New CFTC Restrictions to Affect Many Commodity Pools

Buried in the Enforcement provisions of Dodd-Frank is a definitional change that will affect the operation of many commodity pools that trade off-exchange or over-the-counter (OTC) forex. As the CFTCs final rules on OTC forex are written, counterparties that intermediate OTC forex transactions will not be able to act as counterparty to U.S. retail investors unless such counterparty is registered with the CFTC in the necessary capacity. The question becomes, who is considered a retail investor. Retail investors include anyone who is not an Eligible Contract Participant (ECP). ECPs are institutional market participants whom Congress is not particularly concerned about protecting either because they are sophisticated or have sufficient assets to bear the risk of their own trading decisions. ECPs have traditionally included commodity pools with greater than $5 million in total assets, managed by a registered Commodity Pool Operator (CPO). However, Dodd-Frank Section 741(b)(10) amends the definition of ECP with respect to commodity pools such that any commodity pool with non-ECP participants will not be considered an ECP. For individuals and entities, ECP status requires greater than $10 million in assets. So, once this definitional change becomes effective in July of 2011, any commodity pool, regardless of its size, with investors that have less than $10 million in assets will be subject to the CFTCs recently adopted final regulations on off-exchange forex. Note that the ECP asset test sets a significantly higher threshold than the Qualified Eligible Person (QEP) standard. It is also notable that the ECP asset threshold for individuals was raised by Dodd-Frank, as well, and will require $10 million invested on a discretionary basis after July 16, 2011. The most cumbersome restrictions that non-ECP commodity pools will have to adhere to include the restrictions on counterparties, leverage, and hedging. After October 18th, 2010, when the CFTCs final rules on off-exchange forex become effective, non-ECPs will effectively only be able to trade through registered counterparties. Generally, this includes Futures Commission Merchants and Registered Foreign Exchange Dealers that are registered with both the CFTC and NFA. For non-ECP clients, these counterparties will only offer 50:1 leverage on major currencies and 20:1 leverage on minor currencies. Further, registered counterparties will not be able to facilitate hedging strategies, as they will be required to close out offsetting positions, even if the client specifically requests otherwise. This development will have significant implications for many commodity pools that trade OTC forex contracts and although this change will not become effective until July 2011, commodity pool operators should begin to consider how this will affect their business.