Diminishing Limit Contracts

This week saw the price of “WTI” futures for the May delivery month traded on the New York Mercantile Exchange crash below zero for the first time.

This unprecedented event highlights the physical-settlement aspect of these instruments and lays bare the perils of trading them close to the delivery month during a supply glut. No doubt speculators who were caught holding these physical contracts with no intention of taking delivery learnt an expensive lesson.

This brings us to the topic of position limits, which doesn’t attract nearly as much media attention but could equally catch investors off-guard. We have previously argued why manual monitoring of spot-month limits is impractical, especially when trading on multiple exchanges. For those who are still unconvinced that automation is the way forward, we would like to point out that in Europe, exchanges can ‘implement a schedule of decreasing position limits ranging from the point in time when a contract becomes a spot month contract until maturity’. Other major exchanges across the world such as the CME can also impose ‘subsequent spot-month limits’ which are identical in substance. This means that exchanges can impose multiple position limits throughout the spot month, and therefore, compliance professionals must monitor spot-month limits daily even if there is no trading activity. This renders spot-month limits monitoring significantly more onerous than single-month or all-month monitoring.

To illustrate, Euronext Derivatives Paris has imposed over 10 different limits on rapeseed (ECO) futures within the spot month. Can anyone seriously claim they are not fazed by these diminishing limits?

Our Position Limits service can integrate exchanges’ calendar data and diminishing limits into our rule engine so that our client’s position data is automatically checked against the correct spot-month limit for that day. Our platform displays the current applicable limit as well as other diminishing limits not yet in effect. A user will receive a warning if their holding is below the current limit but is still above the next diminishing limit. This intuitive design aims to forewarn users of the need to unwind some of their positions incrementally.

At FundApps, we frown upon error-prone compliance processes and aim to automate as much as possible. Our Position Limits service can also source various contract information such as netting method, conversion ratio and aggregation type, ensuring calculations are done correctly and consistently with minimal user input. This, in turn, allows compliance professionals to focus on other regulatory matters.

To find more useful position limits content and to stay up to date with the latest regulatory developments, join FundApps' Position Limits group on LinkedIn.