Here comes the CFTC: the regulators keep coming back for more

The latest batch of rules from the US Commodity Futures Trading Commission (CFTC), which come into effect on December 31, 2012, will require many firms currently outside the CFTC’s supervision to register as Commodity Pool Operators (CPOs).

A new exemption test – the de minimis test – will need to be applied by firms daily to check their levels of commodity interest against thresholds for initial margin and net notional value. Until now, many had relied on an exemption for pool products, such as private trusts, allowing them to trade some commodities and not have to register with the CFTC. But, with the Dodd-Frank Act granting more authority to the CFTC against a backdrop of increased reporting and registration requirements generally, that exemption has gone.

The test needs to be applied daily on all of the asset managers’ pools or portfolios of derivatives and only one of two such tests must be passed to qualify for the exemption. The first is focused on the initial margins and premiums of their commodity interest (i.e. the liquidation value) which needs to be less than 5 percent of the portfolio. The second is to check that the notional value of all commodities interest is less than 100 percent of the portfolio.

The irony in all of this is that the de minimis test – which translates from the Latin as ‘of small things’ – will in fact present significant hurdles, not to mention substantial costs, for those that fail the exemption test and have to register as a CPO. And who would want to bet against the CFTC introducing more rules and requirements, adding still more costs, in the future? Let’s remember, there’s no revenue benefit for asset managers here.

This looks like another example of regulators coming back for more as they take the power invested in them to apply rules, introduce more complex reporting and enable ad hoc examinations and inspections in pursuit of a more stable financial infrastructure. With the US Securities and Exchange Commission (SEC) and the CFTC both stepping up their game (the SEC focused on individual security derivatives, the CFTC on all other types of derivatives), life on the compliance desk is not going to get easier any time soon. Firms that are required to register with the CFTC as a CPO will need to build out six areas of compliance: ethics training for key personnel; an annual compliance review; the production and application of a policies and procedures manual highlighting precisely how they are complying; a disaster recovery plan; a process for registering all new employees with the CFTC and an annual branch office examination. Furthermore, registered firms will have to change their offering document to new investors, produce additional data in their annual reports and alter their daily record-keeping of transactions.

Given that the CFTC’s latest change to its registration requirements is about to subject a new group of asset managers to the costs and challenges associated with being governed by an additional regulatory body in order to deal with a small minority of high risk participants, it’s perfectly understandable that the industry is questioning whether we need both the SEC and the CFTC to do a job that could easily be handled by a single authority.

One thing is certain, though, when the new rules come into play the CFTC will undoubtedly flex its muscles; random inspections and examinations will probably come thick and fast, directed especially at those firms that will be doing all they can to remain exempt. With anything more than a handful of portfolios to test and provide audit trails for on a daily basis, automation of the compliance function is going to be the only realistic option if firms are to avoid falling foul of the regulator.

One Response to “Here comes the CFTC: the regulators keep coming back for more”
  1. Matt Grinnell says:

    Since this was posted the volume of applications to the National Futures Association (NFA) to register as a CPO, CTA and Associate Person (AP) has ‘swamped’ the organisation. It became such an issue that the firms applying for registration were fearful the registration process would not be completed by the Jan 1 2013 deadline and would prohibit them from trading in commodity interests with NFA members.

    Fortunately, the CFTC stepped in and issued a no-action letter (CFTC Letter No. 12-68) on Dec 21st to permit firms awaiting registration confirmation to trade as normal as long as they:
    1) Submit their application to the NFA by Dec 31 2012, and
    2) Operate in compliance with the CPO, CTA or AP regulations beginning on Jan 1 2013.

    I think this clearly illustrates that the burden of new regulation is a two-way street and goes some way towards dispelling the myth that the regulators live in ivory towers.

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