Fund Managers: Get Ready to Monitor Phone Calls on Swap Deals

It isn’t often that regulators take into account the concerns of market participants on the difficulties in implementing new rules.

When it happens it is a great relief — particularly for some fund managers who are already struggling to meet new trading and clearing requirements for swap contracts.

But when it comes to the recent decision of the Commodity Futures Trading Commission (CFTC) to grant them relief from new recordkeeping requirements for oral communications, fund managers shouldn’t get too happy. The reprieve will be short-lived, so they shouldn’t throw caution to the winds.

“Fund managers, who are commodity trading advisors, need to think carefully about preparing for the oral recordkeeping requirements, as there is no clear indication on whether or not the CFTC will grant a permanent exemption,” says Julian Hammar, an attorney with Morrison & Foerster in Washington DC.

As if trading on new electronic platforms and processing trades through central clearinghouses with new collateral management requirements weren’t hard enough, the CFTC also issued new recordkeeping demands for written and oral communications for buy and sell-side firms, including futures commission merchants (FCMs), larger introducing brokers and retail forex traders. The goal is to catch fraud, such as misinformation on the risk of a transaction or frontrunning client orders.

Execution Discussions

The saving grace: the US regulatory agency has just allowed commodity trading advisors (CTAs) to wait until December 31 before they have to start recording all electronic conversations– telephone, voicemail, chat rooms and instant messaging — related to swap transactions executed on swap execution facilities (SEFs) and designated contract markets (DCMs). The rule covers all discussions on quotes, solicitations, bids, offers, instructions, trading and pricing that leads to the execution of a transaction in “commodity interest, ” which the CFTC defines as a commodity futures contract, a commodity option, a swap or foreign exchange contract.

The CFTC’s decision to postpone the recordkeeping requirement, announced last Friday by its Division of Swap Dealer Intermediary Oversight and Division of Market Oversight, was quickly praised by the Asset Management Group (AMG) of the Securities Industry and Financial Markets Association (SIFMA) which had vigorously lobbied to exempt CTAs from the CFTC’s recordkeeping rules. “We strongly commend the CFTC for taking today’s action to extend the relief previously provided to registered commodity trading advisors that are members of SEFs or DCMs,” writes SIFMA’s AMG in a statement.

Yet given that the CFTC hasn’t given the asset managers a get-out-of-jail-free card, the AMG says it will continue lobbying for an exemption and urges its members to use the extra time to prepare for the inevitable. Compliance directors at three CTAs contacted by FinOps Report also aren’t encouraged by the CFTC’s recent no-action letter which gave little detail even on its rationale for a reprieve. “We don’t think the CFTC will rule in our favor based on past experience,” says one compliance manager at a New York-based fund management shop.

The CFTC’s new deadline represents the second reprieve granted to some asset managers. The new recordkeeping rule for both oral and written communications effective December 21, 2013 still applies when it comes to written communications. While commodity pool operators (CPOs) were exempt from the CFTC’s recordkeeping rules, CTAs weren’t; they were just given a break until this May and only when it came to oral communications. In its no-action letter to the AMG last Friday, the CFTC did not elaborate on why it did not address the AMG’s request that it also grant CTAs an exemption from recordkeeping requirements for written communications. The CFTC’s two divisions simply said it a footnote that it considered it “appropriate” to only deal with oral communications.

CTAs are naturally annoyed that the CFTC has distinguished between CTAs and CPOs which both manage investment funds and execute trades in swap contracts. One possible rationale: CPOs manage pools of funds, while CTAs advise individuals, so they need to follow a higher standard of fiduciary responsibility. Still, even legal experts don’t agree. “The goal is to prevent fraud and the potential exists in both categories,” notes Hammar.

Go Bother Others

What does the AMG suggest the CFTC do? Leave the recordkeeping to dealers, FCMs and others. Requiring some fund managers to also monitor oral communications is merely duplicative as they already trade exclusively with dealers and FCMs. “As a result, these covered conversations would already be subject to taping by dealers and FCMs, since the compliance date for those entities has passed,” writes the AMG in an April 17 letter to the CFTC.

One would think that in an age of high-technology, monitoring phone calls would be a piece of cake. Apparently not so. In asking for them to keep track of all communications related to a transaction, the CFTC is requiring financial firms to be able to “reconstruct” the entire transaction which could easily include a dozen separate phone calls and written interactions through emails, text messages, landlines and mobile phones. When the CFTC comes calling — aka does an audit — the firm must be prepared to find a needle in a haystack.

In its letter to the CFTC asking for relief for CTAs, the AMG cites a six-digit cost of complying with the oral communications rule — and that doesn’t even include ongoing expenses related to training, planning and overseeing the filing and storage systems for the oral records, designing and maintaining search and production capabilities and retrieving tapes, upon request. The total price tag could ultimately depend on the number of employees whose conversations must be recorded as well as the sophistication of the technology used, says the AMG.

The trade group  is so concerned about the cost that it warns that some fund managers may avoid trading swaps on SEFs and DCMs altogether. “Avoiding SEF mandated swaps would mean that an asset manager would use alternative risk management and investment products even though the foregone swaps may provide the most efficient means of satisfying a hedging or investment need,” says the AMG.

None of the five compliance specialists at US fund management shops contacted by FinOps Report would comment on whether they would change their trading strategies as a result of the CFTC’s recordkeeping requirements, although there has been plenty of industry talk that new regulatory burdens could prompt them to turn to exchange-traded futures and options or swap-like products. Most of the compliance managers estimate the cost of phone monitoring at US$200,000 just to implement the necessary technology and training. They have yet to tabulate ongoing expenses, but are annoyed that they may have to meet the CFTC’s recordkeeping requirements. One of the key reasons: they have to determine who at their firms fall under the CFTC’s rules and to be on the safe side they will likely start recording every conversation, because swap transactions are often conducted alongside fixed-income deals for hedging purposes.

Who Will Be Recorded

“For fund managers who haven’t done so already, now is the time for portfolio managers, traders and compliance specialists to decide who will be recorded, which technology to use and to document their procedures,” says Mark Miller, US general manager for TeleWare, a London-headquartered firm specializing in mobile phone recordings which entered the US market last year. “It’s a similar process to what dealers, FCMs and others will have to do.”

Fund managers might end up with far fewer individuals to record than dealers or FCMs, but the onus for complying might fall far more heavily on the trading desk than the compliance department, predicts Miller. The reason: fund managers typically have smaller generalist compliance units — those specializing in non-trading related rules — than their sell-side peers. Therefore, when it comes to any regulations affecting trading, the decisionmaking is typically deferred to the compliance monitoring desk within their trading operations.

“We are calculating the total costs and meeting with mobile phone monitoring specialists to understand the available options and the level of difficulty of implementing each one,” one fund management compliance director tells FinOps. Like others who responded, he adds that just training the staff to understand the new oral recordkeeping requirements will be a daunting challenge.

CTAs do have two options which could ease or even eliminate their compliance burdens, but each comes at a price. CTAs might decide to eliminate all conversations related to over-the-counter derivatives trading on SEFs and DCMs on mobile phones. It’s a stance already taken by some large dealers and would certainly cut down on the compliance headaches and cost. But such limits which would practically ban them from doing any business offsite.

Yet another: pass the buck to a member of an SEF or DCM to operationally handle a trade, while retaining an advisory role. Because the CFTC’s oral recordkeeping rule won’t apply to CTAs, unless they are members of an SEF or DCM, they can shift the compliance burden if they shift the responsibility for trade execution. Such a scenario sounds counterproductive to the spirit of the CFTC’s intentions, yet would be legally viable.

Even so, the inconvenience and costs must be weighed against the benefits. “CTAs that don’t have direct access to an electronic trading platform will  have to rely on a member to execute their trades and likely pay execution costs,” cautions Hammar.