Request for Comment on Options for a Proposed Exemptive Order Relating to the Trading and Clearing of Precious Metal Commodity-Based ETFs; Concept Release

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of options for a proposed exemptive order and request for comment; concept release.

SUMMARY:

Recently, the Commodity Futures Trading Commission (“Commission,” or “CFTC”) has been confronted with the question of how to treat certain transactions on fractional undivided interests, or shares, in single commodity investment products referred to as exchange traded funds (“ETF” or “ETFs”), primarily in the metals complex. The ETFs have in all relevant instances been structured as trusts (singularly, “ETF Trust” or “Trust”), the assets of which consist of holdings of one specific physical commodity. The explicit and sole investment objective of each of these ETF Trusts is to track as nearly as possible the spot price of the underlying physical commodity less the expenses of trust operations. The listing of these ETF shares provides shareholders with efficient exposure to commodity market price movements. These Precious Metal Commodity-Based ETFs have primarily focused on holding either gold or silver, with a recent expansion into palladium and platinum. The Commission has issued Orders pursuant to Section 4(c) of the Commodity Exchange Act (the “Act”) permitting the trading and clearing of certain transactions on these Trusts as, respectively, options on securities and security futures. The Previous Orders have provided exemptions from certain provisions of the Act, or the Commission's regulations thereunder, which might have been transgressed by trading or clearing, among other things, options and futures on Commodity-Based ETFs. The exemption mechanism has enabled the Commission to reserve judgment as to the jurisdictional classification (i.e. commodity or security) of Commodity-Based ETFs and options and futures on Commodity-Based ETFs while at the same time providing a mechanism to ensure both that the Commission's regulatory oversight needs are satisfied (whether through regulation by the Securities and Exchange Commission (“SEC”) or by attaching conditions to the exemption orders) and that novel products may be introduced without undue delay for market participant and investor use.

More recently, the Options Clearing Corporation (the “OCC”) has sought approval of rules permitting similar treatment of options and futures on certain ETFs based on palladium and platinum.

The Commission is issuing this Release to solicit comments on: (i) Options for a proposed exemptive order in connection with the OCC's request for approval of a rule change; and (ii) the Commission's treatment of Precious Metal Commodity-Based ETFs generally, including whether the Commission should exempt the trading and clearing of certain options and futures transactions on gold and silver, and/or palladium and platinum, Commodity-Based ETFs on a categorical basis.

DATES:

Comments must be received on or before November 1, 2010. All comments must be in English, or if not in English, accompanied by an English translation.

ADDRESSES:

Comments may be submitted by any of the following methods:

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.
• E-mail: CommodityETFs@cftc.gov. Include “Commodity Based ETFs” in the subject line of the message.
• Fax: 202-418-5521.
• Mail: Send to David A. Stawick, Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
• Courier: Same as mail above.

All comments received will be posted without change to http://www.CFTC.gov/.

FOR FURTHER INFORMATION CONTACT:

Ryne Miller, Attorney Advisor, 202-418-5921, rmiller@cftc.gov, or David Van Wagner, Chief Counsel, 202-418-5481, dvanwagner@cftc.gov, Division of Market Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1151 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Part I—Proposed Exemptive Order

A. Background

The first Commodity-Based ETF in the U.S. was listed and traded on the New York Stock Exchange (“NYSE”) in November 2004. Since that time, Commodity-Based ETFs have generally focused on the precious metals of gold and silver, with palladium and platinum having been the subject of a Commodity-Based ETF only recently.

The structure and trading of Commodity-Based ETFs is virtually identical to traditional ETFs listed and traded on national securities exchanges. Shares of ETFs are bought and sold throughout the trading day on national securities exchanges. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value (“NAV”). Instead, large institutional investors known as Authorized Participants (“APs”) buy shares of the ETF directly from the Trust in creation unit sizes (“Creation Units”), varying from 25,000 to 200,000 shares, generally in exchange for an in-kind deposit of securities. Conversely, APs may sell or redeem shares of an ETF only in Creation Unit size and generally in exchange for portfolio securities (“Redemption Baskets”). In limited cases, such as an ETF investing in illiquid securities or derivatives, APs may deposit cash instead of securities in exchange for shares of an ETF. For Commodity-Based ETFs, Creation Units and Redemption Baskets require the delivery of the relevant physical commodity plus any cash based on the ETF's NAV. ETF shares are traded on national securities exchanges at market prices that may, and do, differ from NAV.

APs, who are typically exchange market makers or specialists, use their ability to exchange Creation Units with their underlying assets to provide liquidity for the ETF shares and help ensure that their intraday market price approximates the NAV of the ETF. Other investors trade ETF shares on national securities exchanges in the secondary market. The ability to purchase and redeem Creation Units and Redemption Baskets gives ETFs an inherent arbitrage mechanism intended to minimize the potential deviation between the market price and NAV of ETF shares. Existing ETFs (including Commodity-Based ETFs) have daily transparent portfolios, so that APs and investors know exactly what portfolio assets they must assemble if they wish to purchase a Creation Unit. The national securities exchanges that trade ETF shares disseminate an updated indicative NAV throughout the trading day, typically at 15-second intervals.

Although similar in practice to traditional ETFs that invest in securities, by law, Commodity-Based ETFs are not subject to specific SEC regulation under the 1940 Act. Instead, Commodity-Based ETFs are subject to SEC disclosure review by the SEC's Division of Corporation Finance as well as exchange regulation.

Based on the belief that options and security futures trading benefits the liquidity and relative success of the underlying ETF, the national securities exchanges and ETF sponsors have sought to be able to trade options and futures on Commodity-Based ETFs. In 2008, the Commission and the SEC provided regulatory approvals and exemptions so that options on shares of the streetTracks Gold Trust (predecessor to the SPDR Gold Trust) (symbol: GLD) would be able to be listed and traded on the various options exchanges. Since 2008, the Commission has permitted options and futures on several other gold and silver Commodity-Based ETFs.

From a procedural standpoint, the issue of the regulation of Commodity-Based ETFs comes before the CFTC through filings by a contract market or a clearing organization in its capacity as a CFTC registrant, requesting Commission approval of certain proposed rule change(s) which would permit it to treat options and futures transactions on such ETFs as options on securities and security futures, respectively. In order to approve such rule changes, the Commission has issued exemptive orders for the options or futures in question pursuant to its exemptive authority under Section 4(c)(1) of the Commodity Exchange Act (“Act”), 7 U.S.C. 6(c). As noted above, the Commission has issued three such exemptive ETF orders, all of which have been confined to options and futures on shares of specific physical gold and silver ETFs.

Notably, in issuing the Previous Orders providing Section 4(c) exemptions for options and futures on gold and silver ETF shares, the Commission did not make any finding that the options were either options on securities or options subject to the Act, nor did it make any finding that the futures were, or were not, security futures. Rather, the exemptions permitted the trading and clearing of options and/or futures on the Commodity-Based ETFs as, respectively, options on securities and security futures. In doing so, the Commission reserved making any affirmative determination as to whether shares of Commodity-Based ETFs are more properly characterized as either commodities or securities. That is, the exemptions have enabled the Commission to reserve judgment as to the appropriate jurisdictional classification of Commodity-Based ETFs and options and futures on Commodity-Based ETFs. The Commission's approach is consistent with the framework envisioned by Congress. In the future, and upon the Dodd-Frank Wall Street Reform and Consumer Protection Act's (“Dodd-Frank Act”) effective date, certain provisions in the Dodd-Frank Act will provide the Commission and the SEC with a legal and procedural framework to use exemptive authority to tailor joint regulatory solutions for novel products that raise jurisdictional questions—such as those raised by Commodity-Based ETFs and options and futures on Commodity-Based ETFs.

B. Pending OCC Submission—Transactions on Palladium and Platinum ETFs

By a submission dated March 1, 2010, the OCC has submitted for Commission approval, pursuant to Section 5c(c)(2) of the Act and Commission Regulations 39.4(a) and 40.5, a proposed amendment to an interpretation of Article I, Section 1.F.(8) of their By-Laws. The interpretation, as amended, would state that the OCC will clear and treat as options on securities any options on ETFS Palladium Shares (“Palladium Products”) or ETFS Platinum Shares (“Platinum Products”), and will clear and treat as security futures any futures contracts on the Palladium and Platinum Products. Section 5c(c)(3) of the Act provides that the Commission must approve any such rules or rule amendments, which includes a proposed amendment of an interpretation, submitted for approval unless it finds that the rules or rule amendments would violate the Act. The Commission initially extended the review period of the OCC's submission by forty-five days, pursuant to Commission Regulation 40.5(c)(1), to June 1, 2010. By letter dated June 1, 2010 and pursuant to Commission Regulation 40.5(c)(2), the OCC consented to a further extension of the review period to September 30, 2010. While the OCC's pending rule submission deals with options and futures on two specific palladium and platinum Commodity-Based ETFs (the Palladium and Platinum Products), the Commission is also requesting comment on options for a proposed exemption that would permit the trading and clearing, as options on securities and security futures, of options and futures on gold and silver, and/or palladium and platinum Commodity-Based ETFs on a categorical basis, i.e., regardless of issuer.

C. Regulatory Implications of Precious Metal Commodity-Based ETFs

The Commission is issuing this Release because, among other things, the Commission believes that options and futures on Commodity-Based ETFs may raise certain regulatory issues due to their economic similarity to options on commodities and futures on commodities traded on designated contract markets. The Commission's concerns include the potential that futures contracts based on the commodities underlying the ETFs could be affected by withdrawal of the deliverable supply for futures contracts, and also, that the Commission would lack the jurisdictional capability to surveil persons with positions in the Commodity-Based ETFs.

The concerns are heightened by the reality that options and futures on Commodity-Based ETFs allow market participants to take positions in instruments that appear economically similar to Commission-regulated products, including products that would otherwise fall under, for example, the Commission's market and trade practice surveillance and large trader reporting system. By taking positions in options and futures on Commodity-Based ETFs traded on national securities exchanges, which can achieve the same investment objectives and are functionally the same as Commission-regulated products, market participants potentially avoid incurring any obligation to comply with the Commission's rules and regulations (although the market participants do remain subject to the existing regulatory regime applicable to the securities markets). Beyond this concern, the Commission has examined, and continues to examine, the palladium and platinum markets relative to the gold and silver markets to review empirical findings which may justify a different regulatory resolution for the Palladium and Platinum Products as compared to the Commission's approach to gold and silver ETF products under the Previous Orders (discussed further at section D, infra).

At the same time, the Commission is seeking comment as to whether the trading and clearing (as options on securities or security futures) of options and futures on all or some Precious Metal Commodity-Based ETFs should be categorically exempted from the Act to the extent necessary to permit them to be so traded and cleared, whether absolutely or subject to conditions. Related to that issue, the Commission has been encouraged by market participants to adopt a “generic” approach for addressing the transactions in question on Precious Metal Commodity-Based ETFs as opposed to the existing process of performing a case-by-case basis review. This Release is intended to assist in the Commission's consideration relating to a potential “generic” approach, and the Commission is seeking comments to that end.

D. Empirical Observations: Palladium and Platinum v. Gold and Silver

There are significant empirical differences across the precious metal markets which may support the Commission taking a different regulatory approach with respect to options and futures on Commodity-Based ETFs holding palladium and platinum than it has previously taken with respect to options and futures on Commodity-Based ETFs holding gold and silver.

Global palladium and platinum supplies are considerably smaller in volume than supplies of gold and silver, and come predominantly from mine production concentrated in a small number of countries, namely, South Africa and Russia (“Producer Countries”). These factors make palladium and platinum markets potentially more susceptible to tightness during periods of economic growth and subject to potential supply shocks from isolated events in either of the Producer Countries. Palladium and platinum futures markets consequently become more susceptible to price volatility that may result from relatively small changes in demand. These concerns were observed in January 2010 when the Palladium and Platinum Products were initially listed for trading on NYSE Arca, resulting in an apparent one-time increase in short-term demand for physical palladium and platinum, and the NYMEX palladium and platinum futures markets entered nearby backwardation. Indeed, the Prospectuses for the Palladium and Platinum Products, dated December 30, 2009, and filed with the SEC, acknowledge that purchase of the shares may affect the prices of palladium and platinum, respectively, and may impact the supply of, and demand for, palladium and platinum, respectively.

In addition to these distinguishing features, industrial demand constitutes a greater percentage of the total demand for both palladium and platinum as compared to industrial demand as a percentage of total demand for gold and silver, and palladium and platinum have traditionally not been held for investment purposes to nearly the same extent as gold and silver. Accordingly, the Commission requests comment on whether these empirical differences suggest the need for a different regulatory approach for options and futures on the Palladium and Platinum Products, or any palladium or platinum Commodity-Based ETF, as compared to options and futures on the gold and silver Commodity-Based ETFs covered by the Previous Orders.

Part II—Issues for Comment

The Commission requests comment, taking into account all of the issues presented in this Release and considering the Commission's future treatment of options and futures on Precious Metal Commodity-Based ETFs as required pursuant to the Dodd-Frank Act, on each of the following options for a proposed exemptive order:

1. Is there any reason the Commission should not provide a categorical Section 4(c) exemption for the trading and clearing of the transactions in question on gold and/or silver Commodity-Based ETFs?

2. Are the palladium and platinum markets sufficiently distinct from the gold and silver markets to justify a different regulatory approach, for the purposes of a Section 4(c) exemption, for options and futures on the Palladium and Platinum Products (i.e. the specific ETF products identified in the OCC's pending submission) as compared to that for options and futures on gold and silver Commodity-Based ETFs.

3. More generally, should the Commission consider extending such a Section 4(c) exemption to options and futures on palladium and platinum Commodity-Based ETFs on a categorical basis (i.e. without respect to issuer)?

4. If the Commission continues granting Section 4(c) exemptions, whether on an individual or categorical basis, when presented with a request to allow options and futures on Commodity-Based ETFs, should the Commission include additional conditions and requirements? For example, should the Commission consider imposing large trader reporting obligations, position limits, or other analogous requirements when exempting options and futures on Precious Metal Commodity-Based ETFs from the Commission's jurisdiction?

Related Matters

A. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (“PRA”) imposes certain requirements on federal agencies (including the Commission) in connection with their conducting or sponsoring any collection of information as defined by the PRA. At least some of the options for a proposed exemptive order described above, if issued with substantive reporting or similar conditions, would require a new collection of information from any entities that would be subject to the proposed order.

B. Cost-Benefit Analysis

In considering the options for a Section 4(c) exemption allowing the trading and clearing as options on securities any options on gold, silver, palladium, and platinum Commodity-Based ETFs, and to clear and treat as security futures any futures contracts on gold, silver, palladium, and platinum Commodity-Based ETFs, Section 15(a) of the Act, as amended by Section 119 of the Commodity Futures Modernization Act of 2000, requires the Commission to consider the costs and benefits of its action before issuing an order under the Act. By its terms, Section 15(a) as amended does not require the Commission to quantify the costs and benefits of an order or to determine whether the benefits of the order outweigh its costs. Rather, Section 15(a) simply requires the Commission to “consider the costs and benefits” of its action.

Section 15(a) of the Act further specifies that costs and benefits shall be evaluated in light of five broad areas of market and public concern: protection of market participants and the public; efficiency, competitiveness, and financial integrity of futures markets; price discovery; sound risk management practices; and other public interest considerations. Accordingly, the Commission could in its discretion give greater weight to any one of the five enumerated areas and could in its discretion determine that, notwithstanding its costs, a particular order was necessary or appropriate to protect the public interest or to effectuate any of the provisions or to accomplish any of the purposes of the Act.

The Commission is considering the costs and benefits of the options for a proposed order described above in light of the specific provisions of Section 15(a) of the Act, as follows:

1. Protection of market participants and the public. National securities exchanges, OCC, and their members who would intermediate the above-described options and security futures on gold, silver, palladium, and platinum Commodity-Based ETFs are subject to extensive regulatory oversight; however, this regulatory oversight in the securities markets does not completely parallel the oversight programs seen in CFTC regulated markets.

2. Efficiency, competition, and financial integrity. The options for a proposed exemption may enhance market efficiency and competition since they could encourage potential trading of options and security futures on the gold, silver, palladium, and platinum Commodity-Based ETFs through modes other than those normally applicable; that is, designated contract markets or derivatives transaction execution facilities. Financial integrity will not be affected since the options and security futures on gold, silver, palladium, and platinum Commodity-Based ETFs will be cleared by the OCC, a DCO and SEC-registered clearing agency, and intermediated by SEC-registered broker-dealers.

3. Price discovery. Price discovery may be enhanced through market competition.

4. Sound risk management practices. The options and security futures on the gold, silver, palladium, and platinum Commodity-Based ETFs will be subject to OCC's current risk-management practices including its margining system.

5. Other public interest considerations. The options for a proposed exemption may encourage development of derivative products through market competition without unnecessary regulatory burden.

After considering these factors, the Commission has determined to seek comment on the matters discussed above. The Commission invites public comment on its application of the cost-benefit provision.