Apr 25, 2023 By: Matt Anderson Interest Income Is Back Over the course of the last decade, regulated firms have had to navigate an economic landscape characterized by near-zero interest rates. This period is now firmly behind us. As of the date of this article the Federal Reserve Funds Rate is 4.83%. The shift from near zero interest rates to 4.83% rates holds important implications for a wide range of economic activities including trading in Commodity Futures Trading Commission (“CFTC”) and National Futures Association (“NFA”) regulated products. This is an area that Turnkey believes is currently being overlooked by regulators, Commodity Trading Advisors (“CTA”), and managed futures investors. Collecting yield on cash deposits at a Futures Commission Merchant (“FCM”) or through the purchase of treasury instruments accessible in futures trading accounts is already starting to generate a meaningful return. Interest and Trading Performance In the not-so-distant past it was relatively common for FCMs to pay customers interest on cash deposits. It was also common to see CTAs use treasury instruments, available for purchase via traditional futures trading accounts for cash management purposes, to maximize earnings on excess margin. These practices largely ended as rates approached zero. During the “old days” when meaningful interest could be generated in futures trading accounts, CTA’s were required to disclose to investors, how income generated from interest would be included in trading performance calculations. Similarly, CTAs were required to disclose whether or not an incentive fee would be due on gains generated from this interest income. Prior to 2007 and 2008 it was common to see this discussion played out within CTA disclosure documents and advisory agreements throughout the industry. That all changed once rates moved toward zero. Unintended Consequences After the financial crisis of 2007 and 2008 the Wall Street Reform Act or “Dodd Frank” was passed into law. This legislation was one of the largest and most comprehensive regulatory overhauls for the financial services industry in US history. The crisis itself, as well as Dodd Frank, increased compliance costs, awareness, and employment opportunities dramatically. Candidly, Turnkey itself was started during this era in an effort to help the commodities industry adjust to Dodd Frank’s sweeping changes. With interest rates collapsing, significant regulatory change on the horizon, and a large number of new “compliance professionals” on the scene interest rate disclosures largely fell by the way side. With no interest being paid, no material or meaningful passive income was available to be generated. In this environment trading results were little impacted by interest income, CTAs were not incentivized to apply cash management techniques, and notionally funded accounts entered their so-called heyday. The past decade has created an entire generation of traders, investors, and compliance professionals who have never dealt with passive interest income. How to Handle Interest Income There are two schools of thought about interest income: Interest income paid on cash deposits or treasury holdings for cash management purposes belong to the account holder. Interest income is passive and the trader had nothing to do with the gains. Since the trader had nothing to do with the gains they should not be entitled to an elevated rate of return on their trading results or incentive income on gains stemming from interest yield. Interest income paid on cash deposits or treasury holdings is the responsibility of the CTA managing the investors account. Without the CTA yield cannot be maximized and if the CTA believes cash on deposit or treasury holdings are the best way to generate income then so be it. The investor has the ability to exit the CTA strategy at any time if they are unhappy with the results and the interest income included in the trading results is a component of the overall strategy outcome. The trader therefore should be able to claim the returns from interest income as well as compensation in the form of an incentive fee on that income. Turnkey does not take a few on which school of thought is correct. It has been our experience that either approach is fine. What is critical however is that the CTA and the investor properly agree to which path will be taken. As noted above CTAs should include this discussion within disclosure documents and advisory agreements. How interest income will be handled for both performance and incentive fee calculations is critical to avoiding disagreements. Disclosure of Interest Income and Fees With interest rates back above zero, it is imperative that all CTA’s revisit their disclosure document and advisory agreement. These documents must accurately reflect the changing interest rate environment. Turnkey has already observed several CTA’s attempting to claim interest income without having the proper documentation enabling them to do so. Failure to reconsider rate of return and fee calculation language within customer disclosures and agreements may result in non-compliance with industry regulations, accounting best practice standards, and result in a lack of transparency for clients resulting in complaints or worse litigation. How income from interest is considered within a trading strategy must be clearly articulated in 2023. While it may not have been something that was discussed over the past decade, it is something that is bound to come up at some point in the near future. Turnkey strongly recommends that all CTAs promptly review and update their disclosure documents to ensure that they are up-to-date. Any changes must be disclosed to customers in advance of implementation and should be filed with NFA as applicable. Conclusion If you require assistance in evaluating a disclosure document, advisory agreement, or performance calculation and fee language contact Turnkey today. Our team of compliance and accounting professionals is well versed in this area. We have a great deal of experience that we’d be happy to share with you to ensure you do things the correct way. If you need assistance in this area please feel free to contact us today to see how we might be able to help.