I just came across this speech by a former Acting Chairman of the CFTC. The speech discusses Commodity Pool Operators in the context of hedge funds. The original speech can be found here. Continue reading
As we announced earlier, the NFA promulgated rules which were approved by the CFTC which gave the NFA jurisdiction over retail off-exchange foreign exchange trading by its member firms. What this essentially means is that if:
(i) you are currently a NFA member (e.g. you have a commodity/ futures pool or direct commodity/ futures accounts) and
(ii) you trade forex in the pool or account, or have an outside pool or account devoted to forex trading,
then you will need to update your disclosure documents with the NFA. The disclosure documents will need to contain all of the information required for non-forex disclosure documents and the update must be completed by November 30. Please see NFA to Begin Regulating Forex. Continue reading
This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008. The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.
The following expert provides a good summary of the roles and duties of both the U.S. Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) with regard to hedge funds and their commodities trading activities. Specifically, the report describes the central ways that these groups regulate hedge funds, including the following:
Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.
One item to note is that this report was prepared in early 2008 so it does not include the subsequent jurisdictional grant to the CFTC to regulate spot forex. This grant was provided by the Farm Bill, passed by Congress in June of 2008 (please see CFTC announces retail forex fraud task force). Subsequent to passing the Farm Bill the CFTC began drafting regulations (yet to be formally proposed) to require the registration of forex managers. When the CFTC and the NFA eventually regulate the spot forex markets and require forex managers to be registered, it is likely that their duties will increase with regard to forex hedge fund managers, who are currently unregulated at the federal level.
With regard to future regulatory oversight of hedge funds by the CFTC and the NFA, there will probably not be greater mandates for registration. One thing that could be done is to take away the CPO exemptions, but this seems unlikely.
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CFTC Can Monitor Hedge Fund Activities through Its Market Surveillance, Regulatory Compliance Surveillance, and Delegated Examination Programs:
Although CFTC does not specifically target hedge funds, through its general market and financial supervisory activities, it can provide oversight of persons registered as CPOs and CTAs that operate or advise hedge funds that trade in the futures markets. As part of its market surveillance program, CFTC collects information on market participants, regardless of their registration status, to monitor their activities and trading practices. In particular, traders are required to report their futures and options positions when a CFTC-specified level is reached in a certain contract market and CFTC electronically collects these data through its Large Trader Reporting System (LTRS).[1] CFTC also uses the futures and options positions information reported by traders through the LTRS as part of its monitoring of the potential financial exposure of traders to clearing firms, and of clearing firms to derivatives clearing organizations. CFTC collects position information from exchanges, clearing members, futures commission merchants (FCM), and foreign brokers and other traders– including hedge funds–about firm and customer accounts in an attempt to detect and deter manipulation.[2] Customers, including hedge funds, are required to maintain margin on deposit with their FCMs to cover losses that might be incurred due to price changes. FCMs also are required to maintain CFTC-imposed minimum capital requirements in order to meet their financial obligations. Such financial safeguards are put in place to mitigate the potential spillover effect to the broader market resulting from the failure of a customer or of an FCM.
According to CFTC officials, the demise (due to trading losses related to natural gas derivatives) in the fall of 2006 of Amaranth Advisors, LLC (Amaranth), a $9 billion multistrategy hedge fund, had no impact on the integrity of the clearing system for CFTC-regulated futures and option contracts. The officials said that at all times Amaranth’s account at its clearing FCM was fully margined and the clearing FCM met all of its settlement obligations to its clearinghouse. They also said that the approximate $6 billion of losses suffered by Amaranth on regulated and unregulated exchanges did not affect its clearing FCM, the other customers of the clearing FCM, or the clearinghouse.[3]
CFTC investigates and, as necessary, prosecutes alleged violators of the Commodity Exchange Act (CEA) and CFTC regulations and may conduct such investigations in cooperation with federal, state, and foreign authorities. Enforcement referrals can come from several sources, including CFTC’s market surveillance group or tips. Remedies sought in enforcement actions generally include permanent injunctions, asset freezes, prohibitions on trading on CFTC-registered entities, disgorgement of ill-gotten gains, restitution to victims, revocation or suspension of registration, and civil monetary penalties. On the basis of CFTC enforcement data, from the beginning of fiscal year 2001 through May 1, 2007, CFTC brought 58 enforcement actions against CPOs and CTAs, including those affiliated with hedge funds, for various violations.[4] A summary of the violations cited in the actions includes misrepresentation with respect to assets under management or profitability; failure to register with CFTC; failure to make required disclosures, statement, or reports; misappropriation of participants’ funds; and violation of prior prohibitions (i.e., prior civil injunction or CFTC cease and desist order).
Pursuant to CFTC-delegated authority, NFA, a registered futures association under the CEA and a self-regulatory organization, oversees the activities, and conducts examinations, of registered CPOs and CTAs.[5] As such, hedge fund advisers registered as CPOs or CTAs are subject to direct oversight in connection with their trading in futures markets.[6] More specifically, to the extent that hedge fund operators or advisers trade futures or options on futures on behalf of hedge funds, the funds are commodity pools and the operators of, and advisers to, such funds are required to register as CPOs and CTAs, respectively, with CFTC and become members of NFA if they are not exempted from registration. Once registered, CPOs and CTAs become subject to detailed disclosure, periodic reporting and record-keeping requirements, and periodic on-site risk-based examinations. However, regardless of registration status, all CPOs and CTAs (including those affiliated with hedge funds) remain subject to CFTC’s anti-fraud and anti-manipulation authority.
Our review of NFA documentation found that 29 advisers of the largest 78 U.S. hedge funds (previously mentioned) are registered with CFTC as CPOs or CTAs. In addition, 20 of the 29 also are registered with SEC as investment advisers or broker-dealers. According to NFA officials, because there is no legal definition of hedge funds, it does not require CPOs or CTAs to identify themselves as hedge fund operators or advisers. NFA, therefore, considers all CPOs and CTAs as potential hedge fund operators or advisers. According to NFA, in fiscal year 2006 NFA examined 212 CPOs, including 6 of the 29 largest hedge fund advisers registered with NFA. During the examinations, NFA staff performed tests of books and records and other auditing procedures to provide reasonable assurance that the firm was complying with NFA rules and all account balances of a certain date were properly stated and classified. Our review of four of the examinations found that 3 of the CPOs examined generally were in compliance with NFA regulations and the remaining 1 was found to have certain employees that were not properly registered with CFTC. According to examination documentation, subsequent to the examination, the hedge fund provided a satisfactory written response to NFA noting that it would soon properly register the employees.
According to an NFA official, since 2003 NFA has taken 23 enforcement actions against CPOs and CTAs, many of which involved hedge funds. Some of the violations found included filing fraudulent financial statements with NFA, not providing timely financial statements to investors, failure to register with CFTC as a CPO, failure to maintain required books and records, use of misleading promotional materials, and failure to supervise staff. The penalties included barring CPOs and CTAs from NFA membership temporarily or permanently or imposing monetary fines ranging from $5,000 to $45,000.
[1] According to CFTC officials, the LTRS captures 70 to 90 percent of the daily activity on registered futures exchanges.
[2] FCMs are individuals, associations, partnerships, corporations, or trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract market or derivatives transaction execution facility; and in connection with such solicitation or acceptance of orders, accept money, securities, or property (or extend credit in lieu thereof) to margin, guarantee, or secure any trades or contracts that result or may result therefrom.
[3] In the CFTC complaint filed against Amaranth Advisors, LLC; Amaranth Advisors (Calgary), ULC, and Brian Hunter, CFTC alleged that the defendants attempted to manipulate the price of natural gas contracts on the New York Mercantile Exchange, Inc., in 2006. Complaint for Injunctive and Other Equitable Relief and Civil Monetary Penalties under the Commodity Exchange Act, CFTC v. Amaranth Advisors, LLC, No. 07-6682 (S.D.N.Y., July 25, 2007).
[4] Because “hedge fund” is not a defined term under the CEA or any other federal statute, CFTC and NFA records do not identify whether a commodity pool is a hedge fund. Thus, CFTC cannot report on the exact
number of examinations that involve hedge funds. In the event the CPO or CTA self-designates itself as a hedge fund, the Division of Enforcement typically incorporates that designation in the enforcement action, and that designation is often used in the press release notifying the public of the enforcement action.
[5] A registered CPO or CTA seeking to engage in futures business with the public or with any member of NFA must itself be a member of NFA.
[6] For the purpose of this report the term “hedge fund advisers” includes, as the context requires, CPOs, CTAs, or securities investment advisers.
Other HFLB articles include:
A common question for hedge fund managers which are registered as commodity pool operators is whether they also need to be registered as commodity trading advisors (CTA) with the NFA. The answer is generally no.
There is no need for a commodity-based hedge fund manager (i.e., CPO) to register as a CTA so long as the manager’s commodity trading advice is restricted solely to advising the pool it is running. This applies to BOTH CFTC/NFA Registered AND unregistered pool operators. However, if the CPO has clients outside of the pool which the CPO provides advice to regarding commodities, then the manager may need to be registered as a CTA.
Rule 4.14(a)(4) applies to those managers which are registered as CPOs with the NFA. Rule 4.14(a)(5) applies to those managers which are not registered (exempt) as CPOs. The full rules are below.
Rule 4.14(a)(4)
A person is not required to register under the Act as a commodity trading advisor if it is registered under the Act as a commodity pool operator and the person’s commodity trading advice is directed solely to, and for the sole use of, the pool or pools for which it is so registered.
Rule 4.14(a)(5)
A person is not required to register under the Act as a commodity trading advisor if it is exempt from registration as a commodity pool operator and the person’s commodity trading advice is directed solely to, and for the sole use of, the pool or pools for which it is so exempt.
Please contact us if you have any questions. Other HFLB articles related to this topic include:
Related HFLB articles:
Question: does my commodity/futures trading firm need to register as a CTA?
Answer: Generally Section 6m(1) of the Commodities Exchange Act (“CEA”) requires that any person (or firm) which falls within the definition of a CTA be registered as such. Section 6m(1) of the CEA states:
“It shall be unlawful for any commodity trading advisor or commodity pool operator, unless registered under this chapter, to make use of the mails or any means or instrumentality of interstate commerce in connection with his business as such commodity trading advisor or commodity pool operator”
The Commodities Exchange Act (“CEA”) specifically defines a Commodity Trading Adviser (“CTA”) as:
“any person who– (i) for compensation or profit, engages in the business of advising others, either directly or through publications, writings, or electronic media, as to the value of or the advisability of trading in– (I) any contract of sale of a commodity for future delivery made or to be made on or subject to the rules of a contract market or derivatives transaction execution facility; (II) any commodity option authorized under section 6c of [the CEA]; or (III) any leverage transaction authorized under section 23 of [the CEA]; or (ii) for compensation or profit, and as part of a regular business, issues or promulgates analyses or reports concerning any of the activities referred to in clause (i)”
Because the above definition is quite broad, Congress specifically excluded certain groups from the definition. These groups include:
I have previously discussed how to register as a CTA in the article titled How to register as a CPO or CTA.
Question: are there any exemptions from CTA registration?
Answer: Yes. Section 6m(1) of the CEA states:
That the [registration] provisions of this section shall not apply to any commodity trading advisor who, during the course of the preceding twelve months, has not furnished commodity trading advice to more than fifteen persons and who does not hold himself out generally to the public as a commodity trading advisor. [emphasis added]
To fall within the above exemption, both elements must be met. That is, the CTA must
The question then becomes what does “holding out” as a CTA entail?
The CFTC views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients. Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 6m(1).
The CFTC specifically gave such guidance in the following letter.
CFTC Letter No. 97-26
March 26, 1997
Division of Trading & Markets
Re: Section 4m(1): Exemption from CTA Registration
Dear [_______]:
This is in response to your letter dated January 29, 1997 to the Division of Trading and Markets (the “Division”) of the Commodity Futures Trading Commission (the “Commission”), whereby you inquire as to whether you may claim an exemption from registration as a commodity trading advisor (“CTA”) pursuant to Section 4m(1) [now 6m(1)] of the Commodity Exchange Act (the “Act”). *
Based on your letter, we understand the pertinent facts to be as follows. You intend to sell subscriptions to a fax service (the “Service”) entitled “A”, of which you are the sole designer. The Service will provide subscribers with buy and sell recommendations for Eurodollar futures and option contracts traded on “X”.
Section 4m(1) [now 6m(1)] of the Act generally requires that a person who provides commodity interest trading advice to the public must register as a CTA. Section 4m(1) does, however, provide an exemption from registration as a CTA for a person who satisfies two conditions: (1) during the course of the preceding twelve months, he has not furnished commodity trading advice to more than fifteen persons; and (2) he does not hold himself out generally to the public as a CTA. The Division views “holding oneself out as a CTA” to include such conduct as promoting advisory services through mailings, directory listings, and stationery, or otherwise initiating contact with prospective clients.** Thus, unless a CTA restricts his clients to family, friends, and existing business associates, a CTA generally will be viewed as holding himself out to the public as a CTA and would not be able to claim the exemption from registration in Section 4m(1) [now 6m(1)]. This is true whether or not the CTA is advising fifteen or fewer persons, since in order to qualify for the Section 4m(1) exemption, the CTA must satisfy both conditions. [Emphasis added]
Thus, if you plan to solicit clients other than immediate family members, friends, and business associates, you would be holding yourself out as a CTA and would be required to register as such prior to marketing the Service. You would also be required to comply with all other provisions of the Act and Commission’s regulations thereunder applicable to registered CTAs, including Section 4b and Section 4o,*** the antifraud provisions of the Act, Part 4 of the Commission’s regulations applicable to CTAs, and the reporting requirements for traders set forth in Parts 15, 18, and 19 of the Commission’s regulations.
The advice provided herein is based upon the representations that you have made to us. Any different, changed or omitted facts or conditions might require us to reach a different conclusion. In this connection, we request that you notify us immediately in the event your activities change in any way from those as represented to us.
If you have any questions concerning this correspondence, please feel free to contact me or Monica S. Amparo, an attorney on my staff, at (202) 418-5450.
Very truly yours,
Susan C. Ervin
Chief Counsel
* 7 U.S.C. §6m(1) (1994).
** Division of Trading and Markets Interpretative Letter 91-9, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,189 (Dec. 30, 1991). We have enclosed a copy of this letter for your reference.
*** 7 U.S.C. §§ 6b and 6o (1994).
Many hedge fund managers choose to utilize futures and/or commodities in their trading purposes. Generally such managers will need to register as commodity pool operators (“CPO”) and as commodity trading advisors (“CTA”). The hedge fund itself will be deemed to be a commodity pool. For purposes of the Commodities Exchange Act (“CEA”), a future and commodity are functionally equal as it relates to hedge fund manager registration. Registration as a CPO or a CTA is an often overlooked part of the hedge fund formation process. Your attorney should discuss the requirements for registration and whether any exemptions from registration are available.
In addition to hedge fund managers, retail foreign exchange (“Forex”) managers may very soon be required to register because of the recently passed “Farm Bill.” The retail Forex markets have been very loosely regulated and the CFTC and NFA have been clamoring for authority to regulate this are of the markets. Accordingly, this article will give you the basics on how to register as a CPO and/or a CTA.
A very general outline of the CPO registration process is as follows:
Prerequisite – the Series 3 exam
Each CPO or CTA firm will need to have at least one Associated Person (AP). Generally an AP will be anyone in the firm who has contact with clients in something more than a purely administrative or clerical role. All managers and non-clerical employees will be APs. All APs must have passed the Series 3 exam. Information on the Series 3 exam:
Like the Series 65 exam, I highly recommend you spend plenty of time studying for the exam. If you would like some suggestions on various study guides, please let me know.
Filing the application forms with the NFA
During this process your compliance professional will: gain access to the NFA’s registration system on your behalf, input certain basic information on the Form 7-R (for your CPO/CTA firm) and Form 8-R (for the initial AP) – generally you will provide this information to your compliance professional prior to completing these forms, and submit the 7-R and 8-R on your firms behalf.
After the Form 7-R and 8-R have been submitted you will need to pay for registration ($200 registration fee for the CPO or CTA; $85 for each associated person or principal; $750 for NFA membership (this is an annual fee)). After payment has been submitted, the NFA will review your application. Typically registration should be complete within about 3-5 weeks. The next step will be to have your disclosure document approved by the NFA – your compliance professional can help you with this process.
You will be able to check on your registration through the NFA’s BASIC system.
Definitions
According to the CFTC website, the definition of CPO and CTA are as follows:
Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so.
Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options.
Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant.