In late January 2014 the National Futures Association (“NFA”) announced to its membership they were:

“…reviewing the current regulatory structure applicable to Commodity Pool Operator (“CPO”) and Commodity Trading Advisor (“CTA”) operations. In particular, NFA is looking at ways to strengthen the regulatory structure governing CPO operations to provide greater protection for customer funds… [and] exploring ways to ensure that CPOs and CTAs have sufficient assets to operate as a going concern.” 

NFA then solicited input from its membership (now the general public) regarding the concept of imposing a capital requirement on its CPO and CTA members for the first time.  They also requested comments on a variety of other proposed customer protection measures.  To direct the comments NFA provided a list of questions covering a wide range of topics.  Over the past month Turnkey Trading Partners (“Turnkey”) has spent many hours talking to our clients and contemplating this proposal.  Based on our experience and research the following presents our perspective on the most important of these questions.

Basis for Opinion

Turnkey’s perspective and role within the commodity futures industry is unique and valuable.  Originally formed by a former NFA supervisor, the company was named by Hedgeweek as North America’s Best Regulatory Advisory Firm in 2013.  This award was won in part because of Turnkey’s breadth of service offerings to Commodity Futures Trading Commission (“CFTC”) registered, NFA member firms.  Since its inception Turnkey has assisted literally hundreds of people in establishing successful CTA and CPO operations.  This experience has allowed Turnkey to not only participate in the recent growth of the managed futures space, but to help guide it.  In particular, Turnkey has relationships with FCMs, IBs, CTAs, CPOs, private investors, and allocators all of whom deal on a day to day basis in the managed futures industry.  Turnkey is also regularly retained for consultation and/or expert witness support by law firms attempting to determine why registered firms have failed.

Is There Even A Problem?

While no one wants to see investors lose money, statistically there simply doesn’t appear to be a major problem in the CTA/CPO universe when it comes to misappropriations.  According to NFA’s representations, during the last three years, 24 (92% of 26 total) Member Responsibility Actions (“MRAs”) were taken against CPO and/or CTA Members.  Of these cases they cite only 1 CPO claiming to have taken customer funds to support day to day business operations.  The rest presumably misappropriated customer monies or misrepresented reporting information for more nefarious reasons.

From NFA’s website, as of January 31, 2014, there were a total of 4,184 NFA members.  Of these members there were at least 2,707 firms registered as either a CTA or a CPO.  However, it can be confidently assumed there are more firms registered in the CTA and CPO categories than this figure suggests.  Numerous firms are registered in several categories (FCM, IB, CTA, CPO etc) but are only represented by their highest membership classification.  Thus, in the best case, over a three year period NFA was forced to issue an MRA to less than 1% of CTA/CPO member firms.  Of these firms, only one claimed they used funds to cover operating costs after their malfeasance had come to light. Based on these figures the better question to ask is: “Had a CPO or CTA capital requirement been in place for the last three years would it have resulted in less or even zero MRAs being issued?”  Perhaps better yet: “Would such a requirement have protected CTA/CPO investor money?”

A CTA Capital Requirement

Should NFA impose a minimum capital requirement on CTA Members? Unequivocally the answer here is; No they should not.  The case for no capital requirement at the CTA level is very simple.  A CTA holds no funds, can’t control funds, and only maintains a connection with their customers through a revocable power of attorney in a managed account setting.  It is virtually impossible for a CTA to misappropriate the funds of their customers since client funds are held on deposit with an FCM.

The current lifeblood of the commodity interest industry within the United States is managed futures and the development of emerging managers.  According to the CME the space has grown by 700+ % since 2002.  With certainty, a CTA capital obligation will damage the emerging manager space and starve the growth engine of our industry.  In reality a capital obligation for CTAs is likely to harm managed futures investors by:

– Increasing barriers to entry thereby reducing CTA choice, variety, and fee competition

– Forcing more managers to rely on exemptions and to operate away from regulation

– Creating more regulatory costs for the industry (NFA for oversight/Customers as fees increase)

– Making the United States regulatory structure less competitive globally

Presently CTA’s pose no direct risk to investors with respect to the misappropriation of funds.  Perhaps the largest benefit and risk deterrent to CTA managed accounts is that they are transparent.  On a daily basis, if an investor is unhappy or uncomfortable with what they see occurring in their account they can immediately terminate their relationship with the CTA.  In addition to this many CTA customers have Introducing Brokers or Futures Commission Merchants monitoring the trading of their accounts. Should a CTA increase risk dramatically, there is a high probability their IB or FCM would notice this and sound the alarm.  Lastly, it is almost irrelevant to investors that a CTA is a going business concern.  In the event a CTA no longer has the resources to operate they will simply stop trading and deregister. Under such circumstances investors can easily engage another advisor.  There simply is not a good argument for a standard CTA to have a capital obligation.  Such an obligation would not protect investors in any meaningful way but would likely harm them in the long run.

A CPO Capital Requirement

Should NFA impose a minimum capital requirement on CPO Members? The answer to this question is; No they should not.  However, this response is not as straight forward as it is for a CTA.  While a CTA has no control over customer assets, a CPO in almost all instances can direct pool capital accounts.  For this reason there is an opportunity for the misappropriation of customer assets by CPOs.  The question, then becomes: Would a capital requirement protect customer funds?

NFA’s data and Turnkey’s experience confirms that, with rare exception, misappropriation of fund assets are the result of CPO malfeasance.  Unfortunately, this makes developing appropriate regulations to aide in prevention very difficult.  A person who is willing to intentionally violate rules, mislead, and eventually commit fraud to steal investor money does not care about compliance regulations.  Accordingly effective regulations are those that are designed to increase the rate of fraud detection by increasing transparency.  In our opinion a capital requirement does not address the fund misappropriation issue in any meaningful way.  Such a requirement would not in and of itself prevent or help to detect the misappropriation of investor assets by a CPO.

Instead such an obligation would negatively impact investors by reducing choice due to higher barriers to entry, increasing overall compliance costs, and reducing industry competitiveness globally. Instead of a capital obligation we would suggest the following cost effective alternatives:

Required Balance Confirmations: NFA should implement and require regular electronic balance confirmations for CPOs.  Recently the CFTC required pool quarterly reports (“PQR”) to be filed with the NFA.  This quarterly report already requires funds to provide detailed information on fund activity.  While PQR’s are not due until forty-five days after quarter close, an additional requirement to report FCM and bank balances to the NFA within 10 business days after quarter close should be adopted.  These balances would then be confirmed by the NFA in a timely manner.  They also could be compared to the PQR once submitted.  This process would provide NFA with valuable information about the overall accuracy of fund reporting and allow balances to be confirmed quickly.  While this might increase the reporting burden for CPO member firms, the practice is already in place for FCM members and should be easy for NFA to implement.  In our opinion, timely confirmation of fund balances is the only realistic way to detect possible misappropriations and deter CPO malfeasance.

Experience Obligation – Turnkey Trading Partners is routinely contacted by individuals who have little to no industry experience but want to start a “hedge fund”.  These individuals generally do not understand the difference between the functionalities of a CTA and/or a CPO.  They most certainly do not understand the regulatory obligations applicable to either entity.  In our opinion, under most circumstances, these persons should not be allowed to form and operate a commodity pool independently. In an attempt to better qualify the individuals eligible to run a CPO NFA should require a minimum experience obligation.

Such an obligation might be that within each CPO at least one associated person and listed principal must have been continuously registered within a regulated financial industry (CFTC, SEC, Insurance, recognized international regulator etc.) for the last two calendar years.  Similarly such a person must not have had any disciplinary history in which they were personally charged with material (supervisory, sales practice, record keeping etc.) regulatory infractions.  Exceptions could be considered to allow certain individuals with a documented history in fund operations.  Persons with the appropriate licensing qualifications should still be allowed to register as an AP with a CPO. These persons would not however be able to form such a company independently but would need at least one experienced operator.  In our opinion this would reduce the number of unqualified fund managers in the space substantially.

Increased Registration Due Diligence – Turnkey’s role as a compliance consultant makes us familiar with the IB and FCM registration process.  For both IBs and FCMs NFA requires substantially more information from prospective registrants than is required for either CTAs or CPOs prior to membership approval. With respect to CPO applicants, increased due diligence should be conducted.  NFA could review the experience obligation mentioned above and ask firms about their third party relationships.  At this time NFA may also choose to request CPOs provide an operations manual demonstrating that they are aware of their regulatory obligations.  CPOs should no longer be approved after simply logging into NFA’s systems, checking several boxes, filing a few forms, picking an exemption, and submitting membership dues.

Third Party Service Providers

In NFA’s request they ask a variety of questions about requiring CTA and CPO members to utilize independent third party service providers. In each instance the answer to this question is; No, they should not implement such a requirement.  While Turnkey would stand to benefit from the implementation of such an obligation we believe it would hurt customers as well as CTA and CPO businesses more than it would help them.  It is possible a third party obligation may reduce the number and frequency of customer abuses; But at what costs?  Better still are these costs worth the potential benefit? As noted above less than 1% of managers in the last 3 years had significant problems at their operations.

Investors Dictate Market Change – From the failure of Enron, to Bernie Madoff, then to MF Global and Peregrine Financial Group regulators have blanketed the financial markets with rules and regulations.  It should be noted however that each of these events caused investors, well ahead of regulator action, to require more transparency.  The demands of both investors and regulators have driven the cost of operating a CTA and/or CPO relentlessly higher.  As it stands, the majority of fund participants already require the use of a third party administrator. They also often require regulatory oversight in at least one reputable jurisdiction globally. Perhaps most importantly, at the fund level, they also generally require certified financial statements and regular reporting (sometimes daily) of investment holdings.

NAV Valuation and Performance Reporting – In soliciting comments on this subject, the NFA states that most disciplinary matters involved misuse of customer funds and/or misstating performance information.  It is safe to assume disciplinary actions for this type of behavior were not generated by firms attempting to properly follow NFA rules.  This again is clearly evidenced by the low rate of incident in MRA actions amongst all CTA CPO registrants.  Accordingly, we do not believe the benefit of requiring an independent third party for accounting in general outweighs the costs to the industry.  Rather than requiring CTAs and CPOs to engage an outside firm for NAV and/or performance calculations, Turnkey would suggest an alternate approach that would be more effective.

As part of the “Increased Registration Due Diligence” discussion above, NFA should require CTAs and CPOs to report at registration and then at least once annually whether their accounting will be done in-house or by an independent third party.  Firms intending to calculate performance in-house or those using a third-party provider that is unfamiliar to NFA would be held to a different standard.  These firms would be required to provide NFA with documentation demonstrating their methodology for proper performance calculation. Similarly, these firms should also agree to an onsite NFA audit within a specific time frame.  A similar practice is in place for firms with a net capital obligation that choose not to file audited financial statements at registration.

Each of these practices would allow NFA to ensure that firms understand how to properly compile such reports.  Requiring an outside third party to compile either performance or NAV reports may improve mathematical accuracy in some instances. It will not however stop nefarious firms from producing their own figures and committing outright fraud should they choose to do so.  A simple demonstration of reporting practices with a review from NFA will ensure firms don’t error in their presentation methodologies.  Similarly an enhanced audit cycle should detect malfeasance sooner.

Higher Expenses Increase Trading Risk – Turnkey Trading Partners believes the CPO industry is at a virtual tipping point.  The costs of operating a fund are regularly and have traditionally been passed on to investors.  These costs have made fund products unattractive to many.  As fund expenses rise, managers must take more risks to generate positive returns over break-even costs.  Adding an obligation for funds to use a third party administrator will further drive up operational expenses, indirectly increasing risk.  This will in turn drive even more investors away from fund products and reduce the competitiveness of the US commodity fund industry even further.

Authorized Disbursements – A service offering we currently provide is accounting for small to medium sized pools.  Generally our role with a fund does not require us to have a day to day relationship with pool participants.  Turnkey has found that, for a variety of reasons, neither our clients nor their investors want us to interact directly with these participants.  In the event we, or any other provider, were required to facilitate the movement of fund assets for our clients and their participants our rates would have to increase.  Assuming liability for mistakes, as well as the risk that a fund manager or fund participant may misrepresent information regarding a disbursement, will require us to increase our margins.  Furthermore, requiring a third party to implement disbursement controls will add an additional layer of bureaucracy for both funds and their participants.  This may equate to additional gains or losses for investors due to delays in redemption requests or increased fund lock up periods.

Emerging Managers are the hallmark of the managed futures industry.  At one point in time, the largest and most successful CTAs and CPOs were emerging managers.  Turnkey clearly believes that, as an industry, we need to be at the forefront of protecting investors. However, we also need to foster an environment that allows talented traders an opportunity to launch and grow a business.  Striking an improper balance between regulation and innovation will be a detriment to everyone interacting with our industry.  We encourage every registrant to comment on NFA’s proposal prior to the April 15, 2014 deadline.  Firm’s that don’t have the time to create their own comment letter may contact us via to request a template for simplified filing with NFA.