The latest batch of rules from the US Commodity Futures Trading Commission (CFTC), which come into effect this month, will require many firms currently outside the CFTC's supervision to register as Commodity Pool Operators.
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. The alternative is to register with the CFTC and create and implement a range of costly and detailed compliance requirements touching training, process, reporting and human resources.
Until now, many asset managers have 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 bottom line is that this looks like another example of regulators coming back for more. There is an increased level of scrutiny and responsibility being placed on the financial services industry. Regulators are taking 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 security futures, the CFTC keeping an eye on commodity futures), life on the compliance desk is not going to get easier any time soon.
Firms that are required to register with the CFTC will need to build out six areas of compliance including: 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. The scope of requirements is far-reaching.
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. Of course, with such a range of new requirements, there is no guarantee that these regulations will not be amended or refined by the CFTC once they are put into practice.
It's a tall order for firms to implement this de minimis test daily or fall subject to another regulatory body for what is actually a relatively low-risk field overall. For those firms that do have to register and comply, the costs will be significant. And who would want to bet against the CFTC introducing more rules and requirements – adding still more costs – in the future? If there is one thing we have learned about the post-crisis regulation environment, it is to expect the worst.
It is important not to forget that there are no revenue benefits for asset managers involved here. They are being required to go through a significant compliance loop with all the attendant costs and upheavals in order to do precisely the same business they have always done. It's another case of the majority, who operate in a low-risk environment, being forced to pay the price for the tiny minority of high-risk players.
Not surprisingly, given the implications of CFTC regulations, asset managers have become focused on the de minimis test and how they manage that process to ensure they fall outside the CFTC's jurisdiction. Of course, the irony in all of this is that the de minimis test – which translates as, "of small things" – will present significant hurdles to those that do not meet its requirements.
The test needs to be applied daily on all of the asset managers' pools or portfolios of derivatives to prove that the firm qualifies for CFTC exemption. The firm has to pass one of two such tests. The first is focused on the initial margins and premiums of their commodity interest (i.e. the liquid value of the portfolio) which needs to be less than 5 percent. The second test is to check that the notional value of all commodities interest is less than 100 percent of the portfolio.
The move by the CFTC to change its exemption rules so drastically and introduce the de minimis test underscores again the need for proper, scalable automation of compliance functions. You could, in theory, manage the test manually using tools like Excel if it were an occasional requirement. But this is a daily procedure and trying to run this manually is hardly an efficient use of time and resources. More importantly, with perhaps anything between 50 and 100 portfolios to test and on which to provide audit trails, automation is the only realistic option.
It's another nail in the coffin for manual compliance and reinforces the value of the relationship between asset managers facing sudden operational challenges in order to comply with new regulation and an organization like Fidessa, which is committed to providing timely technology solutions. The CFTC situation is a good reminder of why this relationship counts.
One thing we can be sure of when the new exemption rules come into play is that the CFTC will be expected to flex its muscles and make examples of asset managers skirting the registration or not adequately complying with CFTC requirements after registration. 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.
Furthermore, this is just the latest wave of regulation to be introduced to the financial markets. There is bound to be more with the pressure being put on regulators to bring transparency to every corner of our industry.
Meanwhile, some pertinent questions are being asked about whether we really need both the SEC and the CFTC to oversee the same organizations that do business in both worlds, and if they are properly aligned.
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 CFTC to do a job that could easily be handled by a single authority.