Dec 22, 2023 The Commodity Futures Trading Commission (CFTC) has recently put forth proposed changes to Regulation 4.7. The proposed changes encompassing adjustments to the definition of Qualified Eligible Participants (QEP) as well as reporting requirements for Commodity Trading Advisors (CTA) and Commodity Pool Operators (CPO). These potential amendments, if adopted, are anticipated to have broad-ranging implications across the entire commodity futures industry. Background In 2010, the Commodity Exchange Act (CEA) underwent amendments through the Dodd-Frank Act, defining terms such as “commodity pool operator”, “commodity pool,” and “commodity trading advisor”). Part 4 of the CFTC’s regulations specifically govern CPOs’ and CTAs’ activities, detailing compliance requirements. Regulation 4.7 offers exemptions for registered CPOs and CTAs catering to “Qualified Eligible Persons” (QEPs) from certain part 4 compliance rules. Although this exemption has been neutered in the past, the CFTC’s proposed adjustments will likely remove any remaining benefits of the 4.7 exemption for both CPOs and CTAs. The CFTC Proposal seeks to update Regulation 4.7 in four primary ways: increase financial thresholds impose minimum disclosures introduce an alternative account statement schedule and enhance the overall structure of the regulation. The reason or this, the CFTC contends, is that the regulation has not been revisited since 1992. They believe that since that time the industry has evolved significantly. In Turnkey’s experience, 4.7 exempt advisors and funds, primarily enjoy the benefit of not having to file disclosure materials with the National Futures Association (“NFA”) prior to first use and once annually thereafter. They also are not beholden to certain performance reporting obligations that retail advisors must adhere to. Should either of these benefits disappear or be encumbered in anyway, there would be little benefit of filing for a 4.7 exemption in the first place. This issue is further exacerbated by the CFTC’s proposed increase in QEP financial thresholds. Increased Financial Thresholds Regulation 4.7 (a) divides the Qualified Eligible Person (QEP) definition into two distinct categories, specified in paragraphs (a)(2) and (a)(3). The first category comprises individuals who are considered QEPs without the need to fulfill an additional “Portfolio Requirement.” The second category includes individuals who must satisfy this Portfolio Requirement to qualify as QEPs. To qualify as a Qualified Eligible Person under the portfolio requirement, individuals must currently meet the following criteria: (1) possess securities (including pool participations) and other investments with a combined market value of at least $2,000,000 (Securities Portfolio Test); (2) maintain at least $200,000 in exchange-specified initial margin and option premiums with a futures commission merchant, within the six months preceding the sale of a pool participation or the opening of an exempt account with a Commodity Trading Advisor (Initial Margin and Premium Test); or (3) own a portfolio combining Securities Portfolio Test and Initial Margin and Premium Test elements, meeting or exceeding 100% of the required amounts. The Commission notes that inflation, has significantly impacted the current monetary thresholds in Regulation 4.7(a)(1)(v). They believe the existing thresholds may no longer adequately reflect the intended high level of investor sophistication, acumen, and resources envisioned by the Commission when the Portfolio Requirement was initially adopted in 1992. Adjusted for inflation the $2,000,000 threshold in the Securities Portfolio Test is equivalent to approximately $4,270,000, and the $200,000 threshold in the Initial Margin and Premiums Test equates to around $427,000. This DOUBLES the minimum standards currently in place. In Turnkey’s experience it is already difficult for advisors and brokers to identify QEP’s for investment into 4.7 exempt programs. Such a large increase in minimum financial thresholds very likely will eliminate the ability for current exempt advisors to continue forward as they are today. Potential Impacts The proposed changes to the Portfolio Requirement have the potential to impact the scale, structure, and quantity of 4.7 exempt trading programs within the commodity interest markets. Advisors will have to “downgrade” to retail offerings which will require them to incur greater compliance and accounting costs. These costs will largely be passed on to program participants and erode rates of return. Alternatively, and Turnkey believes this will be the path many advisors take, 4.7 advisors will simply close down. A large percentage of registrants operating under 4.7 exemptions only support “friends and family” money. They do not actively solicit; they do not generally have more than 15 participants. Under such a scenario these advisors may choose to terminate registration all together if possible. Others may turn to proprietary trading or family office models. This, in turn, could influence the pattern of investments in commodity interests and overall industry volumes. Worse, altering the QEP definition might lead to a reduction in the flow of non-commercial funds into commodity interest markets. This could potentially escalate the costs and further reduce liquidity for commercial traders who utilize futures markets for risk hedging purposes. The National Futures Association publicly opposed much of the commissions thinking with these adjustments. They make many of the same arguments that Turnkey independently notes above. If you would like to review NFA’s published comments to the CFTC you may do so by clicking here. Are Net Capital Requirements Next? Turnkey Trading Partners prides itself on its commitment not only to staying abreast of current trends but also to anticipating how today’s regulatory changes might impact the future. In this context, a major concern for the futures market, should be whether the CFTC applies this approach to all industry rules and regulations. A wholesale adjustment of financial obligations to adjust for inflation from 1992 could have wide ranging negative impacts. Of particular concern would be net capital minimums, minimum margin amounts, and other capital-based rules and regulations. Having collaborated with numerous futures commission merchants and introducing brokers worldwide, doubling net capital requirements would be painful for many smaller firms. It may also force many independent IBs to consider becoming guaranteed IBs reversing a trend away from this model. This in turn would put more regulatory pressure on already strapped FCMs. The commodity interest industry is not “young.” Many of its registrants are approaching retirement and simply may not care to continue operations if their business has been marginal in recent years. These projections underscore the interconnected nature of regulatory changes and their potential far-reaching effects across different segments of the financial industry. The CFTC should be looking to improve access and choice within the markets it regulates. Proposals of this nature will have little benefit and will not protect customers. Instead, they will promote further consolidation which is the last thing anyone should want. Tell the CFTC What You Think The CFTC has specifically asked for public input regarding this potential increase to the minimum QEP thresholds. If you would like to make a comment to the commission please click here. Any other inquiries or questions regarding this article please feel free to contact Turnkey directly. We offer consulting advice on issues such as this daily and would be happy to discuss how this may impact your business. Please contact us here.