Dodd-Frank Position Limits – A year of living dangerously
By Shane Henley, Global Head of Monitoring Solutions at CubeLogic.
October 24, 2022
As the first anniversary of Dodd-Frank position limits approaches, we reflect on the prospect of enforcement by the CFTC and the many challenges energy and commodity trading firms continue to face in effectively managing this risk.
Dodd-Frank Position Limits were implemented in January 2022 after almost a decade of delays. While CFTC position limits themselves are not new, Dodd-Frank introduced 25 “Core Reference Contracts” which extend beyond agricultural contracts, the historical scope of CFTC position limits, to include metals and energy contracts. While 25 contracts seem benevolent at first glance, the effective scope is much broader and includes many “linked” futures and options contracts, ostensibly capturing any contracts which directly or indirectly reference the 25 Core Reference Contracts. Some of these are traded on different exchanges adding to the complexity. The final elements of the Dodd-Frank position limit rules are due to take effect in 2023. These include a substantial change to the position limit exemptions regime and the introduction of the requirement to capture, aggregate and monitor Economically Equivalent Swaps.
What have we learnt about managing Dodd-Frank position limits since January this year, and what should firms be thinking about as the regime matures and the probability of regulatory enforcement rises?
CFTC enforcement – waiting for the big one?
Perhaps characteristic of newly implemented market regulation, Dodd-Frank position limit enforcement has been muted since the regulation entered into force. In September 2022, the CFTC issued a fine for USD720,000 to a Chinese agricultural trading group for, amongst other things, position limit violations. While technically a breach of CFTC position limits (see here), the alleged transgressions occurred in 2020 before Dodd-Frank position limits entered into force. The case is of interest however, particularly as the civil penalty was not limited solely to the fines issued by the CFTC, but also a more substantial fine of USD3.3million was imposed by ICE Futures US, the Exchange on which the transgressions took place (see here).
So when will Dodd-Frank position limit enforcement by the CFTC begin? Will the CFTC look to the exchanges to flag within-exchange breaches (analogous to the case highlighted above)? Does the Federal regulator have the necessary capabilities to identify Dodd-Frank position limit breaches? Specifically, will they be equipped with the data access and analytics to identify, for example, intraday position limit breaches? Time will tell but firms with Dodd-Frank position limit exposure should not wait to find out. Instead they should ensure that the operational challenges posed by this regulation are adequately addressed and any gaps and control weaknesses are properly managed.
Challenges for effective Dodd-Frank position limit management
What are some of the challenges posed by Dodd-Frank position limits and has your organisation equipped itself to deal with them? Here’s a closer look at a few of them.
Position Limits apply at all times – including intraday
The applicability of Dodd-Frank position limits is perpetual – firms must remain within their limits at all times, including within day. Despite this, many firms are still limited to end of day (EOD) monitoring rather than intraday. Does this matter? So far, the lack of enforcement precedent might have deprioritised the need for active intraday monitoring in the minds of many. Some may question whether the CFTC and the exchanges are equipped to identify within day position limit breaches and whether this is a priority for them. Time will undoubtedly tell.
Parallel Monitoring of Dodd-Frank and Exchange position limits
While Dodd-Frank position limits share many similarities with exchange position limits, they are not identical. For energy and metals contracts, Dodd-Frank only applies Spot limits removing the implicit “early warnings” from, for example, the front month contract positions. Likewise, given differing parent/child aggregation relationships (including cross exchange aggregation), the monitoring of Dodd-Frank position limits must be performed independently but also in parallel with exchange position limit monitoring. To monitor both manually is burdensome and risky. Despite this, many firms still pursue this approach.
Group aggregation and related complexities
As for exchange position limits, Dodd-Frank position limits apply at Group level in most cases. As the CFTC enforcement case referenced above illustrates, both the CFTC and the exchange surveillance teams will enforce breaches where subsidiaries are used in attempts to disguise positions. Barring wilful intent, many firms may simply not be in a position to monitor Dodd-Frank position limits across all group entities in a robust and systematic way.
Similarly, many firms rely on their FCMs or clearers to provide EOD position limit reports. This presents challenges for firms that use multiple FCMs/clearers and trade common or related contracts from a position limits perspective (and Dodd-Frank in particular) given the cross-exchange aggregation requirements for some limits.
Dodd-Frank introduced changes to the existing CFTC exemptions regime, including expanding the categories of so-called “enumerated” hedge exemptions and the removal of the widely used risk management exemption, the latter coming into effect in January 2023. The CFTC has confirmed their expectation that exemptions should not be generally claimed across trading activities in a particular contract. Rather, trades qualifying for exemption must be accurately identified and assigned to the correct exemption “bucket”. This becomes increasingly complex to manage and monitor, particularly on an intraday basis, in cases where multiple exemptions have been granted for the same or related contracts within a group.
Failing to properly apply and track legitimate exemptions from an operational perspective can rapidly lead to inadvertent position limit breaches and unwanted scrutiny from the Federal regulators.
Position aggregation and netting rules and step-down limits
Dodd-Frank introduces a number of position aggregation rules, which while not inherently complex in their own right, are a challenge to manage manually. Spot limits apply on a per-exchange basis for the cash settled Natural Gas futures contract so netting positions between, for example, NYMEX and ICE is not permitted. Similarly, cash-settled reference contracts may not be netted with physically delivering contracts for Spot limit purposes.
Further, having previously applied to agricultural contracts under CFTC rules, Spot “step-down” limits have been introduced for the WTI Light Sweet crude contract. The Spot limit tightens in progressive “steps” in the last few days before contract expiry. With over 40 referenced contracts, many with different expiry dates, manually tracking positions against the step-down profile is complicated and potentially risky.
After a Year of Living Dangerously – What comes next?
As the first anniversary of Dodd-Frank position limits approaches, few would deny that the probability of Federal enforcement is rising each day. What should Compliance officers be considering with regard to monitoring and managing this risk? Here are a few ideas.
- Undertaking a review of your current position limit management approach, with a specific focus on Dodd-Frank compliance, is recommended. Are your existing arrangements robust and reliable from a system and process perspective? Would they endure a rigorous examination by the CFTC in the event of an invasive investigation?
- Post-implementation fatigue often leads to gaps emerging as both the business and system expertise, some of which might be external to your organisation, demobilize to other projects or roles. Ensuring that the business processes around your position limit management system remain effective is critical. For example, is the business and/or technical process for assigning hedge flags to trades robust, thereby ensuring that positions are aggregated correctly net of exemptions? Likewise, are position data feeds functioning and providing complete position data, and are your positions being applied against the correct Spot dates?
- Depending on the nature of trading undertaking by your organisation and your natural proximity to Dodd-Frank limits, consider whether EOD position limit monitoring is appropriate and proportionate for the regulatory risk profile of your organisation. What seemed suitable a year ago might well not stack up today.
- Review any position limit management arrangements that rely on third-party performance. It is fairly common that energy and commodity firms rely exclusively on position limit reports produced by their FCM/clearers. Does Compliance have sufficient visibility over the position aggregation and netting methodologies applied? Likewise, are there rigorous checks and balances in place to ensure that all positions are captured? How are positions aggregated if split across more than one FCM/clearer? As compliance professionals will be all too aware, compliance accountability remains with the organisation regardless of who produces the position limit reports.
- The Dodd-Frank Final Rule on position limits mentions “manipulation” 224 times. The CFTC and US lawmakers see a strong and inextricable relationship between effective position limit management and the potential for market abuse. Many market abuse enforcement cases include an element of position limit breaches and this trend will more than likely continue. Compliance should consider how to effectively integrate the monitoring for market abuse alongside position limit monitoring given their symbiotic relationship.
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