A Buy-Side Guide to Regulatory and Transactional Issues Related To Derivatives and Repurchase Agreements

HomeCommodity Pool OperatorsAttention Non-U.S. Funds and Advisers: Registration Exemption for Offshore CPOs, CTAs and IBs That Use Non-Cleared Derivatives

On February 12th, the Division of Swap Dealer and Intermediary Oversight (the Division) of the United States Commodity Futures Trading Commission (CFTC) issued CFTC Letter No. 16-08.  This no-action letter clarifies that an intermediary located outside of the United States (a Foreign Intermediary) will not need to register as commodity pool operator (CPO), a commodity trading advisor (CTA), or an introducing broker (IB), as long as the following conditions are met:

The Foreign Intermediary is located outside the United States; and

The Foreign Intermediary acts only on behalf of  persons located outside the United States.

This posting provides additional information in respect of this no-action letter, which we expect will be of interest to non-U.S. hedge funds and investment advisers that use CFTC-regulated derivatives in connection with their investment strategies.

Background: CFTC Regulation 3.10(c)(3)(i) and Why This Relief Was Necessary

CFTC Regulation 3.10(c)(3)(i) is an exemption from registration as a CPO, CTA, or IB available to a Foreign Intermediary such as a non-U.S. hedge fund manager.  The exemption applies to activities that involve commodity interests (i.e., CFTC-regulated derivatives such as futures contracts, swaps, etc.) executed bilaterally or over a CFTC-regulated futures exchange or swap execution facility (a SEF).

A Foreign Intermediary can rely on this exemption, as long as the following conditions are met:

The Foreign Intermediary is located outside the United States;

The Foreign Intermediary acts only on behalf of  persons located outside the United States; and

The commodity interest transaction is submitted for clearing through a registered futures commission merchant (FCM).

The third condition means that a Foreign Intermediary is unable to rely on CFTC Regulation 3.10(c)(3)(i), if any of its derivative investment activities involve bi-laterally executed, non-cleared contracts (e.g., an over-the-counter (OTC) swap of the type that is commonly entered into by parties pursuant to an ISDA Master Agreement).   As pointed out by the trade associations that sought this relief (the Investment Adviser Association and the Asset Management Group of the Securities Industry and Financial Markets Association), this condition is not reasonable since not every swap isrequiredto be clearedor even capableof being cleared by an FCM (i.e., no central counterparty offers to clear a particular swap).

Given that background, many non-U.S. market participants have been scratching their heads for the past several years: they appeared to have an exemption from registration as a CPO, a CTA or an IB available to them, but could not rely on that exemption because of a completely unrealistic condition.

The Division appears to agree.  This is the exact language of the Divisions No-Action Position:

The Division believes that Regulation 3.10(c)(3)(i) was not intended to impose an independent clearing requirement on commodity interest transactions involving Foreign Intermediaries that the [Commodity Exchange Act] and [CFTC] Regulations do not otherwise require to be clearedAccordingly, the Division will not recommend an enforcement action against a person located outside the United States, its territories or possessions engaged in the activity of [a CPO, a CTA, or an IB] in connection with swaps not subject to a [CFTC] clearing requirement only on behalf of persons located outside the United States, its territories or possessions.[Footnotes omitted.]

Put another way, a Foreign Intermediary can rely on the exemption available under CFTC Regulation 3.10(c)(3)(i), even if its activities involve bi-laterally executed, non-cleared derivatives.

Administrative History: Thou Shalt Not SolicitU.S. Customers

This no-action relief is a significant and important development for non-U.S. funds and advisers.  And, the issuance of the relief presents market participants with a good opportunity to reflect on the administrative history of this exemption.  In connection with its adoption of CFTC Regulation 3.10(c)(3)(i) in 2007, the CFTC made the following point:

If a person located outside the U.S. were to solicit prospective customers in the U.S. as well as outside of the U.S., [the exemption under CFTC Regulation 3.10(c)(3)(i)] would not be available,even if the only customers resulting from the efforts were located outside the U.S.Exemption from Registration for Certain Foreign Persons, (Nov. 14, 2007) 72 FR 63976 at 63978 (footnotes omitted), availablehere.

Or, as I have said before in another context, the CFTCs view can be summarized as follows: Our markets are your markets (but stay away from our investors).

Good day.  Good no GREAT St. Valentines Day present! (At least if you like derivatives law).  DR2

The Derivatives and Repo Report offers insights into regulatory and transactional issues related to derivatives and repurchase agreements. Our goal is to provide meaningful and timely information to buy-side market participants, including: mutual funds, hedge funds, exchange-traded funds (ETFs) and their investment advisers; corporate end users; nonswap dealer banks; and other end users of derivatives and repurchase agreements.

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The Derivatives and Repo Report offers insights into regulatory and transactional issues related to derivatives and repurchase agreements. Our goal is to provide meaningful and timely information to buy-side market participants, including: mutual funds, hedge funds, exchange-traded funds (ETFs) and their investment advisers; corporate end users; nonswap dealer banks; and other end users of derivatives and repurchase agreements.