UPDATE 2-Ag swaps require special treatment in CFTC rules

* Law implies extra protection for farmers in OTC market

* Should there be more restrictions on ag swaps?

* Rule likely published late November

* Ethanol unlikely to be ag commodity for position limits (Adds details starting in fourth paragraph)

By Roberta Rampton

WASHINGTON, Aug 4 (Reuters) - The U.S. Commodity Futures Trading Commission faces a "major policy issue" as it crafts rules on agricultural swaps as part of implementing its new authority to police and regulate Wall Street, a CFTC lawyer said on Wednesday.

The law implies that farmers trading over-the-counter agricultural swaps should have added protections beyond what is available to traders of other commodities, said Don Heitman in materials prepared for an advisory committee meeting on Thursday.

The new Dodd-Frank financial reform law signed by President Barack Obama in July is the broadest shake-up in U.S. financial services law since the Great Depression and gives the CFTC broad jurisdiction over the OTC derivatives market.

CFTC teams are scrambling to prepare rules for 30 different topics under the Dodd-Frank act, some of which require more than one rule to be written. [ID:nN21183568]

The act does not affect forward contracts, exchange-traded futures, and options on futures, but other types of agricultural derivatives are covered by the law, which generally requires swaps move through clearinghouses.

Swaps entered into before the law passed are grandfathered, as are existing exchange-cleared OTC swaps like the CME Group's (CME.O) corn and soybean basis swaps and calendar swaps, Heitman said.

Farmers typically don't trade OTC swaps, which are usually used by large commercial grain firms, especially when the parties seek longer-range fixed prices than the normal two- to three-year life of futures contracts, market makers say.

The law will require the CFTC to grant exemptions under section 4(c) of the Commodity Exchange Act for agricultural swaps to trade at all, Heitman said.

That requirement "seems to imply that farmers and other persons trading agricultural swaps should be subject to some kind of additional, special protections beyond those available to persons trading swaps in other physical commodities," he said. (Link: link.reuters.com/kud43n )

Under the 4(c) exemptions, the CFTC will only allow OTC agricultural swaps that are not listed on a "designated contract market" like the CME to be bought by "eligible contract participants," which tend to be large institutional or commercial traders, Heitman said.

But he said farmers seeking to hedge risk with an OTC swap could seek permission from the CFTC to use swaps if they are a "corporation, partnership, proprietorship, organization, trust, or other entity" with a net worth over $1 million, or if they have either at least $10 million invested on a discretionary basis, or $5 million if the trade is for hedging.

An internal team must address the issue in rules for trading agricultural swaps that it plans to recommend to the CFTC -- rules that would likely be published in late November, Heitman said, noting rule-making efforts so far are "preliminary and subject to change."

It must consider whether there should be more restrictions on who can buy or sell agricultural swaps, or other conditions for traders -- or alternatively, whether to allow them to have the same terms and conditions as OTC swaps in other physical commodities, he said, inviting industry comment on the issue.

The CFTC must also publish a definition of "agricultural commodity," likely in mid-October, Heitman said.

The definition probably will include commodities used for food, feed or fiber, but exclude industrial products such as ethanol, he said.

The definition will be important for speculative position limits. Limits for agricultural commodities must be issued within 270 days of the act's enactment, while limits for other commodities have a deadline of 180 days.

(Additional reporting by Christine Stebbins in Chicago; Editing by Lisa Shumaker and David Gregorio)