Hedge Funds Seek FinReg Relief

Terry Flanagan

Rules could lock funds and commodity pools out of institutional FX market.

The hedge fund industry is lobbying for a relaxation of rules by the Commodity Futures Trading Commission that it says will hamper funds’ ability to participate in FX markets.

Industry groups, including the Global Financial Markets Association and the Managed Funds Association, are asking the CFTC to clarify the definition of “eligible contract participant” or ECP in its Dodd-Frank rulemaking.

They’ve requested that funds with total assets exceeding $5 million and comprised of “highly sophisticated individuals” be permitted a safe harbor; in other words, that they be permitted to be categorized as ECPs.

Without such a safe harbor, the ECP definition may hamper the ability of certain legitimate market participants to remain in the institutional FX market.

“So long as a fund is not formed specifically for the purposes of evading the regulations, then there is no reason why private funds and pools should not be considered ECPs,”  Trish Rogers, co-chair of the financial institutions group at Moye White, told Markets Media.

For example, an investment fund started with seed money from principals of its investment manager and other sophisticated investors, may not be eligible to be an ECP, and therefore would be prohibited from trading FX with its dealer counterparts.

“A lot of the funds that would be affected by a limited scope are active players in the FX markets already, and taking them out of the market would be a significant and adverse disruption,” Rogers said.

The safe harbor would exclude “bucket shops and fraud artists” who seek to evade application of retail FX regulations, the MFA and GFMA said.

Based on a review of 35 enforcement actions brought against such entities in 2010 and 2011, only three of the 35 cases involved a hedge fund with assets in excess of $10 million.

The scope of the CFTC’s ECP definition is critically important because many financial counterparties have arrangements in place with hedge funds and traditional commodity pools that are dependent upon their status as ECPs.

The Dodd-Frank Act makes it unlawful for a non-ECP to enter into a swap other than on, or subject to the rules of, a regulated exchange. Hence, non-ECPs would be excluded from executing swaps on a swap execution facility (SEF) or bilaterally.

Hedge funds and traditional commodity pools are functionally different from retail FX pools in that they don’t pool retail cash for the purpose of gaining exposure through currency-based instruments.

Inasmuch as a hedge fund engages in retail FX transactions, that activity is at most incidental to the fund’s normal investment activity and should not disqualify it as an ECP.

The Dodd-Frank Act contains major reforms to the derivatives market, including requiring that standardized or vanilla OTC swaps be executed on an SEF or exchange, and be cleared through a CCP.

The CFTC has noted that while the Act precludes non-ECPs from executing swaps on an SEF, it also opens up the swaps market to non-ECPs by permitting them to execute swaps on a regulated exchange.

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