Traders call for one regulatory voice

A popular myth is that futures trading is inherently risky and thus deserving of increased regulatory scrutiny. In many situations, this fuels dual regulatory burdens for trading advisors and pool operators. However, with the recent performance of stocks suggesting long-only equity strategies can lose money and with the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) cooperating more fully on rules for single stock futures, some regulatory relief may be in sight.

One of the adjustments non-U.S. fund managers must make when deciding to offer products in the United States is that they will come under the jurisdiction of two regulatory agencies. Most European and Asian countries have one regulatory authority that oversees fund managers. In the United States, however - where the CFTC has oversight authority for futures trading and the SEC oversees securities - a money manager comes under the jurisdiction of at least these two regulators. With the advent of single stock futures and narrow-based indexes, which are defined in governing legislation as "hybrid products," the regulatory distinction has become even more muddied.

While the differences between equity and futures markets call for different regulatory approaches, money managers could operate more efficiently if they did not face two regulatory masters. That was what was behind the CFTC gathering industry representatives in Washington in September to discuss managed funds issues and explore ways possibly to eliminate regulatory overlap.

The roundtable addressed whether the two regulatory agencies could coordinate on definitions of sophisticated persons, communications with prospective participants, how to address security futures products and several other issues.

OUT OF THE PAN, INTO THE POOL

A common problem mentioned was the broad nature of who must register as commodity pool operators (CPO).

"We have a definition of a commodity pool that...captures any entity that does one futures transaction .... [T]here is a recognition that is too broad of a definition," says Jane Kang Thorpe, director of the CFTC's division of clearing and intermediary oversight.

The upshot of the rule is that a hedge fund that trades primarily equities but may occasionally hedge a portion of its portfolio with a stock index or other futures product must register with the CFTC as a CPO.

Besides being a burden to fund managers, the CFTC's CPO rules may have a chilling effect on security futures.

"An unregistered hedge fund, if it wishes to trade security futures, would be in perfect compliance with the securities laws but it is our laws, the Commodity Exchange Act, that says if any entity trades one futures contract whether it is a pork belly or a futures on IBM, it must be registered as a CPO," Thorpe says. "The vast majority of hedge funds are unregistered [so] they would be acting consistent with securities laws but violating the CEA under current laws."

David Harris, general counsel of Nasdaq Liffe Markets (NQLX), voices the NQLX's concerns that current regulation may prevent hedge funds from taking advantage of security futures products: "We have a group of people right now with an immediate need for single stock futures, who are not going to use them," Harris says. He supports proposals enumerated at the roundtable by the Managed Funds Association (MFA) and National Futures Association (NFA).

The NFA's de minimus proposal would set a maximum threshold of futures exposure within a portfolio that would be allowed without the manager having to register as a CPO. The MFA has suggested the CFTC adopt a rule that would allow fund managers, limited to qualified purchasers, exemption from registration. The exemption would work similarly to exemptions from registration on the securities side.

Beyond the two proposals, Harris would like to see the CFTC use its powers under the CEA to exclude hedge fund managers trading security futures from CPO registration. His reasoning is many hedge funds trade only securities products and though securities futures are an attractive product, they will have the weight of additional regulation.

"For the managers of such funds, whose sole involvement in the futures markets will be trading in security futures products, the burden of complying with a new regulatory structure will significantly reduce or eliminate the attractiveness of these new products," Harris says.

Given that regulatory cost, which goes far beyond just registration costs, according to Harris, managers would choose to hedge cash securities with functionally related products such as options on securities and equity swaps that would not require them to face additional regulation as would security futures. This, he claims, puts exchanges trading security futures at a regulatory disadvantage to other security products, which is what that the two regulators worked so hard to avoid.

Bob Paul, general counsel for OneChicago, NQL)Cs main competitor in security futures says he agrees with Harris' position.

GOING PUBLIC

Perhaps the products that face the most onerous dual regulation are public commodity pools. Because of their structure, pools come under security laws and because they trade futures they come under CFTC rules. Their retail nature, however, means that they do not get .exemptions afforded private funds.

Publicly offered commodity pools face oversight from the SEC, the CFTC, the National Association of Security Dealers (NASD), the NFA and each state in which they are offered.

Terri Becks, chief financial officer of the CPO and commodity trading advisor (CTA) Campbell & Co., estimates the start up cost for a public commodity pool to be in excess of $500,000. Campbell operates a public futures fund with $1.3 billion under management. Commodity pools are required to update disclosure documents, which must receive clearance from the CFTC, SEC, NASD and 50 states, every nine months. Becks says that process alone takes four months because they face conflicting guidance from the various regulators, which can result in a document not as clear and concise.

"When we take our commodity pool and try to fit it into SEC guidelines, we feel it leads to confusion," Becks says.

Others, while acknowledging both the CFTC and SEC have an oversight role in public pools, suggest the regulators stick to their own area of expertise.

"The SEC is expert in the public offering process; public pools should be fully subject to SEC rules in this respect. The CFTC, on the other hand, is expert in commodity pool disclosures; public pools should be fully subject to CFTC rules and only CFTC rules in this respect," notes Steven Olgin, chief administrative officer of MLIM Alternative Strategies.

Gunter Mathis, CFO of Austrian-- based Quadriga Asset Management, which is in the process of registering a commodity pool with the SEC, calls the process of registering a public commodity pool lengthy and expensive. Mathis estimates it will cost Quadriga almost $1 million to complete the registration requirements of its pending program. He says the way securities and futures are divided with separate New York and Chicago mentalities is something unique to the United States and he isn't sure they would have proceeded if they knew the process would be so cumbersome.

Privately offered commodity pools don't face state-by-state review, and publicly offered mutual funds are exempt through the National Securities Market Improvement Act of 1996. Public commodity pools, however, must face stateby-state review, which makes the process long and adds tremendous cost.

Public pools also fear that current rules will lock them out from offering security futures. Hedge funds are prohibited not only from advertising but also from holding themselves out to the public as advisors. Public funds by their nature hold themselves out, which could require them to register as an investment company.

Another sticking point is that public pools must deliver lengthy final prospectuses to potential investors before they can approach them. This is required despite rules that require possible customers to receive and sign off on the final prospectus before investing in the pool. Pool operators would like the ability to send out simple factual preliminary solicitations to gauge interest before delivering the final prospectus.

FUND OF FUNDS

In Europe, fund of fund managers are increasingly looking for CTAs to add to their portfolios. While hedge funds have outperformed overall equity markets during this bear market, their performance has not been stellar and indicates that hedge funds may not be as non-correlated to equities as touted. CTA programs have proven continuously that they are a non-correlated alternative to volatile equity markets. A fund of fund choosing to allocate to a CTA, however, requires the fund of funds to register as a CPO.

Mathis says a growing number of fund of funds managers in Europe are making allocations to CTAs, but that this is not happening in the United States because of the CPO registration requirement.

"I am surprised at how few fund of funds have CTAs in their portfolios," Mathis says. He adds that because most managers would not have more than 10% to 15% of their portfolios in a CTA, the added cost of registration is too big of a hurdle to overcome.

It was suggested at the roundtable that the CFTC should reverse its position that requires fund of funds that allocate any of their portfolio to a CPO or CTA be registered as a CPO.

"We do not believe the operator of [aJ fund of funds is operating `for the put, pose' of trading commodity interests, which is a necessary element to determine commodity pool status," Jack Rigney, partner in law firm Seward and Kissel LLP, noted at the roundtable.

KILLING THE MYTH

Hedge funds and futures trading long have been saddled with labels of "risky" and "volatile." That is true despite the current nature of the stock market. Stock traders who have seen their investments cut by half still declare futures too risky of an investment. This myth may have helped perpetuate burdensome regulation, but at what cost?

Several attendees of the roundtable pointed out that dual regulations, instead of protecting the public, have harmed the public by locking it out of non-correlated strategies that may have protected wealth in recent times. These attendees say it is a myth hedge funds and futures are more volatile than traditional long-only strategies.

"The bear market in stocks has laid to rest any idea that managed futures investments are more risky than equities," says George Crappie, co-chairman and CEO of CTA Millburn Ridgefield. "The full panoply of protections offered to investors under the Investment Company Act of 1940 - for example, leverage limits and diversification requirements - permitted mutual funds investing in nothing but dot-coms. There seems to be no rationale for singling out futures pools."

This year managed futures have outperformed both traditional mutual funds and other alternative investments, but most managed futures programs are private placements - requiring investments upward of $250,000 - because dual regulation is expensive and creates a barrier to entry for all but the largest managers, such as Campbell & Co. and JWH & Co. Streamlined regulation could allow retail-sized investors benefits enjoyed by professionals.

Giving hedge funds and managed futures a more retail look will be a significant force in the industry in coming years, according to Quadriga's Mathis. He says that managed futures have proven to be one of the few areas- that are non-correlated to typical stock and bond portfolios.

"Professional managed futures programs are not as risky as typical long-- only strategies," Mathis says.

The roundtable exhibited an uncommon level of agreement on many issues, according to those in attendance. Futures professionals also were impressed with the presence of SEC officials, perhaps foreshadowing greater cooperation between the regulators.

"One of the primary purposes of the roundtable was to identify [areas] where both agencies have the same regulatory requirement for certain activities of these pooled investment vehicles - [so] one of us can get out of the way," Thorpe says. She adds that CFTC Chairman Jim Newsome and SEC Chairman Harvey Pitt have developed a good working relationship as a result of their coordination on security futures that will provide the foundation for further cooperation between the two agencies.