Monthly Archives: June 2009

CFTC Addresses 2010 Budget

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CFTC Reports to US Senate Subcommittee on Financial Services – Testimony Provided by Chairman Gary Gensler

On June 2nd, 2009 Gary Gensler of the Commodity Futures Trading Commission (CFTC) addressed the US Senate Subcommittee on Financial Services with a discussion of the issues related to the CFTC’s 2010 Budget.  Gensler stated that the current priorities of the CFTC are to enhance transparency in the marketplace and ensure enforcement of laws governing the financial markets, and that increased funding will be necessary to accomplish these objectives.  Specifically, the CFTC  plans  to grow its professional staff and adopt new technology in order to better monitor the financial markets.  With these goals in mind, the Commission’s FY 2010 budget proposes an increase of $14.6 million,  half of which will be used to maintain FY 2009 level of operations into FY 2010.  In his closing remarks, Gensler stated:

“President Obama has called for action by the end of this year to strengthen market integrity, lower risks, and protect investors. The future of the economy and the welfare of the American people depend on a vibrant Commission to assist in leading the regulatory reform ahead. Additional funding will be necessary to properly implement these reforms.”

The entire text of the testimony is included below and can be found here.

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Testimony by Gary Gensler, Chairman on behalf of the Commodity Futures Trading Commission

Before the United States Senate Subcommittee on Financial Services and General Government, Committee on Appropriations

June 2, 2009

Thank you, Chairman Durbin, Ranking Member Collins, and other members of the Subcommittee. I am pleased to be here to testify on behalf of the Commodity Futures Trading Commission, and I appreciate the opportunity to discuss issues related to the Commission’s 2010 Budget. I am also grateful to have had each of your individual support for my recent confirmation. It is a great honor to serve my country in this capacity.

I come before you today having only served as CFTC Chairman for six calendar days, but with the full knowledge of the failures of our financial regulatory system; failures that affected all Americans and failures that we must ensure never occur again.

The last decade, and particularly the last 21 months, has taught us much about the new realities of our financial markets. We have learned the limits of foresight and the need for candor about the risks we face. We have learned that transparency and accountability are essential and that only through strong, intelligent regulation can we fully protect the American people and keep our economy strong.

As Chairman of the CFTC, I will use every tool and authority available to protect the American people from fraud, manipulation and excessive speculation. I also look forward to working with Congress to establish new authorities to close the gaps in our laws and bring much-needed transparency and regulation to the over-the-counter derivatives market. I firmly believe that doing so will strengthen market integrity, lower risks, protect investors, promote transparency and begin to repair shattered confidence in our financial markets.

I would like to thank the Committee for the $146 million recently appropriated for the CFTC for the 2009 Fiscal Year and special thanks to Chairman Durbin for visiting our Chicago office last year. As a result of this much needed boost in funding, the

Commission has begun to address our alarming staffing levels; levels that recently reached historic lows.

At present, the Commission employs about 500 career staff — roughly equivalent to when the Commission was created in 1975. Three decades later, the futures market has changed in every way: with respect to volume, complexity, risk and locality. What was once a group of regional domestic markets trading a few hours five days a week is now a global market trading 24/7, and what was once just a $500 billion dollar business has exploded to a $22 trillion dollar annual industry.

Ten years ago, the CFTC was near its peak staffing level at 567 employees, but shrunk by 20% over the subsequent eight years before hitting a historic low of 437.

With the increase in FY 2009 funding the CFTC can reach 572 employees.

While this is a start, I believe that merely raising our staffing levels to the same as a decade ago will not be enough to adequately fulfill all of the agency’s missions. In the last ten years, trading volume went up over five fold. The number of actively traded futures and options contracts went up over six fold, and many of these are considerably more complex in nature. We also moved from an environment with open-outcry pit trading to highly sophisticated electronic markets.

In addition to the dramatic evolution of the futures industry, we have experienced the worst financial crisis in 80 years. We also experienced, in my view, an asset bubble in commodity prices. The staff of the CFTC is a talented and dedicated group of public servants, but the significant increase in trade volume and market complexity, as well as rapid globalization, commands additional resources to effectively protect American taxpayers.

For all of these reasons, I feel it is appropriate for our staffing levels and our technology to be further bolstered to more closely match the new financial realities of the day.

In short, despite the recent increase in funding, the Commission remains an underfunded agency. The President’s Budget recommendation of $160.6 million dollars is recognition of this need. Specifically, the Commission needs more resources to hire and retain professional staff and develop and maintain technological capabilities as sophisticated as the markets we regulate.

I’d like to identify some of my priorities and provide some illustrations of how resource limitations have constrained the Commission. Among my priorities will be to:

  • Ensure robust enforcement of our laws. Currently, the Commission’s enforcement program consists of 122 employees — the lowest level since 1984. Though FY 2009 funding will get us back to 141 enforcement employees, this is still below the agency’s peak of 167 and well below what we need given the current financial turmoil. Any financial downturn reveals schemes that could only stay afloat during periods of rising asset values. Our current, and much larger, downturn is exposing more leads than the Commission can thoroughly and effectively investigate. This is true both as it relates to fraud and Ponzi schemes as well as staff intensive manipulation investigations. The regulations we enact to protect the American people are meaningless if we do not have the resources to enforce them;
  • Ensure greater transparency of the marketplace. Also, I believe that commodity index funds and other financial investors participated in the commodity asset bubble. Notably, though, no reliable data about the size or effect of these influential investor groups has been readily accessible to market participants. The CFTC could promote greater transparency and market integrity by providing further breakdowns of non-commercial open interests on weekly “Commitments of Traders” reports. The American public deserves a better depiction of the marketplace. The temporary relief from higher prices does not negate this need, especially given that a rebounding of the overall economy could lead to higher commodity prices;
  • Ensure position limits are consistently applied. The CFTC has begun a review of all outstanding hedge exemptions to position limits. This review will consider the appropriateness of these exemptions and look for ways to institute regular review and increased reporting by exemption-holders. The Commission also has begun a review of the process and standards through which no-action letters are issued. As part of these reviews, CFTC staff will consider the extent to which swap dealers should continue to be granted exemptions from position limits;
  • Ensure the Commission has the tools to fully monitor the markets. We must upgrade the Commission’s mission critical IT systems for the surveillance of positions and trading practices. Neither is robust enough nor have they been upgraded to reflect the vast increase in volume and complexity. Our systems must begin to produce the surveillance reports needed to meet the analytical needs of our professional staff and the transparency needs of the public; and finally,
  • Ensure timely reviews of the many new products and rule change filings of the futures markets. These have lagged due to the growth and complexity of markets and the added responsibilities extended to the Commission in the 2008 Farm Bill. The Farm Bill requires staff to review all contracts listed on Exempt Commercial Markets (ECMs) to determine if they are significant price discovery contracts — if they are, then any ECM that lists such a contract must also be reviewed to determine compliance with a stringent set of core principles under the Commodity Exchange Act.

Other examples that I believe are illustrative of the difficult tradeoffs caused by resource constraints are:

  • The Commission does not conduct annual compliance audits of every Designated Contract Market (DCM)– rather only periodic reviews on average, every three years;
  • The Commission does not conduct annual compliance audits of every Derivatives Clearing Organization (DCO) — rather periodic reviews are conducted of selected core principles that are rotated and completed every three years; and,
  • The Commission does not conduct routine examinations of Commodity Pool Operators, Commodity Trade Advisors, and Futures Commission Merchants – a function currently performed by Self Regulatory Organizations. If the Commission were to perform direct periodic audits our staff would better understand the operations of brokers and managed funds and could better assess compliance with the law and regulations.

These are only a few of our important funding priorities and the workload challenges imposed by resource limitations. There are, of course, others. I hope that this helps the Committee to understand, in a tangible way, the challenges the Commission faces in regulating the futures markets the way the Nation requires.

Although the work of the Commission can be highly technical in nature, the mission of the agency is quite straightforward. The CFTC is charged with:

  1. Protecting the public and market users from manipulation, fraud, and abusive practices and
  2. Promoting open, competitive and financially sound futures markets.

With that context, I would like to address the specifics of the FY 2010 Budget request. The FY 2010 Budget proposes an increase of $14.6 million. Approximately half of the increase is needed to maintain our FY 2009 level of operations into FY 2010. The balance would fund an additional 38 positions.

Twenty-six of the 38 staff would be allocated to principal program areas. Specifically, we would allocate eleven positions to Enforcement, eight to Market Oversight, six to Clearing and Intermediary Oversight, and one to the Chief Economist’s office. The remaining twelve positions will provide critical mission support in the areas of legal analysis and counsel, technology support, international coordination, legislative and public outreach, and human capital and management support.

The additional 38 positions are essential to addressing some of the limitations I mentioned earlier. This increase, however, will not provide the Commission with the critical mass of professional and technical expertise needed to ensure that the growing markets remain free of manipulation and fraud.

For example, our enforcement staff needs to be significantly expanded to:

  • Ensure that crimes are punished to the fullest extent of the law;
  • Develop strategies aimed at quickly identifying and eradicating fraudulent schemes, such as Ponzi and foreign exchange “boiler rooms”; and
  • Importantly, pursue resource-intensive investigations and litigations involving manipulation, including energy-related market abuses, so wrongdoers will not believe they are immune from enforcement simply due to the complexity of an enforcement action.

Insufficient resources in the enforcement division force it to be too selective in the matters it investigates.

Our market oversight operation needs additional highly-skilled economists, investigators, attorneys and statisticians to:

  • Analyze trading reports quickly and thoroughly, indentify potential market problems or trader violations promptly, and avoid market disruptions and pricing anomalies;
  • Conduct timely and complete reviews of regulated entities to ensure compliance with all core principles;
  • Examine exchange self-regulatory programs on an on-going and routine basis with regard to trade practice and market surveillance; and
  • Ensure their compliance with disciplinary, audit trail, record-keeping and governance obligations.

Our clearing and intermediary oversight program needs additional auditors, analysts, and attorneys. This would allow us to:

  • Ensure clearing systems protect against a single market becoming a systemic crisis;
  • Protect investors’ funds from being misused or exposed to inappropriate risks of loss; and
  • Guard against abusive sales practices that harm customers and undermine market integrity.

Our economic research program needs more economists to review and analyze new market structures and off-exchange derivative instruments, especially in light of novel and complex products and practices that call for state-of-the-art economic analysis. Further, additional resources would enhance our economic and statistical analysis, improving transparency of markets and better supporting the Commission’s enforcement and surveillance programs.

We also need to transform the current legacy information technology systems into robust systems capable of efficiently receiving and managing massive amounts of raw data as well as transforming them in to useful analytical and research tools.

The Commission has made a substantial investment in technology over the past two years – focusing first on upgrading obsolete computer hardware to industry standards. We need technology, however, that is as modern and dynamic as the technology-driven markets we are charged with overseeing. Our investment in technology must be more than just periodic equipment upgrades and maintenance. The Commission must leverage resources by employing 21st century technology to protect the American people.

As the Commission informed this Committee in February of this year, the agency believes it needs $177.7 million for FY 2010 to perform its present duties. I look forward to working with this Committee to secure the funding necessary to meet our current regulatory responsibilities.

Before I close, I would like to briefly highlight funding needs that might go along with much needed regulatory reform. The CFTC along with the Administration and other financial regulators is committed to working with Congress on broad regulatory reform. This is particularly true for the markets that the CFTC currently regulates and the markets that may soon come under our regulation.

Specifically, we must urgently move to regulate the over-the-counter derivatives market and address excessive speculation through aggregated position limits.

President Obama has called for action by the end of this year to strengthen market integrity, lower risks, and protect investors. The future of the economy and the welfare of the American people depend on a vibrant Commission to assist in leading the regulatory reform ahead. Additional funding will be necessary to properly implement these reforms.

I look forward to working with the Members here today and others in Congress to accomplish this goal.

Thank you very much. I would be happy answer any questions you may have.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund articles include:

NFA Takes Regulatory Aim at Spot Commodities Markets

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Asks Congress to Increase Scope of Regulation for CFTC and NFA

Last week various employees of the CFTC and the NFA talked with members of Congress regarding certain aspects of the markets regulated by these groups.  Below is testimony from the Chief Operating Officer of the NFA, Daniel Discroll.  In the testimony, Mr. Discoll actually asks Congress to allow the CFTC and the NFA to regulate MORE markets – specifically the off exchange spot metals and energy markets.  While it is commendable that the NFA wants more power to help protect the investors, there are many reasons why this is not a good idea including:

  • The CFTC is underfunded already underfunded (see remarks by Commissioner Gary Gensley, “Specifically, the Commission [CFTC] needs more resources to hire and retain professional staff and develop and maintain technological capabilities as sophisticated as the markets we regulate.”)
  • In 2008 the CFTC was charged with promulgating proposed regulations to require forex managers to register with the CFTC.  This was supposed to be complete by late 2008 – we have yet to see any proposed regulations.  Are we likely to see any quick movements by the CFTC in the spot commodities markets?  Probably not.
  • The CFTC is likely to play a large role in reforming the regulatory framework for the OTC dervitives markets.  See our post on this issue.
  • The NFA, which must be commended for having staff who are generally cheerful and easy to deal with, is nonetheless a slow organization.  Managers who are registered with the CFTC and who have to interact with the NFA face long start-up times because of the overly onerous NFA review requirements.
  • Much of what the NFA does is ineffective – we probably see the most scams from CFTC/NFA regulated entities than we do from SEC/FINRA regulated entities.  Of note was another Ponzi scheme by a CFTC registered FCM, CPO and CTA (see press release).

I am not saying that the CFTC and the NFA should not have the power to regulate these markets.  I am saying that the CFTC and the NFA need to be pursuing the most egregious offenses and that Congress needs to ensure that the CFTC has the funding it needs in order to do its job propoerly.  If Congress does decide to grant jurisdiction over these markets to the CFTC then Congress should also make sure that a funding grant is included in any such rulemaking bill.

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TESTIMONY OF DANIEL A. DRISCOLL
EXECUTIVE VICE PRESIDENT AND CHIEF OPERATING OFFICER
NATIONAL FUTURES ASSOCIATION

BEFORE THE COMMITTEE ON AGRICULTURE, NUTRITION & FORESTRY
UNITED STATES SENATE

JUNE 4, 2009

My name is Daniel Driscoll, and I am Executive Vice President and Chief Operating Officer of National Futures Association. Thank you Chairman Harkin and members of the Committee for this opportunity to appear here today to present our views on closing a regulatory gap that allows fraudsters to sell unregulated OTC derivatives to retail customers.

Since 1982, NFA has been the industry-wide self-regulatory organization for the U.S. futures industry, and in 2002 it extended its regulatory programs to include retail over-the-counter forex contracts. NFA is first and foremost a customer protection organization, and we take our mission very seriously.

Congress is currently expending significant time and resources to deal with systemic risk and to create greater transparency in the OTC derivatives markets. Those are important economic issues, and we support Congress’ efforts to address them. Understandably, most of the debate centers around instruments offered to and traded by large, sophisticated institutions. However, there is a burgeoning OTC derivatives market aimed at unsophisticated retail customers, who are being victimized in a completely unregulated environment.

For years, retail customers that invested in futures had all of the regulatory protections of the Commodity Exchange Act. Their trades were executed on transparent exchanges and cleared by centralized clearing organizations, their brokers had to meet the fitness standards set forth in the Act, and their brokers were regulated by the CFTC and NFA. Today, for too many customers, none of those protections apply. A number of bad court decisions have created loopholes a mile wide, and retail customers are on their own in unregulated, non-transparent OTC futures-type markets.

The main problem stems from a Seventh Circuit Court of Appeals decision in a forex fraud case brought by the CFTC. In the Zelener case, the District court found that retail customers had, in fact, been defrauded but that the CFTC had no jurisdiction because the contracts at issue were not futures, and the Seventh Circuit affirmed that decision. The “rolling spot” contracts in Zelener were marketed to retail customers for purposes of speculation; they were sold on margin; they were routinely rolled over and over and held for long periods of time; and they were regularly offset so that delivery rarely, if ever, occurred. In Zelener, though, the Seventh Circuit ignored these characteristics and based its decision on the terms of the written contract between the dealer and its customers. Because the written contract in Zelener did not include a guaranteed right of offset, the Seventh Circuit ruled that the contracts at issue were not futures. As a result, the CFTC was unable to stop the fraud.

Zelener created the distinct possibility that, through clever draftsmanship, completely unregulated firms and individuals could sell retail customers forex contracts that looked like futures, acted like futures, and were sold like futures and could do so outside the CFTC’s jurisdiction. For a short period of time, Zelener was just a single case addressing this issue. Since 2004, however, various Courts have continued to follow the Seventh Circuit’s approach in Zelener, which caused the CFTC to lose enforcement cases relating to forex fraud.

A year ago, Congress closed the loophole for forex contracts. Unfortunately, the rationale of the Zelener decision is not limited to foreign currency products. Customers trading other commodities-such as gold and silver-are still stuck in an unregulated mine field. It’s time to restore regulatory protections to all retail customers.

Back in 2007, NFA predicted that if Congress plugged the Zelener loophole for forex but left it open for other products, the fraudsters would simply move to Zelener-type contracts in other commodities. That’s just what has happened. We cannot give you exact numbers, of course, because these firms are not registered. Nobody knows how widespread the fraud is, but we are aware of dozens of firms that offer Zelener contracts in metals or energy. Recently, we received a call from a man who had lost over $600,000, substantially all of his savings, investing with one of these firms. We have seen a sharp increase in customer complaints and mounting customer losses involving these products since Congress closed the loophole for forex.

NFA and the exchanges have previously proposed a fix that would close the Zelener loophole for these non-forex products. Our proposal codifies the approach the Ninth Circuit took in CFTC v. Co-Petro, which was the accepted and workable state of the law until Zelener. In particular, our approach would create a statutory presumption that leveraged or margined transactions offered to retail customers are futures contracts unless delivery is made within seven days or the retail customer has a commercial use for the commodity. This presumption is flexible and could be overcome by showing that delivery actually occurred or that the transactions were not primarily marketed to retail customers or were not marketed to those customers as a way to speculate on price movements in the underlying commodity.

This statutory presumption would not affect the interbank currency market dominated by institutional players, nor would it affect regulated instruments like securities and banking products. It would also not apply to those retail forex contracts that are already covered (or exempt) under Section 2(c). It would, however, effectively prohibit leveraged non-forex OTC contracts with retail customers when those contracts are used for price speculation and do not result in delivery.

I should note that NFA’s proposal does not invalidate the 1985 interpretive letter issued by the CFTC’s Office of General Counsel, which Monex International and similar entities rely on when selling gold and silver to their customers. That letter responded to a factual situation where the dealer purchased the physical metals from an unaffiliated bank for the full purchase price and left the metals in the bank’s vault. The dealer then turned around and sold the gold or silver to a customer, who financed the purchase by borrowing money from the bank. Within two to seven days the dealer received the full purchase price and the customer received title to the metals. In these circumstances the metals were actually delivered within seven days, so the transactions would not be futures contracts under NFA’s proposal.

In conclusion, while NFA supports Congress’ efforts to deal with systemic risk and create greater transparency in the OTC markets, Congress should not lose sight of the very real threat to retail customers participating in another segment of these markets. This Committee can play a leading role in protecting customers from the unregulated boiler rooms that are currently taking advantage of the Zelener loophole for metals and energy products. We look forward to further reviewing our proposal with Committee members and staff and working with you in this important endeavor.

CFTC Proposes Reforms to Over-The-Counter Derivates Trading Regulation

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Statement of Gary Gensler Chairman, Commodity Futures Trading Commission

On June 4th, 2009, Gary Gensler, Chairman of the Commodity Futures Trading Commission, held a hearing before the Senate Committee on Agriculture, Nutrition and Forestry to address the importance of enacting broad reforms to regulate over-the-counter (OTC) derivates.  Gensler emphasized that such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade in order to build and restore confidence in our financial regulatory system.  Below is a summary of the reforms proposed in CFTC hearing:

I.  Comprehensive Regulatory Framework

A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

1.  Lower systemic risks

  • Setting capital requirements for derivative dealers;
  • Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
  • Requiring centralized clearing of standardized swaps; and
  • Requiring business conduct standards for dealers.

2.  Promote the transparency and efficiency of markets

  • Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;
  • Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;
  • Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to the CFTC and other regulators;
  • Requiring centralized clearing of standardized swaps;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;
  • Requiring the timely reporting of trades and prompt dissemination of prices and other trade information

3.  Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits

  • Providing CFTC with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;
  • Providing CFTC with authority to set position limits, including aggregate position limits;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems;
  • Requiring business conduct standards for dealers.

4.  Protect the public from improper marketing practices.

  • Business conduct standards applied to derivatives dealers regardless of the type of instrument involved;
  • Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities

To best achieve these objectives, Gensler  recommends implementing two complementary regulatory regimes: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses.

II.  Regulating Derivatives Dealers

The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

 II (a). Capital and Margin Requirements

 The Congress should explicitly require regulators to promulgate capital requirements for all  derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin  requirements, on all transactions by these dealers will help prevent the types of systemic risks  that AIG created. No longer would derivatives dealers or counterparties be able to amass large  or highly leveraged risks outside the oversight and prudential safeguards of regulators.

 II (b).  Business conduct and Transparency Requirements

 Business conduct standards should include measures to both protect the integrity of the market  and lower the risk (both counterparty and operating) from OTC derivatives transactions.

 To promote market integrity, the business conduct standards should:

  • Include prohibitions on fraud, manipulation and other abusive practices
  • Require adherence to position limits established by the CFTC on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets
  • Ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions.
  • Require derivatives dealers to be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions, including retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository
  • Provide transparency of the entire OTC derivates market by making this information available to all relevant federal regulators and making aggregated information on positions and trades available to the public
  • Provide clear authority for regulating and setting standards for trade repositories to ensure that the information recorded meets regulatory needs and the repositories have strong business conduct practices

III.  Regulating Derivates Markets

All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.  Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks.  To fully achieve these objectives, both of these complementary regimes must be enacted – Regulating both the traders and the trades will ensure that we cover both the actors and the actions that may create significant risks. To regulate both derivates and the market itself, the following areas need to be regulated:

a) Central clearing
b) Exchange-trading
c) Position limits
d) Standardized and customized derivates
e) Authority

III (a).  Central Clearing

Central clearing should help reduce systemic risks in addition to the benefits derived from  comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting  of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in  the OTC derivatives market are not cleared, and remain as bilateral contracts between individual  buyers and sellers. In contrast, when a contract between a buyer and seller is submitted to a  clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the  clearinghouse is substituted as the counterparty to the contract and then stands between the  buyer and the seller.

Clearinghouses then guarantee the performance of each trade that is submitted for clearing.  Clearinghouses use a variety of risk management practices to assure the fulfillment of this  guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily  discipline of marking to market the value of each transaction.

The regulations applicable to clearing should require central clearinghouses to:

  • Establish and maintain robust margin standards and other necessary risk controls and measures
  • Have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants
  • Have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a firm
  • Implement rules that allow indirect participation in central clearing

III (b).  Exchange-Trading

Market transparency and efficiency would be further improved by moving the standardized part  of the OTC markets onto regulated exchanges and regulated transparent electronic trading  systems.  Furthermore, a system for the timely reporting of trades and prompt dissemination of  prices and other trade information to the public should be required. Both regulated exchanges  and regulated transparent trading systems should allow market participants to see all of the bids  and offers. A complete audit trail of all transactions on the exchanges or trade execution   systems should be available to the regulators. Through a trade reporting system there should be  timely public posting of the price, volume and key terms of completed transactions.

III (c).  Position Limits

Position limits must be applied consistently all markets, across all trading platforms, and  exemptions to them must be limited and well defined.  The CFTC should have the ability to  impose position limits, including aggregate limits, on all  persons trading OTC derivatives that  perform or affect a significant price discovery function with respect to regulated markets. Such  position limit authority should clearly empower the CFTC to establish aggregate position limits  across markets in order to ensure that traders are not able to avoid position limits in a market  by moving to a related exchange or market. Gensler anticipates that this new authority will  better enable the CFTC to protect the integrity of the price discovery process in the futures  markets and protect the public against fraud, manipulation and other abuses. 

III (d).  Standardized and Customized Derivatives

It is important that tailored or customized swaps that are not able to be cleared or traded on an  exchange be sufficiently regulated. Regulations should also ensure that customized derivatives  are not used solely as a means to avoid the clearing requirement. Genlser proposes that the  CFTC accomplish this in two ways:

  1. Regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps.
  2. Ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems

Additional criteria for consideration in determining whether a contract should be considered to  be a standardized swap contract should include:

  • The volume of transactions in the contract
  • The similarity of the terms in the contract to terms in standardized contracts
  • Whether any differences in terms from a standardized contract are of economic significance
  • The extent to which any of the terms in the contract, including price, are disseminated to third parties

III (e).  Authority

Lastly, to achieve the goals described above, the Commodity Exchange Act should be amended  to provide the CFTC with positive new authority to regulate OTC derivatives. The term “OTC  derivative” should be defined, and the CFTC should be given clear authority over all such  instruments. To the extent that specific types of OTC derivatives might best be regulated by  other regulatory agencies, care must be taken to avoid unnecessary duplication and overlap.
 As new laws and regulations are enacted, the CFTC should be careful not to call into question  the enforceability of existing OTC derivatives contracts. New legislation and regulations should  not provide excuses for traders to avoid performance under pre-existing, valid agreements or to  nullify pre-existing contractual obligations.

IV.  Conclusion

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide the CFTC and other federal agencies with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Today’s complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage.

Hedge Fund Investors – What are investors looking for?

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Are Hedge Fund Managers Lowering Fees?

There are a few common topics which have been coming up lately in my conversations with managers.  Of these probably the question of greatest interest deals with what sort of fee structure investors are looking for right now and what kinds of fee concessions are manages granting to investors.  In the article below Bryan Goh (First Avenue Partners) addresses these issues and shares his thoughts on the hedge fund industry after a recent conference.  This article was reprinted from Byan’s blog called Ten Seconds Into the Future by Bryan – I highly recommend this blog for all hedge fund managers.  [Another blog I highly recommend is Compliance Building by Doug Cornelius.  This blog will be a great resource for anyone interested in issues involving compliance issues.]

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The month of June is replete with hedge fund conferences. Conferences earlier this year were either poorly attended, or else investors attended them for the free breakfast or lunch, a chance to commiserate with fellow sufferers of the global financial crisis/hedge fund witch hunt. What a differences a couple of months of rising markets make.

I recently attended the Goldman Sachs European Hedge Fund conferences held in London a couple of days ago. Over 50 hedge fund managers attended to present their funds and a rough count of what must have been over 300 investor groups showed up if not to allocate soon then at the very least to window shop.

The quality of managers was in general very high. Perhaps the weaker managers had been washed out or were facing legacy issues and thus not investable, there was clearly a Darwinian dynamic at work. The organizers would have been very selective as well so as not to waste investors time. Or maybe it was just that Goldman Sachs simply had a bigger client base and could move further into the right tail of quality. Or, dare I say it, Goldman’s clients were of a better quality. I don’t know, all I know is what I saw. 5o over managers, all to a greater degree, investable if one was so inclined to their strategies.

Many established managers previously closed to new investment, or usually reluctant to be presenting at capital introduction events were presenting. Only recently, Israel Englander’s much vaunted Millennium was out looking for new capital at a number of conferences around the globe. These managers have experienced outflows of capital, redemptions which may be uncorrelated to the quality of their performance in 2008, and find that they have capacity to replace this exiting capital, as well as are faced with rich opportunity sets upon which to capitalize and thus have improved capacity.

Panel upon panel of strategy specific discussions were held and all well attended. Investors were clearly looking for new ideas, a sign of recovering risk appetite and the need to put capital to work. In every discussion, the macro landscape was an issue of great importance. At each panel, regardless of the uncorrelated or non-directional nature of the strategy from event driven to market neutral strategies, moderators and panel members were clearly focusing on the macro landscape, on regulation, on government intervention, and how these would impact the functioning of markets in which they invested. One thing was clear, there was no consensus as to the health of the global economy. Goldman Sach’s Head of Global Economic Research Jim O’Neill was of the opinion that the worst was over and that a V shaped recovery was underway. His team forecasts better than expected growth from economies like the BRICs driving global growth. Hedge fund manager’s, however, were almost evenly split 50:50 between bulls and bears, with the bears with the slight edge in extra time. Student’s of Murphy’s Law and other dynamic system theories will tell you that this is a healthy balance and likely to prolong current trends whether rising or falling and that reversals occur when the balance is jeopardized one way or the other.

What was really interesting for this observer, was that despite the lack of consensus over economic growth and market direction, each manager saw immense investment opportunities in their own particular strategies and markets. This would appear to be an inconsistency at best and more cynically, disingenuity at worst. Not so, in my view.

Of all the strategies represented at the conference, there was consensus among the respective manager groups, that the opportunities for profit generation were great. Equity long short, Distressed Debt, Merger Arbitrage, Volatility, Multi Strats. They all saw ways that they could make money, yet none of them could agree on whether the economy had stabilized, whether growth would resume or falter, whether inflation would rise or sink into deflation, whether markets would rise and fall. There is a larger lesson for students of economics, but that is not our aim here.

One can argue that macro leads micro, I’m not quite sure how yet, but in the narrower context of this discussion, micro leads macro. What these managers are individually telling us is that there are micro strategies that can be profitable. A macro analysis of the strategies that these managers employ will simply not be granular enough to capture the opportunities they talk about. And yet, when sufficient numbers of them make money, when sufficient capital is put to work in these opportunities, the macro structure of the trades becomes evident. This is the natural evolution of strategy.

Fees and Terms:

The industry has been debating if there has been any fee compression in the wake of the financial crisis of 2008, and hedge funds’ apparently failure to perform as advertised. I have defended the performance of hedge funds through the initial stages of the crisis, but that is the subject of another discussion. At the Goldman conference, there was definitely a growing number of managers charging less than the usual 2 and 20. 1.5 and 15, and even 1 and 10, fees were seen. Encouragingly, I met a handful of managers who were either considering or in the process of establishing a holdback provision with a vesting period, on performance fees, whereby a portion (say 50%) of a year’s performance fees are held in escrow and a negative performance fee is applicable to the amound held back.

Liquidity terms were also a lot more logical. Illiquid strategies did not shy away from lock ups, while well performing or big name hedge funds with liquid portfolios and strategies, passed on that liquidity to investors. Some managers went as far as to formally exclude so-called gates, restrict suspension of NAV rights to specific circumstances, and specify side pocket provisions more explicitly. It appears that the events of 2008 have precipitated a much welcome self regulatory campaign.

Strategies:

Equity long short managers were in abundance, naturally, given their market share of the hedge fund industry. The diversity of styles within what many consider a relatively simple strategy makes it a very interesting area to analyse and invest. There are managers who are driven by the philosophy that fundamentals, that is earnings, cash flow generation, financial strength, matter most in determining valuations. There are those who are traders, for which fundamentals are secondary, and what matters most is how a stock’s price has behaved and is behaving. Still others, have a macro or thematic approach, and apply these to equity investing. The trading style managers were bullish, arguing that increased volatility and dispersion in equity returns represented opportunity for profit. It also represents opportunity for loss as well of course. Alpha can be negative. Some of them were bullish on the market, some were bearish on the market, but there was general enthusiasm for the opportunity to trade. Fundamentally driven stock pickers were similarly upbeat about their strategy, arguing that the last 6 months have seen a wholesale disposal of risk followed by in the last 6 weeks, a reversal of this risk aversion, and that such large systemic moves create mispricings in individual companies which they seek to exploit. As always there were some very clever approaches to equity long short. There was a manager who had a very strong macro view, and invested a lot of time in macro research, then researched company fundamentals in an attempt to understand the impact of macro developments on company fundamentals. There was another manager which analysed only audited financials and ignored all street and interim data, and then built sophisticated models to obtain their own interim numbers. All these various managers had credible reasons why their approaches would work. In 2005, I would not have believed them; today I am a lot less skeptical.

Convertible Arbitrage managers were conspicuously absent from the conferences. The best performing strategy in 2009, albeit the worst performing strategy in 2008, convertible arbitrageurs were too busy making money from the market to attend a capital introductions event. Moreover, who would listen, they would argue, most investors having being burnt in 2005 and then again in 2008. There are good reasons why the strategy is working and is likely to work further, but the managers were too busy working it than selling it. Good for them.

Distressed Debt has been a preferred strategy since late 2007. That, however, was an expensive false start. By the end of 2008, with insufficient defaults and a catastrophic dislocation in credit markets from LIBOR to swaps, from ABS to corporate, from cash to synthetics, distressed debt managers had suffered considerable losses. Rational, no memory investing would have suggested getting back into distressed investing in 2009 and to their credit, investors have been bullish on distressed investing once again. A number of surveys taken in 1Q 2009 ranked distressed investing as one of the top 3 hedge fund strategies among investors for 2009.

One of the least favored strategies, if investor survey’s are to be believed, is merger arbitrage. It may surprise one to learn that on a rolling 12 month basis, merger arbitrage has been one of the best performing hedge fund strategies, behind global macro and CTAs. Merger arbitrage, or risk arb, was well represented at the Goldman conference and it was clear that risk arbitrageurs were very much excited about the opportunities before them.

Since July 2008, M&A transactions numbered over 5000 representing over 1 trillion USD in value, and deal flow continues on the back of cashed up corporate buyers seeking strategic assets, distressed sales from corporate restructurings, distressed sellers and government interventions. Company’s are happier to do deals in rising stock markets and easing financing conditions. Also, BRICs and other EM markets outbound transactions have been strong and remain an area of considerable potential growth.

Deal spreads have been volatile. The dislocation of markets in 2008 represent a stepwise repricing of an over arbitraged space. Deal spreads of circa 10-11% blew out to 50 – 60% before settling at current levels of 15 – 20% IRR.

The financial crisis of 2008 has also reduced the number of participants leading to a much less crowded space. Bank prop desks have exited or significantly reduced their books and hedge fund capital dedicated to risk arb has shrunk more than proportionately to the industry. Many risk arb funds drifted into a much too early play in distressed credit as quite often the resources if not the skill sets are the same. M&A very often wanders into litigation and distressed investing is very much about litigation. While a pure risk arb strategy would have done relatively well in the last 12 months, the contamination from a catastrophic credit strategy has hurt many multi strategy funds with large risk arb books resulting in poor performance and redemptions. The reduced capital employed in risk arb not only results in wider deal spreads but allows more time for analysis and deal selection leading to more selective participation.

A renaissance for hedge funds:

Since hedge fund indices have been compiled, that is 1990, until the present, with the exception of 1998 and 2008, hedge funds have steadily generated positive absolute returns. These returns have seen varying correlations to the returns of other traditional asset classes such as equities and bonds, as well as varying information ratios over time. From 2005 to 2007 hedge funds’ returns exhibited increasing correlation to traditional asset classes, decreasing returns to invested capital, increasing inter strategy correlations and increasing leverage. These features are interrelated and are directly related to the amount of capital dedicated to hedge fund strategies.

With more capital deployed in arbitrage and relative value strategies, continuous risk was more evenly distributed, volatility was dampened, volatility of volatility and correlations was also dampened, credit spreads converged, other arbitrage and relative value spreads also converged. The only way to maintain return on equity was to increase the level of leverage, a practice eminently feasible in an environment of cheap credit. Return on capital at risk, however, compressed to unsustainably low levels.

Such periods of calm accumulate imbalances for discontinuities. It would seem that a protracted reduction in continuous risk results in an accumulation of gap risk. In 2008, that gap risk was crystallized resulting in a discontinuous reduction in systemic leverage and thus capital employed  in arbitrage and a concomitant system wide widening of arbitrage and relative value spreads.

This is one of the more plausible explanations for why, in an economy clearly in decline, with recovery highly uncertain and non-robust, with differing opinions and outlook for financial markets, arbitrageurs are optimistic about their profit generation potential across almost all, if not all, hedge fund strategies.

Arbitrageurs will be required once again to police arbitrage and relative value spreads to bring convergence to no-arbitrage pricing, to bring relative value valuations in line and to aid in the efficient allocation of capital. In a sense, and to a certain extent, the real economy is reliant on the arbitrageur in the healing process, and therefore, one factor for the rate of recovery, or repair, of the real economy, will be the rate at which capital is redeployed to take advantage of mispricings and other arbitrage opportunities.

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Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

Advisors Tell SEC to Rethink Proposed Custody Rule

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Overwhelming Majority of Investment Advisors Disagree with Proposed Changes to Custody Rule

In an effort to deter fraudulent activity, the SEC has proposed to amend Rule 206(4)-2, also known as the ‘custody rule’, to require that all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets. According to this proposal, there would be no exception to the annual surprise inspection requirement for advisors who possess custody of client funds solely because they withdraw funds from client accounts for payment of a client’s fees. Of the 20 responses submitted to the SEC by investment advisors and related industry professionals, 2 respondents supported the proposal and 18 respondents were opposed. Several  of the respondents on both sides of the issue concede that, for those cases where a registered investment advisor does not use a qualified independent custodian, the proposed legislation offers a necessary higher level of scrutiny and oversight.

Respondent Rosamond R. Dewart, retired federal employee, states:

 ” I would support the proposed rule if […] it could accomplish the intent of the rule. Investment  advisers certainly need more scrutiny. I have lost confidence in the entire financial sector.”

However, the majority of respondents argue that the surprise examination requirement will grossly and negatively impact small-to-medium advisers who fall who only possess ‘custody’ of client accounts as described above. 

Carolyn Santo, a CFP from Hawaii, asserts in her response:

 “The proposed changes to the SEC rules involving making investment advisors pay for surprise  audits on themselves is a classic example of an unwieldy and clumsy attempt to protect the  investing public from a super micro-minority in the world of white collar crime.”

Those opposed to the proposed changes argue that, due to a number of recent enforcement actions against investment advisors alleging fraudulent conduct , many regulators and politicians assume that the ability to withdraw fees from a client account gives investment advisors complete control of the cash inside the account. Many assert that this assumption is simply not true, and additionally point out that the costs assumed for the surprise audit may be unrealistic and unfair to small-to-medium advisors, forcing some advisors to pass these costs along to client investors.

Peter J. Chepucavage, General Counsel of Plexus Consluting LLC, states:

 ” We think the added cost is disproportionate to the added compensation, a fact often present  in one size fits all regulation.”

Another respondent, John M. Smartt, Jr., CPA, adds:

 ” The additional proposed regulation, annual audit, is a significantly higher cost without  significant benefits. An estimated $8,100 audit charge would cost me more than 10% of my  current gross income (as a Tennessee RIA)”.

Some opposed to the new regulation have offered some constructive suggestions as to compliance alternatives that the SEC ought to consider:

  • Changing the definition of “custody” for accounts held at regulated third party custodians such as brokerage firms and/or trust companies
  • Increasing public knowledge by disseminating information about the entire industry
  • Increasing investigation of Red Flag situations (i.e. large withdrawals and lavish spending)
  • Establishing a substantial reward for information leading to the discovery of a financial scam
  • Requiring a higher level of disclosure of the independent custodian to the client when cumulative withdrawals are greater than an established percent of the account’s value for the prior quarter.

With regards to the suggestion for greater disclosure, Warren Mackensen, founder of Mackensen & Company, Inc., strongly encourages the SEC to implement the following additional four (4) client protection controls for advisers who debit fees from client accounts to avoid unnecessary an costly annual surprise examinations by a CPA firm:

  • Requiring custodians to limit fee deductions to, say, 2%, which would provide sufficient investor protection that the adviser is not absconding with client assets
  • Requiring at least quarterly statements directly from the qualified custodian (our clients receive monthly statements)
  • Requiring the custodians to send statements in any month in which a client fee was deducted (more immediate notice to the clients if statements are otherwise quarterly); and
  • Requiring the investment adviser to send an invoice showing the fee calculation directly to the client so that the client may compare the fee computation with his/her monthly statement showing the debited fee.

Others opposed to the proposed changes have noted the following additional points with regards to client protections already in place when an adviser uses a qualified custodian:

  • The third party custodian already acts as a gatekeeper to the advisors ability to pull funds from client accounts, making it virtually impossible for a an advisor using a major third party custodian, such as Charles Schwab, TD Ameritrade, Fidelity, etc.) to ‘drain the account’ through fees, as they will not process withdrawals that exceed a certain percentage per year. 
  • Any advisor who is able to deduct fees from client accounts needs written authorization to make payments to anyone other than the client, adding an extra layer of protection for the client.

Overall, it appears that the overwhelming response to the proposed legislation indicates that the majority of investment advisors would prefer that the SEC adopt less costly and less time-consuming compliance alternatives  to maximize investor protection.  With regards to the anticipated effectiveness of the proposed legislation, Carolyn Santo writes,

 ” The wrongful taking of client assets is a criminal act, and increasing the regulatory burden on  the entire industry is not going to lessen the fact that a small number of people are dishonest  and will steal from clients.”

To view all comments submitted to the SEC regarding the proposed amendments to Rule 206(4)-2, including discussions from the above-cited respondents, please visit:
http://www.sec.gov/comments/s7-09-09/s70909.shtml

New Initiative to Assist in the Sale of Devalued Loans and Securities: Public Private Investment Program

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Public Private Investment Program and its Regulatory Measures

In a statement set forth on May 20th, 2009 before the Senate Banking Committee, Timothy F. Geithner, U.S. Secretary of the Treasury, discusses the rehabilitative financial programs and regulatory measures proposed by Congress in response to the nation’s financial upheaval and economic uncertainty.  These initiatives are introduced as a follow-up to the Emergency Economic Stabilization Act (EESA), passed by Congress in October of 2008 with the specific goal of stabilizing the nation’s financial system and preventing catastrophic collapse.  One such initiative designed to assist in the sale of devalued loans and securities is the Public Private Investment Program (PPIP).

The PPIP is designed as part of an overall strategy to resolve the crisis as quickly as possible with the least cost to the taxpayer. As asset prices have been pushed to extremely low levels, obtaining private financing on reasonable terms to purchase these assets has become increasingly difficult, further reducing the ability of financial institutions to provide new credit. The resulting uncertainty about the value of these assets has also constrained the ability of financial institutions to raise private capital.  The PPIP is intended to restart the market for those assets lost in the course of deleveraging, while restoring bank balance sheets as these devalued loans and securities are sold.  Using $75 to $100 billion in capital from EESA and capital from private investors – as well as funding enabled by the Federal Reserve and FDIC – PPIP will generate $500 billion in purchasing power to buy legacy assets, with the potential to expand to $1 trillion over time. By providing a market for these assets, PPIP will help improve asset values, increase lending capacity for banks, and reduce uncertainty about the scale of losses on bank balance sheets – making it easier for banks to raise private capital and replace the capital investments made by Treasury.

PPIP will follow three basic principles in its strategy:

  1. Making the most of taxpayer dollars:  Maximize utility of taxpayer resources under the Emergency Economic Stabilization Act (EESA) by partnering with the FDIC, the Federal Reserve, and private sector investors
  2. Sharking risk with the private sector:  Ensure that private sector participants invest alongside the government, with the private sector investors standing to lose money in a downside scenario and the taxpayer sharing in profitable returns
  3. Taking advantage of private sector competition to set prices for currently illiquid assets:  Use competing private sector investors to engage in price discovery, reducing the likelihood that the government will overpay for these assets

The PPIP will have two major components – securities and loans. The Legacy Securities program will target commercial mortgage-backed securities and residential mortgage-backed securities, and the Legacy Loans Program is designed to attract private capital to purchase eligible legacy loans and other assets from participating banks through the availability of FDIC debt guarantees and Treasury equity co-investments.  The terms of funding provided for both parts of the PPIP, including fees, will be set in a way that is designed to limit the risks faced by U.C. taxpayers while still meeting the objective of generating new demand for legacy assets.  In addition, those participating in the program will be subject to a significant degree of oversight to ensure that their actions are consistent with the objectives of the program. The U.S. Secretary of the Treasury expects the PPIP to begin operating over the next six weeks.

In response to the heightened systemic risk experienced by the securities markets due to rapid growth of the largest financial institutions, a more conservative regulatory regime is also being proposed to govern the sale of loans and securities. In addition to addressing the potential insolvency of individual financial institutions, the new regulatory measures are designed to ensure the stability and consistency of the system itself. The new comprehensive reforms will offer the following improvements:

  • Meaningful & simply stated disclosures that actual consumers and investors can understand
  • Clear , reasonable, and appropriate financial choices offered to consumer
  • Clear accountability, authority, and resources for protecting consumers and investors
  • Global consistency with U.S. standards for financial regulation
  • Material improvements to prudential supervision, tax compliance, and restrictions on money laundering in weakly-regulated jurisdictions
  • Resolution authority that would grant additional tools to avoid the disorderly liquidation of the largest (systemically significant) financial institutions

Geithner concludes his discussion by stating that the central obligation of the U.S. Treasury is to ensure that the economy is able to recover as quickly as possible. To achieve this recovery, the Treasury commits to restore 1) a stable financial system that is able to provide the credit necessary for economic recovery, 2) the strict observance of comprehensive regulatory reforms that deter fraud and abuse while rewarding innovation and performance.