On today’s episode Niels Kaastrup-Larsen is joined by Jennifer Sunu, who is the director of compliance at the NFA, Arthur Bell, CPA and managing member of Bell Tower LLC, and JP Bruynes, who is a partner at the law firm Akin Gump.
Listen in to today’s episode as we focus on how the managed futures industry is organized, how it has changed since the industry started, who the key players are and what role do they play, and how regulators keep an eye on all these players to ensure they play fairly.
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Welcome back to another edition of Top Traders Round Table, a podcast series on managed futures. My name is Niels Kaastrup-Larsen, and I’m delighted to welcome you to today’s conversation with industry leaders and pioneers in managed futures, brought to you by CME Group.
Today I’m joined by Jennifer Sunu, who is the director of compliance at the NFA, Arthur Bell, CPA and managing member of Bell Tower LLC, and JP Bruynes who is a partner at the law firm Akin Gump.
First of all welcome and thank you so much for taking time out of your busy schedules to join me for our conversation regarding some of the things that go on behind the scenes of the managed futures industry. I’m very excited about our session today, not least because you really are the “A” team in this industry. So our listeners are in for a real treat. Now, before we jump into today’s topic, share with me a short version of your own background and how you got to where you are today.
Maybe, Jennifer, why don’t we start with you? Tell us about your journey and how that lead you to the NFA and perhaps what has kept you there for quite a while.
Jennifer, so I’ve been at NFA since:
I think that we do serve a good service to the industry in general in terms of keeping the fraud at bay and protecting customers. So that’s what kept me there for so long.
Yeah, so your journey inside the NFA, has it been more or less in the same area of expertise or has that changed over the years?
I’ve primarily been in compliance, but also spent some time in market regulation and actually headed up our New York office for a few years and then came back to Chicago to be a director of compliance here. So, I’ve been a little bit all over the place, but mainly in compliance.
Sure, sure, just for my last question, just for the benefit of the listeners, when did the NFA actually get founded? How long does it date back?
JenniferSo, it’s been around since:
Wonderful, great stuff. Now, to me, you’re kind of an icon in this industry. I don’t think I’ve ever attended a conference in the last twenty-seven years or so without getting something to bring home that had the name Arthur Bell on it and deservedly so, you were given a lifetime achievement award at the CTA forum earlier this year, so, congratulations on this recognition of your contribution to our industry. Please share with us some of your long journey and where that has taken you.
Arthure been in this industry since:
Our main office is in Baltimore, Maryland. Then we have offices in New York City, in Ireland, and in the Cayman Islands. So, my experience has been in pretty much every aspect of managed futures: auditing, tax preparation, compliance, regulatory matters. I’ve been on various committees with the CFTC, worked with the NFA. I was an arbitrator for the NFA for a number of years. However, I had so many clients I was often conflicted out of the arbitration. So, one side or the other, or the lawyer, or the parties involved, it was kind of interesting.
So, that’s my background in this industry for many, many years.
Sure, fantastic, excellent. Now, what about you JP, I know that you also have a long career, but this time on the legal side of the alternative investment space. You’ve been recognized by the Who’s Who in the legal 100, I’m told, a number of times. You’ve spoken on many interesting topics over the years. I picked up things like, ‘Turning Your Business Into a Hedge Fund’, and ‘Starting and Seeding a Fund’, which I know are topics that many managers, or want to be managers, are interested in. Why don’t you, in your own words, put some color on your path in this industry.
JPgraduated from law school in:
Sure, fantastic, great. Well, as you can hear it is clearly an “A” team that we have assembled here today. Now, our conversation will focus on how the managed futures industry is organized, who are the players, what role do they play, how regulators keep an eye on all of these players to check that they play fairly, so to speak. So, I’m going to start or stay with you, JP, for a little bit longer and ask you to talk about the basic structure of our industry and the roles that each of these players has within it.
OK, let’s just talk about the regulatory landscape for a second. So, in the United States, at the federal level, there is the United States Commodities Futures Trading Commission, which is the federal regulator of commodity futures. It has many swaps markets.
Over the years they have outsourced or delegated a number of their primary functions to the National Futures Association, which Jennifer is a representative, which is a self-regulatory organization. So, the National Futures Association has historically processed the registration of individuals, proficiency testing, review of disclosure documents, more recently reviews of periodic, quarterly and reports for CPOs and CTAs. So, that’s sort of the U.S. landscape in terms of regulators.
In the U.S. landscape, in terms of market participants, we primarily focus on the representation of commodity pool operators and commodity trading advisors. Unless a firm is engaged in a de minimis amount of futures trading, if it is located in the United States and has one investor, and does trading in futures in a pooled vehicle, the firm needs to be registered as a commodity pool operator. Absent some exceptions for firms that operate very small pools, or that have a very limited amount of dollars under management.
On the managed account side, most firms are registered with CFTC and are members of NFA as commodity trading advisors. So, the distinction between a commodity pool operator is somebody who operates a fund versus a commodity trading advisor that has managed accounts. Most firms are probably registered in both capacities.
Sure, sure. Now, you kind of jumped a little bit into my next question which was really more on the regulatory side. But, Jennifer, I’m going to try and pick up from where JP left off, because, from the outside, when you look at it, of course, the U.S. has a number of different regulators, the SCC, the CFTC, NFA, to name a few, and it can be a little bit confusing to some. Why do we need so many, so to speak, and how do you feel that they’re different, and perhaps also, how do you coordinate, if at all, any efforts between the three of them?
So, for the two government regulators, in this area, which is the SCC which handles the securities, and the Commodity Futures Trading Commission that handles commodities, it’s really separated by the products. Although there is a lot of overlap, in terms of firms, lots of firms trade both securities and futures. One government agency regulates one area, and one government agency regulates the other. As you can expect, that’s just due to the fact that there is a lot of different constituencies that deal with Congress and they’ve decided to keep it separate.
I know that the CFTC and the SCC try and have some coordination, and there have been different harmonization things going on over the years, and there are certain things that, if you have certain requirements on the SCC side, then maybe you don’t have to have those on the CFTC side. So, there is a little bit of trying to coordinate between those two agencies, but by and large, they’re very separate.
The difference between the CFTC and NFA is that, as JP is stating, CFTC is the government agency, NFA is the self-regulatory organization for CPOs and CTAs. The main difference between the two is that we are the ones that really have the mainline oversight for CPOs and CTAs, whereas the CFTC has more of a hands-off oversight. They tend to oversee us as we regulate the CPOs and CTAs, but for example, they don’t do a lot of examinations themselves of those firms. They rely on NFA to do those exams.
Sure, sure, sure.
I would just say, Jennifer, the CFTC, by and large, is now primarily focused on rulemaking and major enforcement actions.
I think that’s a great point, yes.
It’s interesting to hear about the history of these agencies. I clearly remember when I started out in the managed futures industry that the general impression by people when you mention the words hedge fund was that these were investment funds that had absolutely no regulation and could do whatever they wanted. So, I do think it’s important to distinguish between the CTA side of the alternative investment industry and the old hedge fund side, so to speak, at least from an historical perspective when it comes to regulations. Is that something that maybe one of you can talk a little bit about how that is different and how, maybe, since we are talking about managed futures today, how that has been regulated for many decades by now.
I think, from our perspective, we have always looked at our regulation responsibilities, just in terms of the futures area unless there is a pool that has been identified with us that trades other products. So, we will look at other products that are included in a listed pool, but firms are not required to list pools with us that trade only alternative products; that don’t trade futures. If they choose to list those with us then we are required to look at everything in there. So, there are a number of pools that are listed with us that don’t trade futures at all, but for whatever reason, they decide to include those under our jurisdiction.
Yeah, yeah. Did you want to add something JP?
JPighly unregulated until about: the same time, at the end of:
That’s correct. We had, I think ten thousand or twelve thousand new pools come in and about 1,800 new firms, I think.
OK, yeah. Well, the good news is that nowadays, anyone whether they call themselves a hedge fund or CTA, it’s all regulated now and I think investors can take a lot of comfort in knowing that.
Now, that we have heard about the overall structure of the industry today, perhaps you, Art, can give us an historical perspective as to how the industry has evolved in the last forty plus years that you’ve been actively involved, and get your perspective as to whether this evolution has been beneficial for the industry and the investors around the world who, at the end of day, trust their money to CTAs and other service providers in this space.
Well, as I mentioned, I started in the mid-seventies. At that time there was no CFTC, no NFA, and in fact what regulation there was came from the agricultural department since they had experience with the grains, they were the natural party to look over it. At that time there were no financial instruments traded. There was a much, much smaller market.In:
They later, as Jennifer mentioned, delegated much of that to the NFA. I would say that you might say that any of the compliance work, the nitty gritty financial reporting, the investor information that was put out, the market materials were all delegated to the NFA with the oversight of the CFTC.
We also saw, at this time, that the regulations continued to exempt the large players, certain other players, setting rules for very small groups and how they had to regulate, if they had to regulate. Gradually that has changed whereby today the rules are much broader, capture far more, but they are far less prescriptive and more likely based on general objectives and themes rather than dictating and micro-managing exactly how things occur.
This regulation, now, is much more acceptable to the industry. They are able to work with it more easily. They are able to get help from the NFA. The NFA has a history of being very proactive with managers, helping with things, particularly with marketing materials which have often been the problem area. You can submit materials in advanced to the NFA for review and acceptance.
It’s not an endorsement, it’s just saying “yes, it is in compliance or recommending some changes in areas where maybe it’s a little bit too aggressive in the market and that has been quite successful and generally welcomed by the industry as an opportunity, especially for new traders – people coming into the industry where the regulations are difficult to understand if you don’t have perspective and experience. So, the NFA has been very helpful in that regard.
I think today things run quite smoothly. There is still the occasional bad apple and the NFA and the CFTC are quite good at ferreting them out. There’s much more reporting. Reporting is electronic now rather than paper and therefore the NFA can sort through it and the CFTC. However, most of that reporting goes to the NFA and they can sort through that very efficiently, identify things that are a little bit askew and investigate further.
Sure, sure. Now, thanks very much for that. I was actually also trying to get a broader perspective of the industry as a whole. You, obviously, focused on the regulatory side. So, if I can ask you, JP, to talk a little bit about... just because we have a very broad audience listening to our conversation, maybe to introduce the different actors that we have in the managed futures industry as a whole, not necessarily just focusing on the regulator side. You know the different kinds of managers and so on and so forth, just to give a broader perspective before we dive into some of the more nitty gritty stuff that I want to talk to you about today.
Sure, thank you. So, I think we’ve talked a little bit about the difference between a CTA and CPO. The other categories of firms out there, that are very relevant to both are introducing brokers and Futures Commission Merchants. Futures commission merchants are, in essence, clearing brokers for futures and, increasingly, certain swaps and other derivatives. They have custody of customer funds and possessions.
An introducing broker has neither custody of customer funds nor positions, but often times is useful in routing orders or executing trades and often times provide capital introduction services to their clients for CTAs to manage accounts for. Both firms are subject to financial requirements with the Futures Commission Merchants being subject to much greater levels of capitalization. Introducing brokers can either be guaranteed by a Futures Commission Merchant or be independent, in which case they do have some capital requirements.ch I haven’t seen one since:
Sure, sure. I think that’s very helpful. Now, before we move on I thought it could actually be interesting... We’re talking about the managed futures industry that we all have been involved in for a number of decades, but maybe, since you’re not coming from the manager side (none of you) and therefore you might look at things a little bit differently, maybe we could talk about why people should even consider making an investment in the managed futures industry, or with a CTA, and of course there are different types of CTAs, etc. We can make it broad. We can make it very specific. That’s perfectly fine. From your perspective, just having the acumen from a non-manager point of view, why should people even consider this? Maybe Art, I can turn to you first on this one.
OK, fine, well, certainly any large portfolio, and I would only suggest managed futures for a larger portfolio because you don’t want to put all your money into futures and I don’t think there’s any CTA or CPO that advocates that. So, putting a percentage in managed futures gets you diversification that is generally uncorrelated, not negatively correlated necessarily, but uncorrelated with other investment opportunities, particularly equities. So, that’s one reason to do it, is the diversification.
Secondly, you get what might be called free leverage. By that I mean you only have to put up margin deposit on a contract that has a huge amount of value. So, rather than having to put up all the money to buy five thousand bushels of grain, you can buy a futures contract on five thousand bushels in putting up a small deposit on that. That deposit money would have to be increased if the value of the contract decreased and vice versa. You can actually take out money if the value of the contract increases. You still have to maintain margin requirements. Margin requirements can change during the life of a contract, so you don’t know for certain how much you have to put in. So, those are two reasons to put in it.
You get a different perspective from the standpoint of the manager. So, you get that as opposed to what you would get with equities, whereas in equities there’s a general common denominator. There are a lot of variations, but generally, you’re getting one theme from investment managers of equities and bonds that you’re not getting in futures. So, those are three reasons that you might invest in futures.
Sure, sure. JP, Jennifer, do you have any other thoughts on this?
I think Art summed it up quite nicely.
JPures for tail protection. So,:
Now, in my preparations for our conversation today I was wondering if we could approach this a little bit like a case study to showcase what it takes to set up a CTA business today from a product/accounting point of view and what you need to structure, and how do you structure your offerings, what regulation is required, and not least what you’re allowed to do in order to attract new investors to your fund, which we may also touch upon a little bit later. Since we have a global audience, perhaps we can also talk about what the steps are, if you are, say, a firm based in Europe that wants to raise assets in the U.S. Now JP, since you have given a talk about ‘How To Organize Your Business For Success’, I thought maybe why don’t you take the lead on this small managed futures crash course. What’s the evolution for someone who wants to start out as a manager in this business? What dots do they need to line up so to speak?
OK, so the first thing to point out, I think, is that registration with the CFTC and membership in the NFA is a fairly low barrier to entry as opposed to firms located in Europe, you may have to register as an alternative investment fund managers. The single biggest gating issue is that at least one person has to take and pass the series three examination. Over the years I’ve met thousands of individuals who have taken the series three examination and only met one who didn’t pass it the first time. So, it’s not a particularly difficult examination, but it does require some preparation.
There is also a fingerprinting and background check requirement which has gotten very easy over the years. For managers located outside of the United States, depending on where they are located, fingerprinting is very easy in London, and in Switzerland, if you’re located in India it may be a little more difficult. So, firms can expect that it will take between two to six or eight weeks to become registered and a member of the NFA, at which case they can be up and running in order to have a hedge fund or a commodity pool.
If a firm is targeting more retail type investors they would need to submit the fund offering document for review and comment by the NFA. Most of our clients rely on an exemption known as CFTC Rule 4.7 whereby if they limit their investor types to certain qualified investors, which are basically individuals who have an investment portfolio of two million dollars or more, or certain professional investors, or non-U.S. people, then you can bypass having to file the disclosure document or offering document with the NFA. There the manager just remains subject to anti-fraud provisions that they can’t have misleading information or state misleading material information in the offering document. So, that takes a little bit of doing to get the offering document done. That can be done concurrently while the firm is pending registration.der the U.S Securities Act of:
On the managed accounts side, there is a very similar regime that once a firm is registered it can file a 4.7 election and not have to submit its commodity trading advisor disclosure document with the NFA, provided that its customers are these sophisticated investors known as qualified eligible persons.
Sure, sure, that’s great. Now Art, you know, we’ve heard of some of the preparations, but there are also certain documents that need to be prepared and I wonder whether that’s also something that you, on your side, help out with before they are fully ready. How do you see the initial phase, if there’s anything to add to what JP was talking about?
I will take that question and expand it just a bit. I agree with JP that entry is easy but success is very difficult. Anyone that looks to get into it has to understand what their edge is, why are you different? What do you have that is going to be able to attract investors? For example, if you have a trend following system you’re going to be like a thousand other traders out there and you’re not going to have much success raising money unless you can define some reason why you are better, different or significant, or have history, have experience. You’ve got to have something along those lines or you will not succeed.
It is also essential to have counsel and accountants that are experienced in this industry. If your lawyer is also your barber you are in the wrong place and you’re going to have trouble. I know that these professionals are expensive, but you have to have a budget adequate to get the help that you need or you will make mistakes or have errors that can have a very long-term impact on you. If you end up with an NFA or possibly CFTC action against you for some possibly even innocent mistake, but none the less some error, or you make some trade error because you haven’t had the right advice, it is almost impossible to overcome that for somebody starting out.
Also, starting out, you’re going to have to have real money, whether it’s your own money that you may have accumulated or money from family and friends, you have to have a trading history or you’re just not going to get many people, or any people, to invest with you. Hypothetical trading just doesn’t do it. Proformas just doesn’t do it. People believe as I do, I’ve been in this industry for forty years, I’ve never seen a bad hypothetical. That certainly doesn’t do much for their credibility.
Thanks for expanding on that, for sure. It’s a very important point. Now Jennifer, before a firm is allowed to make use of all of this preparation, which I’m sure will take a little bit of time and cost a little bit of money, as we’ve heard, the regulator comes into the picture. Tell me a little bit about the initial interaction and how the new actors in this industry usually start the dialogue with you, as a regulator, and also how that dialogue evolves over time as the firm gets up and running.
Sure, so as JP was mentioning, the first interaction that a firm is going to have with NFA is during the registration process. They’re filing their applications with us. They’re showing us that they passed the series three exam. They’re listing out all of the principals which would be any officers of the officers of the firm, any owners of the firm that own ten percent or more, anyone who has a controlling influence. So, they would have to get background checks on all of those people through the fingerprint process. They’d have to register any brokers with us. Those are the people that solicit accounts and handle the orders on behalf of the firm. So, those are the people that would need the series three exam.
So, we’re involved in that whole process. We’re reviewing the results of the fingerprint checks. So, if there is anything that comes back that shows that there could possibly be a statutory disqualification for an individual we will go through that information and determine whether or not that person should be registered, and if we do allow them to be registered, whether or not there could be conditions on that registration. So, for example, somebody might be able to come in, but they might not be allowed to supervise other brokers, for example.
JP also talks a little bit about the disclosure document process. That’s another part that we get involved in very early on in the firm’s membership process. We do have a team in the compliance department that reviews all the disclosure documents that are submitted and looks to make sure that they are complete and in accordance with the CFTC regulations.
We don’t verify the accuracy of a lot of the information in those documents, but we do to some extent. So if, for example, it lists out background information that shows that the person was registered at other firms previously, we’ll compare that to the information that we have and make sure that’s accurate. But, if for example, they list performance in there, we’re not going to, at that point, request support for that performance. We’re going to calculate it and make sure that it’s calculated correctly, but we’re not going to necessarily ask for the support.
The other things that I think that firms need to be aware of as they’re getting off the ground, and I completely agree with Art that having qualified consultants and accountants and attorneys helping you with this process really goes a long way, is just the amount of procedures and programs that you need to have in place to make sure that you can effectively run your operations. For example, each firm is required to have a cybersecurity program. A lot of firms that we deal with say, “I don’t have my own plant form that I use. I don’t handle customer funds,” or things along those lines. We have an interpretative notice that deals with the cybersecurity program and helps give guidance to firms and allows for some flexibility based on their operations, but there are certain requirements that need to be at least addressed in those programs and it’s important for firms to have a good understanding of what is required in that area.
A disaster recovery program is another area that we require. So, it’s just important for firms to realize that there are a lot of things that need to be in place as they’re getting off the ground. I think one thing that’s very helpful to firms, as they are newly registered with NFA, is that we have a document that we offer called the Self- Examination Checklist and that’s available on our website. It goes through all the different areas of a firm’s operations. It breaks it up by registration category, so separate documents for FCMs, IBs, CPOs, and CTAs, and goes through, step by step in the different areas, what information is required, or to make sure that your procedures, for example, include certain pieces. We really encourage firms to go through that at the beginning of their operations to make sure that they’ve identified all of the areas that need to be identified.
Sure, sure. Once they’re up and running and they pass the first hurdle what’s the ongoing dialogue like with the NFA?
So, I think the biggest thing that firms get concerned about is when are we going to come and actually do an examination of the firm. We do about six hundred examinations a year and we have about thirty-six hundred members. So, as you can imagine, not every firm is going to be examined every year. Some will, depending on the type of business that they do, or the risks involved, but with some, there may be several years in between exams.
We don’t really have a set time period that we’re required to do most firms, but we have a pretty robust risk system that we use in conjunction with just humans looking at information and saying, “Ooo, here’s a problem here. Let’s go take a look and do an examination.” We will identify all of the firms that we feel that we need to go and examine during that year.
Most of the exams that we do are announced, so we will contact you ahead of time. Usually it’s between two and four weeks ahead of time and let you know when we’re planning on coming, give you a list of documents that we would be looking at and really try and make sure that you’re aware of what kinds of things we’re going to be looking at during the course of our testing. Very rarely will we just show up at your door one day and say, “Hi, we’re here to conduct an exam.”
Yeah, yeah, that’s great. Now, I want to move onto other topics, but I also want to stay on this just a little bit longer because I think it is interesting. I want to hear your perspective... JP started out by saying that the barriers to entry are very low, and Art added to that about that success is that it’s very hard to stay there. When I hear you talk about what is required, it certainly isn’t that easy and you need to, as Art was saying, you need real money to pay good advisors in the beginning.
So, just out of curiosity and maybe compared to your experience ten, fifteen, twenty, years ago, is there a risk in the way things have evolved that we might lose some emerging talent that just simply can’t come up with that kind of money to get started? It is an entrepreneurial industry. If you go back and you look at the people that are very successful today, they didn’t start out with all these things in place, necessarily. So, I just want to raise the question and see what you think about this.
Just one thing that I would think is that I know Art had talked a little bit earlier about having a track record. I think one thing that we see firms stumble with is that they get registered before they have any type of track record and then start trading just proprietary funds and realize, maybe, that they might not be as successful as they hoped that they would be. So, I would suggest that if there are any firms out there, to really try and build your own personal track record with your own funds, and if you’re successful then at that point you start thinking about registering as opposed to registering and having to worry about all of these requirements as you’re also trying to build a track record.
Yeah, I think that’s a great point, Jennifer, thanks for that.
I agree with that as well. Having some trading experience before you register will identify if you have the ability - if you know what you’re doing. If you do have some stumbles while you’re trading proprietary trading, maybe just getting an understanding, you don’t necessarily have to disclose what your proprietary trading is.
Yeah, yeah. Now, before we move on maybe we can change gears for a moment. We’ve been talking about what it takes to start up as a manager in this industry, but how about looking at all of this from the investor’s point of view. What should investors be looking for when they start their due diligence process? What are the questions that they should be asking that may not be in the standard DDQ templates that most people seem to be using?
I don’t know who wants to start out on this, but I think that’s also very relevant in this context.
I’ll jump in here. I tell folks, that are just starting out, that they have to get very serious about infrastructure and investors who are looking to invest with managers, especially new managers. You need to look at the infrastructure to see what plans they have in place, who the personnel are, what their background is, are they likely to succeed, what happens if the principal is unavailable, what happens if they are ill or on vacation, who are their lawyers, who are their accountants. You want to look at all the things that say, “Yes, this is a good business,” whether they’re making widgets or trading futures. Is it a business that has a plan, that has the proper people doing the right things, the right professional advisors? All of that infrastructure is critical in an assessment of whether or not they’re likely to succeed apart from their trading ability.
Yeah, yeah, absolutely. JP, what do you see on this?
I think that the investors do due diligence and all the points that Art has mentioned I’m absolutely in agreement with. I think that people should also, as investors, spend some time actually reviewing fund terms and legal documentation to understand what terms they are getting rather than just signing a subscription agreement that they read the documents they should read the fund offering documents from cover to cover and also the partnership agreements. They should make sure that the fund documents accurately reflect what the rights and obligations of the investors are. I think that goes to Arts point that a fund that has recognized service providers you’re not going to have any hidden surprises where the documents don’t match.e obligations under NFA bylaw:
Typically, if they’re looking at track records, you should make sure that you’re looking at an apples to apples comparison. That’s why even many managers that are 4.7 exempt and Art will chime in on this, but it used to be that all managers were particularly CTAs and also CPOs had to prepare thirteen column performance tables so that their performance would be very comparable. Now the NFA has allowed for more flexibility in performance reporting including presentation based on account size, but I still think that when you are looking at two track records you should be able to get comfortable that both managers are reporting their performance in pretty much the same manner.