Last month Futures interviewed Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler shortly after the passage of the Dodd-Frank Act. Gensler spoke of the CFTC’s role in writing rules for the law and cooperating with other regulators to implement it. Since then, the agency already has completed some of its work -- rules for retail foreign exchange trading -- though most of the rules won’t be complete until next summer, a year after Dodd-Frank became law.
We wanted to look closer at how the law can affect different areas of the futures industry and chose experts to examine what the law will mean to these key sectors.
How financial reform will affect managed money
By David Matteson
Inasmuch as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) represents a wholesale revision to the regulation of financial services in the United States, it follows that the managed money sector of financial services also will be greatly affected. The scope of the changes will be significantly influenced by the rules to be adopted by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Because most of those rules have not been proposed, much less adopted, we are left to speculate as to what 2011 and beyond will mean for alternative investment products. Here are the implications for private funds and their advisors:
Removal of de minimus
The Act removes the most common exemption from the investment adviser registration requirement for advisers to private funds under the Investment Advisers Act of 1940, as amended (“Advisers Act”). The de minimus exemption applies to an adviser with fewer than 15 clients in any 12-month period that does not hold itself out generally to the public as an investment adviser. This exemption is commonly relied on by private fund managers advising fewer than 15 funds because each fund is generally treated as a single client of the manager without regard to the number of underlying investors in the fund under Rule 203(b)(3)-1 of the Advisers Act. A private fund is defined in Section 402 as any pooled investment vehicle that would be an investment company under the Investment Company Act of 1940, as amended (the “1940 Act”) but for sections 3(c)(1) or 3(c)(7) thereof.
Implications: Every alternative manager that manages some type of securities that had relied on the de minimus exemption from registration with the SEC as an investment adviser will have to find another exemption or register.
New exemptions for advisers with less than $150 million
Section 408 creates a new exemption from registration for advisers to private funds with total assets under management in the United States of less than $150 million. These advisers are subject to such recordkeeping and reporting rules that the SEC determines.
Such advisers may have to register under one or more state laws. Section 408 provides that the SEC must consider the systemic risk posed by mid-sized private funds when prescribing registration and examination procedures for advisers to those funds. The Act does not define “mid-sized private funds” but, presumably, they are smaller private funds whose advisers are not eligible for the $150 million exemption.
Section 410 of the Act maintains the minimum amount of assets under management for registration with the SEC at $25 million. However, it provides that investment advisers with between $25 million and $100 million in assets under management may not register with the SEC, unless the adviser otherwise would be required to register with 15 or more states. The SEC may increase the $100 million threshold by rule.
Implications: The threshold for hedge fund managers to register with the SEC has changed from “counting the clients” to “counting the AUM.” The good news is that hedge fund managers with less than $150 million under management will be exempt from SEC registration. Earlier versions of the legislation had placed that threshold as low as $30 million or $50 million. The bad news is that advisors that are exempt from federal registration likely will have to register in one or more states where the adviser and clients are located. This may involve multiple state registration processes and rules that are not uniform.
New exemptions for family offices and venture capital
The Act changes the definition of investment adviser to exclude family offices (Section 409) and add exclusions from registration for advisers to venture capital funds (Section 407). The Act directs the SEC to define “venture capital fund” within one year of enactment. Venture capital fund advisers relying on the exemption are subject to such recordkeeping and reporting rules as the SEC determines are necessary or appropriate in the public interest and for the protection of investors. There are no recordkeeping or reporting obligations for family offices.
Implications: Private equity funds did not get the “pass” that family offices and venture capital advisers received. The definition of family office to be adopted by the SEC will be critical in determining the breadth of this exemption. Many family offices render services to non-family clients and operate in a quasi-commercial capacity and may not be able to qualify as a family office.
Recordkeeping and reporting requirements
In addition to the existing regulatory and reporting obligations of registered investment advisers, Section 406 requires registered investment advisers of private funds to provide the SEC and a newly created Financial Stability Oversight Counsel (FSOC) with additional information about each private fund they manage. The Act also directs the SEC to conduct periodic inspections of all records of private funds managed by registered investment advisers. These records will generally be treated as confidential and not subject to public disclosure. The records must include a description of: 1) assets under management and use of leverage; 2) counterparty credit risk exposure; 3) trading and investment positions; 4) valuation methodologies; 5) types of assets held; 6) side agreements or side letters; 7) trading practices; and 8) such other information as the SEC, in consultation with the FSOC, deems necessary and appropriate in the public’s interest and for the protection of investors or for the assessment of systemic risk.
Implications: Most of the discussion in the popular press during the Dodd-Frank deliberations related to the new registration requirements. In fact, the process of getting registered as an investment adviser with the SEC is simple and straightforward. The difficult and more costly aspects of registration are the compliance programs that are required and the ongoing reporting obligations.
David Matteson is a partner with Drinker Biddle & Reath LLP and heads their managed futures practice.
The impact on introducing brokers and retail traders
By Karen K. Wuertz
Faced with the daunting task of reading and analyzing the 2,315 pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), an individual may not notice some of the less-publicized aspects of the legislation, especially pertaining to introducing brokers (IBs) and retail over-the-counter (OTC) forex traders. However, that doesn’t diminish the impact certain provisions of the Dodd-Frank Act will have on these groups.
For example, Section 732 of the Dodd-Frank Act requires futures commission merchants (FCMs) and IBs to implement conflicts-of-interest systems and procedures to ensure that any person within the firm relating to “research or analyses of the price or market” are separated by appropriate informational partitions within the firm from the review, pressure, or oversight of persons whose involvement in trading or clearing activities might potentially bias the judgment or supervision of the persons.
The CFTC has not yet written any rules with respect to Section 732, and, because of the broad nature of the Act’s language, the challenge to the CFTC will be to develop a rule that satisfies the Act’s requirements while not imposing unworkable standards. These new systems and procedures could be particularly burdensome to smaller IBs with limited resources.
The Dodd-Frank Act also contains several provisions that become effective in mid-2011, which close certain regulatory gaps in the retail forex area. First, with regard to Zelener contract forex products or “rolling spot,” the May 2008 Farm Bill ensured that the CFTC has antifraud authority over these Zelener forex transactions, but the dealers that offer these contracts are not required to be one of the enumerated counterparties outlined in the Act and, therefore, retail customers of these firms do not get all of the regulatory protections they need (see Zelener).
The Dodd-Frank Act closes this gap by requiring a person acting as a counterparty to forex Zelener contracts to be registered as an FCM. Presumably, the CFTC also could allow this person to register as a retail foreign exchange dealer. The Act also amends the definition of commodity pool operator (CPO), commodity trading advisor (CTA) and IB to include a registration requirement for other intermediaries that may engage in activity relating to forex Zelener contracts. The legislation goes even further in regard to non-forex Zelener contracts. The Act prohibits retail trading in Zelener-type futures look-alike products other than forex unless the transactions are done on-exchange. Therefore, with certain exceptions, firms will be prohibited from offering these types of contracts to the retail public unless the contracts are traded on-exchange.
A second regulatory gap closed by the Dodd-Frank Act relates to the list of the types of otherwise regulated entities that can act as counterparties to retail customers in off-exchange forex futures. The list currently includes banks, insurance companies, investment bank holding companies, FCMs, broker-dealers and “financial institutions.” Financial institutions are defined to include a range of highly regulated types of businesses, including, for example, federal or state credit unions and depository institutions covered by the Federal Deposit Insurance Corporation (FDIC). The definition of “financial institution” also includes “foreign banks” as defined in the International Banking Act of 1973, which covers any institution in any foreign country that engages in activities usually associated with banking in that particular jurisdiction.
The “foreign bank” exemption has become an increasingly popular means for forex counterparties to circumvent U.S. regulatory requirements designed to protect retail customers. The Dodd-Frank Act addresses this circumvention by providing that a financial institution only qualifies as an enumerated counterparty if it is a United States financial institution. This could dramatically impact U.S. retail customers who currently trade forex with entities located outside the U.S. When this provision becomes effective in mid-2011, it may be illegal for non-U.S. financial institutions to offer retail forex trading to U.S. customers. The Act also eliminates insurance companies and investment bank holding companies from the list of enumerated counterparties.
Even U.S. customers trading OTC retail forex through a U.S. bank or broker-dealer could be affected by the Dodd-Frank Act. Section 742 of the Act provides that if the otherwise regulated “enumerated counterparty” to retail forex OTC transactions (i.e. FCMs, broker-dealers, U.S. financial institutions) has a federal regulatory agency, the agency must issue rules governing OTC retail forex transactions by mid-2011. If the Federal regulatory agency does not issue forex rules, then the counterparty may be prohibited from entering into those OTC retail forex futures transactions.To date, the CFTC is the only federal regulatory agency to issue rules for retail forex, which become effective October 18, 2010. Therefore, unless other federal regulatory agencies act, the impact of this language could be that only FCMs could engage in OTC retail forex futures transactions after mid-2011. At this time, non-FCM counterparties whose federal regulators do not meet Section 742’s requirements could still engage in this activity by registering an affiliate as an FCM subject to the CFTC’s rules.
Although it may be too early to determine accurately the ultimate impact of the Dodd-Frank Act on IBs and retail traders, it’s safe to say the regulatory landscape has definitely changed.
The Commodity Futures Modernization Act of 2000 sought to (among other things) clarify the CFTC’s authority over retail foreign exchange trading. However, a District court ruled in the CFTC v. Zelener -- and the Seventh Circuit Court confirmed in 2004 -- that the CFTC did not have authority over certain retail forex trading because the contracts in question were not futures but “rolling spot” contracts and the CFTC authority was only for futures. The CFTC Reauthorization Act of 2008 closed the Zelener loophole and Dodd-Frank requires any entity offering retail forex trading to belong to a Federal regulator, which must have written rules by a specific date.
Karen K. Wuertz is senior vice president, strategic planning and communications at the National Futures Association.
Dodd-Frank: Game changer for futures brokers
By Gary DeWaal
The recently passed Wall Street Reform and Consumer Protection Act is a potential game changer for futures commission merchants (FCMs). But navigating a response to it is probably as treacherous as charting a course through the famous Strait of Messina between the legendary monsters Scylla and Charybdis: one bad maneuver and an exciting opportunity could easily turn into a costly mistake.
Let there be no mistake: centrally cleared over-the-counter (OTC) swaps processed through FCMs for ultimate customers are nothing new. Since May 31, 2002, the New York Mercantile Exchange (now part of CME Group) has been clearing energy OTC products on its Clearport platform. Currently 500,000 OTC agricultural, credit, energy, green and metals contracts of all types are cleared through Clearport daily, and other OTC commodity contracts are cleared through platforms offered by ICE Europe and SGX Asia Clear. Likewise, interest rate swaps have already begun clearing through the International Derivatives Clearinghouse as well as the CME, in the latter case in connection with trades initially executed through the new ERIS platform.
These facilities all share one important characteristic: they are open clearing systems where end users can access important OTC products that are ultimately carried at robust clearinghouses, and intermediated by FCMs.
The new legislation in the United States and similar regulation proposed by the European Commission to be overseen by the new European Securities and Market Association -- by mandating the central clearing and execution of most OTC swaps -- could increase by large multiples the amount of contracts available to FCMs to both intermediate on behalf of their customers as executing broker, but also to carry as clearing broker. This is the theoretically good news, but this theoretical good news is enveloped in many difficulties.
Efficiency means that somebody’s margin will be cut
First of all, change isn’t always easy and there is a need for some cultural change for dealers. They may very well not want to give up the large bid-ask spreads they have been deriving over the years in the sale of swaps bilaterally to ultimate clients. Instead, they may be tempted to delay and complicate implementation of the reform legislation. Moreover, dealers and their lobbying partners will try to convince regulators that only dealers can possibly offer cleared swaps to end users. They will propose standards to exclude brokers as much as possible, along the lines of the current LCH Swap Clear and ICE Trust models. Regulators must be mindful that this is nothing more than a plea for “business as usual” and resist efforts at closed clearing and execution platforms.
Operating profitably under the new rules
Secondly, even presuming regulators will encourage open clearing and execution systems, FCMs must figure out how to conduct this business profitably. This will be far more difficult than it seems. Why? First, there will be many new exchanges and swap execution facilities, not to mention clearing houses, likely to be created to offer these new products as well as the existing platforms. The costs of connectivity by FCMs will be very high with the likelihood that only a few of these facilities will be successful. This is in addition to the incremental costs FCMs will likely incur that are associated with new processing and risk systems necessary to accommodate this OTC business, as well as salaries for additional trained staff.
Moreover, the cost of capital in carrying OTC positions for customers will likely be higher than carrying futures positions, because even if capital requirements are at the same level as for futures (8% of margin requirements), swap positions typically have longer durations than futures positions and therefore, are likely to be held, in most cases, for a longer period of time.
Accounting for errors
Finally, errors will occur and FCMs need to accrue (either in practice or in theory) for the possibility of defaults by some of their own clients, let alone those of other clearing members for which they will be responsible potentially through the default mechanism of clearing houses.
The question is how will customers be willing to pay for all these costs? Certainly, the old model of charging customers a one shot prenegotiated flat charge at the initiation or close out of their position will have to be reevaluated, particularly in today’s near zero interest rate environment. Charges will probably have to include a component reflecting the length of time a position is carried. Customers should be willing to pay this enhanced charge because of the diminishment of the bid ask spread on OTC products that is likely to come about because of central execution. But while this might be accepted when these new products launch, institutional memories are short and competition will surely drive down commissions over the long term.
FCMs will have to carefully develop their business plans to accommodate this potentially large amount of new business. The potential new volumes are alluring, but the costs will also be quite high. FCMs will have to be selective in choosing which exchanges, SEFs and clearinghouses they support. Because if they choose the wrong ones, they could be at risk of not just wasting resources, but also of losing potential clients. This all might cause some interesting joint ventures to develop among today’s competitors as well as a further swell of consolidations.
Thus, FCMs must be clever like the legendary sailor Jason, who along with his Argonauts was able to successfully navigate Scylla and Charybdis. It certainly is possible, but there is no doubt that there are high risks as well!
Gary DeWaal is senior managing director and group general counsel for Newedge.
Implications for Trading Over-the-Counter Derivatives
By David Matteson
Title VII of the Dodd-Frank Act provides for comprehensive regulation of over-the-counter (OTC) derivatives by the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC). The exemptions from the Federal securities and commodities laws for OTC derivatives are eliminated and replaced with a system that gives the SEC regulatory authority over security-based swaps (SB swaps) and gives the CFTC regulatory authority over all other swaps. Participants in both the swap and SB swap markets will be regulated by both the CFTC and SEC.
The regulatory program will require most OTC derivatives to be traded on an exchange or swap execution facility (SEF) and cleared through a clearing agency or other organization. It will also require most participants and firms engaged in trading such derivatives to register as swap market participants, satisfy capital requirements and report all derivatives activities to either the CFTC or SEC.
Non-financial entities that engage in swaps or SB swaps to reduce the commercial risks of their businesses will not be required (but may if they wish) to have their swaps and SB swaps traded on an exchange or other trading facility and cleared through a designated clearing organization. This so-called “end user” exemption recognizes the commercial hedging benefits arising out of customized OTC derivatives entered into by non-financial companies.
The CFTC and SEC will consult with each other and other regulators before either commences any rulemaking with regard to swaps, SB swaps and other related defined terms in Title VII. After consulting with each other and other regulators, the CFTC and SEC will issue its own rules, regulations or orders within 360 days after the date of enactment of Title VII. In addition, the CFTC and the SEC are required to treat functionally or economically similar products or entities in a similar manner and issue joint regulations for mixed swaps.
Implications: The Act creates a grand plan for regulation of the OTC derivatives market, a multi-trillion dollar industry that previously had been largely unregulated and certainly unregistered. In less than one year, the CFTC and SEC are directed to propose and adopt volumes of rules, definitions and studies regarding swaps. These two agencies have a history of sporadic cooperation and frequent disagreements. There are significant commercial interests that are competing as well, and they can be expected to lobby their primary agency to write the rules favorably to them. While each of the CFTC and SEC has a very capable and experienced leader, the political and commercial pressures will be significant, in an already difficult and brand new area for regulation.
Swaps versus SB Swaps and Other Definitions
Title VII defines swap broadly enough to capture nearly all OTC derivatives other than SB swaps. SB swaps are swaps based on a narrow-based index, single security or loan, or the occurrence or nonoccurrence of an event relating to a single insurer. Other main defined terms are as follows:
- Major Swap/SB swap participant – any swap/SB swap dealer which maintains a substantial position in swaps/SB swaps for any of the major swap/SB swap categories and whose outstanding swaps/SB swaps create substantial counterparty exposure that could have serious adverse effects on the U.S. financial stability or banking system.
- Financial Entities – a broad category of major swap/SB swap participants. These are entities not subject to Federal bank capital requirements with significant leverage or swap/SB swap positions, such as state banks, credit unions, mortgage lenders, insurance companies, hedge funds, commodity pools, ERISA plans and advisors to such entities.
- Substantial position – the CFTC and SEC shall define by rule or regulation the threshold of “substantial position.”
- Swap/SB swap dealer – holds itself out as a dealer in swap/SB swaps; makes a market in swaps/SB swaps; regularly enters in swap/SB swaps with counterparties in the ordinary course of business; or engages in any activity causing it to be commonly known in the trade as a dealer.
- Regulated swap/SB swap entity – is a swap/SB swap dealer or a major swap/SB swap participant.
- Swap/SB swap execution facilities – a trading system or platform in which multiple participants have the ability to execute or trade swaps/SB swaps by accepting bids and offers.
- Swap/SB swap data repository – any business that collects and maintains information or records with respect to transactions or positions in swaps/SB swaps entered into by third parties for the purpose of providing a centralized recordkeeping facility for swaps/SB swaps.
Implications: The CFTC and SEC will have to define what it means to have a substantial position in swaps. If they set the standard too low, they will be overwhelmed with a population of new swap registrants that could impede their efforts to regulate the marketplace. If they set it too high, they won’t have the information and oversight to properly protect the markets from further systemic risk and provide the necessary market oversight.
Regulation of the Swaps/SB Swaps Markets
Title VII provides that central clearinghouses will clear swaps/SB swaps. All swaps/SB swaps must be submitted to a central clearinghouse if a clearinghouse has been approved to clear that particular type of swap/SB swap.
Swaps will be cleared by derivative clearing organizations (DCOs) and SB swaps will be cleared by clearing agencies. The DCOs’ and clearing agencies’ rules must prescribe that all swaps/SB swaps submitted to the DCO or clearing agency with the same terms and conditions are economically equivalent within the DCO or clearing agency and may be offset with each other. The CFTC and SEC must review each swap/SB swap or type of swap/SB swap to make a determination that such swap/SB swap or type of swap/SB swap should be required to be cleared. A DCO or clearing agency must submit to the CFTC or SEC for prior approval the type of swap/SB swap the clearing agency seeks to accept for clearing. The CFTC and SEC must establish rules within one year for a DCO’s or clearing agency’s submission for review of swaps/SB swaps or type of swaps/SB swaps.
The CFTC and SEC are required to take necessary actions if either determines swaps or SB swaps or any type of swap or SB swap should be subject to mandatory clearing but no clearing agency has listed the swap/SB swap. These actions may include imposing margin and/or capital requirements on the parties to such swap/SB swap.
Swaps/SB swaps entered into before the date of the enactment of the mandatory clearing requirement must be reported to a registered swap/SB swap data repository or the Commissions no later than 180 days after Title VII’s effective date. The mandatory clearing requirement will not apply until the CFTC or SEC has required clearing of the swap/SB swap and a DCO or clearing agency has been approved to clear the swap/SB swap.
Implications: The new law mandates greater exchange and clearinghouse transactions, which creates commercial opportunities. The CME and other significant market players are vying for the dominant position for trading and clearing swaps. They have the advantage over other new entrants since exchange traded and cleared swaps resemble the existing model for exchange traded futures. With the stakes as high as they are in terms of potential revenue streams for the exchange/clearing associations, we can expect an ongoing battle for market share.
Exceptions to Clearing and Exchange Trading Requirements.
Title VII includes an exemption from the exchange trading and mandatory central clearing requirements if one of the parties is an “end user.” An end user is a person who is: 1) not a “financial entity;” 2) using the swap/SB swap to hedge or mitigate commercial risk; and 3) notifies the applicable regulatory agency how it will meet its financial obligations under the swap or SB swap.
Implications: One of the many battles fought on the floor of Congress while the bills were in committee was the scope of the “end user” exemption. The commercial entities made a compelling case that their risk mitigation use of swaps and other derivatives were never the source of the excessive leverage or risk taking by Wall Street and other financial entities. However, if the exemption is too broadly defined, it could result in not enough exchange trading/clearing of swaps and defeat the purpose of removing counterparty risk from financial entities.
Registration and Regulation of Swap Dealers and Major Swap Participants
Swap/SB swap dealers and major swap/SB swap participants must also register with the CFTC and/or the SEC. The Commissions have broad authority to determine the substantive scope of regulation.
Swap/SB swap dealers and major swap/SB swap participants that are not banks must meet the capital and margin requirements that will be established by rule by the Commissions. Those entities that are banks must meet the capital and margin requirements established by the banks’ applicable regulator. The CFTC, SEC and bank regulators also must establish rules for reporting and recordkeeping of these entities.
Title VII further lists the duties of each registered swap/SB swap dealer and major swap/SB swap participant. These duties include monitoring trading and establishing risk management procedures (including conflicts of interest procedures) and designating a chief compliance officer. The CFTC and SEC will have the authority to censure and/or place limitations on the activities, functions or operations of any swap/SB swap participant registered with CFTC or SEC.
Implications: Dealers in securities have always been subject to regulation and capital requirements. Now, dealers in swaps will have to register as well. However, under the new law, even those entities that aren’t dealers, but those that simply engage in a significant amount of swap trading will have to register and satisfy capital requirements. The impact on hedge funds and other trading funds will depend on where the SEC and CFTC set the threshold for registering as a major swap participant.
The author would like to acknowledge the hard work of all of the attorneys in Drinker's Investment Management Group in preparing the summary of the financial reform legislation.