How Regulation Affects CTAs
The regulatory framework for the financial industry is changing. Jonathan A. Golub discusses issues of particular relevance to commodity trading advisors in the United States.
Mr. Golub is a lawyer whose practice involves advising hedge fund investment advisers, commodity trading advisors and commodity pool operators on regulatory matters. He is an attorney in the financial services, private funds and capital markets group of the law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP.
“There may be significant compliance costs for market players, whether they be futures commission merchants or commodity trading advisors.”
We are in a very interesting era of regulatory change that will affect the alternative investment fund industry. What is occurring is a political process that is happening at multiple levels. There are proposals in the US Congress and at regulatory agencies—and they are not necessarily all on the same page. So much is going on that it takes an effort to stay apprised of the latest regulatory and legislative developments. Here we will review three key areas of interest to commodity trading advisors.
Potential for Dual Registration
There have been attempts since 2005 to get more hedge fund advisers to register with the Securities and Exchange Commission. Toward this goal, both the Senate and House versions of the financial regulatory reform bills currently under consideration in Congress would, among other things, eliminate the private adviser exemption in the Investment Advisers Act of 1940 that allowed most private fund investment advisers to escape federal registration.
Under current law, investment advisers are permitted to register if they have at least $25 million in assets under management and must register at $30 million AUM unless an exemption applies. The Senate bill would increase the minimum eligibility threshold for investment adviser registration to $100 million. This means investment advisers with at least $100 million AUM will very likely have to register federally if the Senate version of the bill is enacted.
It is also possible that investment advisers with AUM below the $100 million threshold will be required to register in one or more states. Where it gets complicated is that an adviser can get caught between state and federal registration. For example, under New York law you are exempt from registering as an investment adviser if you are exempt from federal registration. However, if you are not permitted to register federally (because your AUM does not meet the $100 million threshold) this is not an exemption. This means a New York-based investment adviser may be required to register in New York and would have to conduct a survey of the registration rules in every other state where its investors are located to determine if investment adviser registration is required in those states as well.
In contrast, the House bill does not raise the AUM threshold from its current levels but contains an exemption from registration for those investment advisers solely advising “private funds” (typically, hedge funds) with the AUM of that adviser being $150 million or less. Oddly, the House bill does not address managed accounts. So, if the House bill were enacted, an investment adviser with $3o million in AUM in managed accounts but no funds would be required to register whereas an investment adviser with $150 million in AUM all in a single private fund with no managed accounts would not have to register.
What does this mean for commodity trading advisors? If you trade futures contracts only, you are not considered an investment adviser subject to the Investment Advisers Act of 1940 and typically would only have to look to the registration rules under the Commodity Exchange Act. But if you trade any securities, including certain “cash equivalent” instruments that might be deemed to be a security, that can make you an investment adviser as well as a CTA and potentially subject to SEC registration.
Many CTAs are likely to trade some cash equivalent instruments such as interests in money market funds, treasuries and so forth. However, it is not always clear to what extent such cash equivalents are deemed to be securities. CTAs trading instruments that are ostensibly cash equivalents should discuss with legal counsel how to analyze those instruments to determine if they are securities and, if trading them in sufficient amounts, whether it is necessary to register as an investment adviser.
Note that many currently registered investment advisers are also CTAs. There is an exemption, which remains intact in the Senate bill, that if you are a registered CTA, then you should not be subject to federal registration as an investment adviser so long as your securities trading is not your primary business. This exemption is modified in the House bill so that only registered CTAs advising private funds are exempt from investment adviser registration.
Depending on which version of the bill makes it through Congress, a CTA may find it worthwhile considering CFTC registration as an alternative to SEC registration or accept dual registration with the SEC and the CFTC.
Speculative Position Limits in Energy Contracts
The Senate and House financial regulatory reform bills contain a provision for speculative position limits for certain commodities. The bill remains in flux at this time and what exactly will become law is uncertain.
Separately, the Commodity Futures Trading Commission proposed to establish new position limits on four energy products—light sweet crude oil, Henry Hub natural gas, New York Harbor gasoline blend and New York Harbor No. 2 heating oil. Three categories of position limits are proposed—for all months combined over 12 months, single month and spot month.
Similar statutory limits already exist for agricultural commodities. Currently, the various commodity exchanges impose their own speculative position limits and accountability rules on traders of futures contracts referencing energy commodities and other commodities not covered by the statutory limits on agricultural commodities.
Earlier studies by the CFTC did not show that speculation caused the oil price spike in 2008 or other big commodity price volatility. Thus the causal link that might justify more stringent limits on speculative trading has not been proven, but the issue remains controversial and politically sensitive. According to news stories, three of five CFTC commissioners expressed some skepticism about the energy position limits proposal.
The Futures Industry Association is opposed to the proposed limits and has asked the CFTC to hold off until a final financial regulatory reform bill is passed into law. If it turns out that what Congress passes is different from what the CFTC decides, then the CFTC would have to reconcile its rule with the new law, so it makes sense for the agency to wait for the law to pass.
What comes out will no doubt have an impact on futures-related businesses and their costs. There may be significant compliance costs for market players, whether they be futures commission merchants or commodity trading advisors. To track all the positions, an FCM or CTA would have to implement new procedures, possibly new software. In addition to the costs, the risk of failing to effectively track positions could increase.
An FCM would have to monitor all positions in referenced contracts. As the proposed CFTC rule stands, there is no exemption for independent account controllers, which means that an FCM would have to aggregate all accounts. If there is an affiliated trading operation that trades independently, how the FCM would monitor those trades is an issue. By contrast, in agricultural position limits this problem does not arise because there is an exemption for independent account controllers. It is unclear what the justification is for not having the same exemption for energy contracts.
Trading Certain Foreign Futures Contracts
CTAs should ensure they are in compliance with CFTC rules relating to the trading in the US of futures contracts on broad-based security indexes and options thereon. This is not an issue arising from new regulations but rather a compliance issue that CTAs may not always be aware of.
If broad-based security index futures and options thereon are traded on a foreign exchange, the CFTC’s Office of the General Counsel must issue a no-action letter allowing the sale of such instruments in the US. This is because the CFTC wants foreign exchanges to be subject to a regulatory regime comparable to the US, as a protective measure for American customers. The presence of US investors in a fund triggers this rule, regardless of where the trading takes place.
This is a compliance issue that matters. I encountered in my practice a CTA based outside the US that traded unapproved contracts in a fund with US investors and had to unwind the positions in a hurry when it emerged that it was in violation of the rule. The untimely unwinding of positions, or a hasty restructuring of a fund to segregate US investors from the profits and losses of unapproved futures contracts, can negatively impact the bottom line of a fund and lead to administrative headaches.
A CTA that wants to trade a non-approved foreign futures contract can not apply to the CFTC for a no-action letter. The foreign exchange has to do that. Then the CFTC will review the regulations governing that exchange. This review can take time. People who want to start trading in an unapproved foreign futures contract should factor in the lengthy CFTC approval process.
The CFTC website has a searchable list of foreign index futures contracts that are approved for trading in the US. CTAs should check the list before trading foreign contracts. If you want to trade the Korean KOSPI index, you can see which KOSPI contracts are approved.
What if you’ve inadvertently traded an unapproved contract? You might operate an offshore commodity pool with no US investors and not need to pay attention to CFTC approval. But if there are US investors in the fund, even if they came in indirectly via a feeder fund, the CFTC rule applies. It also may be possible to segregate the US investors from participation in the unapproved contracts through an allocation of profits and losses. We don’t know how closely the CFTC is looking at this issue, but they have the authority to bring sanctions in case of violation.
There are separate considerations with respect to the trading of foreign security futures, i.e., a futures contract on a single security or on a narrow-based foreign security index listed for trading outside the US. These are jointly regulated by the SEC and the CFTC and, until recently, US persons were precluded from trading such instruments.
In response to a recent order issued by the SEC relating to such instruments, the CFTC recently issued an advisory clarifying its position with respect to the trading of such instruments by eligible contract persons and non-eligible contract persons. Due to the complexity of these rules, it is recommended that CTAs wishing to trade such instruments consult an attorney to determine which activities would be inconsistent with federal securities laws.
I would urge CTAs that have American clients to check any foreign futures contracts they plan to trade before they take a position in order to avoid unwinding any unapproved positions at a bad time. Furthermore, if you want to trade unapproved foreign futures contracts extensively, it would be worth considering implementing this strategy in a separate fund for that purpose and not admit US investors into that fund.