Due to the rapid rise and rapid fall of the crude oil market in 2008, the CFTC has recently proposed a new rule on speculative position limits for the energy markets. Numerous comments have been sent to the Commission and the debate is ongoing over the economic, legal and philosophical merits of imposing position limits on these very liquid markets. It’s all very interesting and important, but rather than debating the merits of these proposed rules, in this article, I would like to demonstrate for you that the current rules on speculative position limits can have unusual and surprising consequences when the regulators apply their own interpretation to the application of these rules.
Speculative position limits have been part of the futures regulatory environment since 1938 and they are incorporated into the Commodity Futures Modernization Act of 2000. The stated purpose of position limits is to curb excessive speculation and prevent unreasonable and unwarranted price fluctuations. The CFTC already imposes position limits on the agricultural commodities, and the Exchanges have been delegated the authority to impose position limits on most other futures contracts.
There are three varieties of speculative position limits:
- A limit on a maximum position in a single contract month of a commodity
- A limit on the maximum aggregate position in all contract months of a commodity
- A reduced position limit for the spot or delivery month of a commodity that comes into play as the contract approaches the delivery period
My discussion will be limited to the position limits applied to the delivery period as the outright and aggregate limits affect fewer customers; however, the same principles and rules apply to all speculative position limits.
You may remember from your Series 3 training, for example, that in the absence of a hedge exemption, 600 lots is the maximum position for spot month corn, wheat and soybeans. These limits are the maximum net long or net short that any one person may hold or control during the delivery period.
The CFTC and the Exchanges monitor positions through their access to trade and clearing records. In addition, the FCMs are required to file “large trader” reports for end of day reportable positions held by their account holders or by their account controllers. These “large trader” reports aggregate and report positions held by common owners and common controllers and they are filed with the Exchanges and the CFTC daily. Large trader reporting represents a simple and objective way to determine whether there has been a position limit violation at the end of each trading day. Most traders would assume that the end of day position size is the standard for determining a violation.
End of day position size, however, is not the sole criteria for determining a position limit violation. The CFTC has advised that spot month position limits have been violated if the net long or net short (including the futures equivalent of an options position 1) exceeds the 600 lot limit at any point in time during the day. From a practical standpoint it may be impossible for a customer to know his exact net position at each moment, especially if he is trading pit versus screen. The sequence of fills in the pit relative to fills on the screen may make it very difficult to determine a net position. Nonetheless the CFTC has recently reiterated this interpretation and stated further that exceeding intraday speculative position limits is a violation of the Commodity Exchange Act, and a momentary intraday violation is not remedied by reducing the position by the close of the day.
If that interpretation wasn’t complicated enough, the CME Group exchanges have an even more restrictive interpretation2 of interday and intraday position limits. The CME aggregates existing intraday positions with the potential fills of working orders. “Any person making a bid or offer that would, if accepted, cause such person to exceed the applicable position limits shall be in violation of this rule” 3(Rule 443). For example, if you were long 200 delivery month corn, you would violate intraday position limits by having working buy orders in the market that exceed 400 lots, thus giving you the potential for a long position exceeding 600 lots if your orders were filled. You would also be in violation by having working sell orders which if filled would result in a short position in excess of 600 lots.
The CME Group includes spreads containing the delivery month in the calculation as well as outright positions. Customers have become used to placing large orders particularly in the calendar spreads so that they can participate in those markets that allocate fills pro rata on Globex. The FCM, IB and Associated Persons need to monitor the orders of their customers and make sure that their customers are aware of the speculative position limits, particularly the reduced limits in the delivery period. In addition to the customer, the CME also holds the customer’s FCM and Associated Person accountable in the event that they accept an order that they know or should know would place the customer in violation of the applicable position limits.
It is clear that there is a great deal more to position limits than the simple end of day position. The Exchanges and the CFTC have interpreted the rules in a rather restrictive manner and customers, APs and FCMs need to be mindful of these interpretations. In the current regulatory environment there will most certainly be more cases brought to enforce these rules and the penalties for each violation get progressively more severe.
This post originally appeared in the National Introducing Brokers Association newsletter, the NIBA Journal on June 15, 2010.
1 The “futures equivalent” of an options position is unlikely to impact spot month limits as the options generally expire before the futures delivery period. Futures equivalents may effect the single month and aggregate speculative position limits with the additional complication that the “futures equivalent” of an options position is constantly fluctuating as the market moves up and down.
2 CFTC Division of Market Oversight- Advisory Regarding Compliance with Speculative Position Limits, PR 5819-10, dated May 7, 2010.
3 CME Market Regulation Advisory Notice RA 0909-5, dated September 14, 2009