By James Bibbings – Over the past four years I have worked with countless CTAs to steer them through a variety of regulatory and business problems. Whether I spent time working with them as a regulatory auditor at the National Futures Association, as an institutional accounts manager, or through my independent consulting firm, I have seen nearly everything the managed futures trading industry has to offer. At the same time, I’ve also seen the most common mistakes new CTAs make, a few of which I’ve outlined below.
Before we get started, I would like to make clear that commodity rules and regulations should be looked at on a case by case basis by a qualified professional. It is important to keep in mind that many times in regulation there is not an all encompassing answer to even the most basic questions. Simply put, the way US commodity laws and rules are structured allows room for one off, sometimes subjective, decisions to be made by NFA or the CFTC. Thus, the following points hold true most of the time, however depending on your specific circumstances, these rules and examples may be applied differently.
Mistake Number One: Not All Exemptions Apply To Standard US-Based CTAs
In my dealings with private clients, and through my experiences as a regulator, I have been asked with alarming frequency about the CFTC’s part four exemptions and how they relate to CTAs (click here for a link to part 4). For a myriad of reasons, people generally seem to want to avoid as much regulation as possible. To an extent this is understandable, especially given the cost and complexity of trying to navigate all of the requirements that come from having any form of oversight. However, it is equally important to recognize that regulation within the marketplace is not something to be feared. In fact, in many ways regulation is necessary to protect public interest and raise investor confidence; two things that benefit us all. Therefore, it is truly important to understand the exemptions which are available to CTAs and the reasons behind them.
At this time the following exemptions are the only ones which are available to standard, US based, CTA registrants:
1. CFTC Regulation 4.7: Provides relief from certain part 4 requirements to commodity trading advisors that deal with only qualified eligible participants (“QEP”). In this instance a QEP is defined by specific financial requirements spelled out by the CFTC and may include individuals or institutions. To read up on the specifics of QEP eligibility requirements follow the link provided above.
2. CFTC Regulation 4.14: Offers complete relief from registration as a commodity trading advisor. This exemption is used when the activities conducted by a commodities business do not meet the definitional guidelines set forth by the CFTC to be considered a CTA. To find out more about the eligibility requirements for this exemption follow the link above as well.
As I suggested with most regulations, things are generally never cut and dry. That being said, I will add that it is possible to petition the CFTC for a special exemption on a case by case basis. It is however impractical to discuss all of the terms of this process within a brief article such as this. Therefore, for all intents and purposes the provisions of parts 4.7 and 4.14 are all that are available to standard CTAs doing business within the US, and servicing US clients at this time. All other part four exemptions apply to commodity pool operators (“CPO”) or combination CTA/CPOs.
Mistake Number Two: Ongoing Regulatory Requirements
Once an individual or company has applied to become a trading advisor and has been accepted by NFA, the regulatory road does not stop there. Although CTAs do not have a capital requirement, and are considered by many to be the “simplest” registration category, as an NFA member and CFTC registration there are still many requirements which must be upheld. I often find that people are dumbfounded by the amount of regulatory work that must be completed to keep a CTA operating. It seems that most believe only registration and a disclosure document is required for operations. In my experience, a vast majority of people do not fully understand, or are not aware, of the other requirements that go into running a regulated business.
Based on this misconception the following are some of the major requirements that must be upheld in order to operate and maintain a fully compliant CTA:
Your CTA must maintain accurate financial books and records. This means that your business will need to maintain a basic accounting system. You will be required to keep track of your cash receipts and disbursements, maintain a general ledger, and properly report your company’s liabilities. Although your CTA will not have a statuary capital requirement, it is wise to be able to prepare an NFA/CFTC compliant balance sheet. At a bare minimum you will need to review and update your accounting on a monthly basis and have accurate records available upon request.
In addition to this, as a CTA you will be required to properly calculate all of your trading performance and present it appropriately. This may seem easy, but I can assure you, is the number one trouble spot for the new CTA’s that I work with today. To learn more about your performance reporting requirements I would recommend reviewing NFA’s compliance rule 2-34 and the CFTC’s Regulation 4.35.
As a CTA you will also be required to maintain the following procedures and policies:
General Business, Account Opening, Supervisory, Privacy, Disaster Recovery, Ethics Training guidelines, Ethics, Order Handling, and Promotional Material.
Within each of these documents you will be required to implement policies which are tailored to keep your CTA in compliance with all applicable CFTC regulations and NFA rules. Here it should be noted that across firms, procedural manuals may vary to accommodate differing business models and staffing situations. However, each CTA must evaluate their operations and ensure that the documents they have on file are adequate. Further still, once each of these documents has been created, appropriate personal will need to review and enforce the requirements listed. These same staff members will also be required to attest to these reviews in writing. Any and all documentation related to procedural compliance is then required to be kept on file and available for review upon request.
Your Disclosure Document
As most people know, you will be required to maintain an accurate and up to date disclosure document. This document must be specific and unique to each trading program that will be offered by your CTA. In addition, your disclosure document will have a laundry list of regulatory requirements which are subject to your trading practices. To see firsthand what is required within a disclosure document, visit the NFA’s CTA disclosure document guide.
As a piece of advice, it is almost never in your best interest to try and include hypothetical performance results within your document. NFA and CFTC restrictions in this area are very stringent and getting to the point of appropriate presentation can be incredibly time consuming and costly. It would also not be wise to seek outside help with your disclosure document from a third party that does not have extensive experience in commodities regulation.
Mistake Number Three: Ongoing Disclosure Document Maintenance
Once you have properly implemented your accounting system, developed acceptable procedures, and sent your disclosure document to NFA for acceptance what’s next? At this time you will be ready to look for client funds and try to start trading profitably for them. Assuming this goes well for you, at some point you will trade client accounts for an entire month; what do you do then? What you will do, if you are actively soliciting for new funds, is to update your disclosure document and re-file it with NFA.
Furthermore, once you are actively trading for client accounts it is required that any material changes to your trading program be included in your disclosure document. Under this requirement, at the end of each month it is necessary that you update your document by including material program changes and inputting all applicable information into your performance capsulation.
For reference a standard performance capsule looks like this:
• Name of CTA (or person trading the account): Sample CTA
• Name of Trading Program: Offered Trading Program
• Inception of Trading by CTA (or person trading the account): January 1, 1986
• Inception of Trading in Offered Program: January 1, 1989
• # of accounts currently traded pursuant to the program: 123
• Total nominal assets under management: $30,673,000
• Total nominal assets traded pursuant to the program: $21,746,000
• Largest monthly draw-down: 16.87%/December 2004
• Worst peak-to-valley draw-down: 31.60%/May 2004 –April 2005
• Number of profitable accounts that have opened and closed: 32
• Range of returns experienced by profitable accounts: 1.32% – 19.78%
• Number of losing accounts that have opened and closed: 7
• Range of returns experienced by unprofitable accounts: -0.43% – -24.53%
The capsule also includes simple performance figures which must be presented in gridded chart format. Typically, within this chart, the months traded will run down the vertical axis while years run across the top. To see a performance table, review the disclosure document guide link I provided you above.
After you have updated your document, your CTA is then required to re-file it with NFA. Then, after NFA sends you notice of acceptance, any new client that you solicit must also be given your most recent disclosure document. In addition to providing new clients with your updated document, under the material change requirement, it may also be necessary for you to supply your existing customers with an amended document for their re-approval.
Instances which would require you to send a new document to your current customers may include but are not limited to: Your CTA hiring a new trader, changing clearing firms where accounts are held, having a change in commission rates, after adjusting performance and/or management fees, if your CTA encounters a material business event that alters trading performance, or in any other instance which may reasonably alter a person’s investment decisions with your company.
How to Avoid These Mistakes and Others like Them
As you can see from the limited number of examples I have provided above, becoming a CTA can be a complex process. Operating efficiently and appropriately, while staying within the regulations takes a great deal of foresight and research. While it is possible to manage CTA compliance on your own; through many hours of reading, writing, and direct communication with NFA or the CFTC, I would recommend not doing so. Remember, that as a CTA your customers are with you because of your trading knowledge. They want you to be the best trader and financial steward of their hard earned money that you can possibly be. Let’s face it; trading successfully is tough enough, so why have regulation on your plate as one more thing to worry about?
It is my opinion that the biggest mistake any aspiring CTA can make is to journey down the regulatory road alone. So for my last bit of advice, as you begin to explore the possibilities of starting your own CTA, leave the regulation up to a qualified and experienced professional. From a cost perspective the amount of time you’ll save and the sheer headaches you’ll avoid will more than offset the costs. Further still, and this is one thing almost everyone forgets, once you begin operations it is imperative that you free your mind as much as possible. Although you can never be entirely free from regulatory burdens, you’ll certainly want to focus as much of your effort as possible on your trading and your customers.
James Bibbings is the CEO of Hugo James Consulting (“HJC”), a firm that supports all commodity specific regulatory and business needs. Prior to starting HJC in 2007, Bibbings worked with the National Futures Association (“NFA”) as a supervising auditor. During his time with NFA he was involved in over 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations. Bibbings currently holds a series 3 license, was previously a partner at a commodities brokerage, and also worked at a currency desk in the Chicago Board of Trade. Bibbings be reached at email@example.com.