Position Limits – are they coming or going?

There has been a lot of news recently about changes to the US and European Position Limit regimes for commodity derivatives. If you haven’t been following these developments closely, where exactly do things stand and what do they mean for energy and commodity trading firms?

Below we take a closer look at the situation in the three main regulatory jurisdictions impacted by these changes namely the US, EU and the UK.

United States – Dodd Frank Position Limits are (finally) on their way

After almost a decade of delays, Dodd-Frank Position Limits were finally passed into law in December 2020 and published in the Federal Register in January 2021[1]. The final rule covers 25 “Core Reference Contracts” extending across Agricultural, Metals and Energy markets. Nine of these contracts are “legacy” Agricultural contracts previously covered by CFTC Position Limit rules, which will now also be in scope of Dodd Frank. At first glance 25 contracts seems fairly light touch. The scope expands significantly however when one also includes the various “linked” futures and options contracts, essentially including all contracts which directly or indirectly reference the 25 core contracts. What perhaps came as a surprise to some is that, in a few cases, linked contracts are traded on a different exchange to the core contract, making it necessary to aggregate and monitor positions across venues.

So how many linked contracts will there be? The Division of Market Oversight (DMO) team at the CFTC has obligingly published a non-binding “staff workbook[2]” providing an initial view comprising of 280 contracts. Over 50 of these aggregate into contracts traded on an entirely different exchange. Naturally this list might change before the rules are in force, hence the onus is on firms affected to do their own due diligence to ensure that they are fully compliant.

In addition to linked contracts, Dodd Frank follows in the footsteps of the MiFID II regime requiring “Economically Equivalent Swaps” (contracts that have identical material contractual specifications to the on-exchange referenced contracts) to be subject to Position Limits. CFTC staff have publicly acknowledged[3], however, that not many Economically Equivalent Swaps are anticipated and this requirement is primarily a backstop to prevent firms circumventing Position Limits by creating lookalike contracts off-exchange. The same experience has indeed played out for Economically Equivalent Over the Counter contracts (EEOTCs) under MiFID II.

So when do these rules enter into force? While the effective date for the final rule was 15 March this year, the key compliance dates have been staggered starting on 1 January 2022, when Dodd Frank rules apply to the 16 new Core Referenced Contracts and linked contracts (this excludes Economically Equivalent Swaps). By this date affected exchanges must also have set position limits for these contracts (as exchanges carry the responsibility for setting federal Position Limits subject to review by the CFTC) and have granted exemptions which conform with the new rules under Dodd Frank. From 1 January 2023 Position Limits will apply to Economically Equivalent Swaps.

Firms should be aware that Dodd Frank Position Limits have a number of quirks including multiple step-down spot limits for some contracts and netting rules distinguishing physical from financially settling contracts. In addition to the cross-exchange aggregation, this is likely to make the manual monitoring of these limits more challenging.

Firms should also take note that Dodd Frank introduces new rules around Position Limit exemptions with the expansion of so-called “enumerated hedges” and the removal of the Risk Management exemption which many firms currently rely on.

European Union – Smaller but sharper

Under the guise of providing relief to European capital markets due to the Covid-19 pandemic, the so-called MiFID II “Quick Fix[4]” legislation was passed into European law in February this year. The Quick Fix includes plans to reduce the scope of commodity derivative position limits under MiFID II to include only “significant” or “critical” derivatives and agricultural commodity derivatives (“critical” being defined as contracts with an open interest of at least 300,000 lots on average over a one-year period). EEOTCs will remain in scope. Changes were also introduced to make it easier for certain financial entities to be exempted from Position Limits when they hold positions on behalf of non-financial entities with legitimate hedging positions. The same will extend to liquidity providers.

The legislators also acknowledge that “significant dissimilarities exist in the way positions are managed by trading venues” in the EU and that “position management controls should be reinforced where necessary”. Further thinking on this is provided in a consultation paper (CP)[5] published by ESMA in May. The CP proposes moving the responsibility for Position Limits away from the national regulators to the Exchanges, harking back to pre-MiFID II days. The revised rules would require them to set both hard limits for critical contracts as well as mandatory “Accountability limits”, at least for physically settling commodity derivatives, in both the spot and forward timeframes. Accountability limits are essentially “soft limits” but should not be ignored as, if surpassed, the Exchange will have the right to request information on the positions and in some cases instruct firms to reduce their positions. The CP has also left the door open for stricter controls but ESMA will likely take guidance in this respect from market stakeholders, including the exchanges themselves.

The Quick Fix rules are due to enter into force on 28 February 2022. Further legislative proposals are expected towards the end of 2021 following the consultation mentioned above. In the meantime ESMA[6] is encouraging national regulators not to “prioritise” enforcement against firms breaching non-Agricultural, non-critical contract Position Limits in the lead up to next February. Whether national regulators will take heed of this non-binding request is unclear, particularly given the lack of legal certainty over what constitutes a “critical” contract.

Should firms be rejoicing over these developments? Many would agree that the national regulators have not exactly outdone themselves at enforcing MiFID II Position Limits. This is partly due to lacking the tools and manpower to actively monitor the market combined with the fact that, as financial regulators, they have far bigger fish to fry. Exchanges are far better equipped to monitor and enforce Position Limit breaches, particularly if they are legally mandated to do so. So while the MiFID II regime might be downsizing, it will most likely have far sharper teeth. Firms active in this space should take heed.

United Kingdom – Going its own way?

The UK government published its own consultation[7] covering Position Limits as part of a broader Wholesale Markets Review initiative earlier this month. Since the EU’s Quick Fix applied after the end of the Brexit Transition Period, it did not apply to the UK. This leaves the future of MiFID II Position Limits for major UK exchanges like ICE Futures Europe and the London Metals Exchange in the hands of the UK authorities. They wasted little time in describing the MiFID II Position Limits regime as “poorly designed” and “inefficient” and suggesting they see scope to “go further” than the EU Quick Fix to ensure that the UK regime “best serves UK and global markets in the long term”.

So with a free hand, has the UK taken a radically different path from the EU? Not really. Based on the CP, the thinking seems very much aligned to the EU proposals although the consultation is not quite as detailed as the draft technical standards provided by ESMA. Like the EU, they also call for Position Limit setting, monitoring and enforcement to be moved back to the Exchanges and they support the reduction in the number of contracts that should be subject to Position Limits. Also like the EU proposal, limits would be reserved for “critical” or “significant” contracts, principally meaning contracts that are physically settled or where the underlying commodity is Agricultural (although mentioning but not specifying a minimum threshold like the EU proposal does). The FCA would provide the necessary framework of rules and requirements and will retain the right to intervene in cases of excessive market volatility. The UK proposal also does not explicitly call for the application of “soft” Accountability limits suggesting a somewhat narrower focus than the EU proposal.

The next few months may however see more convergence as both proposals evolve following the respective consultation responses. From a political perspective, regulatory equivalence remains a highly contentious topic post-Brexit. This might implicitly place a cap on significant unilateral regulatory divergence by the UK, at least until the question of equivalence has been settled.

Like the EU, the UK Financial Conduct Authority (FCA) who is responsible for Position Limit enforcement under the local MiFID regime, issued a “no action” style supervisory notice[8] saying that they won’t take Position Limit enforcement action against firms that exceed Position Limits on cash-settled commodity derivative contracts unless the underlying is an Agricultural commodity[9].

So should firms active on UK Exchanges be celebrating this likely downsizing? As for the EU regime, it’s a double edged sword. Position Limits are certainly not going away and with the ones that remain likely to be far more actively monitored and enforced by the Exchanges, enforcement risk might indeed be heightened.

So what should firms be doing?

As a priority firms should review their exposure to Dodd Frank Position Limits and consider the operational and technical requirements necessary to effectively monitor and manage this exposure. The CFTC are likely to be less forgiving than the Exchanges when it comes to careless breaches. This review should consider the new exemption rules and whether new or revised applications are necessary, particularly for firms reliant on the Risk Management exemption.

For the EU and UK MiFID regimes, firms are advised to monitor the outcome of the ongoing consultation processes and consider their exposure accordingly. Accountability limits should not be ignored as they can affect the overall risk position and introduce the need for firms to always be clear as to what they are trading and why. This obviously gets more complex to manage the larger and more geographically dispersed the group gets. Agricultural traders in particular should strongly consider automating their Position Limit monitoring capability as enforcement is far more likely once enforcement of these limits passes to the Exchanges. This by no means exempts Energy and Metals traders – while having a smaller pool of contracts to monitor, the cost of getting it wrong is likely to be far higher under the adapted regimes and hence a proper risk review is also strongly recommended.

Conclusion

In short, Position Limit coverage on US markets is destined to increase in 2022 with the introduction of Dodd Frank Position Limits while UK and EU coverage is destined to reduce in 2022. A reduction in coverage however is not the same as Position Limits going away – on the contrary, enforcement risk is likely to increase.