Registered Introducing Brokers (“IBs”) operating as so called “voice” or “chat brokers” focus largely on making markets or providing execution services. These brokers do not typically open or introduce futures accounts to a Futures Commission Merchant (“FCM”) in a traditional manner. Instead, they act as neutral intermediaries, matching institutional buyers and sellers, that are looking to transact in large volumes of futures contracts known as blocks. Alternatively, they may conduct “give-up” business and execute orders on behalf of clients. In either scenario, these types of brokers leverage their deep market relationships and experience to privately negotiate trades that would typically be difficult to execute on a traditional electronic order screen.

When an IB matches a buyer with a seller for a block trade, the broker submits the transaction details to the appropriate exchange (typically via CME Group (“CME”) or Intercontinental Exchange (“ICE”) for reporting and clearing.

Introducing brokers operating in the above fashion have no involvement in opening the underlying customer account with the FCM. Often, the clients they work with are unregulated, multi-billion-dollar, corporate conglomerates, proprietary trading groups, or institutional financial entities. Block futures, by definition, cannot be traded by the retail public and access to these markets are limited to customers that qualify as Eligible Contract Participants or “ECP”. Since the customers in this sector are typically large, and there is not a formal account opening process for introducing brokers working in this space, these clients wield tremendous commercial leverage. Unfortunately for brokers, many such customers, utilize a “take it or leave it” attitude if the broker would like to handle order flow for them. In other words, the customer, not the broker, dictates their own brokerage rates, may choose to dismiss standard onboarding workflows, and often refuses to provide mandatory background information.  Faced with losing substantial, foundational business, many voice and execution brokers yield to the pressure.

It is understandable how and why introducing brokers in these markets cave to their customers.  However, accommodating customer demands creates a compliance vacuum. The National Futures Association (NFA) does not accept “client pushback,” “market pressure,” or “historical industry norms” as an excuse for deficient compliance programs or record retention. This systemic lapse in onboarding due diligence has long resulted in recordkeeping and supervisory violations industry-wide. This can leave firms highly exposed to heavy financial penalties or direct enforcement referrals to the Commodity Futures Trading Commission (CFTC). What’s a broker in this position to do?

De-Mystifying NFA Bylaw 1101 for Execution and Block-Trade Brokers

The most critical, yet frequently misunderstood, oversight in hurried onboarding is the complete failure to perform due diligence under NFA Bylaw 1101. Turnkey has written on the subject extensively.

At its core, Bylaw 1101 states that no NFA Member may carry an account, accept an order, or handle a transaction for or on behalf of any non-member entity that is required to be registered with the CFTC. The most common Bylaw 1101 violations Turnkey sees, and NFA looks for, are with potential commodity pool operators who are not registered with the CFTC. Unfortunately, NFA Bylaw 1101 carries with it a strict liability standard. In layman’s terms, this means that if you conduct business with an unregistered entity that should be registered, you are in technical violation of the rule, regardless of your intent, fault, or whether or not you were aware of the violation. Strict liability takes the position that you either knew or should have known not to do business with the client.

Due to this standard, execution brokers face a difficult decision, push back against a large customer or meet the regulatory hurdle to comply with NFA Bylaw 1101? In making this decision it is important to remember that NFA does not just penalize the act of doing business with an illicitly unregistered entity. Rather, they can take action simply on the fact that a member firm cannot demonstrate they attempted to verify a customer’s registration status. NFA evaluates processes as well as outcomes. As a regulator they are more frequently writing up internal control weaknesses if firms do not, or cannot, support with documentary evidence processes.

Eligible Contract Participant Evaluation

Another obligation that block futures brokers must validate is whether or not a customer is eligible to participate in these privately negotiated transactions. Under the Commodity Exchange Act (“CEA”) and exchange rules, the only market participants eligible to trade this way are those who qualify as ECPs. Many brokers in this space believe that FCMs and the underlying exchanges were a trade will be blocked for clearing check this status. That assumption is correct, however, relying on the FCM or the exchange is not sufficient to meet applicable regulatory obligations as an IB. Just like with NFA Bylaw 1101, executing brokers must validate ECP status prior to accepting orders from these types of clients.

What to Expect – NFA Audit Time

When an NFA audit team arrives, client onboarding and recordkeeping files are among the very first items requested.  During this part of the exam, reviewers routinely uncover:

• Missing or Incomplete Account Paperwork: auditors routinely find that corporate entities have not provided fully executed brokerage agreements, don’t provide authorized trader listings, have not provided Bylaw 1101 or ECP attestations, or in some cases have not officially agreed to brokerage fee and commission terms. All of these things can be highly problematic during a review.

• Failure to Track Client Metrics: The NFA explicitly demands an accurate, readily accessible accounting of your client base. Firms sometimes fail to track their clients by geographic type (distinguishing between domestic U.S. and International accounts) as well as the total number of active clients utilizing their execution services. Traditional screen trades are required to be accounted for differently than block futures transactions. Similarly, account receivable and account payable processes for FCM executed deals vs bi-laterally negotiated deals are completely different.
• Absence of an Evidence Trail: In the eyes of the NFA, if a compliance check is not documented, it never happened. Verbal assurances from a conglomerate’s legal department will not satisfy an auditor looking for a physical or digital paper trail. Turnkey observes clients scouring chat and voice recording records to find rate sheets. Repapering client files after the fact, or scrambling to obtain signatures or copies of records from clients while NFA is in the office.

As Turnkey Trading Partners has previously highlighted, the NFA aggressively pursues firms that fail to establish adequate supervisory frameworks over third-party relationships. In the cases above, firms are falling down during exams because they do not have in place a robust customer onboarding due diligence process or they do not have systematic controls in place to manage follow up and record keeping shortcomings. What begins as a poorly handled onboarding file can quickly snowball into large penalties if left unchecked for long periods of time.

How Turnkey Trading Partners Can Help

You do not have to choose between losing lucrative institutional block business and maintaining your regulatory registration.  In Turnkey’s experience record keeping and supervisory short comings are almost always procedural. Working with Turnkey can help your firm to identify process breakdowns before they start. Our team can help to implement best practice standards, educate on industry regulatory requirements, and ensure that customer account documentation is compiled properly. Turnkey has been in business for many years and is one of the industry’s leading CFTC and NFA consulting firms. We specialize in equipping introducing brokers with the robust operational framework needed to withstand rigorous regulatory scrutiny.

Contact Turnkey Trading Partners today to schedule a consultation, fortify your onboarding paperwork, and ensure your firm remains audit-ready, year-round.