Let’s See All the Cards: Pre-Trade Monitoring and Position Limits

Let’s See All the Cards: Pre-Trade Monitoring and Position Limits

A recent advancement in position limit compliance encapsulates the term “RegTech” quite well. Pre-trade monitoring – tracking orders before they are executed and settled on markets, and often enabled within an investment manager’s OMS – is increasingly being leveraged as a technology that can be integrated into a regulatory monitoring system.

A platform for position limit regulations is an ideal candidate for this: such limits are usually a fixed position size that may not be exceeded, and therefore compliance is made easier in being able to see how accruing orders would affect a total position size (i.e. how near you may be to a position limit). In contrast to “post-trade” regimes such as major shareholder thresholds – which generally allow you to cross any threshold you like, as long as you then submit a disclosure – for the investment manager position limits are a game of Blackjack. You want the freedom to build up an aggregate position as much as your trading strategy demands, but in no circumstances do you want to exceed “21,” or whatever the position limit is for any particular security.

Taking the metaphor further (apologies, I’ve never been to Vegas and am making up for it here), the standard “post-trade” approach to position limits has required the investment manager to consider cards that are hidden and unknown. While the settled trades and aggregate position can be seen (the cards dealt face-up, and their total), unknown are the outstanding orders still in play (the face-down cards). Pre-trade monitoring solves this problem: all of your orders are viewable, and aggregated for a potential total position. In other words, because you see every card you can draw, you know precisely how to get as close as possible to your limit without exceeding it. This is important for the market player, whose profit margins ultimately may depend on this type of transparency.

Of course, pre-trade functionality does exist in an asset manager’s OMS (order management system), and tracking orders through an OMS has served many purposes for risk, compliance and other matters.  But as my CSS colleague Mike Marmo, a product head with a strong OMS background, pointed out to me recently, in many respects an OMS is not sufficient for addressing certain regulatory regimes such as position limits. For one, the OMS would need to consider the position limit levels, so that a limit breach could be alerted to the investment manager. This would be particularly challenging given the nature of position limits, which apply to derivative contracts such as futures and options only during specified calendar periods (notably the “spot effective period,” as well as other times related to contract maturity). Additionally, an OMS attempting to handle position limit compliance would require additional translation capability, for certain reference data about exchange products subject to the limits.

Another aspect of position limits, that typical OMSs are not designed to accommodate, are the position calculations. These are very particular and vary not just by the regulator or exchange involved, but also according to the specific product held. Aggregation requirements for similar products, for example, often entail different “parent contract” codes, ratio adjustments and positive-negative correlations, across hundreds or thousands of different contracts on just one exchange. Some products, additionally, trigger a notional calculation of holdings for position limit purposes as the expiration of the contract nears (a “diminishing balance”), according to a particular formula.

Because typical OMSs are limited in such ways, the marketplace has recently witnessed a demand for position limit “pre-trade” functionality from regulatory platforms. Such regulatory applications, if robust enough, would already have in place a position limit rules engine, appropriate calculations, integration of reference data, and technical as well as regulatory support. To also handle the pre-trade function, for real-time monitoring, integrated API capability would then be required, to facilitate alerts to the relevant trader or portfolio manager.

Those technical aspectsare important for genuine pre-trade compliance. Some liberal uses of the term “pre-trade” refer in actuality to post-trade monitoring, that simply occurs more often (e.g. intraday position monitoring, reflecting transactions that have already been executed). While that represents an improvement over a once-a-day evaluation of positions, it still does not offer the investment manager with a window into its outstanding orders building up during the course of a trading day. To deliver real pre-trade capability, a regulatory monitoring platform is likely undergoing a substantial improvement project. Whether that platform rests in-house with an asset manager, or else outsourced through a vendor, pre-trade functionality therefore represents an investment in technology, and a market player’s bet that it will improve both regulatory compliance and investment decision-making.