Recently, there seems to be a substantial uptick in manager demand to launch hedge funds that primarily invest in off-exchange forex transactions with retail customers (such transactions, “Retail Forex”). Retail Forex differs from traditional exchange-traded foreign currency futures (e.g., CME Swiss Franc or Japanese Yen futures) in that the trading does not take place on an “organized exchange” (such as the CME, CBOT or other board of trade), but rather occurs on specialized electronic venues that are registered as a futures commission merchant (“FCM”) or a retail foreign exchange dealer (“RFED”).

Before launching a hedge fund that invests in Retail Forex, managers must be aware of the registration requirements imposed by the Commodity Futures Trading Commission (“CFTC”) as enforced by the National Futures Association (“NFA”). In most instances, a manager will need to register as a commodity pool operator (“CPO”) if it plans to trade Retail Forex. Cole-Frieman & Mallon LLP (“CFM”) has extensive experience assisting clients navigate this complex regulatory environment.

CFTC Jurisdiction and Registration Requirements

Following the 2008 Financial Crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) which amended the Commodity Exchange Act (“CEA”) to provide the CFTC with jurisdiction over Retail Forex. Specifically, Sections 2(c)(2)(B) and 2(c)(2)(C) of the CEA confer jurisdiction over any agreement, contract, or transaction in foreign currency:

• that is a future entered into with a person that is not an eligible contract participant (“ECP”) (i.e., a derivatives Retail Forex transaction); or
• offered to, or entered into with a person that is not an ECP on a leveraged or margined basis (i.e., a leveraged spot Retail Forex transaction).

A retail customer is any party to a Retail Forex trade who is not an ECP. ECPs generally include (i) individuals and entities with assets of more than $10 million and (ii) entities formed by a registered CPO with assets of more than $5 million. However, except as discussed below, a pooled investment vehicle does not qualify as an ECP with respect to Retail Forex unless all of its direct participants qualify as ECPs, even if the pool has assets in excess of the thresholds denoted above (the “Look-Through Rule”). Importantly, unless the manager is registered as a CPO, a non-ECP pool generally may not trade Retail Forex on an FCM or an RFED.

Therefore, a manager that trades in Retail Forex on behalf of a pooled investment vehicle must generally register with the NFA as a CPO and “Forex Firm.” This means that at least one principal and associated person of the manager must pass the Series 3 (National Commodities Future Exam) and Series 34 (Retail Off-Exchange Forex Exam) administered by FINRA.

Disclosure Document and Disclosure Obligations

Generally, absent any exemptive relief (discussed below), a registered CPO of a Retail Forex hedge fund must deliver an NFA-approved “Disclosure Document” (i.e., a PPM) to prospective investors by no later than the time it delivers a subscription agreement to such prospective investors. Importantly, the Disclosure Document must be filed with the NFA using the NFA’s Electronic Disclosure Document Filing System prior to its delivery to prospective investors. The Disclosure Document must include:

• general disclosures (e.g., risk factors [including Retail Forex-specific risk factors], general information about the CPO’s principal(s), and description of the investment program);
• performance disclosures (e.g., past performance of other pools/accounts, monthly rate of return of the pool, and
• fee disclosures (e.g., brokerage commissions, fees incurred to maintain open Retail Forex positions, and fees or costs included in the bid/ask spread).

Retail Forex pools must also include additional risk disclosures related to the potential insolvency of their counterparties, their status as a creditor in such insolvency, and the fact that they may receive lesser protections on their margin deposits versus exchange-traded futures.

Qualifying as an ECP, Exemptions from CPO Registration and Disclosure Relief

As may be evident, full CPO registration and Disclosure Document approval can be a long, resource-intensive journey; however, our process-oriented approach at CFM can help shorten lead times and preserve resources. Additionally, there are a number of potential exemptions we analyze for clients that may reduce certain disclosure obligations or eliminate the need to register as a CPO altogether.

Pools that Qualify as ECPs/De Minimis Exemption

Notwithstanding the Look-Through Rule mentioned above, a Retail Forex pool can qualify as an ECP if the pool:

• is not formed for the purpose of evading the CEA;
• has total assets exceeding $10 million; and
• is formed and operated (i) by a registered CPO or (ii) by a CPO who is exempt from registration pursuant to CFTC Rule 4.13(a)(3) (the “De Minimis Exemption”).

Assuming the assets test is met, and while not relieving the CPO registration requirement, clause (i) allows pools in which not all participants are themselves ECPs to engage in Retail Forex. Clause (ii) provides a similar result (the pool can trade Retail Forex), but is particularly helpful for managers that only trade a de minimis amount (perhaps as a minor element of the pool’s overall investment program) since the manager would not have to register as a CPO. Among other requirements, the De Minimis Exemption requires that:

• the pool at all times meets one of the following tests:
  • the aggregate initial margin required to establish commodity interest positions (including Retail Forex) does not exceed 5% of the liquidation value of the pool’s portfolio; or
  • the aggregate net notional value of the pool’s commodity interest positions does not exceed 100% of the liquidation value of the pool’s portfolio; and
• the exempt CPO makes the required notice filing with the NFA.

Actual Delivery

A leveraged spot Retail Forex transaction as described above does not constitute Retail Forex if it results in “actual delivery” (i.e., a physical exchange of one currency for another) within two days. In such situations, there is no CPO registration requirement assuming all such leveraged transactions fulfill the actual delivery requirement.

CFTC Rule 4.13(a)(2)

CFTC Rule 4.13(a)(2) provides an exemption from CPO registration for managers that:

• only operate pools with 15 or fewer participants at any time; and
• the total gross capital contributions such pools receive do not in the aggregate exceed $400,000.

Notably, contributions by the principals and certain of their family members do not count toward the $400,000 limit. This exemption may be particularly useful for managers intending to operate a Retail Forex incubator fund.

CFTC Rule 4.7

CFTC Rule 4.7 exemptive relief is available to pools whose participants all meet the higher qualified eligible persons (“QEPs”) standard (generally, (i) an accredited investor with a $2 million investment portfolio or (ii) a qualified purchaser). Although the manager of such a pool must still fully register as a CPO, the upshot is that the Disclosure Document does not need to be reviewed and approved by the NFA and the pool obtains certain other disclosure, reporting, and recordkeeping relief. This partial exemptive relief could be beneficial for large Retail Forex pools with institutional investors that otherwise do not qualify for the De Minimis Exemption.

Conclusion

The Retail Forex regulatory landscape has become increasingly complex post-Dodd-Frank and managers wishing to pursue investment strategies in Retail Forex should map out a process early on to ensure their trading is CFTC/NFA compliant. CFM specializes in this process and helps both emerging and established managers alike register as CPOs, if necessary, and confidently launch funds that invest in Retail Forex.

Authored by Anthony Wise, Partner at Cole-Frieman & Mallon LLP