DMAXX

Why Compliance is the New Black

: 02 Aug 2016

Earlier this year, the NFA implemented rules that CTAs, CPOs and others must have in place a cyber security and compliance plan that provide a detailed outline on the firm’s daily behavior in following the rules, as well as a step-by-step disaster recovery plan.

Although the regulator isn’t calling in these plans, it will check them during an audit, and if you aren’t prepared, you’ll be in violation. Compliance has been upped largely due to Dodd-Frank rules, but also because the NFA and exchanges are under increased scrutiny by the CFTC.

That said, there are key areas of compliance across all regulators that need to be part of the game plan for a firm’s daily operations. Here are important aspects to include in your plan:

1. Know your vendor and customer:  NFA Bylaw 1101 “prohibits NFA Members from doing business with most non-members that are required to be registered with the CFTC as an FCM, IB, CPO, or CTA.”  Basically, you must do business with your own. It’s up to the CTA to make sure clients, business associates, and brokers are all registered or exempted. The NFA requires you to be able to show not only the process your personnel takes to check out the potential vendor, and that means checking them through BASIC, you need to keep all the documentation on had to show your research.
   
   You can roll the dice and assume vendors are members, but that’s not good business. For example, let’s say you know three friends, traders, who pooled their money to invest in your CTA. First, you must make sure the key person is a qualified investor, but you also must make sure if they are a pool, all investors are qualified, and you must retain documentation confirming the fact.  In other words, if they are representing themselves as a pool or FCM, they must be registered with the NFA.  For more details on 1101, go to: https://www.nfa.futures.org/NFA-faqs/compliance-faqs/bylaw-1101/index.HTML
   
   
2. Make sure from a CTA standpoint, your automated systems allocating trade orders are “equitable and fair.” This should be checked quarterly.
   
   
3. Related to #2, make sure that all accounts within a program have substantially the same performance and that performance is what your marketing materials state for the program.  If different accounts have substantially different performance, the regulators may take the stand that you actually have more than one program.
   
   
4. Not only must a CTA know who he’s dealing with on multiple levels, he needs to know what his vendors are doing, especially FCMs. One compliance expert says a CTA needs to be on top of not only filled orders, but the source data as well.  FCMs don’t necessarily hold the old back up files of trade audits (and if they do, some charge for it), and if an exchange comes asking for it, a CTA must be able to put his hands on records and source data that can build an audit trail or trading activity, and be able to produce it in a short amount of time.
   
   
5. Sometimes slip-ups can happen due to changing regulations but often they happen due to bad communications between an FCM and client. For example, those who trade metals might be using exchange for physicals (EFPs), which are executed thru the FCM to get a futures equivalent position. In some cases, block trade rules come into play, meaning there are minimum lot sizes to a trade. The CTA must understand the rules when dealing with an executing brokers so he doesn’t unintentionally break any. 
   
   As an example,  if a CTA is doing a gold trade, but the executing broker could only get a partial fill, thus it’s not a block trade but an EFP, but the CTA doesn’t know this and if the FCM doesn’t do the paper work – and sometimes they don’t – the CTA is in trouble. Be on top of those trades; in the past, it used to just be a venal sin: one of not knowing. Today it’s a mortal sin, says one expert, stating that CTAs must follow up on trades.
   
   
6. Allocation of expenses between the manager and funds, and between funds has been the focus many recent examinations and common issues have included charging expenses that are not fully disclosed to investors and charging one client an expense where another does not pay the same expense.  Examiners have been aggressively drilling down on expense allocations even when the amounts are minimal.

While NFA audits have not been as frequent during the past few years due to the recent influx of new members, the NFA has recently reached what they consider appropriate staffing levels and you should expect audit frequencies to return to normal.  It’s time to make sure you are dressed appropriately for the party.

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Dana M. Comolli is president of DMAXX (dmaxx.com), a back office software design firm for alternative investment managers. TheBooks software is designed for the trader, and is built to do price, position and order management, reconciliation, trade accounting, performance reporting, risk and data management and act as a gateway to a wide variety of execution platforms. You can reach Dana at: [email protected]