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| On the topic of Commodities Index hedging disruption – nuanced because of the presence of regulator- or exchange-imposed position limits – I found the below language in a confirm from BNP which I think handles the position limits issue quite well:
| | {{manual|DC|2005|Hedging Disruption|Section|12.9(a)(ii)|short}} |
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| “'''Commodity Hedging Disruption'''” means that due to (a) the adoption of, or any change in, any applicable law, regulation or rule or (b) the promulgation of, or any change in, the interpretation by any court, tribunal or regulatory authority with competent jurisdiction or any applicable law, rule, regulation or order '''(including, without limitation, as implemented by the CFTC or any exchange or trading facility)''', in each case occurring after the Trade Date, the Hedging Party determines in good faith that it is contrary to such law, rule, regulation or order to hold, acquire or dispose of its Hedge Positions (in whole or in part) including (without limitation) '''if the Hedging Party's Hedge Positions (in whole or in part) are (or, but for the consequent disposal thereof, would otherwise be) in excess of any allowable position limit(s) in relation to any particular exchange(s) or other trading facility (it being within the sole and absolute discretion of the Hedging Party to determine which of the relevant assets or transactions are counted towards such limit)'''.
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| “'''CFTC'''” means the U.S. Commodity Futures Trading Commission.
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| “'''Hedge Positions'''” means, in relation to the [Index], any purchase, sale, entry into or maintenance of one or more positions or contract in futures or exchange-traded options or commodities or over-the-counter derivatives referencing commodities, in each case entered into in order to hedge individually or on a portfolio basis the Hedging Party's obligations under this Transaction.
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| One subtlety: because position limits apply to a trading book, or even across all trading books in a group, it is possible for the [[hedging disruption]] to be entirely unrelated to the specific hedge for the transaction. This is the reason for the Hedging Party’s discretion to determine which assets are counted towards the limit.
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| Note that this wouldn’t necessarily capture activity where the breach of position limits is caused by a change in option delta inside an existing index to which the business has exposure, as might happen where an index rebalances:
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| Example: say we have:
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| - A number of small delta 1 trades referencing WTI Crude
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| - A large net option delta on the S&P GSCI is large (i.e. we are long a large notional on the GSCI)
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| - We are hedging all these trades with WTI Crude futures such that across the whole book we are close to our position limit for WTI Crude.
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| - If the GSCI then rebalances to weight more heavily in favour of crude
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| Here our implied hedging position may take us over our Crude position limits, without there having been any active event to have precipitated this. Commodities futures roll monthly, so it isn’t as if we can grandfather the existing hedges.
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| There’s no “change in law”, as there’s been no change in the regulatory environment
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| it is only a hedging disruption if the provision allows it to “be within the sole and absolute discretion of the Hedging Party to determine which of the relevant assets or transactions are counted towards such limit” (i.e. the option delta of any given trade is below the position limit)
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| it may be an increased cost of hedging, because there are ways of hedging the risk – through derivatives which therefore using up someone else’s position limits, and that cost can fairly be attributed pro-rata across the whole book.
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2005 ISDA Commodity Definitions
A Jolly Contrarian owner’s manual™
Resources and navigation
Section Hedging Disruption in a Nutshell™
Use at your own risk, campers!
If “ Change in Law” applies and a Change in Law occurs, the Hedging Party may terminate the affected portion of the Transaction upon at least two Business Days’ notice to the other party specifying the date of such termination (or such lesser notice as may be required to comply with the Change in Law). Upon such notice the Transaction will terminate and the Hedging Party will determine the Cancellation Amount payable by one party to the other in good faith using commercially reasonable procedures as of the date the Transaction was terminated (or such other dates as would be commercially reasonable), which may include dealer quotations, market data and Hedging Party’s internal pricing and valuation models for similar transactions with third parties.
In this section:
“Cancellation Amount” means the gains or losses the Hedging Party would incur under prevailing circumstances in replacing (i) the material terms of the Transaction, including payments and deliveries scheduled for after termination and (ii) any option rights under the Transaction.
“Change in Law” means that due to any change in any Rule, or any Regulator promulgating or changing its interpretation of any Rule, after the Trade Date the Hedging Party determines in good faith that it is not permitted by such Rule to hold, acquire or dispose of its Hedge Positions, including where they would exceed any permitted position limits on any exchange or trading facility (it being within the Hedging Party’s sole discretion to determine which of its positions count towards any such limit).
“Hedge Position” means any position in commodities, exchange-traded commodity derivatives or over-the-counter commodity derivatives entered into in order to hedge the Hedging Party’s obligations under this Transaction.
“Hedging Party” means the party specified as such in the Confirmation or, if none, either party.
“Regulator” means any court, tribunal or regulatory authority with competent jurisdiction.
“ Rule” means any applicable law, regulation or rule binding on the hedging Party, including the rules of any Exchange. |
Full text of Section Hedging Disruption
Related agreements and comparisons
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Content and comparisons
The 2005 ISDA Commodity Definitions do not have a definition of Hedging Disruption, but it is common enough to invent one, butchering the equivalent provision from the 2002 ISDA Equity Derivatives Definitions.
Summary
You might have cause to regret that should you be hedging a commodity derivative transaction with futures when the regulator changes, or imposes, position limits on those futures. We could imagine the sort of language you see in the panel being useful if so.
One subtlety: because position limits apply to a trading book, or even across all trading books in a group, it is possible for the Change in Law to be entirely unrelated to the specific hedge for the transaction. This is the reason for the Hedging Party’s discretion to determine which assets are counted towards the limit.
Indexes are complicated
Note that this wouldn’t necessarily capture activity where the breach of position limits is caused by a change in option delta inside an existing index to which the business has exposure, as might happen where an index rebalances:
Example: say we have:
- A number of small delta 1 trades referencing WTI Crude
- A large net option delta on the index is large (i.e. we are long a large notional on the index)
- We are hedging all these trades with WTI Crude futures such that across the whole book we are close to our position limit for WTI Crude.
- If the index then rebalances to weight more heavily in favour of crude
Here our implied hedging position may take us over our crude position limits, without there having been any active event to have precipitated this. Commodities futures roll monthly, so it isn’t as if we can grandfather the existing hedges.
There’s no “change in law”, as there’s been no change in the regulatory environment. It is only a Change in Law if the provision allows it to “be within the sole and absolute discretion of the Hedging Party to determine which of the relevant assets or transactions are counted towards such limit” (i.e. the option delta of any given trade is below the position limit). It may be an increased cost of hedging, because there are ways of hedging the risk – through derivatives which therefore using up someone else’s position limits, and that cost can fairly be attributed pro-rata across the whole book.
See also
References