The hedge fund and securities industries are concerned that the proposed definition of eligible contract participant under the Dodd-Frank Act will cause substantial disruptions to financial markets. In a joint letter to the SEC and CFTC, the Managed Fund Association and SIFMA urged the Commissions to adopt changes to the definition allowing private funds and other commodity pools to qualify as eligible contract participants, provided that the funds and pools were not formed for the purpose of evading the definition.
The associations believe that private funds and commodity pools should be able to rely on Section 1a(18)(A)(v)(I) of the Commodity Exchange Act without the need to look through to determine whether every direct or indirect investor/participant is an eligible contract participant. Thus,they urge the Commissions to clarify that a hedge fund or traditional commodity pool will continue to qualify as an eligible contract participant by relying on Section 1a(18)(A)(v)(I), which, as amended by Section 721(a)(9) of Dodd-Frank permits a hedge fund having assets exceeding $10,000,000 to qualify as an eligible contract participant.
The scope of the eligible contract participant definition is critically important because Sections 723(a)(2) and 763(e) of Dodd-Frank make it unlawful for a non-eligible contract participant to enter into a swap or security-based swap other than on a designated contract market or a regulated exchange. Also, many financial counterparties have arrangements in place with hedge funds and traditional commodity pools that are dependent upon their status as eligible contract participants.
The foreign exchange market is the world’s largest financial market, noted the Commissions, with a deep and liquid marketplace that provides an important adjunct to all of the other financial markets. Institutional investors regularly participate in the market to reduce risks by hedging currency exposures; to convert returns from international investments into domestic currencies; and to make cross-border investments. Private funds, including funds that constitute commodity pools, are significant participants in this market and provide a considerable amount of liquidity to the market.
The associations said that the adoption of the proposed definition without appropriate changes could lead to the disruption of the currency markets and increase the potential for greater systemic risk without accomplishing the regulatory goal of enhancing the protection of retail investors. Many of the funds that would become non-eligible contract participants with respect to foreign exchange trading under the proposed definition are sophisticated investors and significant liquidity providers to the U.S. foreign exchange market.
If the Commissions’ proposed definition were to be adopted, noted the trade groups, it would have the potential of categorizing a significant proportion of traditional institutional accounts managed by sophisticated money managers as retail, which would adversely impact the liquidity these market participants bring to the foreign exchange market through their active participation. In fact, investment funds and commodity pools may be precluded from trading certain currencies at all, warned the associations, since not all currencies have corresponding exchange-traded futures contracts or are represented on retail foreign exchange platforms.
According to the associations, there is no indication that requiring customers that are clearly institutional in nature to trade in the retail markets will add any protection for retail customers. Further, the proposed definition is not consistent with the underlying rationale behind the sophisticated investor framework established through law and regulation by the SEC and CFTC and limits the ability of entities managed by sophisticated money managers that are subject to registration and examination by regulators to qualify as eligible contract participants.
The proposed definition is also likely to preclude institutional accounts from effectively or efficiently diversifying or hedging their portfolio against foreign exchange risk and increase costs for individual investors who are ultimately likely to bear the burden of greater costs. Moreover, if institutional accounts and their counterparties were forced to trade in the retail foreign exchange market, the associations are concerned that many of the firms would have difficulty doing so from an operational perspective.
As a result, it will become very difficult for affected firms to operate within the U.S. In addition, requiring these entities to transact as non-eligible contract participants for foreign exchange will mean that the entities would need to trade with a separate retail-focused dealer and not with the swap dealer that will be the counterparty to the entities on all other transactions. In the view of the associations, bifurcating trading entities will create systemic risk by eliminating the benefits of close-out netting.