Change in Law - Commodity Definitions Provision
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:
“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).
“CFTC” means the U.S. Commodity Futures Trading Commission.
“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.
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.
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 S&P GSCI is large (i.e. we are long a large notional on the GSCI) - 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 GSCI 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 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) 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.