ken had a comment.

 9 MR. DANGER: I just wanted to tee up a

 10 really simple example. Sometimes it's helpful, I

 11 know it's very complicated, the situations that

 12 you are all facing, but it's sometimes simple to

 13 -- good to focus on something simple. So let's

 14 tee up this example, this hypothetical. Let's

 15 imagine that the -- we have an all months combined

 16 --

 17 MR. WETJEN: Maybe you can move your mic

 18 up a little it.

 19 MR. DANGER: I'm sorry. We have an all

 20 months combined limit the Commission has

 21 established, let's imagine that that number is 20

 22 contracts, and let's imagine then a trader has
 44

 1 sold forward three months from now at a fixed

 2 price 50 contracts worth of this commodity -- I'm

 3 sorry -- purchased forward 50 contracts to this

 4 commodity at a fixed price, and the in six months'

 5 time has sold another 50 contracts at a fixed

 6 price. So in that five to six months -- and it's

 7 all at the same locations so those 50 contracts

 8 presumably could be used to satisfy these sales

 9 that are six months out. And so what I'd like you

 10 to have a think about, and maybe talk about is,

 11 would it be appropriate for that trader to hedge

 12 all of its fixed-price sales contract in the

 13 nearby contracts? In other words, put on 50

 14 contracts worth of long fixed-price futures and to

 15 hedge its fixed-price sales six months out, when

 16 the spec limit is indeed 20 contracts. Would that

 17 be bona fide hedging or not? Would that be

 18 increasing risk to the firm? That's all this

 19 trader has on, it's just those simple fixed-price

 20 sales and purchases.

 21 MR. McGONAGLE: So I think you've got Ed

 22 to bite.
 45

 1 MR. PROSSER: When you think about the

 2 way that, in the enumerated Ag space we hedge our

 3 book we look every day for the most effective

 4 hedge that we can find. That hedge might not be

 5 right next to every sale that we have on. But as

 6 you look at each one of those individual sales,

 7 they aggregate into a larger risk; and you then

 8 try to find what is the most effective hedge in --

 9 with location and quantity and quality, and all

 10 those other risks other than price that we talked

 11 about.

 12 So I think the idea that we segregate

 13 each one of our individual transactions and try to

 14 hedge that individual transaction, in Matt's case

 15 would be tens of thousands of transactions a month

 16 and it's impractical. I think that one of the

 17 things that the Commission doesn't understand

 18 quite well enough is the complexity of this gross

 19 hedging concept. A bushel of wheat in Australia

 20 and a bushel of wheat in Indiana, and a bushel of

 21 wheat in Washington, if you throw it all together,

 22 and then hedge it one time, if you've got
 46

 1 purchases and sales, it seems simple.

 2 But the fact is that those have -- those

 3 cash commodities have unique risks all their own,

 4 and they are not equivalent. So forcing us to try

 5 to create some equivalency of cash, before we go

 6 to the derivative, is really the crux of the

 7 problem here when we try to figure out what we are

 8 doing on this gross versus net. The reason that

 9 we don't all hedge gross is because it doesn't

 10 work. It's not an effective hedge. We have to go

 11 out and segment. Ukrainian wheat hedged in

 12 Chicago has an entirely different risk profile

 13 than wheat in the Ohio Valley hedged in Chicago.

 14 And I think that gets to the point where

 15 these businesses are very complex, it's much too

 16 simple just to make these physical commodities

 17 equivalent to the derivative and say that

 18 everything that's left you can hedge, but you have

 19 to offset first.

 20 MR. DANGER: If I might go back to it.

 21 In the very specific hypothetical that I asked

 22 about, is that increasing risk to the firm, or
 47

 1 decreasing risk?

 2 MR. NICOSIA: Ken, if I could try that.

 3 First of all, in the specific question that you

 4 asked, almost never exists. Okay, because you

 5 have quality risk, you have time risk, you have

 6 execution risk, but even as you start to narrow it

 7 down to the one/one-hundredth of a percent of what

 8 we actually do, that falls into that category, you

 9 can have legitimate reasons for that.

 10 For example, it may very well involve an

 11 asset, because that transaction that takes place,

 12 may take place all within your own elevator, for

 13 example, if it were grain. And during that

 14 six-month time period that you have, if you were

 15 going to be locking up grain, maybe you've bought

 16 that exact stuff, and you are going to carry it

 17 forward, maybe you have already bought it forward

 18 and not carrying it. But if you carry it forward,

 19 you have storage income that you want to protect

 20 at that point in time.

 21 Yeah. And when you say protect it,

 22 because as the market moves the value of what you
 48

 1 have changes. So if the Board spreads change over

 2 time, the fact that you do or do not have it

 3 hedged does not mean that the value of what you

 4 have in store does or does not change, because it

 5 does.

 6 And, for example, if the market were to

 7 invert, and you were out long in store, even

 8 though it's against the sale for six months out,

 9 it would be to your benefit to sell that grain out

 10 immediately, and replace it with another purchase

 11 down the road. Conversely, if you went to a very

 12 large carry, in the marketplace, it would behoove

 13 you to maybe buy additional grain today because

 14 you would build on your storage, make more money

 15 by carrying to your six-month sale, and actually

 16 selling out which you had had originally pegged

 17 against that sale for him.

 18 So, these dynamics that take place in

 19 the marketplace is how we manage inventory, how we

 20 manage risk, and create the opportunity that the

 21 markets create, because carries and inverses are

 22 creating the ability to alter the flow of the
 49

 1 commodity that's there, that's our job to react to

 2 it. So, yes, it can definitely be an appropriate

 3 hedge in thinking of how we manage our inventory.

 4 MR. McGONAGLE: Tom, you were up from a

 5 couple minutes ago. I don't know if we passed you

 6 by.

 7 MR. LaSALA: No worries. Thanks, Vince.

 8 A quick comment, observation, I guess, on process,

 9 because there have been a number of comments

 10 around the table what people are used to,

 11 exchanged managed exemptions, I just maybe -- just

 12 take a moment and just clarify that, clearly at

 13 CME Group, we are in the business of managing

 14 exemptions, in enumerated market as well as those

 15 that are non-enumerated.

 16 And frankly, there are differences

 17 between the two. In the enumerated you are bound

 18 to enumerated examples as, you know, detailed in

 19 the regulations. In the non- enumerated there's

 20 broader authority, for example, risk management

 21 exemptions, which in today's world where I know

 22 some of the comments made around the table would
 50

 1 be reflective of things, such as anticipatory

 2 merchandising. So it's one of the challenges, I

 3 think there are two major challenges here today,

 4 and these examples I think are great.

 5 The challenges are, you know, you've got

 6 a circumstance that -- most circumstances I deal

 7 with -- we deal with is in one -- I'm going to say

 8 asset class -- something seems very legitimate,

 9 examples of anticipatory merchandising that we

 10 feel comfortable and grant exemptions, they seem

 11 logical, economically appropriate. You can

 12 demonstrate past performance by the participant in

 13 terms of sales movements. We can grant that;

 14 always sensitive to concentration and the like.

 15 In the enumerated it's not available.

 16 The challenge, you know, I guess I would say, it's

 17 furthered in this exercise that's a challenge for

 18 this Agency, is in the proposal, not only do you

 19 have this disparity, but you are in some regards

 20 taking away. So I have the -- we have the hard

 21 explanation to a company or companies saying on

 22 one hand, this makes total sense, we'll do this
 51

 1 here, it's the exact same thing in another asset

 2 class, and for some reason, it's non-applicable,

 3 and then in the proposal, we seemingly do away

 4 with some of those.

 5 MS. ADRIANCE: I'd like to just ask a

 6 question to follow up, Tom. When you said it's

 7 not available in the enumerated, it sounds as if

 8 -- and I'm trying to understand if I understood

 9 you correctly. Because an enumerated is

 10 available, if it's an enumerated exemption it is

 11 available. I think what you are saying is that if

 12 it -- if this particular trade the trader wants to

 13 hedge is not enumerated, that you are referring to

 14 fact that what is the process for going through

 15 and getting a non-enumerated hedge exempted from

 16 -- or to allow it to be used as bona fide hedge.

 17 Is that what you're referring to?

 18 MR. LaSALA: No. No. I'm sorry. It

 19 wasn't clear. While you could get a

 20 non-enumerated exemption by petitioning the

 21 commission, in markets such as energy, the ability

 22 for us to grant those types of exemptions are
 52

 1 within our discretion as the contract market. And

 2 entities around the table here will tell you that,

 3 well, we've applied for, and I think

 4 appropriately, received those exemptions in the

 5 energy space, yet, that exemption, broadly

 6 speaking, is not simply available because it's not

 7 enumerated in, let's say, the agricultural

 8 markets.

 9 MS. ADRIANCE: So, just to make sure I'm

 10 understanding you correctly. So what you are

 11 bringing up is the issue that under the proposal,

 12 whether or not you, as an Exchange will be able to

 13 grant a particular exemption if somebody comes to

 14 you. You are talking about the limitations that

 15 might be placed on you -- on your ability to grant

 16 an exemption.

 17 MR. LaSALA: It certainly places a

 18 limitation on me; it does. And I think it places,

 19 you know, I guess, additional challenges on the

 20 party requesting that exemption.

 21 MR. McGONAGLE: John?

 22 MR. PARSONS: So I'm going try to
 53

 1 address Ken's question, and I think -- so the

 2 specific question you asked about that particular

 3 hedge, there's a classic case that addresses that,

 4 which is the oil hedge speculation that

 5 Metallgesellschaft did back in 1993, there's been

 6 a whole raft of literature trying to analyze

 7 exactly your question, most of which arrived at

 8 that hedging with the front month for that

 9 particular one was a speculative venture, and

 10 increased the risk of the firm.

 11 I think it's a useful case to look back

 12 at to address some of the other points that have

 13 been made here. I think it identifies very

 14 clearly, that quite often you have companies that

 15 look like end users that are speculating. And in

 16 particular, back then in '93, when there was much

 17 less liquidity in the oil market, they consumed a

 18 huge volume of the front month contracts. They

 19 moved the price when they rolled that particular

 20 strategy, and they had to trade OTC contracts to

 21 try to hide the size of their position, and those

 22 OTC contracts were relevant for moving the prices.
 54

 1 So I think there's a bigger point here,

 2 we have lots of research that demonstrates that

 3 there is speculation done by end users, obviously

 4 not by all end users, and obviously there's a lot

 5 of hedging. I can think of a particular article

 6 demonstrating that in the chemicals industry,

 7 there's a lot of speculating on interest rates,

 8 more recent literature about lots of commodity

 9 companies' derivatives positions fluctuating far

 10 too much to be counted as hedges for those

 11 companies' positions.

 12 You know, when we talk about this gross

 13 hedging point, many people have pointed out, I

 14 think accurately, that oftentimes companies don't

 15 structure their hedges that way because there's

 16 geographical-basis risk. But you can see my point

 17 about speculation in the same way. There are lots

 18 of electricity companies that trade derivatives in

 19 regions of the country where they have no physical

 20 positions whatsoever. They are running a

 21 proprietary trading book in that particular

 22 transaction.
 55

 1 So I think it's true that it's very hard

 2 to impose this kind of gross hedging criteria,

 3 because for a lot of real hedges that's not how

 4 it's managed. But I think you have the real

 5 problem of how to distinguish some actual

 6 speculation that really does go on, from real

 7 hedging. And I think there are only two ways to

 8 do that. One is measurement, quantification,

 9 which companies regularly do do, because they want

 10 to measure and show that they are reducing hedge.

 11 There is no other way for senior

 12 management to maintain serious control over

 13 operations without some kind of quantification.

 14 But there's also lots of other business practices

 15 that have been discussed here. I think we are

 16 repeating a conversation that we had over the

 17 Volcker Rule, which successfully focused on what

 18 are the actual documentation business practices,

 19 compensation practices, and so on.

 20 We can't look at any transaction

 21 independently of how it's actually operated in the

 22 company, and it seems to me we arrived in that at
 56

 1 a very successful resolution, you know, everything

 2 remains to be seen; but it was realistic because

 3 it looked at what companies actually did and tried

 4 to distinguish them. And you can distinguish

 5 proprietary speculative trading from hedges, and

 6 it happens inside the way companies manage them.

 7 MR. WETJEN: But John, other than

 8 measuring or quantifying the risk as you've put

 9 it, it sounds like you had something else in mind

 10 in addition to that that could be used as a tool.

 11 MR. PARSONS: Well, business practices

 12 do it. Most companies that do speculative

 13 trading, in the way you see those speculative

 14 books managed, are going to be managed differently

 15 than the hedge, and most of the time, hedges are

 16 going to be managed in concert with the physical

 17 positions that they are attempting to hedge, and

 18 there will be a number of forensic or fingerprint

 19 evidence that that's how the company is managing

 20 its operations.

 21 For example, if you are hedging, you are

 22 going to be rewarding your traders for reducing
 57

 1 risk, whereas if you are doing speculative

 2 trading, they are going to be given bonuses for

 3 the size of the profit, which is going to be more

 4 when it's a large profit. If you are giving them

 5 incentives to reduce risks, you are not going to

 6 want to see a huge outsized profit on a particular

 7 transaction. So that's an example of the business

 8 conduct that can distinguish one from the other.

 9 MR. McGONAGLE: Great. We'll turn

 10 quickly to cross-commodity hedging, and then I

 11 want to move back over to anticipatory

 12 merchandising. On cross-commodity hedging, Ron

 13 touched on two items in the overview that he gave,

 14 but we have a qualitative test, a quantitative

 15 test, and there's recommendation or consideration

 16 surrounding whether there's an exit from trading

 17 of that particularly commodity within the final

 18 days of trading.

 19 So, let me put out to the Panel, and

 20 there's this general question, of those three

 21 items. Sort of what -- where should staff be

 22 focusing our time on the comments, where are your
 58

 1 biggest concerns?

 2 MR. RICKS: Mike Ricks. I guess when it

 3 comes to cross-hedging, I mean, I don't know if

 4 you could look at almost any commodity and you're

 5 going to find periods where it's a 100 percent

 6 positive correlation and 100 percent negative

 7 correlation. Just given the time of the year, the

 8 events, the environments. You know, so to assign

 9 an 80 percent correlation in order for it to be a

 10 valid cross hedge, is beyond impossible, simply

 11 because these relationships are so dynamic.

 12 So what a merchant is going to do, is

 13 you could argue that buying a truckload of corn in

 14 the middle of Kansas, which is not deliverable,

 15 and hedging it in Chicago, that could be cross

 16 heading because it's not deliverable. Or buying,

 17 you know, a vessel of corn in the Ukraine, should

 18 that be hedged or not? The merchant is going to

 19 make the decision, basically, how is that going to

 20 -- transaction is going to reduce the risk.

 21 And it may well be that not hedging is

 22 the way to do it. It may well be that hedging
 59

 1 that truckload of corn in Kansas, that may be best

 2 hedged in the wheat pit, because that corn is

 3 going to likely compete with wheat for feed, or it

 4 may be best hedged in Chicago. So how you define

 5 cross hedging in these relationships, like I said,

 6 can go from, you know, negative 1.0 to positive

 7 1.0, and the merchant is going to look at his time

 8 period, which one is going to reduce the risk.

 9 MR. McGONAGLE: So you're focusing us on

 10 -- more on evaluation on the qualitative analysis

 11 and moving away from a quantitative review?

 12 MR. RICKS: Yeah, because I believe

 13 that's what was mentioned in the rules, and 80

 14 percent correlation, or along those lines, and we

 15 are going to look at -- in the window that we are

 16 exposed to that risk, which derivative, or not

 17 derivative, is the best way to reduce that risk.

 18 But what that does too is, it's not just the

 19 action of Cargill, or one firm, or ADM, you know,

 20 it's the wisdom of all the firms making these

 21 decisions. That gets immediately transmitted into

 22 prices. These price signals are transparent, the
 60

 1 whole market sees them. And that's how people

 2 make decisions, that's how we allocate scarce

 3 resources.

 4 That tells the farmer what to grow.

 5 That tells a feeder, should I take corn out of my

 6 ration, increase soya bean meal? That tells the

 7 flour miller, should I use more spring wheat, less

 8 soft wheat? That's why there's so much interest

 9 in this, because we see these signals get

 10 efficiently transmitted every day into the role

 11 that they provide in allocating scarce resources.

 12 And our fear is that with this rulemaking we break

 13 that mechanism.

 14 MR. McGONAGLE: So, I'll turn it to Ron.

 15 But this is sort of the objective identifying

 16 factors to look at -- you know, and what we have

 17 is sort of art and science, the qualitative

 18 factors, the quantitative factors. So, you know,

 19 if we are charged with evaluating why people have

 20 sought a particular hedge for cross-commodity, how

 21 are we able to do that across industry or across

 22 platforms. Ron?
 61

 1 MR. OPPENHEIMER: Yeah. Thanks. So I

 2 just want to point out a couple of things, maybe

 3 for the new Commissioners, that may not be

 4 obvious. Cross-commodity is essentially defined

 5 as any commodity that's not deliverable under the

 6 Exchange Contract. And what that means in the oil

 7 space is that, for example, sour crude is not

 8 deliverable under NYMEX contract, so that's a

 9 cross-commodity hedge.

 10 The energy industry has got a wide

 11 variety of products that come out of the ground.

 12 Sweet, sour, different sulfur specs and the like,

 13 resulting in many, many cross-commodity

 14 relationships there. A variety of grades of

 15 gasoline, and gasoline itself is not deliverable

 16 under the RBOB contract, and then there were many,

 17 many different grades of gasoline. But on top of

 18 that you then have components that go into

 19 gasoline, and those are all considered

 20 cross-commodity.

 21 So this is a vast swath of the hedging

 22 that's done in the energy space, and that's why it
 62

 1 takes on, you know, pretty significant importance.

 2 Some of the commodities that I just mentioned

 3 would not pass the 80 percent test, and therefore,

 4 you know, the presumption was that they -- would

 5 be that they couldn't be used. The blend stocks

 6 that one might hold in tanks in New York Harbor

 7 that will become REBOB would not be usable -- you

 8 couldn't use the RBOB contract.

 9 But then you shift into Five-Day Rule,

 10 and that says you have to get out in last five

 11 days, even if you would be using those blend

 12 stocks to deliver on the actual NYMEX Contract,

 13 that you were trying to hedge with. And that's

 14 one reason why he Five-Day Rule doesn't really

 15 work.

 16 MR. McGONAGLE: But are you proposing

 17 sort of an exception to an exception? Not every

 18 situation is as you present, right? So, if

 19 someone is using your cross- commodity hedge, you

 20 know, in the normal circumstance, do they need to

 21 be standing for delivery?

 22 MR. OPPENHEIMER: No. As I said at the
 63

 1 beginning, there are circumstances where we

 2 recognize the fact they will make some sense.

 3 That's one where it wouldn't. And I'm sorry, I

 4 could just -- two other points. There are also

 5 deliveries that we make, so we might have

 6 inventory in tank where we are making a delivery

 7 that crosses over that five-day period, it's

 8 completely inappropriate to roll out of that

 9 hedge. We are not hedged if you are taking the

 10 commodity in with that contract during that

 11 period, so that doesn't make sense.

 12 The last point I want to make about the

 13 Five-Day Rule is that, you know, the Exchange

 14 monitors their liquidations, and so they are going

 15 to make sure that you have the product that you

 16 intend to deliver, or that you have the capacity

 17 to take the product that you're talking about, or

 18 they are going to get you out of that contract in

 19 an orderly way before the contract goes to

 20 delivery.

 21 And the important point there is that

 22 that warrants additional flexibility in that
 64

 1 five-day period, because what you don't want to

 2 do, is you don't want to chase the hedgers out of

 3 that important spot-month period, because that's

 4 how price convergence works, with having

 5 commercials in that part of the market. And if

 6 you drove them out, what you'd be left with are

 7 speculators in that period, and that's not what

 8 you want for orderly pricing of the contracts.

 9 MR. McGONAGLE: So, before we go to

 10 David, Ken -- I was talking to Ken on the sidebar;

 11 to clarify a question that I had which is, I was

 12 talking about sort of what would staff be looking

 13 at, in order to evaluate the hedge. And then,

 14 Ken, presented the other perspective, it's really

 15 focused on how you would evaluate it. Where is it

 16 important to you, where do you draw those lines?

 17 Sort of, you know, back to this dynamic

 18 evaluation, how do these businesses make sense of

 19 where you get involved in cross- commodities? So

 20 let's go to David.

 21 MR. PEARLMAN: Let me just say before I

 22 answer that question, the Five-Day Rule really
 65

 1 does require focus and attention as Ron pointed

 2 out, and it's a little bit off- topic but we

 3 shouldn't forget that. You said before, Vince, is

 4 it -- you said art and science, and I think --

 5 MR. McGONAGLE: Just as a question.

 6 MR. PEARLMAN: Well, I liked it. And

 7 the real way to look at, from my clients'

 8 perspective of cross-commodity hedge is that it's

 9 an art, because if they could get a perfect hedge

 10 that was right on with their risk they would take

 11 it. And a cross-commodity hedge is sort of a

 12 second best, so that what they have to do is find

 13 something that works for them, in the event that

 14 there isn't a good match.

 15 And it isn't just the question of, is

 16 the product available, there's pricing issues,

 17 there's liquidity issues, there's all kinds of

 18 things that go with this question. One example I

 19 can give you to look at is natural gas liquids.

 20 They had been hedgeable, you know, I think a

 21 pretty good correlation, at least I'm told, with

 22 WTI. And that, because of the natural gas
 66

 1 revolution, et cetera, has diverged.

 2 So the folks who are looking to hedge

 3 these things, they have to find something that

 4 works. You can get quotes on natural gas liquid

 5 swaps, now that's from a swap dealer, they are

 6 going to charge you a significant cost for that,

 7 because there is really not the liquidity that you

 8 would otherwise want. So the individual who is a

 9 seasoned market person, who is charged with

 10 hedging, is going to have to make a judgment.

 11 Since we don't have the answer that we

 12 want, we have and we want to hedge, or maybe not,

 13 because of the expense, we have to pick the best

 14 tool that we have, and we will use our judgment

 15 and our professional, you know, experience to do

 16 that and the market will give us feedback as well,

 17 as we've said. In time, you could find out you

 18 were -- it was perfect or it wasn't perfect. But

 19 going into it, it's more, I understand, of an art

 20 than a science, and to cap it with an 80 percent

 21 correlation just makes it very difficult to have

 22 something that will qualify.
 67

 1 MR. McGONAGLE: Well then -- so it would

 2 be an expectation or a request that the

 3 determination by the firm, that the hedge -- that

 4 there is cross-commodity hedge is a presumption.

 5 A presumption that that's accurate that -- you

 6 know, so how do I evaluate -- well, how can I

 7 objectively evaluate that qualitative

 8 determination?

 9 MR. PEARLMAN: Well, it's hard to

 10 objectively evaluate something that's inherently

 11 subjective in certain ways, because of the

 12 imperfection of the market here, but these people

 13 have to deal with the market on a real-time basis.

 14 And I think one of the things that we could have

 15 is that, as we've all talked about, there is

 16 nothing but documentation, internal to these

 17 organizations, to demonstrate that the activity

 18 that's undertaken, is for the purpose of hedging.

 19 And maybe one thing we could do is, we

 20 could have a presumption that it is hedging, and

 21 it has got some level of correlation in the

 22 product mix. But it could be subject to audit or
 68

 1 some other after-the-fact review, to have the

 2 Commission assure itself that the entity that was

 3 undertaking this cross-commodity hedge which is,

 4 again, based upon its judgment, was in fact taken

 5 for the purpose of hedging.

 6 MR. McGONAGLE: Let's go to Lael, then

 7 Matt.

 8 MR. CAMPBELL: Sure. I need to comment

 9 on this, because cross-commodity hedging is just

 10 necessary in the electricity industry, where there

 11 is just an undeniable relationship between the

 12 price of electricity and the price of the fuels

 13 that generate that electricity. You know, in

 14 certain markets at certain times, the price of the

 15 fuel is going to set the price of electricity in

 16 those markets. If gas -- if it's, you know, a

 17 time where gas generators are setting the market

 18 price, like electricity, the price of gas is going

 19 to correlate very closely with the price of

 20 electricity.

 21 The bottom line is that, throughout the

 22 electricity industry, you know, the relationship
 69

 1 between fuel prices, the prices of the fuel

 2 commodities and the price of electricity have been

 3 correlated. If you look at the Polar Vortex, you

 4 look at the -- what FERC has done in the aftermath

 5 of the Polar Vortex, really exploring the

 6 relationship, the interconnected relationship

 7 between how the gas markets work, and how the

 8 electricity markets work, making big changes to

 9 reflect the need to have a much closer unison

 10 between the way the physical gas and the physical

 11 power markets work.

 12 Many of the electricity products reflect

 13 this correlation. We have heat rate products

 14 which we described in our letter and I may talk

 15 about later, but these products -- these are

 16 electricity products, or even financial products

 17 that are priced based on the relationship between

 18 fuel and electricity. We have tolling agreements

 19 or leases of electricity generators that are also

 20 priced often based on the cost of the fuel that

 21 would generate those facilities.

 22 But the bottom line, to get to what
 70

 1 Vince said, is we are using cross-commodity

 2 hedges. Typically we'll use -- we'll go to the

 3 liquid product, we'll go to the markets that are

 4 most available to us, out the curve, further out,

 5 further forward in the spot month we are probably

 6 going to use gas, or something that's more liquid

 7 to hedge our electricity. As we are moving closer

 8 to the spot month, if there's liquidity in the

 9 electricity financial products, we may move the

 10 hedge into something that's more closely

 11 correlated.

 12 But the bottom line is, and I've talked

 13 about this before. We have risk managers that are

 14 looking at our physical risk exposure, our

 15 financial risk exposure every single day. They

 16 are studying these correlations. If these

 17 correlations diverge, we are losing money, we are

 18 not hedging effectively, and our risk management

 19 group is going to tell the traders, get a better

 20 hedge.

 21 Okay. So we have the built-in

 22 infrastructure in place. John Parsons talked
 71

 1 about that. It's already in place at many of our

 2 companies. We are looking at these correlations,

 3 we are looking at the effectiveness of hedges, and

 4 as I said before, you know, I think the CFTC is

 5 often interpreting complexity as a potential

 6 loophole, but I really think you should be looking

 7 at complexity as -- you know, complexity demands

 8 flexibility, because these markets are complex.

 9 We are managing risks of various things

 10 and various regions, the prices are changing all

 11 the time. It is very complex what our traders and

 12 risk managers do, and they need the flexibility to

 13 be able to do it effectively, consistent with the

 14 industry practice.

 15 MR. McGONAGLE: Thanks, Lael. Before we

 16 go to Matt, Ken had a comment.

 17 MR. DANGER: Just a quick question here.

 18 Again, this whole issue with cross-commodity

 19 hedging is really only focused on the last few

 20 trading days of the Physical Delivery Contract.

 21 So why is there a need to precisely hedge to the

 22 final settlement price on the Physical Delivery
 72

 1 Contract, if the hedge is a ballpark

 2 cross-commodity hedge? For example, why wouldn't

 3 a commercial enterprise try to lock in electricity

 4 supply prices, hedge in the short-dated

 5 electricity contracts whether derivative or cash

 6 forward, and get out of the physical delivery

 7 natural gas electricity -- natural gas futures

 8 contracts, as the natural gas futures contracts

 9 approach expiration?

 10 MR. CAMPBELL: I can answer that real

 11 quickly. Sorry. You're talking about

 12 electricity, so I'll just answer it quickly. I

 13 think we would if we could. I mean I think we are

 14 going to seek the best hedge, the most liquid

 15 product to hedge our risk. So if there is

 16 liquidity in the electricity product in the prompt

 17 month -- spot month, sure, we'll use that.

 18 As I mentioned before, you know, there

 19 are times where gas is setting the price of

 20 electricity in certain markets during certain

 21 times of the year, based on weather events. And

 22 in those situations gas is a perfectly well
 73

 1 correlated hedge to keep into the spot-month

 2 period. So, again, it's less about -- again, it's

 3 about preserving the flexibility, not limiting the

 4 ability in the variety of ways that our risk

 5 managers can manage risks.

 6 MR. DANGER: Is it a hedge if you're --

 7 if you don't have production facilities?

 8 MR. CAMPBELL: No. That's a different

 9 question.

 10 MR. McGONAGLE: Go ahead, Ron.

 11 MR. OPPENHEIMER: Yeah -- no -- I just

 12 want to say I don't see it as just an issue for

 13 the last few days of the expiring contract. If

 14 some of the cross-commodity relationships that I

 15 mentioned before were not permitted, we wouldn't

 16 be able to recognize them across the curve, with

 17 respect to any and all-month limits, and so it's a

 18 problem there as well.

 19 MR. McGONAGLE: So let's go to Matt,

 20 he's been patient.

 21 MR. JANSEN: Yes. Thank you. You know,

 22 if I think about the way the actual expiration
 74

 1 process works today and, you know, you have the

 2 exchanges with the oversight, as well as Vince and

 3 his team with the oversight. I mean and in the --

 4 starting even with first-notice day, and going

 5 into the expiration in many of the commodities and

 6 contracts where we operate, there is an increasing

 7 amount of dialogue between the commercial and the

 8 oversight.

 9 On, okay, this is your position this

 10 morning, how do you -- how do you see the market

 11 dynamics today? And so, in terms of how do you --

 12 your question about how do you evaluate that, I

 13 believe that that process is in place today, and

 14 it works. And that dialogue, I think you find,

 15 it's actually quite direct and to the point. And

 16 as you go into the -- you know, the actual

 17 expiration, there's an increasing amount of

 18 dialogue.

 19 Or it's, okay, what are the economics

 20 today? What are the alternatives? And that is a

 21 process that I think serves us very well, and so I

 22 just wanted to respond to your question about how
 75

 1 do you analyze that. It's really on a

 2 case-by-case basis because as so many have pointed

 3 out, that there are lots of dynamic inputs that

 4 influence these different commodities, but the --

 5 you know, at the moment, and as the expiration is

 6 occurring, that's between the -- let's say, the

 7 hedger and the regulator -- whether it's the

 8 Exchange, or, Vince, in your team, that dialogue

 9 is, I think works well.

 10 MR. McGONAGLE: Thanks. We are going to

 11 go to anticipatory merchandising in a second.

 12 Joe, your card was up.

 13 MR. NICOSIA: I just wanted to touch

 14 briefly, when you're talking about the

 15 qualitative, quantitative tests that were there,

 16 and I would suggest that the quantitative tests,

 17 not only is not necessary, but it is actually the

 18 -- the actual opposite of what it is that you

 19 should be looking at, because it's not a matter

 20 that the correlations must remain stagnant or

 21 static to where it is, because the breakdown in

 22 the correlation is, in and of itself, a reason to
 76

 1 use cross-commodity hedging.

 2 If you took an example, and Mike touched

 3 on some of the simpler ones, if you had corn

 4 having to compete with wheat, the corn-wheat ratio

 5 very well may break down, but that's because it's

 6 either trying to force feed wheat into the

 7 marketplace, or it's trying to do the opposite.

 8 Another perfect example would be in the vegetable

 9 oils around the globe.

 10 The fact that the relationship between

 11 soy oil, and canola or rape or palm, may break

 12 down from the point A to whatever you may consider

 13 to be necessary, might be the exact reason why, if

 14 you were trying to price out soy oil in the world

 15 because of shortage of supply, then the canolas

 16 and rapeseeds and others would become cheaper,

 17 you'd want to buy those, hedge them in soy,

 18 because then you can go to the end user, and as

 19 those spread become wider, cause the

 20 substitutability, the elasticity of demand, and

 21 the only way to lock that in, to allow you to

 22 present that to them, is to be able to buy the
 77

 1 cheaper product, hedge in the more expensive

 2 product, and then allow the elasticity of demand

 3 to narrow those arbs.

 4 MR. McGONAGLE: So would you leave it as

 5 an indicator for making the determination a

 6 quantitative factor, but not a requirement?

 7 MR. NICOSIA: I think -- really I think

 8 it's more of a reasonableness test that's

 9 appropriate. It should be able to -- if someone

 10 can show you the need and/or the reasoning behind

 11 why the one is a -- as you would call it -- a Risk

 12 Mitigant Factor of why the ability to buy to

 13 canola and then sell soy oil as a relationship

 14 that -- most of the relationships are very obvious

 15 that exist, and some of them maybe need a little

 16 bit more explaining of why someone with an ethanol

 17 plant maybe buying corn and selling RBOB. Or

 18 something to the extent, that from there to

 19 ethanol, ethanol to the substitution into gas

 20 makes perfect -- really -- makes perfect sense at

 21 one point in time. So I think there is a -- it's

 22 much more of a reasonableness test, probably, more
 78

 1 than it's a quantitative test.

 2 MR. DANGER: I mean, your example about,

 3 market prices being high and low in different

 4 commodity groups, another perspective on that is

 5 in a way you are requesting hedge exemption to

 6 speculate on the cross-commodity spread between

 7 these two different commodities.

 8 MR. NICOSIA: Well, in some of them

 9 though, because they are different commodities in

 10 and of themselves don't mean they are not in the

 11 same space. But even when those would leave space

 12 from one to, say, corn to ethanol, or corn to even

 13 eventually, to say an RBOB, it is a product of

 14 conversion that takes place, where you eventually

 15 reach that through the commodity and value chain.

 16 So there is this relationship, and the

 17 difference there is you have conversion cost that

 18 -- your asset that takes place, you have your

 19 marketing cost. And at times the market will

 20 adjust, and our ability to move our hedges between

 21 commodities, is something that's very prudent to

 22 do. It's not adding speculation. It's actually
 79

 1 doing what the market place is asking us for. You

 2 know, if there's too much ethanol relative to the

 3 demand in one point in time versus gasoline, the

 4 basis -- again this word basis -- is going to

 5 break down between those two.

 6 When the basis gets really cheap that is

 7 a signal to go ahead and store the ethanol, but

 8 the way to lock that in, if you want to store the

 9 ethanol against the higher price of -- against the

 10 substituted gasoline, is you have to lock in the

 11 other side of that hedge. In order, so that you

 12 know that when the relationship comes back to a

 13 normal blend situation, you'll be able to capture

 14 that arbitrage, because otherwise you're just

 15 accepting the lower price of ethanol at that time,

 16 without the ability to be able to lock in, what

 17 you can do better with your product.

 18 MR. DANGER: But that -- I mean, I think

 19 that's the basic question here. I mean, if you're

 20 talking about arbitrage, capturing arbitrage

 21 differentials, versus hedging, then the question

 22 is, when you took those positions, was that really
 80

 1 a speculation in a sense? And you can view it as

 2 a hedge, perhaps, but there might have been -- it

 3 might not be fully risk-reducing, value neutral in

 4 a sense. And so you're able to take those

 5 positions to essentially capture that spread

 6 differential.

 7 MR. NICOSIA: Yeah. But I don't

 8 consider that speculating at all, it's what is

 9 normally done in the norm of our business. That

 10 is our business; that is what we do. So the

 11 ability to prevent our assets from losing money,

 12 to being able to respond to the market call, to

 13 either hold back product, to store it or to create

 14 more of it, is exactly -- we have to be able to

 15 lock in the other side of the transaction.

 16 MS. ADRIANCE: So this really -- what

 17 Ken is bringing up is that we are trying to -- we

 18 are going to ascertain, we or the Exchange has to

 19 ascertain, when is it speculation versus when is

 20 it hedging? You talked about a reasonableness

 21 test, but at some point along the way, somebody is

 22 going have to make a decision, make a
 81

 1 determination, and what we are trying to get here

 2 is in a sense tools, what do we use? It's been

 3 mentioned that the quantitative test is a little

 4 too rigid, and the qualitative then is much of

 5 reasonableness and -- so basically it gets back

 6 to, what other standards do we basically -- are

 7 you suggesting that we put it back into the hands

 8 of exchange because they have the experience? Are

 9 you suggesting that we come up with a test? We

 10 have a test that is a useful test, and what would

 11 that reasonableness test involve?

 12 I mean, basically what it gets down to

 13 is as, as was pointed out pointed out, we have to

 14 make this -- we have to understand what are we

 15 looking at, what are we dealing with, and how do

 16 we ascertain what is? And so our questions go to

 17 -- what Ken is bringing up is -- when we look at

 18 it, it may not look -- it may not be clear to us

 19 when we are at -- really serious intent to reduce

 20 risk, there's intent to manage risk.

 21 MR. DANGER: How do you know today that

 22 it was a hedge, but tomorrow it was a spec
 82

 1 position, right? I mean today it was a

 2 cross-commodity hedge but then tomorrow it's --

 3 you know, really, you know, boss I really want to

 4 speculate on that derivative position, but I've

 5 got this physical here. And so when you show it

 6 to the Commission it will look like a hedge, but

 7 really your intent was to speculate. How do you

 8 differentiate between these two scenarios?

 9 MR. NICOSIA: Yeah. I think it's

 10 important to realize that when you try to identify

 11 a hedge, no matter, even if it was the most

 12 perfect hedge. You know, you are buying corn in

 13 Illinois and you're selling corn futures. That in

 14 and of itself is a form of speculation, because it

 15 is a change, it is a hedge, because you are

 16 changing your outright ownership to a basis

 17 ownership. You may call it speculation, we would

 18 call it hedging. Someone else would just say,

 19 well, all you've done is change your risk profile

 20 from one of outright to one of relative; right.

 21 It's a change in risk profile. The

 22 ability to get more -- right down to your point of
 83

 1 how you try to identify speculation would probably

 2 be from the standpoint, if the transaction has

 3 absolutely no underlining cross relationship, or

 4 no underlining cross quantity justification.

 5 That's your answer.

 6 MR. McGONAGLE: So, change is a good

 7 word to move on to the next topic. And let's look

 8 at anticipatory hedging and focus on

 9 merchandising. We want to get perspectives about

 10 how we could -- the Commission could consider a

 11 hedge exemption surrounding merchandising and how

 12 do we -- anticipatory merchandising, and how do we

 13 deal with the real challenge of articulating the

 14 satisfaction of the economic purpose test, that

 15 the merchandising, looking at potential contracts

 16 down the line, as giving a basis today to

 17 establish a position. Anyone wants to take that

 18 on?

 19 MR. PROSSER: Thanks. Ed Prosser. I

 20 think at the heart of this, the Commission at this

 21 point starts to get a sense that this end-user

 22 class, this physical merchant is kind of a messy
 84

 1 business. It's not cut and dry, things don't

 2 correlate well, there are a lot of risks that we

 3 are trying to offset inside of our businesses. If

 4 we had an enumerated product on a DCM for each one

 5 of our risks we could, 100 percent, hedge, go on

 6 down the road, and everything would be happy.

 7 But unfortunately, that's not the real

 8 world we live in. We also don't just deal with

 9 price risks. We deal with weather risks, we deal

 10 with the quantity risk, we deal with quality risk,

 11 we deal with location risks. All of those risks

 12 we bring to the table, and we are moving into a

 13 few different enumerated commodities trying to

 14 offset those risks. We have developed strategies

 15 over decades to try to offset those risks on the

 16 exchanges.

 17 We use time spreads to lock in carries.

 18 We use time spreads at times to offset weather

 19 risks, but all of these are a part of the function

 20 where overall we feel like using those particular

 21 contracts, reduce our risk from where we were if

 22 we weren't using them. Sometimes the correlations
 85

 1 aren't as good as we'd like them to be, but they

 2 are the best alternative that we have. The other

 3 thing I'd like to point out, is by doing this

 4 activity, these physical merchants that have one

 5 foot on the physical side, and one foot in the

 6 derivative, do the good work of flipping those

 7 instruments with economic signals to bring

 8 convergence and price discovery to the

 9 marketplace, which is the most important function

 10 of all of these markets.

 11 As we have each of those buckets, the

 12 opportunity to be in each of those sides

 13 simultaneously, or alternatively, it is very easy

 14 for me to determine, you know what, today the

 15 derivative is my best choice. Tomorrow the

 16 derivative goes back - it goes away and I go back

 17 into the physical market. And that goes on

 18 thousands of times, and ultimately it proves the

 19 great public good of converging the derivative to

 20 the cash. And that's what we do in this space,

 21 and it's a big part of that is this anticipatory

 22 merchandising, and anticipatory processing
 86

 1 function that we use today.

 2 MR. McGONAGLE: Mike?

 3 MR. RICKS: Thank you. You know, when

 4 it comes down to the anticipated, in grain

 5 companies and probably energy companies too, you

 6 know, we are continually putting out bids to

 7 producers, offers to consumers on a real-time,

 8 24-hour, seven-day-a-week basis. And we don't

 9 have the luxury of telling a farmer when he can

 10 sell to us, nor do we have the luxury of telling a

 11 consumer when they can buy.

 12 They are the ones that hold the

 13 leverage, they make the decision. So, like all

 14 firms, you are analyzing that risk on a continual

 15 basis, and I think some of the rulemaking

 16 basically said, how can you hedge a risk that you

 17 haven't incurred yet by writing a contract. But

 18 by putting that firm bid out there, and that firm

 19 offer, every firm is going to assign some

 20 probability to that; and those probabilities are

 21 going to change day to day, hour to hour.

 22 By sitting back and not managing those
 87

 1 risks, you are going -- one or two things are

 2 going to happen. First would be, is that all of a

 3 sudden that risk premium goes up. Let's just say

 4 if it's going into a big harvest weekend and we

 5 know we are going to buy a lot of corn, and we

 6 have the ability to pre-hedge those purchases

 7 because the market is not open on Saturday or

 8 Sunday, then we can stand in and buy that corn.

 9 If we are not allowed to pre-hedge, then

 10 either we can't buy the corn, or we have to put a

 11 risk premium on it. The same thing when we are

 12 making an offer. A significant offer to a large

 13 sovereign entity, to a large food company, by

 14 assigning probabilities, and we are continually

 15 working on that, and that's one other reason why

 16 we can't do it on the enterprise level, because

 17 these are all localized decisions based on, you

 18 know, the wisdom of the people, and the experience

 19 of people. What are those probabilities?

 20 And, again, to manage those risks, if we

 21 would wait, you know, until we consume that large

 22 sale, and then hedge, that has a potential to be
 88

 1 more volatile, more price disruptive, and also is

 2 going to carry a bigger risk premium. So I mean

 3 from -- it's kind of the nature of the business

 4 because we are continually putting out a for-sale

 5 sign and a buy sign.

 6 MR. McGONAGLE: Kristin?

 7 MS. ROBERTUS: Yes. I would just echo

 8 the comments of my colleagues here, but I want to

 9 give you a simple example. So if we've had an

 10 unpriced contract, if we've had a sale that is not

 11 a fixed price contract, we still have a

 12 legally-binding obligation to deliver that grain.

 13 And so, if we are going to look at the market, and

 14 the market today is not converged, maybe the

 15 futures market is the cheapest source for us to

 16 purchase that grain. So we would go out and put a

 17 contract on, futures contract, as an anticipatory

 18 hedge that we know we are going to buy.

 19 I would say it's not even anticipatory,

 20 we know that we have this obligation to deliver

 21 the grain. We know we are going to buy it. And

 22 back to Joe's point, we don't have that flat price
 89

 1 risk, but we have that relative value of the

 2 futures price that we have agreed to use in the

 3 future with the customer that's buying the grain,

 4 and the cash price today that's not converged, the

 5 May futures contract, potentially, that we would

 6 be buying as a hedge. What we would do in that

 7 situation would be to sell that deferred contract

 8 and buy the current contract if it's cheaper to do

 9 that, and that's risk-reducing for us, because

 10 it's locking in that spread.

 11 MR. DANGER: I just wanted to tee up a

 12 very simple hypothetical on anticipatory

 13 merchandising or processing. So again, I want to

 14 abstract from the very complex world that you

 15 operate in, and just think about this.

 16 So we've got a firm that started up.

 17 They have no sales, no fixed-price sales, no

 18 fixed-price purchases, no inventory whatsoever.

 19 They then decide what -- they anticipate selling a

 20 lot of -- or merchandising in the future,

 21 anticipate selling a lot of product in the future,

 22 and as a result they go out and put on 100,000
 90

 1 contracts in corn, in the corn futures contract,

 2 the physical delivery contract. And then they go

 3 to CME or CFTC and they say, well, this a bona

 4 fide hedge because we anticipate selling this

 5 forward.

 6 And so my question to you, and I want

 7 you to think about this, I guess during the break,

 8 and then we can come back and talk about it, is

 9 this reducing risk for this firm, or is it

 10 increasing risk?

 11 MR. McGONAGLE: So, Ken, it comes back

 12 to the economic purpose test. But I know Joe had

 13 his card up.

 14 MR. NICOSIA: Thank you. In regards to

 15 the anticipatory hedging, as well as the inclusion

 16 of merchandising, a couple of comments; one is,

 17 currently the statute had merchandising in, and it

 18 was then removed; the question is whether it

 19 should be replaced or not. But it clearly also

 20 stated, besides merchandising, processing,

 21 producing, end users, where it recognizes the need

 22 for anticipatory hedging.
 91

 1 But even within that, a processer, an

 2 end user, after conversion is a merchandiser,

 3 because they have to sell their product, they have

 4 to market their product, transport it, store it,

 5 they make all those decisions that are being done

 6 completely as a merchandiser. So even within the

 7 realms of what you have, their activities are

 8 merchandising activities, which clearly are

 9 acceptable within the statute that's there.

 10 I think one of the other things that's

 11 important, and we are mentioning again about the

 12 ability, it's also the definition of what is an

 13 anticipatory hedge. Because I would echo what we

 14 have just heard, the ability to go ahead and

 15 procure supply against a fully-committed sale, the

 16 fact that it is a relatively-priced risk as

 17 opposed to an absolutely price risk, is not

 18 anticipatory at all. That boat is showing up, and

 19 you'd better put grain in it, or you're in

 20 default. And the fact that he is not going to

 21 price till a day or two before that boat shows up,

 22 in no way removes the obligation that we have to
 92

 1 perform in order to move our farmers' grains into

 2 that boat from where it is there. It is simply

 3 not an anticipatory hedge whatsoever; it's a

 4 normal course of business.

 5 MR. McGONAGLE: I think we have -- in

 6 getting back to Kristin's hypothetical, or

 7 real-world scenario, a couple of specific items

 8 after the break that we want to get into and sort

 9 of unpack -- un-package that a little bit more.

 10 Ron and Ed, as between you two, and I don't know

 11 who had the card up, so you take us to the break,

 12 Ron.

 13 MR. OPPENHEIMER: Okay, thanks. I'll be

 14 very quick. Two things; first is, you know, you

 15 look at the question and you say is there a basis

 16 for granting an exemption for anticipatory

 17 merchandising transaction that establishes price

 18 risk. What you heard around the table is, they

 19 don't establish price risk, they mitigate price

 20 risk, and so the question is backwards and, you

 21 know, all of the comments are that these

 22 transactions reduce risk.
 93

 1 The other point I wanted to make was

 2 with respect to Ken's question, is that there's a

 3 process that is in place that works, and that

 4 should mitigate any concern that Ken has. Okay.

 5 On the federal level, if you were going to use an

 6 anticipated production hedge exemption or an

 7 anticipated requirement exemption, you apply in

 8 advance. In the energy space, where we are not

 9 under a federal regime, we go to the NYMEX and we

 10 make a case. So if we are brand new, and we have

 11 no contracts, and we have no employees, and we

 12 never chartered a ship, NYMEX might look at us and

 13 say, you're crazy, you're not getting a hedge

 14 exemption for that.

 15 But if we've been in business and we

 16 have the right staffing, and we have the right

 17 systems, and we can demonstrate that there's a

 18 real probability that we are going to be doing

 19 that business, we might convince them. And on top

 20 of that, they have the ability to say, you know

 21 what, we don't like 100,000, that doesn't work in

 22 this market context, you can have an exemption to
 94

 1 50. I don't know what the corn levels are, but

 2 the point is, they have the ability to moderate

 3 that, and we have that going forward even under

 4 the new federal limits for energies and other

 5 physical commodities.

 6 MR. McGONAGLE: Great. So let's go --

 7 oh, Tom.

 8 MR. LaSALA: Just real quick, to echo

 9 Ron's words. What he said was accurate, Vince.

 10 You know, in that very, very scripted tight

 11 hypothetical that Ken put out, the likelihood of

 12 an exemption there with -- you know, we just

 13 started up, we've done nothing. Now let us get

 14 that exemption? No. That's impractical, but

 15 where you've demonstrated, you know, I have sold

 16 and distributed, this history, that is frankly

 17 what we look at, and it is, I think again, just to

 18 state for the record, regardless of what the

 19 underlying exposure is for any exemption. I think

 20 you know that exemptions are not just simply

 21 blanket; meaning that, yes, you are exempt, go

 22 with your free will, unbridled, enjoy.
 95

 1 It doesn't simply work like that. We

 2 look at what the liquidity profiles are in the

 3 market, even if you have requisite exposure, we

 4 look at what the open interest is, what the

 5 liquidation patterns have been in the contract to

 6 make sure that we are not granting an exemption

 7 that gives someone undue concentration or control,

 8 so there is quite a bit of review process around,

 9 you know, what you grant in terms of exemptions

 10 modifying the ask down, tiering those numbers

 11 down.

 12 MR. McGONAGLE: Okay. And I appreciate

 13 that, Tom. So we are going to take -- we'll take

 14 a break, when we come back we'll have about 45

 15 minutes. We are going to talk about testing, firm

 16 bids or offers, synthetic fixings, unpriced

 17 physical purchase or sales; and then a process

 18 surrounding whether there should be an

 19 un-enumerated hedge exemption review, and we'll

 20 try and do that within 45 minutes.

 21 It's about 11:05, if we can come back at

 22 11:20 that would be great. Thank you.
 96

 1 (Recess)

 2 MR. McGONAGLE: So, before we went into

 3 the break we talked about some specific -- we

 4 wanted to get into some specific examples and,

 5 again, the focus here from our perspective, from

 6 the Staff's point of view is, we really want to

 7 get into the details and get as concrete an

 8 understanding about how best to evaluate these

 9 issues. How these risks are evaluated at the

 10 firm, how that information can be reviewed by the

 11 Agency, so we can make, you know, meaningful

 12 decisions with recommendations with respect to

 13 this rulemaking.

 14 So as concrete as you can be during the

 15 remainder of the session is, of course, very

 16 helpful. I do want to turn it to Ken to walk

 17 through some of these specific hypotheticals, or

 18 scenarios, on hedging to get your perspectives on

 19 where we can draw some lines.

 20 MR. DANGER: So I think what we can do

 21 is, we can draw together one of the comments by

 22 Joe, and then another comment by Kristin with
 97

 1 respect to hedging unfixed price contracts. So,

 2 the specific question on the table here is, can

 3 you hedge unfixed price contracts, forward

 4 commitments to supply or purchase with fixed-price

 5 future contracts? Or alternatively, would it be

 6 better to hedge those unfixed- price forward

 7 commitments with another unfixed-price commitment?

 8 And so what I'd like to do is to help us

 9 think about that, is to draw on the experience of

 10 CME. And look to Tom and say, Tom, what's your

 11 thoughts, what is -- on hedging basis risk --

 12 basis contracts with fixed-price futures

 13 contracts?

 14 MR. LaSALA: Ken, in the enumerated

 15 space, I believe that we are bound to have both

 16 the legs, like the purchase of the basis tied with

 17 the sale. So you could have basically a spread,

 18 if you are buying basis on one month, selling

 19 basis on another month, we look for the pairing.

 20 That's the -- in the enumerated space I think that

 21 -- I would say that that's the standard that Joe

 22 Hawrysz's team would abide by.
 98

 1 MR. DANGER: You're right. So there is

 2 an example in CFTC regs that focuses on basis

 3 contracts in different delivery months, but I want

 4 to focus on just a very simple -- again, it's to

 5 help us to focus on the most simple possible

 6 example, because our complex world is built up on

 7 simple things. So, if you have an unfixed-price

 8 contract in one month, right, out the curve some

 9 point in time, can you hedge that unfixed-priced

 10 commitment with a fixed-price future -- fixed

 11 price contract?

 12 MR. LaSALA: You've got an unfixed

 13 purchase somewhere out the curve?

 14 MR. DANGER: Sure, yeah. So you've

 15 promised to purchase corn six months out, based on

 16 whatever the futures price will be at that

 17 particularly point in time.

 18 MR. LaSALA: And you want to --

 19 MR. DANGER: Can you hedge that with a

 20 futures contract? So that's the question, and so

 21 --

 22 MR. LaSALA: Forgive me. Is the hedge
 99

 1 that you are looking to sell futures?

 2 MR. DANGER: Sure. I mean, in this

 3 particular case, or purchase. You know, that's

 4 whatever you think is appropriate there.

 5 MR. LaSALA: Again, I question maybe --

 6 the sale is not obvious to me in that

 7 hypothetical, but if in fact you were -- you

 8 purchased futures in connection with it, and there

 9 was another sale of futures, that somehow

 10 represented something that was along an

 11 anticipatory line, I think that package could be

 12 something that would be acceptable.

 13 MR. DANGER: I think what, I mean, Joe

 14 and Kristin were saying was that when you've got

 15 unfixed-price commitments to purchase, what you'd

 16 want to do is -- and I think what they talked

 17 about is, hedge that risk through the fixing of --

 18 making sure that you have commitments to satisfy

 19 or to get rid of that risk, and the way to do

 20 that, is through -- potentially through futures.

 21 So maybe Joe could help us out on what his

 22 thoughts are, and maybe Kristin.
 100

 1 MR. NICOSIA: Yeah. I'd like to take

 2 you through a real life example, and maybe it's a

 3 little long, so please excuse that. But let us

 4 say -- let us start with we sell 0.5 million tons

 5 to the Chinese, unfixed, for January delivery out

 6 of the Gulf. Now, at that point in time all we

 7 have is an unfixed sale, but we know that it is a

 8 real commitment that we have to go through. All

 9 right, so now let's go ahead and cover that,

 10 because your question is, there's different ways

 11 to cover that, so let's cover them all, and see

 12 what should happen. Let's see what the

 13 differences are.

 14 So the first day I go in; and let's say

 15 I've sold -- not to get too complicated, but let's

 16 just say that I sold it at 90 over to January. I

 17 go into the barge market and I'm able to buy

 18 barges the next day at 82, so I buy them, and they

 19 may be on call, so I buy some quantity, that's

 20 fine. The next day there are barges offered to me

 21 at $12.50, which equates to 88 over. I buy it at

 22 $12.50, I sell the January, that's the proper
 101

 1 hedge. You would say that that's okay.

 2 The next day I move on to the Illinois

 3 River, somebody offers me 90 over down there, I

 4 buy them from them on call. You say that's okay.

 5 Then I tell you, oh, by the way, yesterday those

 6 90 that I bought on call, that 90 undelivered,

 7 they happen to be registered delivery stocks. But

 8 I bought them from the elevator -- the owner in

 9 the elevator, who just happened to sell them to me

 10 at 90 over. You'd say that's fine.

 11 The next day I turn around and I buy

 12 some more, and I buy them at 12.50, and I hedge

 13 them in the January, at 90 over. And then I turn

 14 around, and I tell you, oh, those I bought at 90

 15 were also delivery stocks but I bought them

 16 through the CME, because the elevator operator who

 17 had those other stocks now wanted 95. So I bought

 18 them because they were cheaper, but they were the

 19 seller through the Exchange, but in order to buy

 20 them through Exchange I needed a long November

 21 future, you tell me no, you don't have the right

 22 to have a long November future in order to procure
 102

 1 your cash.

 2 I can buy the same grain, from the same

 3 person, yesterday, and you say it's fine. But

 4 because I bought it from him through the Exchange,

 5 you tell me I cannot do that. That is not

 6 logical. So, I do need the ability to be able to

 7 have a futures position, to be able to procure my

 8 grain, and in that particular case, what we would

 9 do, is we would buy November, sell January.

 10 That would be the equivalent, because it

 11 ends up, when it comes to fruition, delivery, it

 12 turns into a basis trade that offsets our delivery

 13 risk. But since it is the cheapest source of

 14 cash, it is the equivalent of buying cash at that

 15 point in time. And thus it is a legitimate hedge

 16 and a reason to have it done that way.

 17 MR. DANGER: Kristin, did you want to

 18 follow up with any comments there?

 19 MS. ROBERTUS: Now I would say I agree

 20 with that example. I think in our example too,

 21 what we were saying is if we have this legally

 22 binding obligation to deliver and it's the
 103

 1 cheapest route to do that, we will do that.

 2 Again, we would sell, in his example, the January,

 3 buy the November, but in our case we would say, if

 4 the -- that would be if market is not converged --

 5 if the market then converges, we will get out of

 6 that spread position, we would buy back the

 7 January, sell out the November and then go into

 8 the cash market and buy that.

 9 But in our example, too, if we are

 10 pricing with the Chinese in January, we'd likely

 11 have agreed with them that we will take an

 12 exchange of futures. We know we are going to get

 13 a long futures position from that Chinese

 14 customer, and we are just shorting that, it will

 15 be covered when we price the contract. So, you

 16 know, in our example we are saying, this is

 17 happening, and when it's not converged, and we

 18 believe that we're reducing the risk that we have,

 19 and we are also promoting convergence in the

 20 market.

 21 MR. NICOSIA: And to add onto that real

 22 quickly. In that same example that I used, if the
 104

 1 very following day the Chinese priced their

 2 contract, where it turned to fixed and we had the

 3 futures, which is exactly the same. It is a basis

 4 contract, exactly the same as it was the day

 5 before, the next day when I came to you and said

 6 I'm going to procure my beans on the November.

 7 You would say okay, because now it's a fixed price

 8 with a future versus being on call, which are

 9 exactly the same things, but you draw that

 10 distinction between the two, when the relevance to

 11 us is exactly the same. There is absolutely no

 12 difference between those two sets of parameters.

 13 MR. McGONAGLE: Tim?

 14 MR. BARRY: Yeah. I just want to say,

 15 you know, we have both enumerated and non-

 16 enumerated ags, and the type of transaction you're

 17 describing, and what Joe was just describing, in

 18 grains, it's something we see all the time Coffee,

 19 Sugar & Cocoa, and we have for years -- you know,

 20 we've been able to document the bona fide nature

 21 of the unfixed price call, sale or -- call, sale

 22 or purchase. But we've routinely used them, and
 105

 1 seen them work well, for hedge exemption purposes,

 2 and for purposes of managing the risk that the

 3 commercial parties have. So, it would not be

 4 unusual at all in those spaces.

 5 MR. McGONAGLE: Kristin, and then back

 6 to Lael.

 7 MS. ROBERTUS: Yeah. I wanted to point

 8 out, also I think further to what he was saying.

 9 In our example, if the market wasn't converged,

 10 even if we had that fixed price contract on that

 11 July sale, we would take exactly the same action.

 12 We would sell out the January and buy the November

 13 if it was the cheapest option. So it would be no

 14 difference to us the way we would hedge that if it

 15 was unpriced versus priced in a market that wasn't

 16 converged.

 17 MR. McGONAGLE: So we are -- we are

 18 asking back and forth here, and what's come up a

 19 couple of times, so in looking at these hedge

 20 exemptions, so we focused on price risk or some

 21 performance risk, and what is the intention of the

 22 hedge? And so, you know, we are not talking, in a
 106

 1 number of these instances about price risk, you

 2 are talking about -- or are you talking about

 3 performance obligations? And so how do I get your

 4 concerns about whether you are going to get your

 5 product, or be able to deliver your product, risk

 6 concerns surrounding who the counterparties are,

 7 on to an idea of evaluating whether you've

 8 increased risk and are therefore not entitled to

 9 seek an exemption for that reason.

 10 MR. DANGER: A simple -- to tee up the

 11 hypothetical here, or an example, which is, is the

 12 combination of an unfixed-priced contract, and a

 13 fixed-price contract, in these examples that

 14 you're working through, basically the same thing

 15 as just buying a fixed-priced contract? In other

 16 words, with the fixed-priced contract, when the

 17 prices change in the market, the value of that

 18 contract changes, but with an unfixed-price

 19 contract the value of that contract isn't really

 20 changing; there's no real price risk.

 21 What you've got is performance risk, and

 22 so what you have is, with unfixed-price contracts,
 107

 1 you've got concerns about the performance on that

 2 contract. And so what you want to do is, from a

 3 hedging perspective, is match up those risks, and

 4 a way to do that, and I'm looking for your

 5 thoughts on this, is the way you do this, with

 6 hedging that unfixed-price commitment with another

 7 unfixed-price contract, rather than a fixed-priced

 8 contract which would seem to establish price risk.

 9 Or am I getting it wrong?

 10 MR. CAMPBELL: I mean, I want to look at

 11 it from the aspect of a purchaser of an unfixed

 12 price, a physical forward, you know, and I think,

 13 if you are a purchaser of a physical commodity at

 14 an index price, you have price risks that you

 15 should be able to hedge. So, for example, if I am

 16 an electric generator, I have a fuel requirement

 17 that I need to fill. I may enter into an

 18 unfixed-price physical contract to lock in my

 19 supply and make sure I have the supply risk taken

 20 care of.

 21 But just because I've locked in my

 22 supply risk and taken care of that, I still have
 108

 1 price risk, because that forward, physical futures

 2 contract for fuel is at a variable indexed-base

 3 price. I have price risk in the future and even

 4 though it is unfixed, I as the generator should be

 5 able to hedge that risk and lock it in when I see

 6 the opportunity to.

 7 MR. DANGER: Does everybody agree with

 8 that. I mean, is that all unfixed price contracts

 9 have price risk? I mean, is that the consensus

 10 here?

 11 MR. CAMPBELL: From a purchaser's

 12 standpoint, absolutely.

 13 MR. McGONAGLE: Let's go to John.

 14 MR. PARSONS: Yeah. So, if you break

 15 this hypothetical of the supply into two pieces,

 16 which is the contract to sell, and the obligation

 17 to purchase, clearly the obligation to purchase

 18 whenever you enter into the future, you are

 19 reducing the risk, right. Because you have an

 20 obligation at an unfixed price the moment you

 21 execute the futures contract, you've reduced the

 22 risk on that one half of the obligation.
 109

 1 It is true, though, that you've left

 2 yourself wide open on what are you going to

 3 receive for the stuff that you are procuring. So,

 4 you know -- I mean I see where you are coming

 5 from, the total risk is higher, but that was true,

 6 the moment you made -- in the hypothetical he

 7 constructed -- the moment you did the

 8 unfixed-price sale, you created this risk. Now

 9 when you go and procure a piece of it, using

 10 something that is deliverable on the contract --

 11 on the futures market, at a fixed price, you are

 12 reducing the risk on the procurement, but you're

 13 not reducing your total risk.

 14 MR. DANGER: So it seems like -- I mean

 15 just -- you disagree with their ideas on, that it

 16 is a risk-reducing transaction?

 17 MR. PARSONS: Yeah. I think I'm trying

 18 to find a way to incorporate what people are

 19 saying, and clarify. It's clearly a mechanism for

 20 securing -- for procuring your supplies, so you

 21 are going out and doing, and what they are looking

 22 to do is do that at the cheapest price. You are
 110

 1 not reducing your total risk exposure.

 2 MR. McGONAGLE: Ed?

 3 MR. PROSSER: I would like to first

 4 point out that the best way to start a speculative

 5 trade is not to sell a half a million ton of soy

 6 beans to the Chinese. Ken, if there was a perfect

 7 hedge. If there was a basis- only trade, is what

 8 we would call it. Or an unfixed entity, or trade

 9 option out there, we could use that. We spent all

 10 this year in Dodd-Frank trying to make sure that

 11 we get back on Exchange.

 12 Surely we are not wanting to push us

 13 back off into non-enumerated commodities in the ag

 14 space. I mean, I think what we are trying to get

 15 across, I hope we are getting across, this idea

 16 that we are on this continual search for the best

 17 hedge that we have. And a lot of these times we

 18 make the choice of between the best of two bad

 19 options, but it does reduce our risk, because we

 20 do have an obligation. Certainly when that boat

 21 shows up in New Orleans we've got to load it, and

 22 there are opportunities to mitigate some of that.
 111

 1 Is it perfect? No. But it's the best that we

 2 have today.

 3 MR. McGONAGLE: So looking at your --

 4 the example that you started with, so where do we

 5 -- where can we -- where would you put our markers

 6 for identification? And you know, there's

 7 actually going to be an offsetting transaction

 8 that justifies establishing this -- you know, as

 9 someone referred to earlier, this pre-hedge. How

 10 do we -- how are we going to articulate that in

 11 this anticipatory world? Where do we -- what

 12 should we be looking for? And how the firm is

 13 managing its business, and how you're representing

 14 that, the need for the hedge to us?

 15 MR. PROSSER: I'll let Joe finish, but I

 16 would think that in --

 17 MR. McGONAGLE: A number of flags up

 18 now, yeah.

 19 MR. PROSSER: -- in the beginning all of

 20 those things that we've talked about so often, the

 21 204s, the process we go through with our DCMs on

 22 hedge exemptions, again, if you are a new company
 112

 1 and just show up with a fixed -- with an unfixed

 2 hedge, the CBOT is going to start to ask

 3 questions. Have you ever done this business

 4 before? What are you trying to do? I think they

 5 are all --

 6 MR. McGONAGLE: So it's all facts and

 7 circumstances approach effectively? I mean,

 8 that's what we are hearing.

 9 MR. PROSSER: In Gavilon's opinion, yes.

 10 MR. McGONAGLE: Yeah. David, Joe and

 11 then we'll go to Mike and Kristin--

 12 MR. PEARLMAN: Yeah. I'm going to make

 13 a very quick comment, and just in furtherance of

 14 Lael's example, because in the energy world, in

 15 the purchase scenario he was describing, very

 16 often the unfixed supply sale, is from a

 17 counterparty that doesn't have a strong balance

 18 sheet. So if you can get a firm, fixed price from

 19 them that would be fine, if you were comfortable

 20 with their credit. Because if they default, then

 21 you're not going to be able to get the

 22 mark-to-market value that you would get because of
 113

 1 the credit concerns, and you are not going to be

 2 able to do that deal.

 3 So you can bifurcate and actually do an

 4 overall risk mitigating transaction by buying at

 5 spot market from someone who was a logistically

 6 capable supplier, who is going to have no issues

 7 supplying you something at spot market and getting

 8 it to your location. And then you go to the

 9 Exchange and you hedge that with a hedge that is

 10 going to be credit, completely bulletproof.

 11 So you've got both pieces matched up.

 12 You have your supply at a very reliable manner

 13 brought to you, but you couldn't fix that price

 14 and rely on that supplier. And then you have a

 15 way to fix your price, and resolve the credit

 16 issues you would otherwise have with the supplier

 17 and you've reduced overall credit -- I mean,

 18 overall risk, pardon me.

 19 MR. DANGER: I heard you say something

 20 slightly different than what we started out with.

 21 Which was, we have an unfixed -- you have an

 22 unfixed-price commitment and then you went and
 114

 1 fixed that price through a spot contract, and then

 2 you hedged that price risk associated with that

 3 spot -- fixed-priced spot contract with futures.

 4 MR. PEARLMAN: I was going to -- I was

 5 commenting on Lael's example which was, you were

 6 making an unfixed purchase, and then you were --

 7 effectively that existed, and then you were fixing

 8 that price with the futures.

 9 MR. McGONAGLE: Joe.

 10 MR. PARSONS: In response to your two

 11 questions, on the end of the -- the one that you

 12 just asked, which was, how are you able to look at

 13 the need, or the ability to make a determination

 14 about that hedge being proper or not? And you had

 15 that information currently that is available.

 16 You'll see, in order to be able to have that to

 17 justify its position there's two things, the cash

 18 market will have to converge and that the delivery

 19 market is a cheaper source of supply, either due

 20 to time, location, price, quality.

 21 And the other thing is that you have an

 22 offsetting need. So if you turn around and you're
 115

 1 long 20 million bushels at the Gulf as opposed to

 2 a short 20 million bushels at the Gulf, it's two

 3 very different needs of what it is that you have.

 4 You have that information available so that you

 5 would be able to see that and determine it.

 6 To the other question that Ken had asked

 7 about is it a risk-reducing transaction, and in

 8 this case I fully disagree with John. It's

 9 absolutely a risk-reducing transaction. As a

 10 matter of fact when you bring it to the end, it

 11 completely closes it out to zero, so your ability

 12 to take the November, sell the Jan, that is the

 13 same thing as buying 90-over at the Gulf.

 14 The fact that you bought it through the

 15 Exchange because it was a cheaper source of

 16 supply, should in no way have anything to do with

 17 changes of risk. It's not taking on flat price

 18 risk, it's substituting a purchase of basis for

 19 the other, because by being long the Nov, when we

 20 look at only the Nov it looks like you are just

 21 going long one month and it's a flat price.

 22 But if you have -- offsetting other
 116

 1 positions, whether it's a sold January a sold

 2 March, you'll have it as a basis contract, and

 3 that is an almost perfect mitigant against that

 4 basis sale that you have.

 5 MR. DANGER: I mean, I don't want to

 6 speak for John, but I mean I think that John is

 7 going to say something like this; which is, that

 8 when you do that fixed-priced contract, which is

 9 the "risk-reducing transaction" in this case a

 10 long futures contract, if the price of that long

 11 futures contract goes down, then you suffer a loss

 12 on that position.

 13 MR. NICOSIA: No. You don't. Because

 14 you are offsetting, it's the short against the Jan

 15 so as they go down you make it back against the

 16 January. So the November goes down you lose, but

 17 you short the Jan against it, you've locked in

 18 90-off, that's exactly what we do when we hedge,

 19 that's the basis. So there is absolutely no flat

 20 price risk in that scenario whatsoever.

 21 MR. McGONAGLE: Kristin, and then Mike.

 22 MS. ROBERTUS: No. I would say the same
 117

 1 thing. In John's example I would agree, if the

 2 only think we were doing was going long the

 3 November, but the situation we are talking about,

 4 going long the November and going short in the

 5 January, is risk-reducing. We are completely

 6 offsetting both legs of that transaction, so it is

 7 risk-reducing.

 8 MR. McGONAGLE: Mike?

 9 MR. RICKS: Yeah. I would be redundant

 10 at this stage because I -- those were the points I

 11 was going to make. If you have an unpriced sale,

 12 is it appropriate to hedge it with the flat-priced

 13 futures? No. Is it appropriate to hedge it with

 14 a spread position; long the nearby, short the next

 15 month? Absolutely. Is it appropriate to carry

 16 that long, nearby futures position offset with a

 17 short in a deferred into delivery and use that as

 18 a way to fulfill that sale, if that is the

 19 cheapest source of cash? Absolutely, that's how

 20 these markets work.

 21 And to deny that just because -- whether

 22 a contract is priced or not, is purely
 118

 1 happenstance. It's the buyers right to decide

 2 when to price. I mean it's how they manage their

 3 risk; so whether it's priced or not, it's a

 4 commitment, and that's all the people are trying

 5 to say.

 6 MR. McGONAGLE: Ron?

 7 MR. OPPENHEIMER: Yeah. Just a couple

 8 of things; first is, calendar-month average

 9 pricing wasn't in your series of questions, but

 10 this discussion goes, you know, almost identically

 11 to that, and so, you know, if we want to move on

 12 and just park that one, and recognize that when

 13 you go back and analyze, whether or not to grant

 14 that exemption.

 15 The other point I wanted to make, and

 16 it's, you know, I love hearing the traders talk

 17 about it, because they do ways -- do so in ways, I

 18 can't, but you know what I'm hearing, and I think

 19 it's appropriate to pull back just a little bit,

 20 is the questions in this discussion and in the one

 21 on cross-commodity was really about the subjective

 22 valuation of the quality of the hedge; and not at
 119

 1 all about use of anything for excessive

 2 speculation.

 3 And I think it's really important again

 4 that we pull back and we think about what these

 5 rules are here for and what they are intended to

 6 protect, and whether or not it fits in exactly a

 7 definition that exists, and has existed for -- you

 8 know -- in the statute for, you know, tens and

 9 decades, and scores of years, isn't really the

 10 question. The question is whether or not the

 11 Commission should recognize it today, and I think

 12 the overwhelming answer that you hear from the

 13 commercial side is, it has to.

 14 MR. McGONAGLE: All right. We are about

 15 ready to go to the second Panel. You all are

 16 participating in the second Panel, so please don't

 17 get up. But before we do that, we want to check;

 18 is there any area in the conversation today, on

 19 hedging, that we've missed, or that needs to be

 20 underscored? You know, Ron just brought up one

 21 other item that we hadn't talked about, and I just

 22 want to touch that base now, as you were thinking
 120

 1 about what we've discussed this morning, if you

 2 have any sort of final short remarks, let's get

 3 those. Joe?

 4 MR. NICOSIA: Mine will be real short.

 5 I hope our Panel today has been able to provide

 6 you with enough information of why you need to

 7 re-include merchandising into the statute

 8 language. Thank you.

 9 MR. McGONAGLE: David?

 10 MR. PEARLMAN: Riva had asked at one

 11 point, should we let the exchanges make these

 12 decisions, or how should we deal with these

 13 things? And my answer to that question is, yes.

 14 They are doing a great job today in using, in the

 15 non- enumerated space, their knowledge and

 16 understanding, and have the dialogue with the

 17 folks who were seeking the exemptions. And if

 18 there is any way that that expertise can continue

 19 under the new regime at the Federal level as well

 20 as at their level, that would be much appreciated.

 21 MR. CAMPBELL: I just want to reiterate

 22 that -- again, that our companies have risk
 121

 1 management teams that are analyzing and assessing

 2 these risks every day. And, again, if we are not

 3 doing it right, if the trader is not hedging

 4 properly or doing it right, he's losing money for

 5 the firm and he's not doing his job, and there's

 6 going to be consequences.

 7 But, please, do not limit alternatives,

 8 do not limit ways that companies like ours can

 9 manage risk. At the end of the day, when you

 10 limit ways to manage risk, that is going to be

 11 reflected in higher prices for end use consumers.

 12 MR. McGONAGLE: Anyone else? Yeah?

 13 Okay. So let me move to the second Panel. And

 14 what I like about the second Panel is it talks

 15 about a process for non-enumerated exemptions, and

 16 so in my mind, that means we've figured everything

 17 else out, and now we are looking to see what else

 18 could -- needs to be done on a going-forward

 19 basis.

 20 In the Notice of Proposed Rulemaking,

 21 there was some commentary about how to handle,

 22 sort of, transparency. You know, the transparency
 122

 1 goal for non -- for determining further

 2 exemptions. And so we put forth to the Panel

 3 today, this question about whether we should

 4 reserve back regulation 1.47, and if we reserve

 5 back an opportunity for individual request for

 6 non-enumerated exemption, how can we do that in a

 7 way that informs? How can we best do that in a

 8 way that informs the public? So I'll sort of

 9 start with that general policy question, and

 10 solicit your comments about whether and how we

 11 should reserve 147. Go ahead, Ron.

 12 MR. OPPENHEIMER: I'll take a shot. I

 13 think that you have to look at it in two ways, and

 14 I may not offer you a solution to both ways, but

 15 you have to look at it in two ways. Some of the

 16 requests under 1.47 are for systemic types of

 17 changes. You know, structural changes, things

 18 that -- new types of transactions that hadn't been

 19 considered before. As they have been in the past,

 20 most of the requests were for hedging swap risk in

 21 ways that it hadn't been done before.

 22 And those were sort of -- I don't know
 123

 1 what the right word is for it, but maybe call it a

 2 class exemption. And those I could see the need

 3 and the benefit from a public comment type

 4 process. But when you look at the things we've

 5 been discussing today, and the things that were in

 6 the Working Group's petition, those will come up

 7 on a transaction-by-transaction basis.

 8 And there's just not time, opportunity,

 9 or really an appropriate need for subjecting those

 10 to public comment, and for subjecting those to the

 11 lengthy period of time that would be necessary for

 12 that. And it will impede the ability to do a

 13 commercial transaction in the speed with which it

 14 has it be done. So I think you need to -- you

 15 break it up and look at it in two different

 16 pieces.

 17 MR. McGONAGLE: So let me draw that out

 18 a little bit, because we've, I guess, received

 19 some comments or questions concerning whether, at

 20 the time of an application for an exemption, that

 21 the firm submitting the application is good to go

 22 until told otherwise. And whether that's a good
 124

 1 process, and is that a good -- why would that be a

 2 good process?

 3 MR. OPPENHEIMER: I think for the

 4 individual transaction it should be. I think

 5 maybe we'll look at Tom a little bit but, you

 6 know, when you're dealing with the Exchange,

 7 again, what you do is you apply in advance for a

 8 hedge exemption. They tell you the sort of scope

 9 of what you can do if you have an individual

 10 transaction that you need to do, you can do that

 11 within that umbrella. With the structure that is

 12 being set up for federal spec limits, you don't

 13 apply in advance necessarily, and then you just

 14 notify afterwards.

 15 And that flip of the process is what's

 16 creating this problem for you, I think. And so I

 17 think if we revert back, again, to an Exchange

 18 process where, perhaps, you've either told the

 19 Exchange in advance in your initial application,

 20 or you go to the Exchange with the specific

 21 transaction, you'd be in a position where it got a

 22 level of review in a timely fashion, and the
 125

 1 commercial firm was able to do the transaction

 2 they were looking to do.

 3 MR. McGONAGLE: He's drawing you out,

 4 Tom.

 5 MR. LaSALA: So he is. Vince, I do

 6 think that the Exchange would have an appetite --

 7 I know that Tim also -- you know, has some

 8 thoughts on this, so I'm not going to speak for

 9 him, but I think the exchanges would be open to a

 10 1.47-like process but -- but whether you would

 11 say, we are doing it on behalf of the Commission,

 12 we are doing the initial review from the

 13 participant, by the DCM, passing those results on

 14 to the Commission.

 15 I think there's an appetite there where

 16 we can be an effective tool in assisting this

 17 process. I think there are some -- certain

 18 conditions or stipulations we'd need to make in

 19 that. I'd say that, you know, we are acting in

 20 good faith in reviewing the facts and

 21 circumstances, and the appropriateness, as you

 22 would --
 126

 1 MR. McGONAGLE: But would you be making

 2 that information publicly available? Sort of, you

 3 know, masking in some respects I guess, the nature

 4 of the request, but giving information out to

 5 market participants, so that they otherwise can

 6 rely on the exemption that's been provided?

 7 MR. LaSALA: In what I'm contemplating

 8 here, I hadn't; however, I think that there should

 9 or -- there could or should be some type of a

 10 means by which, if you see DCMs coming to the CFTC

 11 with repeat comparable examples that may be the

 12 stimulus for the Agency to maybe even possibly

 13 look at those types of, what you might call,

 14 currently non-enumerated. Maybe they should be,

 15 in fact, enumerated.

 16 So I think, again, a process could yield

 17 light to that. But I do think we need some type

 18 of an understanding that in conducting that

 19 activity, we are doing so in good faith, we may

 20 render those decisions that the Agency, if you

 21 decide otherwise, in hindsight, that you don't

 22 agree, that we haven't somehow violated any kind
 127

 1 of a core principle.

 2 I think we also probably need to

 3 consider some type of a structure where we are not

 4 drawing disparate conclusions, such that I think

 5 it -- you know, example X seems to work by my

 6 review, or my team's review of the activity and

 7 another DCM's review is to the contrary. I think

 8 we have to contemplate how we would do it.

 9 MS. ADRIANCE: It seems as if what you

 10 are suggesting is a maybe an additional process, I

 11 mean there was 1.47, there was the Exchange

 12 processes, there was the proposal which did not

 13 continue 1.47, it's seems like you are talking

 14 about a third, fourth alternative, which was in a

 15 sense, perhaps, a joint effort between the DCMs

 16 and the Commission, that you're envisioning. And

 17 I'd just like to have you, kind of, explain maybe

 18 a little further as to what -- how you think this

 19 might work in terms of -- it sounds like you

 20 thought each Exchange could do, you said, the

 21 initial review, then it would come over to the

 22 Commission. What is it that you say is the most
 128

 1 productive, most -- well, timely, productive, and

 2 efficient way to carry this out?

 3 And we would like to hear. And we've

 4 gotten all kinds of comments as was mentioned. We

 5 would like to hear from your perspective, and I'd

 6 like to actually hear from both of your

 7 perspectives, both exchanges, what is it you view

 8 as the preferred way that we should look at this?

 9 Because I mean we've heard some of the -- you

 10 know, from some of those who use these things,

 11 they want just the most timely, the simplest ways,

 12 obviously, the best for them. What is it from

 13 your perspective?

 14 MR. LaSALA: Riva, again, you know,

 15 frankly the questions that were posed to the Panel

 16 are what provoked the thought as to --

 17 MS. ADRIANCE: Yeah. You're right.

 18 MR. LaSALA: You asked for other

 19 alternatives, and so I did certainly give some

 20 thought to what those alternatives could be, and

 21 there was an eye towards an expeditious handling

 22 on the part of the participant applying. You
 129

 1 know, some -- let's call it, you know, 30-day

 2 window--some structure where the information comes

 3 to the Exchange, and we've got a set amount of

 4 time to respond. If we have questions, we'll have

 5 the ability to go back. We have then the ability

 6 to, you know, do one of, maybe probably three

 7 things. Grant it, deny it, or if the -- you know,

 8 the party doesn't seem to be satisfying us, and we

 9 are saying we don't see this right now, they could

 10 potentially withdraw it.

 11 You know, let's say, for example, we

 12 pass on it positively. We advise the Agency, send

 13 the file over, you've got an ability there to

 14 review it. Again, that seemed like an expeditious

 15 means in attempting to process these. I do thing

 16 that you'd have to have some kind of a process on

 17 your side, where you're looking at the totality of

 18 these documents that are coming at you, and to the

 19 extent that they are consistent, maybe you want to

 20 have a process where you consider moving them into

 21 a more enumerated type classification. If you see

 22 a conflict I think that's probably a bad outcome,
 130

 1 and that should be brought to the attention of the

 2 DCMs. Or if you see it, you know, again, somehow

 3 intercepted, we -- again, Tim and I haven't talked

 4 about it at length, maybe there could be a process

 5 of information-sharing during the initial process,

 6 so that we can collectively see that we are on the

 7 same page.

 8 So I can't say to you that I've thought

 9 from front to back, every possible step, but it

 10 was simply an attempt to come up with an

 11 alternative that I think that the industry was

 12 looking for, because their concern was expeditious

 13 answer.

 14 MR. McGONAGLE: Tim?

 15 MR. BARRY: Yeah. I would agree. And

 16 this is, I think, one of the happy circumstances

 17 where each of the two exchanges looked at the

 18 documents in front of us and came to the same

 19 conclusion. You know, you almost suggested that,

 20 in your question number three, are there

 21 alternatives to the procedure such as exchange

 22 review and approval that would support a
 131

 1 pre-approval reliance. I think we both -- the

 2 light bulb went off on both exchanges at the same

 3 time, that absolutely, that would be an

 4 expeditious, appropriate process, with the

 5 protections that Tom mentioned for the, you know,

 6 presumption of good-faith actions on the part of

 7 the exchange, and that the commercial entity who

 8 has gone ahead and relied upon the initial

 9 favorable ruling from the Exchange.

 10 You know, we haven't talked in any depth

 11 about trying to find a mechanism to ensure that

 12 there would be consistent treatment across the

 13 different DCMs of similar circumstances. That's

 14 clearly is something that we probably should think

 15 about. Obviously anything that would be done,

 16 would be done subject to CFTC final approval and

 17 review, and that would help provide a forum for

 18 ensuring that the two exchanges don't have

 19 disparate outcomes in similar circumstances.

 20 But it does seem to be a reasonable

 21 route, to try to address the concerns of the

 22 commercials that this new process at the CFTC
 132

 1 alone might take too long. While, you know, still

 2 meeting your objectives, and I think that --

 3 MR. McGONAGLE: So then the question

 4 there, in terms of what is expeditious versus what

 5 is time-constrained.

 6 MR. BARRY: Right.

 7 MR. McGONAGLE: So if there's some

 8 marker that's 10 days and yet you are hearing some

 9 of these strategies that are very complex, then

 10 you have the ability at an Exchange or at the

 11 Commission level, frankly, to consider the nuances

 12 in order to consider the application, including

 13 the more broad application, not just for the

 14 submitter. So, I think that's some of the items

 15 that we are trying to get at, and you know, the

 16 management of resources of course by the Agency as

 17 well as the exchanges shouldn't be diminished.

 18 MR. BARRY: Great.

 19 MR. LaSALA: Yeah. Vince, one

 20 additional point, and I don't mean to be a kill

 21 joy here, but I do think that we'll probably have

 22 to think a bit about maybe certain restrictions
 133

 1 with pre-assuming positions, depending on the

 2 market. You know, for example, energy has got a

 3 three-day spot period, if something is -- you know

 4 is -- this is an un-enumerated application to

 5 assume that position and with only three days to

 6 liquidate if we didn't agree.

 7 You know, there's liquidation

 8 circumstances that could come up, so I'm just

 9 simply saying I would have to give some further,

 10 you know, thought to that, and I mentioned it to

 11 Tim. And not all markets, we know they are not

 12 all the same. Some of them have got a lengthier

 13 delivery period, maybe in some it would be

 14 appropriate, you could look at this in the

 15 spot-month circumstance, I might be a little bit

 16 more reserved than other markets that have got a

 17 very, very compressed spot month period, and want

 18 to get that application in advance.

 19 MR. McGONAGLE: All right. So I'm a

 20 little mindful of time, but I know John has been

 21 patient, so.

 22 MR. WETJEN: Vince, can I jump in real
 134

 1 quick?

 2 MR. McGONAGLE: Of course.

 3 MR. WETJEN: Both of you mentioned the

 4 desire to have some sort of presumption of good

 5 faith on the part of the Exchange if you are

 6 reviewing these requests. But what would -- what

 7 do you have in mind? Do you have in mind

 8 basically an understanding between staff and the

 9 DCMs? Or, do you have something more specific in

 10 mind? I'm just kind of curious what exactly -- I

 11 mean we always presume you are all acting in good

 12 faith, in other words, I mean.

 13 MR. LaSALA: Commissioner Wetjen, I

 14 think that what we were both just simply thinking

 15 is, yes, we are acting in good faith. If for some

 16 reason the staff, you know, ultimately in review,

 17 concluded otherwise we -- our comment between us

 18 is, we'd hate to see a core principle action, you

 19 know, coming against -- you know -- either of the

 20 designated contract markets. I'd like to think

 21 that wouldn't happen, but that's just simply the

 22 concern. We certainly act in good faith, and it
 135

 1 would be our intention to do so.

 2 MR. BARRY: Yeah. Precisely, and if we

 3 are going to set this up under Commission regs as

 4 an appropriate process, we don't want to find

 5 ourselves subject to adverse actions at the end of

 6 it, if we've acted in good faith.

 7 MR. McGONAGLE: John?

 8 MR. PARSONS: So, there are lots of ways

 9 of structuring something like this, and most of

 10 which, to pay attention to all of the different

 11 considerations, most of which are beyond me. I

 12 only have two simple points. One is, I think it's

 13 very important for the Commission to have internal

 14 to the Commission the capacity, and that capacity

 15 is only going to be there if it's regularly

 16 exercised.

 17 So if there's deference given to other

 18 institutions for large volumes of these things, or

 19 speed, or what have you, whatever, but there

 20 should be a certain amount of de novo analysis and

 21 review going on within the Commission on this kind

 22 of thing. I also think as far as public comment
 136

 1 period, it's important for things that are

 2 happening in large volume to somehow periodically

 3 come to the fore from the public.

 4 I think it would be very good if we had

 5 some sort of statistics, for example, of the scale

 6 of bona fide hedging exemptions, and of different

 7 types, including those that are being granted that

 8 are non- enumerated. And that would give a

 9 greater capacity for others to sort of say, hey,

 10 wait a second it's time to check into that one,

 11 and let's find out what's inside that category.

 12 MR. McGONAGLE: Great. Thank you. I'm

 13 more mindful of time. I think unless there any

 14 further comments on this particular Panel, we'll

 15 close out this session this morning. My thanks to

 16 all of your feedback, we'll consider all the

 17 comments of course going forward. We are going to

 18 take a break for lunch and we'll start back up at

 19 1 o'clock.

 20 (Whereupon, at 12:06 p.m., a

 21 luncheon recess was taken.)

 22
 137

 1 A F T E R N O ON S E S S I O N

 2 (1:02 p.m.)

 3 MR. McGONAGLE: Good afternoon. Welcome

 4 to the Third Panel. Thank you, our panelists, for

 5 coming today. Before we get started if I could

 6 just have the panelists briefly introduce

 7 themselves and we'll start with Terry Duffy from

 8 CME.

 9 MR. DUFFY: I'm Terry Duffy, the

 10 Executive Chairman and President of the CME Group.

 11 MR. JACKSON: Ben Jackson, President of

 12 ICE Futures U.S.

 13 MR. CARLSON: Layne Carlson, MGEX.

 14 MS. TOMALTY: Hi, I'm Sara Tomalty, Head

 15 of Trading Compliance for BG Group, but I'm here

 16 on behalf of Natural Gas Supply Association, a

 17 national trade association representing integrated

 18 and independent companies that produce and market

 19 30 percent of the natural gas consumed in the

 20 United States.

 21 MR. COTA: Sean Cota with the Petroleum

 22 Marketers Association of America and the New
 138

 1 England Fuel Institute and the Commodities Market

 2 Oversight Coalition.

 3 MR. GALLAGHER: Good afternoon, I'm Ed

 4 Gallagher with Dairy Farmers of America and I'm

 5 also representing the National Council of Farmer

 6 Cooperatives and the National Milk Producers

 7 Federation.

 8 MR. PROSSER: Good afternoon, I'm Ed

 9 Prosser. I'm the Vice President of Agricultural

 10 Trading for Gavailon LLC in Omaha, and I'm here to

 11 represent the National Grain and Feed Association.

 12 MR. JESKE: My name is Jerry Jeske. I'm

 13 Chief Compliance Counsel for Mercuria Energy, a

 14 global energy end user.

 15 MR. McGONAGLE: Great, thank you. Good

 16 afternoon everyone. So our third session today

 17 concerns spot month limits and the conditional

 18 exemption. The Commission's re- proposal would

 19 provide a conditional spot month limit exemption

 20 that allows traders who do not hold or control

 21 positions in the spot month physical delivery

 22 reference contract to acquire positions in the
 139

 1 cash settled contract up to five times the spot

 2 month limit. Some commenters have suggested that

 3 a conditional spot month limit exemption equal to

 4 125 percent of estimated deliverable supply may

 5 have the unintended consequence of draining

 6 liquidity for a physical delivery core reference

 7 futures contract. Other commenters have noted

 8 that market participants may be active in both

 9 physical delivery and cash settled commodity

 10 derivative contracts during the spot month.

 11 And with that, we'll look to our first

 12 question on the Board, which is if the spot month

 13 limit on a physical delivery futures contract is

 14 updated in accordance with a reasonable

 15 deliverable supply estimate, would that increased

 16 level permit sufficient liquidity for bona fide

 17 hedgers, including in cash settled contracts? And

 18 if we can go to Terry Duffy from CME on that

 19 question.

 20 MR. DUFFY: I will be happy to address

 21 that question; would like to make a couple of

 22 other comments if it's okay. When you're looking
 140

 1 at taking a cash contract and giving it 5X, the

 2 position limits that's being settled off of a

 3 physically -- and priced off a physical delivery

 4 contract, I am very concerned about the liquidity

 5 in the price discovery contract. There's been

 6 many examples where people can look for higher

 7 head room to gain advantages for their own

 8 economic being. And what's critically important

 9 to me and everybody at CME Group is the

 10 credibility of our marketplace. I've been in the

 11 business for 35 years. I traded for 23 of those

 12 and there's nothing more important than the

 13 credibility of a market. And if you don't

 14 understand the viable pricing of that or if you

 15 think that pricing is skewed, I assure that will

 16 do nothing for the benefit of the farmers,

 17 ranchers and other producers in this country that

 18 rely on these products to mitigate their risks.

 19 So when you look to increase the position limits

 20 in a cash settled version of a physical contract,

 21 I think you're looking at no different dangers

 22 than you looked at when you had LIBOR. I think
 141

 1 you're looking at dangers that are beyond what you

 2 can possibly control. When you're looking to fine

 3 somebody a half a billion dollars for fixing a

 4 trillion dollar market, now you're looking to

 5 encourage participants to go out of the price

 6 discovery market and put them into a higher

 7 headroom on a derivative of a derivative. Makes

 8 absolutely no sense to me and I think that we

 9 should be very cautious how you proceed in this

 10 because what's critically important is the people

 11 that rely on these products to do their price

 12 discovery, and do their risk management, and have

 13 the confidence that the consumer is going to have

 14 in the actual price of that product.

 15 MR. McGONAGLE: So where do you see the

 16 balance between the cash settled and the physical

 17 contract? How can we draw this appropriate line?

 18 MR. DUFFY: If you want to have a

 19 contract that's settled off cash, create an index

 20 to do so, and then if that position limit is

 21 different that would be one thing, but if it's

 22 being settled off of a physical you will do
 142

 1 nothing more than siphon liquidity out of the

 2 price discovery market and put it into the cash

 3 settled market.

 4 So we have a couple of examples at CME

 5 Group, one being lean hogs, one being feeder

 6 cattle that were originally physically delivered

 7 marketplaces. They ended up going to cash settled

 8 but there's proprietary indexes that were created

 9 with the industry to get the credibility of the

 10 pricing. The contracts that you're discussing,

 11 some of them are just lookalikes of a derivative,

 12 and I think that will be very damaging to the

 13 outcome.

 14 MR. McGONAGLE: Ken in my ear is asking

 15 us if we can focus for a minute on the NG

 16 contract. And looking at current estimates of

 17 deliverable supply potentially for that a contract

 18 might have it at 15,000 for deliverable supply.

 19 Under the current proposal, if we applied 25

 20 percent, that would increase the limit from 1,000

 21 to just under 4,000, approximately. And so if we

 22 did that calculus today, does that alleviate or
 143

 1 what's the CME sort of reaction to --

 2 MR. DUFFY: The reaction to that, sir,

 3 would be that if in fact the cash settled version

 4 is the same as the physical we would not have a

 5 problem if the deliverable supply number was

 6 calculated to modern times. So if that's the --

 7 if I'm answering your properly-- but I cannot harp

 8 enough about how you cannot have separate size

 9 position limits for the same exact contract

 10 especially when the other one is the price

 11 discovery. If you look at our NG contract, which

 12 is critically important here, over the last three

 13 years in a very low volatility period in the

 14 closing range, which is the last 30 minutes of a

 15 trading day of expiration, we've seen a decrease

 16 in our volume, in our physically settled contract,

 17 and an increase in ICE's contract which is cash

 18 settled. So even though we don't have perfect

 19 evidence today of data of what's going on we are

 20 starting to see a pattern that is very disturbing.

 21 MR. McGONAGLE: Mr. Jackson from ICE?

 22 MR. JACKSON: Thank you. So a couple of
 144

 1 comments on that. So first I'll take your

 2 question directly. ICE supports the looking at

 3 what is the deliverable supply today and revising

 4 those estimates and then making those estimates

 5 reflect changes in the futures contracts, the

 6 physically settled contract to the cash settled

 7 contract in lock step with the way the rules are

 8 in place today. We're 100 percent supportive of

 9 that. The main reason is, is that as a market

 10 operator today, one of my main responsibilities to

 11 my market participants is to make sure that we

 12 have futures contracts that do one thing and those

 13 futures contracts have to help facilitate the

 14 convergence of the futures price to the underlying

 15 physical product when it comes down into that

 16 final settlement period. And I highlight that

 17 because when we're talking about the gas contract

 18 specifically, the data points to -- and when I

 19 look across ICE futures U.S. Exchange which

 20 includes agricultural contracts as well as our

 21 U.S. energy complex, natural gas market and

 22 futures market is a model for convergence across
 145

 1 any of the futures contracts that we have. All

 2 the data points to that. So number one we have a

 3 contract that works very well and it's the only

 4 contract where it has the conditional limit today.

 5 Second thing I'd point out is that with

 6 the panel we had this morning and then the panel

 7 this afternoon we're talking about some new rules

 8 that are going to be coming in place. So when you

 9 have, yes the potential for deliverable supply

 10 going up, you have the potential for position

 11 limits going up, but at the same time with

 12 aggregation rules that are proposed, those

 13 aggregation rules, when you're aggregating

 14 positions across ICE, CME, and OTC markets are

 15 immediately going to halve that position. You

 16 also have more restrictive definitions around

 17 hedge exemptions. Another headwind that our

 18 market participants are going to see in certain

 19 contracts where we believe that if you have an

 20 increase in deliverable supply and more energy

 21 that's out there that needs to be hedged, coupled

 22 with headwinds of position aggregation rules that
 146

 1 are coming in place, you put that confluence of

 2 issues on a contract that is the most successful

 3 contract there is in the futures marketplace right

 4 now at helping to facilitate that final

 5 convergence of the cash price to the physical, to

 6 me it is a dangerous combination.

 7 As an operator of markets I believe in

 8 the Hippocratic oath and that's do no harm. We

 9 have a contract right now that works, it works

 10 very well, why change it. And from ICE's

 11 perspective we are a proponent and suggest the

 12 Commission build upon this success by applying

 13 this to other commodities.

 14 MR. MCGONAGLE: I'm not following my own

 15 direction. If we could go to Sara and then to Ed.

 16 Thanks.

 17 MS. TOMALTY: Thank you. I thought I'd

 18 chime in here because most of my comments are

 19 going to be related to natural gas given that

 20 we're a natural gas producer association. First

 21 I'd like to say we're not opposed to speculative

 22 position limits. We think that they serve a very
 147

 1 important role in a well functioning market.

 2 However we do support CME and ICE's efforts to

 3 increase deliverable supply estimates. The

 4 estimates, as CME has stated, come from data

 5 that's from 1996. They also utilize data from

 6 BENTEK, which is a world leader in aggregating

 7 data, but the data they aggregate is based on

 8 what's public to FERC and FERC, as you know,

 9 regulates interstate pipelines. The data does not

 10 see intrastate and in-state production volumes, so

 11 I think they're missing a big piece of the market

 12 that I think CME and ICE can find when they revise

 13 their estimates.

 14 In addition we support raising the

 15 deliverable supply estimate and that serving a

 16 basis for the futures delivery market limits, but

 17 even the revised levels are not likely to provide

 18 sufficient liquidity for our hedging needs in the

 19 cash settled market. An example of this that

 20 we're seeing currently in the market is when ICE

 21 converted futures to swaps and implemented

 22 position limits based on 25 percent of deliverable
 148

 1 supply for all of the new converted cash settled

 2 contracts that are now futures. They're required

 3 by law to set them at 25 percent of deliverable

 4 supply. What we're seeing in the market and

 5 almost immediately after that happened was a lot

 6 of decreased liquidity. Producers have been

 7 unable to set hedges on ICE for the next winter

 8 because the bid-ask spreads are so wide. For

 9 example, in New England for next winter the

 10 bid-ask spreads have increased from about one to

 11 two cents to a dollar, so there's no transacting

 12 going on and we can't set hedges for next winter.

 13 In addition, we're seeing more frequent price run

 14 ups and downs with insufficient liquidity for

 15 market participants to get in and out of those

 16 positions. For example, both Tech Co. M2 and

 17 Transco Zone 6 non-New York have had significant

 18 price run ups this spring of a dollar and that was

 19 on less than one contract trading per day and some

 20 periods two weeks with no transactions. So we're

 21 seeing a lot of movement based on nothing

 22 happening in the market.
 149

 1 And finally energy companies are having

 2 difficulty setting marks at several locations for

 3 risk management purposes because there are no

 4 longer enough transactions to identify marks at

 5 certain trading locations. Therefore we see a

 6 need to increase deliverable supply to set the

 7 basis for the futures limit, but we also see a

 8 need based on the examples we're seeing in the

 9 formerly swap market to have a higher cash settled

 10 limit that's not based on 25 percent deliverable

 11 supply.

 12 MR. McGONAGLE: Ed Gallagher?

 13 MR. GALLAGHER: You may find it odd that

 14 the dairy guy has something to say about gas but

 15 the livestock that support our members do produce

 16 a lot of methane so I thought I'd comment. My

 17 comment is in general and it's going to tie back

 18 to class three markets because we've got some

 19 challenges with the rule on class three, but

 20 there's some commonality relative to cash settled

 21 futures contracts and there's a little bit of a

 22 discriminatory process I think we have to work
 150

 1 through. But in general I think in a lot of

 2 markets the common theme you will hear from me is

 3 everybody is a little different, they have their

 4 own unique issues and we have to figure out some

 5 way to address each of those and a one size fits

 6 all approach may not work across the board. And I

 7 am struck by the fact that when I look at most of

 8 the existing physically delivered contracts, they

 9 at this point have, instead of a 5X ability to do

 10 cash settled contracts, they have an infinite X.

 11 And so I think you folks would have some pretty

 12 good data since you've been collecting some of the

 13 swap data to be able to see what's the size of the

 14 swap market relative to a physical commodity and

 15 what impact if any it's having on the things that

 16 you're concerned about on convergence and other

 17 issues that you have concerns about.

 18 MR. McGONAGLE: Sean Cota.

 19 MR. COTA: I think you really need to

 20 take a look at what the fundamental point of these

 21 markets are, which is, from my perspective,

 22 particularly from our coalition's perspective, is
 151

 1 to supply and purchase commodities. So when you

 2 talk about physical markets in particular and the

 3 28 hard commodities that we're talking about, the

 4 physical deliverable becomes a real issue when

 5 you're calculating, whatever the number is. As

 6 the cash settled becomes a larger percentage of

 7 the total amount of the trading, they really

 8 become economically equivalent. And if the

 9 constraints on them are a lot less, the overhead

 10 expense is a lot less, people are going to

 11 naturally migrate to that. So the folks that like

 12 to --

 13 MR. McGONAGLE: They're going to migrate

 14 away from the physical to the cash?

 15 MR. COTA: Away from the physical to the

 16 cash. And if you're the large section of trading

 17 group, which is, you know, the high frequency

 18 traders, because commodities are where they like

 19 to play the most because there's the most

 20 uniformity in these contracts, what happens is

 21 that the physical contracts get diminished. So my

 22 argument is that if the limits are appropriately
 152

 1 low and equivalent, whether it be cash settled or

 2 physical, that you may suddenly have a market that

 3 changes to supply differently. So for example, in

 4 the heating oil market, the heating oil market

 5 which is the one that I grew up with, the heating

 6 oil is the smallest part of that contract to the

 7 point where it's now no longer the contract, okay.

 8 It's now called that but it's really diesel. So

 9 if you were to have certain markets with -- if the

 10 limits were sufficiently low in those markets, you

 11 would find instead of having one price for the

 12 heating oil which set the price for jet fuel, set

 13 the price for diesel, depending upon the different

 14 points, you'd end up with more contracts for

 15 different supply points. Natural gas is one that

 16 supplied -- there's very little central supply in

 17 it. That's not in the incentive of financial

 18 players because they want to do the most volume in

 19 uniformity in contracts; they're going to have

 20 more liquidity in that. But if you're going to be

 21 actually delivering to a market in this great game

 22 of chicken where you have to decide whether you're
 153

 1 going to actually supply it or take it or settle

 2 out that position prior, the folks that actually

 3 use these markets for their intended purpose, you

 4 need to reinforce that. So 25 percent of a market

 5 is still high. We have three wheat contracts as

 6 an example currently under the old regime.

 7 Generally their limits are lower. Those exchanges

 8 I think are somewhere between five and ten percent

 9 for their own limits and that they seem to have

 10 worked so far. So we're going to have much higher

 11 limits to start with, even at 25 percent. For one

 12 entity to own in an economically equivalent market

 13 150 percent, if they did the max out of the

 14 combined market, to me just seems absurd.

 15 MR. McGONAGLE: So concerns that you

 16 have are setting the position limit or -- sorry,

 17 the spot month limit even at 25 percent is being

 18 too high, and then separately with this

 19 multiplier. So if you have it in a situation

 20 where you could go zero up to 125 percent, that

 21 the 125 is too large. And so the concerns -- I

 22 just want to catch it -- is sort of similar or
 154

 1 different from the CME's about the drain of

 2 liquidity away from the physical contract and

 3 where do we draw that line?

 4 MR. COTA: I think there are two

 5 elements. One is that if you have a differential

 6 in the limits that you will drain liquidity out of

 7 the physical market into the cash settled market.

 8 I think the other element is, if the limits are

 9 lower, people are going to then migrate to other

 10 contracts. If you take a look at for the CME's

 11 Clearport, for example. If you're buying jet fuel

 12 in California, okay, it's the Long Beach jet fuel

 13 contract that's priced off from the heating oil.

 14 It trades, it doesn't trade a lot because everyone

 15 who wants to provide the most liquidity in that

 16 market wants to trade in the heating oil part of

 17 that contract because that's where the money is

 18 made. The rest is risk mitigation. So the more

 19 that you have these limits being really high for

 20 the very high volume ones, the less, in my

 21 opinion, the less flow that will go into those

 22 other markets that actually deliver to those
 155

 1 specific markets.

 2 MR. McGONAGLE: So let's go to Ed

 3 Prosser.

 4 MR. PROSSER: Thank you. I'm going to

 5 limit my comments to the Ag enumerated because

 6 that's the space we play in. And I'd like to

 7 start by echoing Ben's comment, do no harm. These

 8 markets serve two great goals, convergence and

 9 price discovery. Convergence is difficult. In

 10 fact I was trying to think as everybody was

 11 talking, I've been in this space for about 30

 12 years. I don't know any of the Ag commodity

 13 markets that in that time that we haven't totally

 14 changed the delivery process. Terry mentioned

 15 cattle and hogs, both went cash delivery. The

 16 corn and bean contract changed to river delivery

 17 in '98. Recently we changed Kansas City and

 18 Chicago wheat. We worked as an industry with our

 19 DCM to change the contracts fundamentally because

 20 convergence is such an overarching goal. This is

 21 a very delicate balance in the delivery of these

 22 physical commodities, time and space and weather.
 156

 1 I think that before we use arbitrary mathematical

 2 formulas to set spot month limits we need to go

 3 back to the tried and true method where the DCM,

 4 with the local knowledge of each one of the

 5 contracts and the overriding interest to make sure

 6 that that contract has integrity, because that's

 7 who comes to play in that market. We need to

 8 serve that purpose first. Everybody would like it

 9 to be as big as it can be, but the definition of

 10 what it can be needs to start with the DCM to say,

 11 "You know what, in our interest this is the size

 12 of the corral, so we can't take any more cattle

 13 than this. These are the size of our elevators,

 14 this is the all the grain we can put." But

 15 getting away from the DCM's unique involvement in

 16 that process I think would be a mistake.

 17 MR. McGONAGLE: Jerry.

 18 MR. JESKE: Well, I don't want to sound

 19 redundant but I agree with a lot of what Ed just

 20 mentioned. And the one thing that strikes me in

 21 terms of this 25 percent is historically where

 22 does 25 percent come from? I think maybe staff
 157

 1 and the Commission might want to consider the

 2 origins of this arbitrary 25 percent. And as it

 3 relates to deliverable supply, I would say that

 4 the CME's numbers that they've offered up are

 5 rather conservative. Cushing, Oklahoma isn't what

 6 it used to be. The flow of oil in this country is

 7 a lot different than what it was historically

 8 because of the fracking. You ever go over the

 9 Bakken area at night, see how much natural gas is

 10 being flared off? It's substantial. So this

 11 concept of deliverable supply I think needs a

 12 little bit of attention. And hasn't been really

 13 something that to my knowledge has been focused on

 14 enough.

 15 MR. McGONAGLE: So the calculation of

 16 deliverable supply, where should the Commission

 17 consider going?

 18 MR. JESKE: Internationally. The

 19 Commission I believe should consider all aspects,

 20 what the concept of deliverable supply really is

 21 rather than fixing it to a hub because that's not

 22 how the market works. And I think we had a lot of
 158

 1 commentary in the first panel about how one sets,

 2 you know, contracts. Interstate contracting,

 3 right, that's where these rules come from, from

 4 the statute which talks about not to encumber

 5 interstate commerce. Well, as Ed mentioned it's

 6 not broken; I don't know what we're trying to fix

 7 here. And if it's not broken I would encourage

 8 the Commission to be reserved about how they

 9 employ new regulations that are onerous on all the

 10 firms that are already used to a process with the

 11 DCMs and is working well. That's something that I

 12 would hope would be considered wholeheartedly.

 13 MR. MCGONAGLE: Layne?

 14 MR. CARLSON: Thank you. It's going to

 15 sound like a little bit of piling on but it's

 16 really reinforcing the comments that Ed and Jerry

 17 have already made and others on this panel, but I

 18 just want to start off too and say that MGEX

 19 appreciates the opportunity to attend and comment

 20 on the Commission's proposed rule making on limits

 21 for derivatives. But maybe quick background, MGEX

 22 was established over 130 years ago and we're a
 159

 1 designated contract market, and we're a

 2 derivatives clearing organization. As such the

 3 Commission's proposed limits and proposed rule

 4 making are going to have a dramatic effect upon

 5 our marketplace and particularly our participants

 6 who trade from around the world. We have a little

 7 bit of a unique take, but again supporting what

 8 others have already commented on, the Ag

 9 commodities that have traded in our marketplace

 10 since 1881 and our most actively traded contract

 11 is Hard Red Spring Wheat, which is one of the 28

 12 named core reference contracts identified by the

 13 CFTC in its proposal. The Hard Red Spring Wheat's

 14 physically settled contract, which means that the

 15 methodology that's proposed by the Commission to

 16 establish spot month limits, based on that 25

 17 percent of the estimated deliverable supply,

 18 really doesn't take into account some of the

 19 variables that exist. Others have already

 20 mentioned global transportation, weather issues,

 21 supplies, all play a factor in here. Further

 22 there's no strong or consistent correlation
 160

 1 between open interest or open positions entering a

 2 spot month and the actual deliveries that occur

 3 during a spot month. Likewise there's no strong

 4 or consistent correlation between this physical

 5 supply and the actual deliveries that occur during

 6 a spot month in our wheat contract. Therefore

 7 kind of establishing spot month limits based on a

 8 formulaic approach without a demonstrable or

 9 measureable benefit is not something that should

 10 be adopted for our market or for our wheat market

 11 in particular.

 12 And I might also quickly add that the

 13 Commission's proposed formulaic approach to

 14 establish non spot month limits is even more

 15 problematic and is more likely to result in harm

 16 in our marketplace and harm legitimate trade

 17 activity. The primary reason that the

 18 Commission's proposal throws out 75 years of

 19 equality among position limits, among the 3

 20 domestic wheat contracts including Kansas City,

 21 Hard Red Winter, and CME's Soft Winter. The

 22 proposal creates such a wide discrepancy of
 161

 1 position limits that's more likely to inhibit

 2 spread activity among the three wheat contracts.

 3 Inter-market spread trading in wheat serves a

 4 valuable economic purpose. I think the prior two

 5 panels there's been a number of participants who

 6 have emphasized that already. And again position

 7 limits based on a formulaic approach without a

 8 demonstrable, measureable, or even likely

 9 improvement in the fundamental principle of price

 10 risk, price discovery, or risk management is not

 11 good for our marketplace, it's not economic sound

 12 policy.

 13 I would say finally too that the issue

 14 equality among position limits in the three wheat

 15 contracts have been supported by a number of wheat

 16 industry Ag groups and organizations in comment

 17 letters already submitted to this Commission --

 18 and I would urge the Commission to consider those

 19 in their final rule making.

 20 MR. MCGONAGLE: So I segue to the next

 21 question about recommendations concerning a

 22 different methodology in lieu of the 25 percent.
 162

 1 I also note that Ed has his flag up, so, Ed.

 2 MR. GALLAGHER: Thank you. Carrying out

 3 from the previous question leading into the next

 4 question. For class three, the spot month is a

 5 very short period of time of about five days at

 6 the end of each contract which trades monthly.

 7 And so it's really not a relevant issue for us in

 8 the class three markets as long as the single

 9 month limit is less than the spot month limit.

 10 You don't want to have that reversed because that

 11 will create an issue. What our issue is, is that

 12 they're too narrow, the limits that you've

 13 suggested. My interpretation of the rule is that

 14 we've got -- since we've got a cash settled

 15 futures contract and where others have a physical

 16 futures and a cash settled derivative, they've got

 17 basically X plus X, they've got 2X of a limit,

 18 we've only got 1X and that's too constraining for

 19 our market. Relative to again, to dairy, we're

 20 young, we're nurturing, it's growing. We've got

 21 concerns that if you -- there's no practical way

 22 in the class three futures market that whatever
 163

 1 your limits are will impact price discovery

 2 because futures do not impact the cash price

 3 discovery mechanism. There's no concern over

 4 price discovery. It's impossible to corner a

 5 market using class three fluid because of its

 6 perishability. That for our market to err on the

 7 conservative side is more risky than to err on the

 8 liberal side. And we'll see over time, there will

 9 be markets like we haven't gotten into yet, but

 10 our nonfat dry milk market or our whey market,

 11 when they are first introduced, to have a set

 12 number -- so this gets into the second -- to have

 13 a set number of what something could be that is a

 14 base minimum, that it won't go below that number.

 15 And then if you want to have spot month or -- and

 16 our issue is all months combined, single months

 17 and all months combined limits -- if you want to

 18 have those numbers be based on some sort of a

 19 formula, but that the limits will never be any

 20 less than X, I think we'd be okay. And I do -- it

 21 was Jerry that brought up the notion that markets

 22 change, deliverable supplies change, and I think
 164

 1 there can be some risk at them changing in a way

 2 or the perception of what is a deliverable supply

 3 change in a way that creates a problem if you are

 4 doing it only by formula and you don't have some

 5 minimum level, is lacking.

 6 MR. MCGONAGLE: So now I'm wondering

 7 whether I jumped ahead a little bit too quickly

 8 because I wanted to go back and want to hear a

 9 little more about this interaction on the cash and

 10 the physical and the -- you know a calculation --

 11 you know, it's not broken, don't fix it, drain the

 12 liquidity. So how can I -- and so this isn't to

 13 you because -- or maybe it is to you -- but in

 14 dealing with the 2X scenario how do we make sure

 15 that we're preserving market price integrity and

 16 the price discovery process while ensuring against

 17 manipulative behavior? And then sort of how do I

 18 get that balance between the cash and the

 19 physically settled contracts?

 20 MR. DUFFY: If I may I think that you

 21 have to draw the difference on a derivative of a

 22 derivative. If you're looking to set deliverable
 165

 1 supply for both cash settled products and

 2 physically settled contracts, update the

 3 deliverable supply, but the cash settled contract

 4 has to be based on an index. It can't be priced

 5 off of the physical contract. And that's really

 6 where the rubber meets the road here where you're

 7 looking at manipulation, you're looking at all

 8 types of activity that's going to siphon out the

 9 liquidity. I can't harp on this enough; I said it

 10 in my opening remarks earlier. This is exactly

 11 what will happen. What's important is, what was

 12 said earlier down there at the end of the table,

 13 is that hedgers need to have the ability to hedge.

 14 There is hedge exemptions that are available but

 15 then you have to have somebody to take the

 16 opposite side of the market. So if you update the

 17 deliverable supply, you should be able to

 18 accommodate both sides of the trade. But at the

 19 same time, but give somebody five times larger

 20 position again on the conditional side that's

 21 based off of a physical market to me is asking for

 22 real trouble.
 166

 1 MR. MCGONAGLE: Where would you go --

 2 what type of recommendation would you have on that

 3 relationship of one to one or zero to five?

 4 MR. DUFFY: I would have it one-to-one

 5 obviously. I think one-to-one makes sense. I

 6 think it has worked. We could talk about the

 7 natural gas contract all we want. I think someone

 8 at the other end of the table said that these are

 9 27 or 28 different products; they all should be

 10 treated a little bit differently. We're setting

 11 one example that's conditional today and I've

 12 already given you evidence that we're seeing a

 13 decrease in trading going into expiration of these

 14 contracts over the last three years. In a very

 15 low volatility period.

 16 MR. MCGONAGLE: So whether as it applies

 17 to the other contracts a similar type of model as

 18 having a conditional exemption apply to other

 19 contracts?

 20 MR. DUFFY: I don't believe there should

 21 be conditional exemptions for other contracts that

 22 are settled off of a physical market.
 167

 1 MR. MCGONAGLE: If I can go to Ben and

 2 then I'll go to Jerry. So just keep it at NG.

 3 MR. DUFFY: I'm sorry?

 4 MR. DANGER: I guess the question here

 5 was do you just want a condition limit one to one

 6 for NG --

 7 MR. DUFFY: On all products.

 8 MR. DANGER: On all products?

 9 MR. DUFFY: No, on all products.

 10 MR. DANGER: On all products?

 11 MR. DUFFY: I don't -- but I think the

 12 NG decision was a bad decision and I don't know

 13 the basis for what it was and all of a sudden now

 14 it's being introduced into 28 other products which

 15 have nothing to do with NG so I'm still confused

 16 how it happened in NG to be honest with you. We

 17 didn't own NYMEX when that happened.

 18 MR. JACKSON: So let me help there and

 19 let me address a couple of the comments that Terry

 20 made earlier as well. One, I was very confused by

 21 the connection between cash settled contracts and

 22 benchmark manipulation that was brought up
 168

 1 earlier, especially coming from an exchange

 2 operator that has more cash settled contracts than

 3 -- so first that connection on benchmark

 4 manipulation I find interesting. The second is

 5 the data on natural gas liquidity and we've

 6 provided multiple sets of it and it says there's

 7 zero evidence that liquidity has been drained from

 8 the contracts. So I'd be very curious to see this

 9 information and this data for you to share that

 10 with all of us. We believe again what we have in

 11 place today works very well, it acknowledges the

 12 difference between financially settled contracts

 13 and physically settled contracts. I operate in a

 14 world as does Terry where we have both of those

 15 types of contracts. I'd be the first to say that

 16 physically settled contracts have a lot more risk

 17 associated to them, a lot more things that the

 18 exchange has to very acutely manage on a day-in

 19 and a day-out basis when it comes to those

 20 particular contracts, when you're going into the

 21 delivery process, when you're matching buyers and

 22 sellers, making sure that you have buyers and
 169

 1 sellers that can actually take and make delivery,

 2 when you're dealing with third parties that are

 3 part of that ecosystem such as warehouse keepers

 4 for some of the contracts. There are a lot of

 5 different specific risks that those contracts have

 6 that are not present in cash settled benchmarks.

 7 And just for a bit of the history lesson

 8 well, how did we get here? In 2010 the Commission

 9 required that each cash settled contract that

 10 referenced a physically settled contract, that the

 11 spot month position limits were a match and that

 12 they mirrored for all contracts, but in

 13 recognition of two things, one that cash settled

 14 contracts do represent a lower risk and they have

 15 little negative influence on the final settlement

 16 price of the physically settled future, combined

 17 with the fact that at that time a lot of the

 18 natural gas market was moving from OTC to futures.

 19 And a lot of that business was done in cash

 20 settled types of contracts that the Commission

 21 granted this conditional limit on the natural gas

 22 contract at that point in time. So we have four
 170

 1 years of data all of which points to this has been

 2 incredibly successful and I'm complimenting Terry

 3 as having one of the most successfully physically

 4 delivered contracts with the best price

 5 convergence, 10 times better than what he sees in

 6 his corn, wheat, and soybeans futures contracts

 7 today.

 8 MR. MCGONAGLE: So I don't want to

 9 create two panels here. If I can go to Jerry

 10 who's been so patient and then I'll come back to

 11 Mr. Duffy.

 12 MR. JESKE: Well, Vince, in the interest

 13 of keeping the peace, we're a customer of both

 14 exchanges, so in terms of the conditional limit,

 15 we've availed ourselves of that conditional limit

 16 and the spot physically delivered contract is of

 17 course important. I think everybody here would

 18 agree that we want well functioning markets that

 19 are reliable, period. And I don't think there's

 20 any debate about that. Volume means something to

 21 the exchange. It means revenue source, right.

 22 Does it necessarily mean liquidity though? So
 171

 1 let's not get that confused, because really the

 2 issue here is not to be so concerned about what

 3 liquidity or you want to call it volume -- let's

 4 be honest about it, call it volume -- is there

 5 more volume on ICE than there is on CME? That's

 6 really not the concern I think of the market

 7 participants. The concern is convergence and

 8 whether or not convergence operates properly. And

 9 I think Ed mentioned it earlier -- or there was a

 10 couple of mentions to wheat and I would like to

 11 bring to the panel's attention, particularly the

 12 Commissioner's, back in 2009 Professor Irwin,

 13 University of Illinois wrote I thought a very good

 14 study in connection with the wheat contract.

 15 There was a problem there. I think everybody

 16 should focus on that a little bit because that

 17 should be the fear. The fear shouldn't be if the

 18 volume numbers go through the roof at ICE or if

 19 they go through the roof at CME, that's a great

 20 thing; that would be fabulous. It's not a zero

 21 sum game. Everybody should be able to have the

 22 ability to contract freely, whether that's on ICE
 172

 1 or CME, hedge their risk wherever they find it

 2 most appropriate. It's called business judgment.

 3 It should not be a --

 4 MR. MCGONAGLE: So do you see

 5 convergence being affected by the conditional

 6 exemption?

 7 MR. JESKE: I don't think so.

 8 MR. MCGONAGLE: Anyone else want --

 9 MR. JESKE: Again I point to the

 10 empirical evidence which I know of. In fact cash

 11 settlement was one of the potential solutions to

 12 the problem of the wheat contract if you'd read

 13 through the paper. That was an option. I think

 14 Ed mentioned that there was some fixing that went

 15 on in terms of the deliveries but I think, you

 16 know, going back to deliverable supply, going back

 17 to the fundamental commercial participants and

 18 where they take the commodity from point X to

 19 point Y through a delivery perspective. I mean I

 20 can talk about the energy market whether it's

 21 electricity or oil, but you're taking about the

 22 end consumer in the oil spectrum is going to be a
 173

 1 refinery, right. So you need to look at it in

 2 that context. Electricity also needs to be looked

 3 at a little bit more closely. I think there's

 4 some confusion as to what does generation mean.

 5 Load is demand. That is not a factor of supply.

 6 Supply is generation. So I think the generation

 7 capacity that exists in this nation needs to be

 8 looked at a little bit more liberally or at least

 9 maybe more understanding. I'm sorry,

 10 Commissioner.

 11 COMMISSIONER WETJEN: Just to jump in.

 12 Sorry, Jerry. You mention and I think Terry

 13 mentioned it before that two -- was it the feeder

 14 cattle and the hog contract at one point were

 15 physically settled, but no longer are, they're now

 16 cash settled. And presumably that was to address

 17 some kind of convergence issue? Terry?

 18 MR. DUFFY: That was to address a lot of

 19 different issues. As you can realize in the hog

 20 industry the vertical integration that was going

 21 on, the captive supply concerns that were going

 22 on, the credibility of the pricing of how the
 174

 1 price was being -- the contract was being

 2 delivered. You were no longer pricing the

 3 contract as a live contract, it was becoming a

 4 lean carcass and that's the way the industry was

 5 pricing it. So there's a whole host of reasons

 6 why that contract needed to be changed or it was

 7 going to go away and there would not be a price

 8 discovery vehicle for the hog producers of

 9 America.

 10 On the feeders it was a very similar

 11 situation which happened many years ahead of the

 12 hog contract. So yes, that's the history of why

 13 those went that way. It wasn't for just purely

 14 convergence, it was because of the way the

 15 industry had switched.

 16 MR. PROSSER: Commissioner, might I add

 17 thought that in each one of those instances there

 18 was a USDA referee index. That cash index is

 19 created independently of the trade. That is

 20 entirely different than a derivative off of a

 21 derivative when we allow one derivative market to

 22 set the settlement procedure for the other one. I
 175

 1 do think those are two different issues.

 2 MR. MCGONAGLE: Sara, where do we go?

 3 MS. TOMALTY: While I like what Jerry

 4 said about volume not equaling liquidity, we use

 5 the swap market to hedge our huge exposure to

 6 Henry Hub. Global energy companies have exposures

 7 beyond the U.S. and so we need that market to be

 8 sufficiently large. Although we may have a hedge

 9 exemption we need more counter parties. So it's

 10 not just a volume issue, you need counter-parties

 11 in the market with which we can transact. So

 12 setting the limits higher, I think, promotes more

 13 liquidity based -- in terms of counter parties as

 14 well as volume.

 15 You asked what risks are involved in the

 16 futures delivery market versus the cash settled

 17 market; we don't see the same risk involved in the

 18 cash settled market from having a limit at 1,000

 19 contracts because -- well, we're actually

 20 promoting the futures delivery limit to be higher

 21 so we wouldn't want that to be at 1,000 contracts

 22 either. But with respect to the futures delivery
 176

 1 market it actually goes to delivery so there is

 2 more risk of market manipulation. You know, you

 3 actually do have index manipulation, corners or

 4 squeezes, banging the close. I don't think you're

 5 going to see the same risks involved with the swap

 6 market where there's cash settlement.

 7 MR. MCGONAGLE: We do have a trader

 8 question which is going into the spot month why

 9 would a trader be interested in having a large

 10 physical and a large cash position? I put that

 11 out to the broader panel but --

 12 MS. TOMALTY: Oh, can I speak to it?

 13 MR. MCGONAGLE: Absolutely.

 14 MS. TOMALTY: As a global energy company

 15 we have a need to be in the physical market.

 16 Henry Hub is now a liquid market with a lot of

 17 different pipelines delivering to Henry Hub and

 18 there are going to be more pipelines proposed to

 19 deliver to Henry Hub. I think Cheniere is also

 20 adding. So we do have a need to be in the

 21 physical market. We are delivering to Henry Hub,

 22 we participate in the spot market, and often go to
 177

 1 delivery. At the same time we have global

 2 exposure to Henry Hub so we have a need to be in

 3 the cash markets, cash settlement markets as well,

 4 to hedge our exposure. I think we would propose

 5 that you get rid of the obligation to not hold

 6 physical delivery position in order to have a five

 7 times limit in the cash market because I think you

 8 want energy companies speculating in the market.

 9 We transact based on fundamentals. You know, we

 10 are important to the speculative market to bring

 11 markets in line with fundamentals. I think it's a

 12 good thing for energy companies to have some

 13 flexibility to speculate as well as to hedge.

 14 MR. MCGONAGLE: And where would you draw

 15 that line in terms of going from zero and five to

 16 what and what? I mean we're, you know, concerned

 17 -- let me say primarily concerned in the proposal

 18 that talks about the opportunity for manipulation

 19 or disruptive practices between these markets

 20 using one to leverage a result in another.

 21 MS. TOMALTY: We support the cash

 22 settled limit being higher. Whether you do it 5X
 178

 1 the deliverable supply limit or based on some open

 2 interest level. That's up to -- I think the

 3 exchanges are pretty well versed in figuring out

 4 what those levels should be. But, we do need, as

 5 I've mentioned, we need more flexibility, we need

 6 more counter-parties in those markets.

 7 MR. MCGONAGLE: Yes?

 8 MR. DUFFY: I support higher limits for

 9 cash settled contracts also, but not when they're

 10 settled against the physical. If you want to

 11 create an index like the gentleman down at the end

 12 of the table said, when we did create an index

 13 with all different products we worked with the

 14 industry to create one. We just didn't settle it

 15 off of an existing contract that's physically

 16 settled in the marketplace. I think that is a

 17 detriment to the users of the credibility of the

 18 price. Either get rid of the physical market

 19 totally and come up with a cash settled for

 20 everything if that's the way the market wants to

 21 go. It then gives no position limits because

 22 they're all dollars and who cares. We don't have
 179

 1 to worry about it. But that's not the situation

 2 because you go down to the end of the table and

 3 you ask these folks if you want to have cash

 4 settled products and they go out to their user

 5 community they're going to say absolutely not. We

 6 need to have physically delivered products in

 7 order to keep the credibility, the buyability of

 8 that pricing for us to use throughout the

 9 industry.

 10 So we should really break this apart and

 11 say if you want to talk about cash settled

 12 position limits is one thing, but they can't be

 13 based off of a physical market. It's just -- I

 14 don't even understand the concept of that. And as

 15 far as our cash settled business that we have done

 16 we created cash settlement at CME. We came up

 17 with the first cash settled contracts in the early

 18 '80s in our financial products with the industry,

 19 with the government. We worked with everybody to

 20 do this. But on other products it would be easier

 21 to go to cash settled and not have to worry about

 22 the delivery process. But that's not what the
 180

 1 industry needs. So you have to work with what the

 2 industry needs.

 3 MR. MCGONAGLE: Ed?

 4 MR. GALLAGHER: We like cash settled

 5 products and not just in milk. We have some

 6 financially settled swaps in feed grains that are

 7 cash settled that we enjoy because we don't have

 8 to worry about anything to do with delivery in

 9 those positions. So there is a demand from some

 10 of us for some cash settled products.

 11 MR. MCGONAGLE: In these questions that

 12 we've posed here today am I missing anything?

 13 What should we be focusing on? What questions

 14 should I be putting out to the panel? Jerry, you

 15 put your flag up first.

 16 MR. JESKE: Well, I was just going to

 17 mention that optionality is important to

 18 commercial users. So I think the first panel

 19 concentrated on this to some degree. Whether you

 20 have some price exposure that you can hedge

 21 relative to a cash settled or a physically settled

 22 contract you need to have that outward
 181

 1 optionality, you need to be able to do either.

 2 You can take the -- as was discussed earlier --

 3 you can take a position in the futures contract

 4 that is ultimately physically settled in lieu of a

 5 contract with a bilateral party in the cash

 6 market, you have that flexibility. That

 7 flexibility shouldn't be curtailed, should exist.

 8 You have the ability to hedge cargos over the

 9 Atlantic in ICE and CME. They are going to come

 10 over to the Gulf coast and you want to have that

 11 flexibility. I always call it optionality but I

 12 don't want it to get confused with trade options

 13 because trade options is rather confusing. Since

 14 I've mentioned it, I wholeheartedly hope that

 15 trade options aren't part of this because it's

 16 undefined still. The seven part test is nobody's

 17 friend and, you know, I think that's mentioned

 18 earlier events in one of your questions so maybe

 19 that's one point that you might cover.

 20 MR. MCGONAGLE: Agreed. I think I had

 21 skipped over that. Sean.

 22 MR. COTA: I think the question that has
 182

 1 been mentioned that you need to ask is really how

 2 do you measure these markets for a physical

 3 deliverability. In the end I found that physical

 4 delivery markets have always performed ahead of

 5 everybody else, you know. My suppliers would shut

 6 me off quicker than a DCM would. DCM will always

 7 deliver the products. And if I don't have product

 8 I'm out of business. So even if you're

 9 financially cured later as is the case with say

 10 the Bear Stearns derivatives in some instances

 11 you're still out of business. So physical

 12 delivery is a key element of this and if the

 13 question is that these limits don't make sense

 14 then -- first there needs to be ratio. You need

 15 to reinforce the physical market as much as

 16 possible. I agree with Terry that if you don't

 17 think it has validity then get rid of the physical

 18 market altogether for that particular commodity.

 19 But as consumers we need these commodities to be

 20 delivered. If the market needs to be measured

 21 differently then measure it differently. But the

 22 ratios of one and a half times all that exists for
 183

 1 a particular market to me doesn't make sense. And

 2 if you need reference points for a larger

 3 worldwide trading as Sara said, you know, they

 4 have real concerns. There may need to be a

 5 different sort of contract for that that doesn't

 6 exist now.

 7 MR. MCGONAGLE: Ed.

 8 MR. GALLAGHER: I wholeheartedly echo

 9 Jerry's comments on trade options. That would be

 10 a train wreck in the dairy industry if the trade

 11 option -- if a milk marketing contract that has

 12 some volumetric optionality, that in no way, shape

 13 or form was ever devised as a derivative becomes a

 14 swap, it could blow through position limits with

 15 just one contract. It would be a real problem

 16 with the dairy industry.

 17 MR. MCGONAGLE: And so we're going to

 18 hang onto this topic maybe a little more. Ed?

 19 MR. PROSSER: I just wanted to make one

 20 other comment about wheat contract equivalency.

 21 Applying this mathematical formula to each one of

 22 the markets has given the Commission to recommend
 184

 1 that we increase wheat limits in Chicago.

 2 Incidentally we're going to raise Chicago's wheat

 3 limits above both Kansas City and Minneapolis.

 4 Does the Commission know that the physical market,

 5 its smallest production size is smallest in the

 6 United States is Soft Red Winter Wheat which is

 7 the wheat that's represented most closely to the

 8 Chicago market? So it gets back to this idea that

 9 75 years of history and the local knowledge of the

 10 DCMs, I think, should be very well represented

 11 when we decide to set these limits.

 12 MR. MCCONAGLE: Opportunity for closing

 13 comments, observations? All right. Thank you for

 14 a very exciting panel. I appreciate it. We're

 15 going to take a 15 minute break and we'll have our

 16 next panel on aggregation.

 17 (Recess)

 18 MR. MCGONAGLE: Welcome everyone to the

 19 fourth panel session today to discuss aggregation.

 20 And if I can have the panelists introduce

 21 themselves. We'll start with Ken Raisler.

 22 MR. RAISLER: Thank you. Ken Raisler
 185

 1 with Sullivan & Cromwell on PEGCC, the Private

 2 Equity Growth Capital Council -- it's a mouthful

 3 there -- which is a trade association for private

 4 equity interests.

 5 MR. MCCOY: Bill McCoy of Morgan Stanley

 6 and I'm here today on behalf of the Futures

 7 Industry Association.

 8 MR. SWEENEY: Michael Sweeney,

 9 Sutherland Asbill on behalf of the Commercial

 10 Energy Working Group.

 11 MR. NEVINS: Hi. Thanks for having me

 12 here today; it's Matt Nevins with the Asset

 13 Management Group of SIFMA. I work with our asset

 14 managers who manage mutual funds, private funds,

 15 and other client accounts including investments in

 16 these instruments.

 17 MR. CERRIA: Hello, Chuck Cerria from

 18 Hess here on behalf of Commodity Markets Council.

 19 MR. LASALA: Good afternoon, Tom LaSala,

 20 CME Group.

 21 MR. WINDELER: Good afternoon, Curt

 22 Windeler, Director of Market Regulation,
 186

 1 Intercontinental Exchange.

 2 MR. PARSONS: Good afternoon, John

 3 Parsons, MIT.

 4 MR. MCGONAGLE: Great. Thank you. So

 5 the fourth session today as I mentioned is a

 6 discussion on aggregation of positions. In

 7 circumstances where one firm owns an equity

 8 interest in another firm some commenters have

 9 suggested that the only relevant criteria for

 10 aggregation should be whether one firm controls

 11 the other and so focus -- what is the interaction

 12 between ownership and control as well as the

 13 availability of an exception are some of the

 14 questions that we're going to get into. To give

 15 us a little bit of an overview, though, we've

 16 asked Ken to talk about aggregation. Thanks.

 17 MR. RAISLER: Thank you, Vince, and

 18 thank you, thank the Commission and the staff for

 19 organizing this roundtable and for the work that

 20 has been done to date in the aggregation space.

 21 Let me set the stage. I think and predict this

 22 panel might be a little less exciting or perhaps
 187

 1 controversial than the last one. But nonetheless

 2 the issues are extremely important. I believe and

 3 predict there will be consensus on this panel to

 4 the first two issues that the Commission has

 5 raised and that is the issue of importance of

 6 control rather than ownership in evaluating the

 7 issue of aggregation. With proper separation

 8 between trading groups or trading units, we

 9 believe, and I believe the Commission has

 10 supported this in broad terms in the proposed rule

 11 makings, that that is the judgment that needs to

 12 be evaluated rather than the issue of ownership.

 13 If you look at the variety of business group

 14 structures whether they be one company with

 15 different business lines, parent- sub

 16 relationships, joint venture relationships, or as

 17 in the private equity space, private equity funds

 18 and portfolio companies, it is not the ownership

 19 issue that is the material issue to be evaluated.

 20 Instead it's the issue of who controls and how the

 21 separation of the trading activity can be assured

 22 to the satisfaction of the Commission and/or the
 188

 1 exchanges. And that's historically been the case

 2 and we see growth in that area, both in the 10-50

 3 where the ownership is between 10 and 50 percent

 4 and where the ownership is above 50 percent we

 5 don't believe materially that the evaluation

 6 should be significantly different. As long as

 7 there is the control separation, we're in the

 8 right place.

 9 We believe and would recommend speaking

 10 on behalf of PEGCC, and I believe some members of

 11 the panel will have other specific issues with the

 12 rule makings as proposed, but we see three issues

 13 that we recommend clarification with respect to --

 14 in order to put aggregation in the right place.

 15 As I said, I think we're going in the right

 16 direction. The first and most important is that

 17 in the above 50 percent category we don't believe

 18 it makes sense to have the Commission have to

 19 pre-review and approve each application. In the

 20 case of only the private equity space we believe

 21 there'd be literally thousands of such

 22 applications to be reviewed and instead we commend
 189

 1 the Commission's approach in the 10 to 50 percent

 2 category of having a notice filing with the

 3 Commission. That's a critically important point

 4 both in terms of taking into account Commission

 5 resources but also providing certainty to the

 6 marketplace and avoiding an interim step of having

 7 to aggregate for a period of time.

 8 The two other changes that we recommend

 9 are also important but not as important as the

 10 first one. One is that rather than having each

 11 board member of the owned entity make a

 12 representation -- and this is again in the 50 to

 13 above 50 category -- make a representation that

 14 they are not conflicted in terms of getting

 15 information. We believe that representation is

 16 more properly made at the owner entity level who

 17 of course controls those board members and

 18 otherwise is in a better position to make that

 19 representation. And then the last request would

 20 be that there is an unusual provision in the

 21 proposed rule about a penalty period of three

 22 months, a cooling off period of some kind. We
 190

 1 believe that's inconsistent. If somebody is not

 2 in compliance with the aggregation rules as

 3 they're defined they would of course not be able

 4 to take advantage of disaggregation and would have

 5 to aggregate, but as long as they're in compliance

 6 they should be able to come back in without a

 7 cooling off period.

 8 So those -- and I think those changes

 9 made, we would be in extremely good position, but

 10 broadly stated the focus here should be on control

 11 and not ownership. Thank you.

 12 MR. MCGONAGLE: Thanks, Ken. So I

 13 wonder what -- probably makes sense to just wheel

 14 out to the other panelists to hear feedback on

 15 other particular items of interest or concern as

 16 Ken identifies at least on behalf of his clients

 17 on the above 50 percent category an ability to get

 18 a notice filing rather than having the Commission

 19 discretionary review. So I'll put out so I can

 20 see whether on this panel there are additional

 21 issues that we should be thinking about as we go

 22 through this discussion and the comment period.
 191

 1 Matt.

 2 MR. NEVINS: Sure. Thanks again for

 3 having me here today and thanks for doing this

 4 panel; much appreciated, very important issue. So

 5 I'm just going to pick up where Ken left off and

 6 start out by saying from the asset management

 7 community's perspective here, we completely agree

 8 that the key fundamental determinate of

 9 aggregation should be trading control as opposed

 10 to ownership. We think ownership generally should

 11 not be a relevant factor in making the

 12 determination as to which positions get

 13 aggregated. From the asset manager's view this

 14 raises some very unique issues that I'd like to

 15 just sort of get into some of that detail on now.

 16 The first is that in addition to having an impact

 17 on the commodity derivative positions that they

 18 may put on for a fund or a client that they're

 19 managing positions for, asset managers would then

 20 be required to look at the equity ownership in the

 21 funds or the accounts that they're managing. In

 22 other words, if there is an ownership requirement
 192

 1 that goes into the aggregation determination,

 2 they're going to need to look at the level of

 3 equity ownership that they have in an operating

 4 company. And if they're over the relevant

 5 threshold, whether it be 10 percent or 50 percent,

 6 then they are going to have to work with that

 7 operating company to figure out the positions that

 8 that operating company has on and get those

 9 positions taken into consideration with the

 10 positions that the manager itself is putting on

 11 for the fund or account that it's managing. We

 12 think that's completely inappropriate where the

 13 manager has absolutely no control over those

 14 positions that are being put on by the underlying

 15 operating companies. So again we think that

 16 that's an irrelevant part of the equation here.

 17 We think that the focus should maintain on trading

 18 control, on having the ability to select the

 19 individual positions that are being put on.

 20 As far as the requirements related to

 21 making a notice filing or to perfect the exemption

 22 itself, we think that as proposed they'd be fairly
 193

 1 onerous and burdensome. If we're talking about a

 2 situation where ownership of equity, so ownership

 3 of positions is not a relevant factor, then a

 4 notice filing would seem to us to be more

 5 appropriate. If ownership of equity positions as

 6 opposed to ownership of a trading account is part

 7 of the factor that means -- or is part of the

 8 factors that need to be taken into consideration,

 9 then it would require an asset manager to do due

 10 diligence of the positions that are held by that

 11 operating or portfolio company that they've

 12 invested in, coordinate with them to make sure

 13 that they're getting that information or having

 14 some other means of getting a data feed so they're

 15 able to either make the filing that's required to

 16 get an exemption or to actually take those

 17 positions into account and aggregate them in order

 18 to determine their own compliance with the rule.

 19 So I think generally speaking we'd be okay with a

 20 notice filing requirement if there was not an

 21 ownership component of the aggregation

 22 determination.
 194

 1 On the issues that are related to having

 2 a requirement for over 50 percent, I would agree

 3 with Ken that having to go back to the Commission

 4 and seek approval seems unworkable, especially for

 5 an investment manager who has to make trading

 6 decisions on a fairly nimble and quick basis in

 7 order to manage risk in their portfolios and

 8 manage the positions in their portfolios. So I

 9 would agree with the point that Commission

 10 approval should not be required even over 50

 11 percent.

 12 MR. MCGONAGLE: So just focusing for a

 13 second on this ownership question, if we consider

 14 taking away ownership and focused on control then

 15 the ownership set levels is de minimus, 10

 16 percent, 10 to 50 there's certain considerations

 17 for control, and then 50 plus not just the

 18 Commission review but, you know, compliance or

 19 application of not only the control standards set

 20 at 10 through 50 but additional enhanced standards

 21 to evaluate. So how do you see that process

 22 changing? What's important about the control
 195

 1 analysis? Have we articulated in a proposal those

 2 elements that you think would be -- that gets at

 3 the concerns for aggregation just using a control

 4 evaluation?

 5 MR. CERRIA: Hello, Vince. Yes,

 6 actually we think you've done a really good job in

 7 this most recent proposal. I don't think I'm

 8 going to give the full cites but there's really

 9 good nuggets throughout the proposal. I'm going

 10 to point to 150.4(b)(i), (b)(ii), and (b)(iii),

 11 okay, where you're looking at really the essence

 12 of whether the entities are separate, the degree

 13 of separateness, how differently they trade or how

 14 differently they go about their business, if

 15 they're independently run from a control

 16 standpoint, and the day-to-day trading standpoint

 17 which is an in the moment kind of thing, okay. So

 18 that you may have regardless of ownership a senior

 19 vice president or a CFO who has a high degree of

 20 interest in what's going on but his interest is at

 21 a very overarching high level and never really

 22 descends down to the trading day-to-day operations
 196

 1 and you need to focus on the facts and

 2 circumstances there. And this really does need to

 3 be a facts and circumstances analysis, and I think

 4 you've hit on all of the correct factors in those

 5 sections that I've highlighted. So good job on

 6 that part of the proposal.

 7 MR. MCGONAGLE: And then getting at that

 8 if there was a proposal that did not consider

 9 ownership at some level then what balance do you

 10 see for control?

 11 MR. SWEENEY: Yeah, thanks, Vince.

 12 Where I draw the line would be the control test

 13 would be applied at the trading level. I mean, I

 14 think the thing that the Commission has to

 15 consider -- and I do agree with Chuck that the

 16 proposal is a good proposal -- that at the owner

 17 level, there's very little actual day-to-day

 18 business, at least in our experience working with

 19 energy companies, where there's the type of

 20 knowledge, there's obviously expertise in

 21 management and other people who can oversee a

 22 business, because they have corporate governance
 197

 1 responsibilities and fiduciary responsibilities.

 2 But on a day-to-day basis they don't have the

 3 actual real time knowledge to control or direct

 4 the trading at the trading level. So if you were

 5 to structurally put something in you would want

 6 the test and the procedures to be at the trading

 7 level for the recognition that it's not controlled

 8 at the top level of the company. I think that's,

 9 at least in our experience, a fundamental premise.

 10 There's not a lot of folks that we are aware of --

 11 even in various corporate structures. So we have

 12 clients who work with -- they're a single entity,

 13 they have multiple business units or platforms

 14 that trade within it, people that have separate

 15 subsidiaries that are owned. The trading

 16 decisions and the trading functions and the

 17 business dealings are done at that desk platform

 18 level, it's not controlled up top. So I think if

 19 you put it at the trading level to start with the

 20 recognition that the parent level or the owner

 21 level is not directing that and allow people to

 22 show that, at least block, create some sort of
 198

 1 conduit protection for information sharing I think

 2 you start out at a better place.

 3 MR. MCGONAGLE: Bill.

 4 MR. MCCOY: Thank you. Yes, and FIA in

 5 its comment letter echoes some of the same ideas

 6 that with respect to common control over direction

 7 of trading should be the primary focus. And as we

 8 indicated, and as Michael has alluded to, there

 9 may be other functions, risk management functions

 10 where the access to the data may be appropriate so

 11 that -- for example credit functions and other

 12 corporate governance functions that are needed,

 13 compliance functions that need to be aware to

 14 protect the overall enterprise. But that, in

 15 terms of the direction of trading and positions,

 16 where there are appropriate information barriers,

 17 such that traders do not have access to the data

 18 of the other organizational entities, that's where

 19 I think one has to start in looking at segregation

 20 and therefore determination that they may not be

 21 aggregate.

 22 MR. MCGONAGLE: So I want to go to Tom
 199

 1 in a second but I sort of want to pull together

 2 some of the comments starting with Ken. Our

 3 concern about sort of overwhelming the Commission

 4 resources, right, and so, you know, if 50 percent

 5 ownership let's assume that, you know, ownership

 6 is part of a recommendation, if 50 percent

 7 captures too much why, you know, not jettison 50

 8 percent -- move that up and maybe that has a --

 9 and then we're dealing with a smaller group. And

 10 what I'm getting at is, we haven't talked about

 11 this sort of the exception or the catch coming

 12 back around for substantially identical trading

 13 and who's going to have that burden to evaluate

 14 whether in this myriad of subsidiaries or shell

 15 companies or whatever that there's actually more

 16 connection between the trading activity than might

 17 first be known or recognized.

 18 MR. RAISLER: Yeah, I mean I think,

 19 Vince, that PEGCC was of the view that at 50

 20 percent you could create a different standard or

 21 an enhanced standard. Obviously, the rule as

 22 proposed would be that if you're above 50 percent
 200

 1 you need to comply with the 10 to 50 requirements

 2 and then these additional requirements. Certainly

 3 PEGCC would not object to going from 10 to 100 and

 4 not making that draw line at 50. I think, though,

 5 the issue of evaluation, I really would think --

 6 and I think Tom LaSala was about to speak to this

 7 and will when we call on him next -- that the

 8 exchanges historically have looked at that, have

 9 looked at trading in concert, have looked at

 10 accounts that seem to have very similar trading

 11 behaviors and, you know, when that has happened

 12 they have taken action and, presumably, so too

 13 could the Commission. But the presumption is that

 14 the notice filing would be a representation by the

 15 legal entity company, JV Affiliate whatever that

 16 they have in place, the kind of separations that

 17 are in 150.4(b)(ii) and that in so complying

 18 they're stuck with that and if they misrepresent

 19 that to the Commission of course there's the

 20 possibility of review and sanction of them.

 21 MR. MCGONAGLE: So, Tom.

 22 MR. LASALA: Thanks, Vince. I guess
 201

 1 I'll begin with the point about the ownership

 2 simply. I guess the background for my position

 3 is, I think you know for years NYMEX COMEX

 4 administered disaggregation I would say in

 5 compliance with 150.4 and in that context we

 6 didn't have a hard line, you know, drawn in the

 7 sand with 50 percent or a barometer, but it was

 8 control based. You know, looked at the structures

 9 of the organizations, what information was shared,

 10 where were people sitting, what assistants did

 11 they share, what technology did they potentially

 12 share. So we were looking for a distinct

 13 separation, where the separation is clear, is

 14 distinct. And also we would run trading in

 15 concert analysis. So we had that ability, we

 16 exercised that ability. And as Ken said, you

 17 know, where appropriate, we'd look at that today.

 18 So there's a thorough examination. I don't

 19 frankly see the real distinction whether someone

 20 is more than 50 percent or between 10 and 50

 21 percent if in fact you're answering the questions

 22 about the separation identically, you're testing
 202

 1 them the same. I'm not sure why we need to go to

 2 necessarily a higher standard. And, you know,

 3 certainly talk about that. But I guess I was open

 4 and receptive when I thought I heard you say maybe

 5 in support of what Ken introduced earlier that,

 6 you know, a notice filing, that something even

 7 beyond 50 percent might be appropriate. I guess

 8 the point I'll add to that is I would still have

 9 some concerns that maybe for Ken's clients that

 10 some of the requirements that kick in, the no

 11 consolidated balance sheet or the restriction to

 12 the 20 percent of the spec limit for the company

 13 that was owned, while that not might be a problem

 14 for some I think it will be a problem for others.

 15 In the context of the 20 percent it does seem

 16 arbitrary and frankly I'm not quite clear what the

 17 consolidated balance sheet really means if you've

 18 satisfied the full scope of the test.

 19 MR. MCGONAGLE: So where would you make

 20 your recommendation?

 21 MR. LASALA: I would make a

 22 recommendation that there be a notice filing with
 203

 1 no restriction as to percentage. I would

 2 eliminate those last two criteria for an excess of

 3 50 percent and I would advocate that the agency

 4 perform some type of testing in all instances.

 5 You will be getting data with the OCR to do

 6 trading in concert. You'll have that ability. We

 7 have that ability today. So I think that there

 8 should be some back testing. That back testing

 9 arguably could occur, you know, on some repeat

 10 level. I think just remind you -- and I know

 11 you're sensitive to this -- you know, you've got

 12 people notice filing when they're making

 13 representations to you and to us, they're subject

 14 to, you know, being disciplined if they are

 15 misrepresentations or if either of us detect, you

 16 know, basically inconsistency in those

 17 representations. I think people take those

 18 representations seriously and, you know, the

 19 extent that someone, you know, doesn't, they'll be

 20 sanctioned.

 21 MR. MASSAD: Let me make sure I

 22 understand your points. You know a lot of this is
 204

 1 looking for bright lines for us. We're obviously

 2 a Commission of limited resources. We don't have

 3 lots and lots of people to evaluate the facts and

 4 circumstances of every situation. In suggesting

 5 that we use control instead of ownership and in

 6 other areas of the law ownership is an indicia of

 7 control. In the securities area obviously a much

 8 lower ownership is an indicia of being an

 9 affiliate. So I'm trying to understand if you're

 10 arguing for this control and saying even, you

 11 know, even a 50 percent ownership should not be

 12 considered a bright line. Is that I guess because

 13 you think the policy purposes we're trying to

 14 serve here are different because it feels

 15 different than say how other areas of the law

 16 might operate, or maybe there are other areas of

 17 the law where you think a similar standard is

 18 used.

 19 MR. RAISLER: I would emphasize that

 20 there is the percent standard which is sort of a

 21 de minimis standard below which there is no

 22 requirement. I think though that from a variety
 205

 1 of perspectives the way in which companies and

 2 affiliated entities and portfolio companies and

 3 the like trade really has created between them and

 4 their sister/parent, whatever it is, a form of

 5 separation such that if they were to be aggregated

 6 or required to be aggregated it would

 7 fundamentally change their business model. And I

 8 think all that we're asking is that the Commission

 9 recognize the way these organizations are

 10 structured creates a formal separation that allows

 11 representation to be made. I think historically

 12 and the line of 50 percent would be, you could

 13 argue a higher standard because by definition if

 14 you own more than 50 percent of an entity you do

 15 have some element of control of its behavior and

 16 so you need perhaps a more affirmative

 17 representation as is provided in the above 50

 18 percent category, that you're not in fact

 19 exercising certain authorities that you otherwise

 20 have; you're waiving those authorities. But I

 21 think the notion of allowing this to happen is

 22 actually not new as Tom indicated. Although not
 206

 1 formalized in regulation, the proposals people

 2 have had have gone to the exchanges with respect

 3 to relief and the exchange has evaluated the

 4 separation and made that resource determination.

 5 So I don't think we're asking for some radical

 6 adjustment in that analysis.

 7 MS. ADRIANCE: Just to kind of also have

 8 you address-- since what has been suggested by a

 9 number of people here that the focus should be on

 10 control not ownership, however the determination

 11 of control is made-- that the focus should be on

 12 control and not ownership. And I want to just

 13 pull in some -- if anyone can address the CEA, the

 14 language in CEA which does not just limit itself

 15 to focus on control. There is language there that

 16 the proposal was trying to address and so any

 17 feedback as to how the Commission should address

 18 because, you know, obviously we're going to have

 19 to address in any final rule making we're going to

 20 have to address that. What should we be doing?

 21 MR. MCGONAGLE: So congratulations,

 22 Riva. I think you got almost everyone to turn up
 207

 1 their chart. But if we can go to Bill and then I

 2 guess just straight down the line.

 3 MR. MCCOY: Right. Well, I thought to

 4 try to bring this together I was thinking that

 5 we're focusing-- that we're talking about control

 6 and I think the discussion that as Tom mentioned

 7 among the different requirements or the above 50

 8 percent one that many of the market participants

 9 may have difficulties with, and FIA has certainly

 10 highlighted it, is with respect to looking at the

 11 requirement of consolidation and financial

 12 statements under GAAP where, of course, that is

 13 the definition of control as are a number of other

 14 statutory provisions that control. But that's to

 15 some extent corporate control over the entity as

 16 opposed to where, I think the purpose of the

 17 statute, in this case with respect to the limits,

 18 is control over the decision making on the

 19 trading, on the positions, as opposed to general

 20 corporate control. And as I mentioned earlier one

 21 of the things FIA asked for is clarification

 22 regarding how, while there should be no sharing of
 208

 1 data of access of information, among the separate

 2 affiliated entities, where one is seeing

 3 disaggregation with respect to the traders, the

 4 ones who are making the decisions in trading, that

 5 there may be risk managers, credit departments,

 6 compliance groups, et cetera, where some shared

 7 information needs to be in place because from a

 8 perspective of corporate control there needs to be

 9 the oversight, generally, of the enterprise.

 10 However, to the extent that the statute and the

 11 historical perspective that the Commission is

 12 taking and the exchanges have taken, of focusing

 13 on the control of decision making, I think that

 14 underscores why putting in this additional

 15 requirement of reliance on consolidation of

 16 financial statements seems ill placed.

 17 MR. SWEENEY: Okay. A couple of

 18 thoughts. I agree with obviously with Ken and

 19 Bill's comments. Mine will be additive. I think

 20 in terms of when we talk about control and how you

 21 get there and ownership and indicia of control, I

 22 think if you're talking about enhanced standard
 209

 1 applied to entities where ownership interest is

 2 over 50 percent, you know, similar to other rules

 3 proposed by the Commission there can be, you know,

 4 some type, in my view, of corporate delegation or

 5 corporate authorization to allow for that

 6 independent trading by the actual owned entity

 7 where they're specifically authorized to engage in

 8 that activity by the senior management. And that

 9 authorization would be given in the context that

 10 the owning entity would only maintain such minimal

 11 control as is consistent with their fiduciary or

 12 corporate governance responsibilities to

 13 diligently supervise the trader. I mean that's

 14 something to think about. And that would also be

 15 done in the context of other applicable legal

 16 obligations of the owning entity.

 17 And then in terms of the statute, the

 18 Commission still has the discretion to use, you

 19 know, section 4a(a)(7) as, you know, to exempt

 20 from the statute certain activity. If you placed

 21 -- it can be used in concert with the additional

 22 controls if they're present. Just, you know, a
 210

 1 thought. You know, something to think about.

 2 MR. MCGONAGLE: Matt.

 3 MR. NEVINS: Okay. Thanks. I'm going

 4 to try to add onto the comments of all of my

 5 fellow panelists up here. I agree with everything

 6 that's been said so far. Our comment letter in

 7 February went into great detail in explaining our

 8 view and the distinction between corporate control

 9 and trading control. I'm going to try and very

 10 briefly summarize here. I think the question that

 11 the Chairman asked is a very good one. I think

 12 you need to look at other regulations in order to

 13 gauge whether it's appropriate or what the

 14 appropriate level of control is in the context of

 15 position limits and position limit aggregation.

 16 So here you're concerned about potential

 17 manipulation in the market, large size in the

 18 commodities space to potentially take advantage of

 19 positions. I think in other contexts, in the SEC

 20 context on, you know, large trader and ownership

 21 reporting in the FTC and DOJ context with

 22 Hart-Scott-Rodino, it does make sense to look at
 211

 1 corporate control and look at ownership levels for

 2 determining, you know, again using FTC and DOJ as

 3 an example, antitrust concerns for large

 4 acquisitions. Here, where you don't have a common

 5 controller over the positions in commodity

 6 derivatives itself, it doesn't make sense to me to

 7 require aggregation based solely on ownership. So

 8 in other words, if there is a division and a split

 9 between who has the ability to put those commodity

 10 positions into place between the investor and the

 11 investee company, it doesn't seem appropriate to

 12 say, okay, you're imputed to control those

 13 commodity derivatives positions in the market and

 14 therefore aggregate those positions for making a

 15 determination as to whether that parent level

 16 entity has the ability to manipulate the commodity

 17 derivatives market. Where there is a complete

 18 split between the power to put those positions in

 19 place, I think ownership is much less of a

 20 relevant consideration. In fact, it's probably an

 21 irrelevant consideration.

 22 The other thing I'd say just adding onto
 212

 1 my fellow colleagues here, on the over 50 percent

 2 threshold, we also agree that accounting

 3 consolidation is a red herring here. The

 4 accounting rules require a consolidation from time

 5 to time even where ownership levels are slight.

 6 There are, you know, accounting considerations as

 7 to why an entity may be required to be

 8 consolidated on the books, on the balance sheets,

 9 so you have the liabilities and assets shown

 10 together in one place where there really is no

 11 other control. And I think that in order to make

 12 an exemption contingent upon accounting

 13 considerations also does not seem appropriate

 14 here.

 15 MR. MCGONAGLE: So would you recommend

 16 an analysis of control just of the factors that

 17 we've outlined at the 10 to 50 percent level and

 18 not the additional factors, or where do you -- do

 19 you have a line drawn there?

 20 MR. NEVINS: I would focus completely on

 21 control without looking at the ownership

 22 percentages.
 213

 1 MR. MCGONAGLE: Right. I guess what I

 2 was getting at is that there's different

 3 additional control factors at above the 50 percent

 4 and so if we marked away or walked away in some

 5 respect from ownership evaluation, what level of

 6 control analysis gets the job done?

 7 MR. NEVINS: I'm sorry, Vince, I'm not

 8 sure I fully understand the question. But again I

 9 wouldn't make a distinction based on the

 10 percentage of ownership.

 11 MR. MCGONAGLE: So I guess you're saying

 12 that for certain control evaluation there's

 13 outlined a number of factors including the

 14 accounting factor you set out.

 15 MR. NEVINS: Right.

 16 MR. MCGONAGLE: Which only comes into

 17 play at above 50 percent. And so what I was

 18 looking at was sort of the line drawn for control

 19 factors. I think we got -- Chuck had indicated

 20 earlier that he liked --

 21 MR. NEVINS: I wouldn't have put

 22 accounting at all.
 214

 1 MR. DANGER: Yeah, let me just -- this

 2 is part of our learning about your thoughts. And

 3 I get that everybody seems to be not liking the

 4 ownership aspect of this whole thing and so my

 5 question would be what organizational difficulties

 6 do you face in complying with the proposed

 7 position limit rule regarding the ownership

 8 interest over 50 percent? So what are the

 9 organizational difficulties that you face in

 10 dealing with that? So, and that would help us

 11 understand what your troubles are in terms of

 12 complying.

 13 MR. CERRIA: Thanks, Vince. Ken, before

 14 I get to that let me just finish up on what Vince

 15 was -- and I know Vince you were nodding to me

 16 here. And the one prong I think that I would

 17 recommend that I was talking about -- and I'll

 18 just read it out loud, "Procedures that are in

 19 place reasonably effective to protect coordinated

 20 trading decisions by such person." Okay. So that

 21 would be in the 150.4(b)(iii) or (ii). I had one

 22 too many "i" so it's (ii). Okay. So that answers
 215

 1 that.

 2 And, Ken, from an organization

 3 standpoint, I mean, one of the reasons that I

 4 wanted to come here today is because I have

 5 actually many years of experience at this before

 6 the divestitures of downstream at Hess where we

 7 had Hess Corporation in the business as an energy

 8 company, a fully integrated energy company, and we

 9 had Hess Energy Trading Company at the 50 percent

 10 level, it wasn't over, okay. And it still is

 11 actually, which is a worldwide trading company.

 12 And they are very separate and distinct; totally

 13 different corporate missions, like Ken alluded to

 14 a lot of the factors in his remarks a few minutes

 15 ago. And forcing them to share information -- and

 16 I want to note that when we're talking about this

 17 issue, we're talking about not only the futures

 18 positions or whatever, you know, whatever

 19 derivatives are going to be covered by the spot

 20 limits, we're talking about the associated

 21 physical positions, too, which is really the

 22 entirety of the business, okay. And so they just
 216

 1 don't share -- they're set up purposely not to

 2 share information. They are separate and

 3 distinct. They have their own trading platforms,

 4 their own guidelines, risk management. There is

 5 overarching policies from a corporate governance

 6 standpoint, Mr. Chairman, where the enterprise is

 7 examined and -- I'm just telling you how we did

 8 it. It's only indicative of what we did. It's

 9 not something that I'm propagating for everybody.

 10 And so that level of oversight is -- I think I'm

 11 now famous for using altitudinal illusions. So

 12 that's a 50,000 footer, okay. And what we're

 13 talking about here is actually at the root level

 14 of day-to- day trading, okay.

 15 And the other point I want to make is

 16 that these are intraday limits. So, I mean, we

 17 can't be -- I just physically don't think we can

 18 be aware of everything going on all over our --

 19 everybody else's business all over the world

 20 through the day to make sure we don't bump up on a

 21 limit. And obviously I'm talking about at the

 22 last three trading days for energy. And, you
 217

 1 know, and so being aware of all of that and

 2 differentiation about how at the moment a trader

 3 is making decisions is not a normal corporate

 4 process that other corporate departments are

 5 doing, you know. So a trader is a very localized,

 6 regionalized function that's happening right now.

 7 I mean there were comments made in the prior panel

 8 about how localized the decision is. It's a

 9 delicate balance of time, space, and weather. You

 10 know, all of these things are what's, you know,

 11 going on at the time of the trade right now.

 12 And the last thing I want to offer to

 13 Riva's suggestion and even Mr. Chairman's

 14 suggestion with regard to resources -- and this is

 15 like out of the blue so take it for what it's

 16 worth. Earlier panels, the exchanges actually --

 17 now they don't know I'm saying this so, Tom, don't

 18 hit me, but the exchanges offered to help you with

 19 an information sharing process before with the

 20 issues on the prior panel. Riva, if you want to

 21 associate a higher level of review because of

 22 ownership, because you feel indebted to the
 218

 1 statue, maybe involving the exchange in that

 2 review or something would help. You would still

 3 make it effective upon notice so that, you know,

 4 we don't halt the business or retard the business,

 5 but, you know, the exchange has provided a very

 6 valuable function in this aggregation analysis

 7 through the last, you know, 15-20 years, absent

 8 before they harmonized with CBOT, and Tom will

 9 mention that; I'm confident he will. And we

 10 should defer back to that and rely on that. And

 11 it could be a way for you all to use the resources

 12 wisely. I think I'm done.

 13 MR. MCGONAGLE: Tom, another person has

 14 put words in your mouth so let's see, where do you

 15 come out?

 16 MR. LASALA: Vince, I think I was

 17 frankly a bit remiss before to you, the Chairman,

 18 the Commissioners and I didn't -- I left off

 19 probably a various essential component. I did not

 20 mean to be ignorant to the ownership criteria.

 21 And what I mean by that is, just to give you a

 22 little background in terms of structure, we
 219

 1 primarily aggregate in the very first instance on

 2 ownership. So we're looking at that 10 percent,

 3 we're establishing groups in our systems, we're

 4 looking at the positions individually and across

 5 the group. So it would not be at all unusual for

 6 us to get a trigger of a prospective violation

 7 because we're aggregating across the group. So

 8 hypothetically, entities on the same side of the

 9 market trigger what might be, I'll say, a limit

 10 issue or an accountability concern. It is that

 11 that may lead to if it wasn't otherwise initiated,

 12 engagement with the participant that would have in

 13 the past or could lead to this detailed analysis

 14 of, you know, the control base structures and

 15 potential disaggregation. But even when we

 16 disaggregate we still have them, I'll call,

 17 "aggregated in a group" so we're still tracking

 18 the group of companies that have common ownership.

 19 So I think it's a very holistic, you know, I'll

 20 say, analysis as to the corporate structures. So

 21 again I did not want to infer before that I was

 22 ignorant or was throwing the ownership component
 220

 1 out and I had left that out. So I apologize.

 2 MR. MCGONAGLE: I appreciate that

 3 clarification, Tom.

 4 MR. LASALA: Thank you.

 5 MS. ADRIANCE: Yeah, as a follow up to

 6 that. It seems to me that what you're suggesting

 7 is that you think the better process is to use the

 8 tools that you are suggesting you have to, in a

 9 sense, allow -- when you've done a review-- to

 10 allow disaggregation but then to review, follow up

 11 and do a continuing oversight to make sure that

 12 that disaggregation was appropriate. So in a

 13 sense you're starting from the, okay we did the

 14 process, we determined that the control here is,

 15 you know, is enough. All of the factors for

 16 independence, it's reasonable to allow

 17 disaggregation but then -- so the approach would

 18 be let's allow the disaggregation when it seems to

 19 be appropriate, but we'll continue with our review

 20 and that's where we catch a problem rather than

 21 starting out from the other side of well, we can't

 22 allow it because there is an issue of possible
 221

 1 control. So am I understanding that correctly?

 2 That you think you have the tools in place, you

 3 think the ability to go back and look and review,

 4 such that it wouldn't be an issue if there

 5 actually was identical trading strategies, if

 6 there was issues that came up?

 7 MR. LASALA: I'll speak on behalf of CME

 8 Group. I believe we have those tools. I'll let

 9 Kurt speak on behalf of his organization.

 10 MR. MCGONAGLE: Kurt, did you have

 11 something? And then we'll go to Ken.

 12 MR. WINDELER: Yeah. Absolutely. And I

 13 apologize for everybody that thought there would

 14 be a more dynamic exchange between Tom and myself

 15 but we're largely in agreement with --

 16 MR. LASALA: We've disappointed.

 17 MR. WINDELER: Yeah, it's going to be

 18 quite dry. We largely do agree with what Tom has

 19 laid out, in that, look, ICE has a long history of

 20 engaging in the same practices that the CFTC, as

 21 well as other SROs, are engaging in on a daily

 22 basis and that is to surveil these markets, to
 222

 1 adequately manage and administer an effective

 2 position limit monitoring regime that takes in

 3 this information, tries to analyze for that common

 4 control and independence or ownership factors

 5 every step of the way. To Tom's point, in

 6 clarification here, in fact ICE doesn't wholesale

 7 dismiss ownership. That is one of the first

 8 indications of a common trading strategy, a common

 9 aspect to a position that may need to be

 10 aggregated. And to the point that it's a "set it

 11 and forget it" type of situation, that's not the

 12 case whatsoever. Exchanges are actively engaged

 13 with participants from the onset of the initial

 14 large trader report to the identification of a

 15 102, across markets, across contracts, across

 16 accounts we're looking at essentially those

 17 control and ownership structures. And to the

 18 extent that when we engage and have a discussion

 19 with a firm we go through, what I think the

 20 Commission has appropriately identified as, very

 21 good tests for independence in (b)(2)(i).

 22 Essentially those are the tests that we are
 223

 1 looking for that's going to dismiss any further

 2 concern about ownership. And so we are in

 3 agreement that the additional tests for greater

 4 than 50 percent, they largely create a situation

 5 where it's not actually going to be something that

 6 a firm is likely going to be able to relieve

 7 itself of in terms of an exemption.

 8 The last thing I'll say, since it seems

 9 to be a hot topic and a lot of people are chomping

 10 at the bit speak, is that I think that essentially

 11 in order to effectively surveil these markets not

 12 only does it require a lot of manpower, a lot of

 13 systems, a lot of administration, but it also

 14 requires a lot of coordination. And I think

 15 that's most appropriate to say that it needs some

 16 coordination between the SROs, but certainly with

 17 the Commission, because any indication or

 18 determination about aggregation that differs, that

 19 the Commission may make in regards to any sort of

 20 test or not for the federal limits that are being

 21 proposed, and the impacts on those markets,

 22 obviously dramatically impacts the surveillance
 224

 1 that we're doing at the exchanges. And so I would

 2 suggest that not just having this bright line test

 3 as a good measure in good certainty in the

 4 industry, but beyond that, as far as the

 5 implementation goes that there's quite strong

 6 coordination between the surveillance groups to

 7 ensure that what that knowledge that is at the

 8 exchanges is shared with the Commission as well in

 9 what the Commission hears and understands from

 10 their conversations and interactions with the

 11 firms is shared appropriately.

 12 MR. MCGONAGLE: All right. Thanks,

 13 Kurt. Before we go to Ken I did want to put out

 14 for people to think about, one question concerning

 15 questions or concerns surrounding how we've

 16 articulated the substantial identical trading

 17 strategy. I alluded to it earlier but I want to

 18 make sure that to the extent that there's comments

 19 about how we've articulated that as a process,

 20 that we get to hear what you have to say.

 21 So, Ken, back to you.

 22 MR. RAISLER: I'll defer to others on
 225

 1 that last question. But two points if I can

 2 picking up on Tom and Kurt. I appreciate as well

 3 that the Commission has had and continues to have

 4 a Form 40 and now the Form 40S, both of which ask

 5 the question do you -- you know ownership of more

 6 than 10 percent, either owning more than 10

 7 percent or being owned more than 10 percent by

 8 others. So you have that data point consistent

 9 with the exchanges for purposes of evaluation. I

 10 did want to answer Ken's question about the 50

 11 percent and the burden associated with that by

 12 illustrating that in the context as we did in our

 13 letter from the PEGCC. We have a situation where

 14 the PE funds may own dozens of companies. They

 15 may own up to 100 percent of those companies.

 16 Their ownership of those companies is effectively

 17 benign. They often times will put members of the

 18 PE fund or the PE parent on the board of these

 19 portfolio companies, but otherwise they don't get

 20 involved in the business of the portfolio

 21 companies and certainly don't coordinate or even

 22 are not knowledgeable about the trading at the
 226

 1 portfolio company level. And so just imagine a

 2 scenario where you'd have to aggregate all of that

 3 information at the PE fund level and then allocate

 4 to the PE fund portfolio companies whatever

 5 headroom was available under a single limit or

 6 other similar situations. So the model for PE

 7 funds is uniquely ill suited to an aggregation

 8 regime and in fact completely inconsistent with

 9 the business model, which is, there is corporate

 10 ownership but there is no functional control over

 11 a whole variety of activities at the portfolio

 12 company level including, specifically, trading

 13 activities.

 14 MR. MCGONAGLE: Bill.

 15 MR. MCCOY: Yes, thanks. I thought I'd

 16 first address something further about operational

 17 difficulties and then if I may go to Vince your

 18 question regarding substantially identical trade

 19 strategies. So first just another scenario -- and

 20 I agree with what we've heard about a number of

 21 the difficulties of implementation, but another

 22 scenario I wanted to discuss is the presupposition
 227

 1 I think we've been talking about right now is

 2 where the corporate enterprise of many different

 3 affiliates, of various investments in portfolio

 4 companies is almost an ongoing concern state. But

 5 I wanted to address the difficulties in terms of

 6 acquisitions. So a new entity being acquired

 7 there is a host, as you know, or a myriad of types

 8 of issues one has to conduct in due diligence as

 9 part of that. And you could imagine as part of

 10 that a checklist that would include an

 11 understanding of the various types of positions

 12 that the target entity may have in terms of

 13 reference contracts if that entity owns interests

 14 in subsidiaries which owns interests in

 15 subsidiaries and then other interests, it gets

 16 that much more complicated. Add that to the fact

 17 that many of these cases, just the mere fact of

 18 the potential acquisition may be material non

 19 public information, so there's a very small group

 20 that is entitled to have the information prior to

 21 the public announcement of the acquisition. Now

 22 there may be time between that announcement and
 228

 1 actual closing, but that time may be very

 2 compressed. So you can now foresee much of the

 3 operational difficulties of those that need to

 4 implement the calculations for aggregation doing

 5 so in a very short period of time after being

 6 permitted to be aware of that fact.

 7 So one of the things that FIA had

 8 proposed in its letter to the extent that the rule

 9 does look at ownership at any level is to allow

 10 for essentially a safe harbor grace period whereby

 11 in doing -- and the FIA has asked for notice

 12 filing as opposed to approval, that a firm would

 13 be able to during that notice period, or a

 14 reasonable period, be able to submit the notice

 15 filing. And provided that they would be entitled

 16 to not aggregate the positions; the fact that they

 17 fail to provide the filing until that period of

 18 time has gone by would not work against them. And

 19 then further, should a firm fail to timely file a

 20 notice period, then that would be a violation a

 21 notice requirement. But it shouldn't equate to

 22 being a daily violation of position limits going
 229

 1 back to the original date that the acquisition.

 2 So you can see how these operational difficulties

 3 of any type -- what one -- one important theme

 4 here would be that this rule making not somehow

 5 create implications on the capital markets and

 6 merger and acquisition type activity because of

 7 the difficulties of implementing and providing for

 8 the flow.

 9 MR. MCGONAGLE: You would propose that

 10 we articulate in any aggregation that sort of the

 11 failure to make the filing is separate from --

 12 would be separate from some underlying other

 13 violation?

 14 MR. MCCOY: And just because one hasn't

 15 filed if one otherwise would be entitled to

 16 aggregation one should not then be deemed to be in

 17 violation of the position limit itself. So it

 18 would be whatever notice -- failure to file the

 19 notice that would have been required after the

 20 grace period to have gotten.

 21 MR. MCGONAGLE: So I'll say I understand

 22 the point.
 230

 1 MR. MCCOY: Great. If I go to

 2 substantially identical trading strategies, the

 3 FIA in addressing this has noted that there is

 4 obviously here a lack of objective criteria, as

 5 there often is in rule making, and that will

 6 create its own challenges. One of the things

 7 though that the FIA pointed out in its letter,

 8 it's remembering first that the statute of course

 9 ties the concept of concerted trading activity to

 10 an express or implied agreement. And the FIA

 11 asked for clarification because just to show how

 12 one could, in FIA's view, misinterpret the scope

 13 of it, they pointed to example seven in the

 14 position limit proposal whereby this example seven

 15 of Appendix C of bona fide hedging positions where

 16 there was a -- I won't go into all the detail--

 17 but a sovereign entering into a contract with a

 18 farmer whereby payments are made. And one can

 19 look at that bilateral contract and say looks very

 20 much like a swap. Okay, so that's a reference

 21 contract, fine. And then one reads through the

 22 example, it's discussing this in the context of
 231

 1 what constitutes a bona fide hedging position and

 2 the example goes on to indicate where the two

 3 parties have entered into this bilateral contract

 4 and then the sovereign is the party that hedges

 5 its obligations using another reference contract,

 6 that the two parties -- one would read this as

 7 saying the two parties must solely as a result of

 8 that bilateral agreement must aggregate their

 9 positions. And the FIA has said in its letter and

 10 we have stated that we asked for clarification

 11 because this is not an agreement, just based on

 12 the facts that were presented. It's not an

 13 agreement by two parties to act in a concerted way

 14 of each entering into a trading strategy. The

 15 farmer, from his perspective, doesn't care if the

 16 sovereign is hedging its obligations. He just

 17 wants to know his price risk is being covered by

 18 that agreement. There's not an agreement between

 19 the parties to coordinate their individual

 20 trading. So it's a really good example in the

 21 rule as to where there are dangers if we don't

 22 have a clear understanding as to the type of
 232

 1 criteria when we're talking about identical

 2 trading strategies.

 3 MR. MCGONAGLE: Mike.

 4 MR. SWEENEY: Yeah, I just want to touch

 5 base on a couple of operational considerations and

 6 go directly back to Ken's question. From the

 7 commercial energy perspective, a number of

 8 companies have taken efforts already to separate

 9 their trading operations. So you said what are

 10 the challenges of aggregating is you're going to

 11 have to undo that. Now there's certain companies

 12 that will have to remain separate due to other

 13 regulatory requirements and the rule addresses

 14 that. But from my perspective and I think from

 15 the working group's perspective, it's a much

 16 cleaner approach if you focus on independent

 17 control and having the right criteria established,

 18 worked out between the Commission and the market

 19 participants and the rule making process than to

 20 pull things back together for a couple of reasons.

 21 Chuck mentioned first a lot of the trading is

 22 regional and localized. So you can have in one
 233

 1 context folks in Calgary, Houston, and in another

 2 part of the U.S. trading and then they may be

 3 trading the same derivative contract on-exchange,

 4 but what they're hedging in their particular

 5 physical portfolio are distinctly different and

 6 for distinctly different purposes. And they're

 7 not talking to each other; they're not aware on a

 8 real time basis what's going on. And if you force

 9 that aggregation then you create a scenario where

 10 you actually start to have to police those flows

 11 of information more than you would if they were

 12 actually independent and you ensure that they're

 13 -- you know, that the trading is independent.

 14 Another scenario that comes up different

 15 than the one I just mentioned in the energy

 16 industry is that often times different parts of

 17 the business compete. They have distinctly

 18 different missions for what they do and the

 19 purpose they serve in the market and they can look

 20 at a position and have distinctly different views

 21 of how they would use -- you know, an opportunity

 22 to do physical business that then they will go and
 234

 1 hedge, they have distinctly different strategies

 2 and views as to how they would go about it. And

 3 that information flow, if there is information

 4 flow, you're going to have to police that again so

 5 that is not used improperly.

 6 So I think just one point, you know,

 7 what is the challenge? Well, you'd have to put

 8 something back together or put something together

 9 either you didn't have and the time and effort

 10 that would go into policing those flows of

 11 information. I think it's just a much cleaner

 12 approach, assuming people could satisfy your

 13 indicia, ultimately determined, is to keep things

 14 independent at the trading level. And then

 15 whatever is coordinated at the highest level could

 16 come up in a shared circumstance and be very

 17 contained. That's just a thought.

 18 MR. DANGER: I'm just going to ask I

 19 think is the easy question, which is, I mean,

 20 aren't ICE and CME right now applying ownership

 21 perspective on aggregating futures positions right

 22 now? So they're doing this right now and somehow
 235

 1 it seems to be working for everyone, okay. And

 2 so, you know, I'm thinking well what is the

 3 challenge here? So they're doing that in respect

 4 to energy contracts, Ag contracts, metals, and all

 5 that. I think, and maybe I don't completely

 6 understand so I'm looking for clarification on

 7 exactly what's --

 8 MR. LASALA: I think, Ken, we are but by

 9 virtue of the current construct of our rules we're

 10 limited to where we can disaggregate to, you know,

 11 beyond 10 percent to eligible entities. So that

 12 is a constriction that, you know, again I think

 13 that Chuck would be a great example. You know,

 14 that restriction and other commercial entities

 15 that aren't eligible entities are completely

 16 locked out and they might say, you know, for all

 17 the good reasons that he made earlier -- you know,

 18 I have got no look into this group, we are so far

 19 apart, we share no systems, no people, no

 20 anything, yet now you've got me in a position

 21 where you're making me somehow try and coordinate

 22 what I do with this entity when in the normal
 236

 1 course that's not at all what we'd do.

 2 MR. MCGONAGLE: So just for structure

 3 here, so, Kurt -- we'll go Kurt, Chuck -- I know

 4 Matt's been patient but -- and also John. I want

 5 to make sure that we get to him. So we'll go Kurt

 6 and Chuck and then Matt and to John, yeah.

 7 MR. WINDELER: Certainly. And I'll just

 8 clarify that in fact like I mentioned before we

 9 certainly do take ownership into consideration.

 10 That's essentially largely one of the first

 11 indicators to us that there needs to be an

 12 aggregation is you are aware the clearing firms or

 13 reporting firms are one of the front line

 14 indicators to us in the large trader reporting

 15 process to net and aggregate accounts by control

 16 in this special account as it comes across to us

 17 and identify it in a 102. And so ownership

 18 certainly is one of those indicators as we take a

 19 look beyond just what we're collecting in the

 20 large traders. We're looking at 102s, Form 40s in

 21 our discussions with the firms. But I think what

 22 we're trying to say here is that having a separate
 237

 1 test based on a percentage of ownership that sets

 2 out different obligations for seeking exemptive

 3 relief is where I don't think that we're seeing

 4 the value in this process. If we've already

 5 established under (a)(1) that aggregation has to

 6 occur with greater than 10 percent ownership or

 7 control in that test we've already established

 8 that ownership is going to have a factor in it.

 9 It's just the additional tests when you get to a

 10 greater percentage that I think was what we're in

 11 disagreement with.

 12 MR. MCGONAGLE: Chuck.

 13 MR. CERRIA: Okay. Ken, before the

 14 divestiture of the downstream, we were subject to

 15 the new regime and it was very hard. Now you may

 16 not know how hard and it's kind of one the reasons

 17 I wanted to do this today because thank god we had

 18 no violations, okay, but there was a lot of angst

 19 going on behind the scenes at our shops trying to

 20 get information and stay within the limits when

 21 the spot month limit was going. It was very hard

 22 forcing this issue with two very dissimilar
 238

 1 businesses who don't communicate, don't talk, and

 2 take umbrage at knowing that the other guy's got

 3 some position information. So I want that to be

 4 clear, okay. And that's really one of the driving

 5 forces that brought me here today to make sure

 6 that you all are clear that when there is true

 7 separateness and it truly is arms-length, you

 8 know, you really should respect that business

 9 judgment that was made by the entities.

 10 MR. MCGONAGLE: Matt and then John.

 11 MR. MR. NEVINS: Sure. So I'm going to

 12 pick up on something that Ken raised a little bit

 13 earlier. It struck a chord with me and that was

 14 the analogizing to Form 40 which I think is a good

 15 place to look. I think we at SIFMA AMG in our

 16 comment letters and others have made analogies to

 17 Form 40 as well. But I think it raises a very

 18 important distinction for the asset management

 19 industry and that's that there really is a

 20 difference between having a 10 percent control

 21 over -- or more over a trading account versus

 22 having a 10 percent or more ownership interest in
 239

 1 an operating company. And then Ken followed up on

 2 this point as it relates to private equity funds

 3 but it's really even broader than that. It

 4 applies to registered funds, it applies to private

 5 funds that may not be private equity funds, and it

 6 applies to client accounts that asset managers

 7 manage that may not even be structured as a fund.

 8 But the Form 40, you know, requires reporting of a

 9 10 percent or more interest for a reporting trader

 10 or the accounts of a reporting trader. I think

 11 that's again an important distinction. So when

 12 asset managers are filling out a Form 40 they're

 13 filling it out on behalf of the trading accounts

 14 that they own, they're not -- and, you know,

 15 looking to investments that may be in one of their

 16 funds, equity investments over a 10 percent

 17 threshold and then getting the commodity positions

 18 in the underlying operating company. Our concern

 19 is that the way that the proposal was worded could

 20 be construed to go beyond trading accounts and

 21 then require aggregation of interests in an

 22 operating company. And to the point that Chuck
 240

 1 just made, and I think it's a very good one, that

 2 applies to operating companies as well as it

 3 applies to, you know, the fund business that where

 4 you don't have information sharing, naturally.

 5 Why would we wind up in a situation where let's

 6 say a fund manager then needs to try to figure out

 7 a way to go out and reach out to the operating

 8 businesses that their funds are investing in over

 9 a certain equity percentage to get those commodity

 10 positions. You're sort of incentivizing sharing

 11 of information, incentivizing, you know,

 12 potentially even working together where that

 13 otherwise wouldn't exist. So I would support

 14 Chuck's statement that separation should be

 15 maintained.

 16 I think this follows over into some

 17 comments I have on substantially identical trading

 18 strategies. Vince, I know you wanted to go there;

 19 I don't want to monopolize the floor. I'll hold

 20 my comment for now if you'd like and can come back

 21 to that.

 22 MR. MCGONAGLE: Go ahead.
 241

 1 MR. NEVINS: Okay, sure. So I think

 2 substantially identical trading strategies also

 3 raises unique issues for the asset management

 4 industry and I'm going to give you an example in

 5 the fund-of-funds context which has been a great

 6 concern for us. So I think we understand the

 7 purpose and the rationale behind why the

 8 Commission has proposed aggregating substantially

 9 identical trading strategies but it does not

 10 translate well to the fund industry. So you could

 11 have let's say a fund manager that manages a

 12 fund-of- funds which is a very common strategy in

 13 the registered fund space, it's a common strategy

 14 in the private funds space. And indeed for

 15 institutional clients they may have accounts that

 16 a manager manages and then invests in separate

 17 funds within that account. So if you're fund

 18 manager A and you have part of your portfolio --

 19 let's say you manage an asset allocation

 20 fund-of-funds and part of that portfolio is going

 21 to be invested in physical commodity based funds,

 22 right. If two of those funds are deemed to be
 242

 1 substantially identical trading strategies, right,

 2 then that fund manager may then need to aggregate

 3 all of the positions in each of those underlying

 4 funds if they invest their fund-of-funds into both

 5 of those substantially identical trading

 6 strategies funds. I'll try to crystallize that

 7 example a little bit better. Let's suppose you

 8 have a $1 billion, you know, mutual fund that

 9 allocates $1 million to commodity fund investing

 10 and then it takes $100,000 and invests it in, you

 11 know, commodity fund A and $100,000 and invests it

 12 in commodity fund B, and they happen to fall into

 13 the definition of substantially identical trading

 14 strategies. Then you'd have a $200,000 investment

 15 in a $1 billion fund that you as a fund manager

 16 potentially have to aggregate all of those

 17 positions in those underlying funds, fund A and

 18 fund B, up to your fund-of-funds manager and have

 19 that reported in one single aggregation position.

 20 That doesn't make any sense from an asset

 21 manager's perspective. It's something we're

 22 highly concerned about and we think that -- you
 243

 1 know, it gets back to the ownership aggregation

 2 requirements as well as the substantial identical

 3 trading strategy aggregation requirements; that

 4 you need to think about the passive investor's

 5 perspective, whether it's a private equity fund

 6 and the issues that Ken raised earlier, or whether

 7 it's a registered fund, a private fund, or other

 8 client that an asset manager is investing on

 9 behalf of. It's a completely different set of

 10 circumstances. There is not acting in concert and

 11 they shouldn't require aggregation.

 12 MR. MCGONAGLE: John.

 13 MR. PARSONS: Yeah, so I just wanted to

 14 make one comment about some discussion that alarms

 15 me. I'm not sure if I really understand exactly

 16 what's going on. I think most of the indicia you

 17 folks have outlined are very relevant criteria.

 18 What alarmed me is discussions here -- I mean I

 19 understand when you have a parent corporation who

 20 owns two separate corporations, a railroad and an

 21 energy company and they don't really operate them

 22 together and so on as is discussed in some of the
 244

 1 comment letters. I hear here conversation about

 2 trading desks and day-to-day trading strategies

 3 and the like, as if those can be fundamentally

 4 independent. And I find that very alarming. It

 5 seems to me if you have one energy company it may

 6 have a desk in Houston, it may have a desk in

 7 Stanford, Connecticut, but many of the indicia you

 8 described would be relevant. But to imagine that

 9 because day-to-day they operate independently

 10 somehow those positions should not be aggregated

 11 would be very alarming to me. It would seem to me

 12 to violate both what I understand are many ways in

 13 a company that strategies are tied together as

 14 well as the whole purpose of the limits here.

 15 Just to illustrate as an example, but it's only

 16 one, credit considerations certainly are going to

 17 come to bear for both of those desks no matter how

 18 they are operated day- to-day independently,

 19 they're going to come to bear when there are

 20 credit problems for the corporation as a whole and

 21 they're going to force common actions at those two

 22 separate desks and that will impact how the
 245

 1 speculative positions then impact the market. And

 2 that's very relevant for the purposes for which

 3 this rule is here. And I just said I'm alarmed

 4 because from my experience with businesses those

 5 things are not really independent in a -- the way

 6 it's managed as a whole over a longer time frame

 7 and with the corporate structure as it is, makes

 8 it very relevant, the two separate desks being one

 9 position for the purposes of this rule.

 10 MR. MCGONAGLE: We were talking about

 11 the -- from the traders going up and what

 12 responsibility do the owners have looking down.

 13 Chuck?

 14 MR. CERRIA: Collecting my thoughts

 15 because I want to make sure I articulate correctly

 16 what I'm thinking and what the reality is so I can

 17 calm down John's alarming tendencies. So let me

 18 start with you mentioned credit, John, okay. And

 19 credit is one of those overarching corporate

 20 policy procedures and I guess policy that I was

 21 talking about before when I said corporate

 22 overarching policies and procedures are separate
 246

 1 from the day-to-day trading that goes on, okay.

 2 And, yeah, we had credit policies in place that

 3 applies throughout the company and it actually

 4 applied to both the trading company and Hess

 5 Corporation. And so those policies are

 6 implemented though on a company-by-company basis

 7 and that is not really relevant to the positions

 8 that we take when we're hedging our -- or for

 9 whatever purpose we're doing on the futures

 10 exchanges in derivatives, okay. The trading is a

 11 day-to-day -- again corporate is up here, trading

 12 is right down here and, you know, it's not that a

 13 trader for the same company is ignorant of what's

 14 going on around, he's just not in the moment right

 15 now what's going on from an intraday standpoint

 16 across the world or even across the ocean. He's

 17 into his regional localized market and he's doing

 18 what he has to do. And so we need to understand

 19 the differences between overarching corporate

 20 procedures and in the moment trading right now to

 21 hedge a particular transaction that we need to

 22 cover for.
 247

 1 MR. MCGONAGLE: We'll go to Mike and

 2 then if they are just some final comments for the

 3 panel and then we'll close it out.

 4 MR. SWEENEY: Okay. And I'll be quick.

 5 I think that, you know, John make a fair point, in

 6 the context of what we've been discussing when you

 7 -- if we're going to focus on control, standard

 8 trading level control versus ownership we're

 9 talking about an enhanced look that what is

 10 independent trading, lack of control. Some of the

 11 things that just the working group had put out and

 12 just worth reiterating for the record, if you're

 13 going to look at things, look at like, for

 14 tangible things, lack of common guarantors, is

 15 there a provision of independent credit. I think

 16 when you people have separately identifiable

 17 assets, I mean a business that is trading around

 18 -- for example Canadian crude production versus

 19 U.S. crude production, could have definitely --

 20 you can look at it that way, because they're

 21 different assets, they're different risk profiles,

 22 they have different businesses. If you maintain
 248

 1 separate lines of business, there's different

 2 products. You know, you may use the same

 3 derivatives but, you know, for certain things you

 4 may use natural gas for part, you know, hedging

 5 your power business, assuming cross commodity

 6 doesn't get you -- that was an attempt at humor --

 7 but at the same time you're using natural gas for

 8 natural gas trading or other purposes. So you're

 9 keeping some of those additional criteria is

 10 really what we're talking about now I think or

 11 where the conversation has evolved is if you're

 12 going to allow disaggregation above 50 percent

 13 there's certainly going to be an enhanced set of

 14 criteria for the Commission-- I assume that would

 15 be applied if the Commission was going to consider

 16 it to allow this disaggregation. So as you think

 17 about that factor that those things, you know,

 18 sort of tangible things.

 19 MR. MCGONAGLE: Thank you. Matt.

 20 MR. NEVINS: Yeah, I just want to make a

 21 couple of additional comments that are related to

 22 the independent account controller exemption and
 249

 1 some of the things we've talked about already

 2 today. So the first thing I'd say is that I think

 3 and we acknowledged this in our SIFMA AMG comment

 4 letter back in February that the Commission has

 5 moved in a positive direction in some elements of

 6 the rule proposal on aggregation, in particular

 7 including an independent account controller

 8 exemption back into the rule proposal we think is

 9 a positive way of proceeding. I also believe that

 10 including ways to disaggregate, if an ownership

 11 standard is going to be used, above those

 12 ownership thresholds is also appropriate. But as

 13 you've heard today from me and others there can be

 14 some improvements for sure, around -- if ownership

 15 remains a part of this thing -- around how you

 16 perfect those exemptions. As far as the

 17 independent account controller goes, again I

 18 commend the Commission for including that concept

 19 back into the new proposal, but we were a bit

 20 perplexed about why it was conditioned upon

 21 registration status as a CTA or CPO or a general

 22 partner in an exempt or excluded CPO as part of
 250

 1 the test for the independent account controller

 2 exemption. So as you continue to consider how to

 3 move forward we think that is not an appropriate

 4 factor to be taken into account to perfect the

 5 independent account controller exemption. We

 6 think the other factors clearly make sense.

 7 Getting back to the discussion from

 8 earlier, again I would stress that it is the

 9 ability to control trading that is key and

 10 fundamental in general in determining whether

 11 positions should be aggregated which again is why

 12 the independent account controller exemption makes

 13 sense and we think that that concept should be

 14 woven throughout the aggregation proposal in

 15 general, and also be followed in however you

 16 perfect your exemption requirements.

 17 Lastly, as it relates to substantially

 18 identical trading strategies it struck us that you

 19 would be required to aggregate those substantially

 20 identical trading strategies even if you would

 21 otherwise be able to avail yourself of the

 22 independent account controller exemption. That's
 251

 1 something that we also believe at SIFMA AMG does

 2 not make sense. So in other words if you have

 3 completely separate independent account

 4 controllers you have different advisors that are

 5 totally separate and making completely separate

 6 decisions and they have absolutely no commonality,

 7 no indicia of working together, why should their

 8 substantially identical trading strategies,

 9 however that's ultimately clarified and defined,

 10 why should those strategies be aggregated? That

 11 we have separate control, separate trading, those

 12 should remain separately allocated for and not

 13 aggregated.

 14 MR. MCGONAGLE: So separate?

 15 MR. NEVINS: You got it.

 16 MR. MCGONAGLE: Do we have any final

 17 closing comments, remarks? Chuck?

 18 MR. CERRIA: Thanks, Vince. I want to

 19 just mention one thing that I haven't mentioned, I

 20 don't think anybody's mentioned actually. And so,

 21 you know, there was a thought that when you come

 22 up with a rule and you promulgate it that you give
 252

 1 the industry some time to comply before, so it

 2 will be effective, but there's a compliance period

 3 of maybe six months or something like that. I was

 4 going to ask for 15 years, but I think I'll go

 5 with 6 months, okay. Only kidding. But seriously

 6 that's the only other point I want to -- I think I

 7 -- I don't want to keep repeating everything.

 8 MR. MCGONAGLE: All right.

 9 MR. NEVINS: Thank you.

 10 MR. MCGONAGLE: Thank you everybody.

 11 Thanks everyone for their participation. Staff

 12 will consider the comments going forward. This

 13 concludes the staff roundtable on position limits

 14 and aggregation.

 15 (Whereupon, at 3:27 p.m., the

 16 PROCEEDINGS were adjourned.)

 17 * * * * *

 18

 19

 20

 21

 22
 253

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 2 DISTRICT OF COLUMBIA

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 11 employed by any of the parties to the action in

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 22 My Commission Expires: May 31, 2018