During the last quarter of 2011, the National Futures Association (NFA) quietly submitted to the Commodity Futures Trading Commission (CFTC) a proposed Interpretative Notice to NFA Compliance Rule 2-10. NFA's notice commented on, and proposed changing, the allocation of bunched orders for multiple accounts traded by spot forex (NYSE:FX) commodity trading advisors (CTAs). If approved by the CFTC, NFA's Interpretative Notice would effectively prohibit the use of most PAMM trade allocation software programs by retail forex CTAs.
NFA contends that many individually managed forex trading accounts being executed through a PAMM arrangement more closely resemble commodity pools than separately managed individual accounts. The regulatory agency further believes firms executing orders in this fashion are allowing CTAs to effectively operate as pools without having the proper forex commodity pool operator (CPO) registration. NFA is not alone in its thinking.
Recently, some states, such as Pennsylvania, have come down hard on PAMM allocation models. At the state level, PAMM execution in over-the-counter (OTC) FX has been characterized as a mechanism used to create a "synthetic securities product." More specifically, in Pennsylvania, state securities regulators determined that the use of PAMM allocation systems creates "securities," which are subject to their state securities laws. This interpretation, coupled with NFA's notice to the CFTC, has cast a dark shadow over the future of PAMM execution in the United States.
The following is a brief summary of NFA's proposed Interpretative Notice, and related state enforcement actions concerning the treatment of PAMM execution models. We encourage you to seek compliance assistance if you have any questions regarding how these proposed rules (and current state or federal laws) might affect your forex CTA, IIB, CPO or FCM/RFED. The information set forth in this guide is not intended to be all-inclusive and does not constitute legal advice.
What is PAMM?
PAMM (Percentage Allocation Management Module or Percentage Allocation Money Management) allows FX firms, such as CTAs, to manage many individual customer trading accounts in a more efficient manner through bunched orders. The most common models for PAMM allocation software programs are the aggregator model and the FIFO and LIFO models. A description of each of these most common PAMM models follows.
The Aggregator Model. Most forex CTAs that use PAMM implement the aggregator model. The aggregator model places a bunched order of trades on behalf of multiple individually traded forex accounts. It thereafter allocates the profits/losses from the resulting trades according to each customer's account equity as a percentage of the overall total equity of the bunched "master" account. The PAMM aggregator model makes trade reporting comparatively easy for the forex CTA and its accountants because all sub-account execution prices for the individually managed accounts are the same.
The FIFO and LIFO Models. The FIFO and LIFO PAMM models enter trades for individual sub-accounts, as opposed to placing one aggregate trade on behalf of all of the individually managed forex accounts. FIFO and LIFO PAMM models are similar to standard FIFO (first-in-first-out) and LIFO (last-in-first-out) accounting. For the FIFO PAMM model, the first account to receive the trade will be the first one to exit the trade. For the LIFO PAMM model, the last account to receive the trade will be the first one to exit it. The FIFO and LIFO PAMM models have several advantages over the aggregator model, such as reduced slippage (since smaller orders are easier to fill than larger bunched orders) and increased anonymity in smaller trading. The main disadvantage of the FIFO and LIFO PAMM models, as opposed to the aggregator model, is mostly that of increased difficulty in trade reporting. The reporting requirements are increased for FIFO and LIFO PAMM models because trades are sent to different accounts at different times, which results in different execution prices and ultimately different profits/losses being achieved for similarly situated individual accounts managed by forex CTAs.
Why Does NFA Disapprove of PAMM?
In its proposed Interpretative Notice, NFA speaks out primarily against the aggregator PAMM model noted above. From NFA's perspective, the PAMM aggregator model has blurred the line between individually managed forex accounts and a pooled forex fund to such a degree it negates the purpose and structure of individually managed accounts. NFA believes that if a forex money manager intends to manage a commodity pool, then it should register as such - and not as a CTA using technology to create a synthetic fund product.
According to NFA, below are a few highlighted reasons as to why PAMM models, most notably the aggregator model, do not always result in the "fair and non-preferential allocation" of regularly offered and tradable sized lots/contracts to each customer's individual forex account as required under NFA Compliance Rule 2-10:
· Many CTAs are determining the quantity of lots/contracts for a bunched order based on the "master" account's equity, as opposed to the amount of lots/contracts that would be allowed based on the margin equity of an individual account. This is a problem in NFA's opinion because the available equity in some individual accounts might be too low to place a trade for a regularly offered lot/contract size.
· The placement of trades based on the "master" account's equity, as opposed to individual account equity, arguably treats the individual customer accounts as if they were all part of a single pooled fund, while avoiding the required CPO registration.
· Increased restrictions are imposed on individual account holders' ability to withdraw funds due to issues in offsetting large positions of the "master" account.
What Changes is NFA Requesting of CTAs that Use PAMM?
If NFA's proposed Interpretative Notice is approved by the CFTC, CTAs will no longer be able to use PAMM models without also abiding by the following new requirements. While bunching orders will still be permitted, the ability to bunch orders will entail, in part, the following new restrictions. These restrictions apply to all uses of PAMM, where applicable, and not just the PAMM aggregator model.
· CTAs will not be permitted to exceed the quantity of regularly offered and tradable sized contracts that would be permitted based on the equity in each individual account, as opposed to the overall equity of the "master" account.
· When placing a bunched order, the CTA will be required to inform the futures commission merchant (FCM) or retail foreign exchange dealer (RFED) of the number of regularly offered and tradable sized contracts each individual customer account will receive if the order is filled. The FCM and RFED will, in turn, be responsible for (among other things) ensuring that they receive from each account manager sufficient information to allow the FCM/RFED to perform its functions, such as gathering information regarding the number of contracts to be allocated to each account in a bunched order and information concerning the allocation of split and partial fills.
· The CTA will be required to allocate regularly offered and tradable sized lots or contracts to each individual account using a "non-preferential predetermined allocation methodology."
· CTAs must allow investors to make additions and withdrawals from their individual accounts in a "fair and timely manner," and in a manner not affecting other accounts traded by the CTA.
· On a daily basis, the CTA must confirm that all of its forex managed accounts have the correct allocation of contracts.
· On at least a quarterly basis, the CTA must analyze its allocation method to ensure that the customers in the same trading program achieve similar allocation results over time.
Do Blue Sky Laws Also Apply to CTAs that Use PAMM?
As mentioned previously, NFA is not the only regulator taking issue with the allocation methodology used by the PAMM models. State securities law regulators, such as the Pennsylvania Securities Commission, have taken up this issue as well under their blue sky laws. Blue sky laws are securities laws that are imposed at the individual state level. While individually managed forex and commodity accounts typically fall under the sole jurisdiction of the CFTC and NFA, states are able to regulate any transactions that involve "securities." Under many blue sky laws, such as those in Pennsylvania, when accounts are effectively pooled together in order to trade as one "master" account, then the individually traded accounts may potentially be deemed to have been converted into transactions in "securities," thus potentially falling under a state's regulatory power as well.
In most states, the sale of or transactions in a "security" is a highly regulated activity. As a result, various securities registrations and/or exemptions must be satisfied in order to avoid potential regulatory action or rescissions of the transactions. In Pennsylvania, for example, the Pennsylvania Securities Commission permanently halted the alleged "unregistered activity" by a trading advisor using the PAMM model when trading individual retail forex accounts.
While it is uncertain how many other states will take, or already have taken, a similar position as Pennsylvania with respect to the use of PAMM by forex firms, the seriousness of such an outcome should not be underestimated. It is also possible that the U.S. Securities and Exchange Commission (SEC) could likewise assert jurisdiction over trades entered and exited through a PAMM model, since the "pooling" of various accounts' funds may be deemed to occur under a PAMM arrangement.
Firms that allocate trades using a PAMM methodology will need to keep themselves informed of developments in this area. It would be prudent to contact a regulatory professional like Turnkey Trading Partners (NYSE:TTP) to assist you in this effort. TTP has the business acumen, as well as relationships with law firms, such as Henderson & Lyman, to provide you with guidance regarding these proposed (and existing) forex allocation rules.
-James Bibbings and Nicole Kuchera
James Bibbings is the President and CEO of Turnkey Trading Partners (TTP), a firm that supports all commodity and forex specific regulatory and business needs. Prior to founding TTP, Bibbings worked with the National Futures Association ("NFA") as a supervising auditor. During his time with NFA he was involved in approximately 100 investigative audits and was able to gain a deep working knowledge of FDM, FCM, IB, CTA, and CPO operations. Since departing from NFA, Bibbings has owned and operated an independent introducing brokerage and participated in international forums on proposed CFTC regulatory requirements. He has also provided financial markets content for Financial Times, Bloomberg, MSN, Yahoo, FinAlternatives, The Wall Street Journal's Market Watch, Forex Journal, FX Street, and many other highly acclaimed investment publications. Two highly sought after informational pamphlets regarding futures and forex registration authored by Bibbings are currently available for free upon request through his company website. If you have any questions or comments for Bibbings he can be reached directly by email at email@example.com and would love to hear from you.
Nicole Kuchera, JD, LLM is an Associate in Henderson & Lyman's Financial Services Practice Group. She concentrates her legal practice on transactional and litigation support for securities, futures, forex and derivatives industry clients, such as Introducing Brokers, Commodity Trading Advisors, Commodity Pool Operators, Broker-Dealers, Investment Advisers, Futures Commission Merchants, Hedge Funds and Forex Dealer Members. Ms. Kuchera counsels clients regarding a wide range of compliance and regulatory matters involving the rules and regulations of the SEC and the CFTC, as well as self-regulatory organizations and exchanges. She also represents financial services industry clients in a wide range of litigation matters in various forums, including state and federal courts and in industry arbitrations and mediations. Ms. Kuchera also represents clients in general corporate matters, such as business formation, licensing and industry registration.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.