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April 30, 2009

By E-Mail (FinancialEntities@iosco.org)

Mr. Greg Tanzer
Secretary General
IOSCO
C / Oquendo 12
28006 Madrid
Spain

Re: Public Comment on the Hedge Funds Oversight: Consultation Report

Dear Mr. Tanzer:

National Futures Association (NFA) appreciates the opportunity to comment on the IOSCO Technical Committee's Hedge Fund Oversight Consultation Report. NFA is a registered futures association under the U.S. Commodity Exchange Act (CEA) and an affiliate member of IOSCO. NFA is the industry-wide self-regulatory body for the U.S. futures industry and regulates the activities of over 4,000 member firms and approximately 50,000 registered account executives who work for those firms.

One of NFA's responsibilities is to monitor the regulatory requirements for registered commodity pool operators (CPOs) and their non-exempt commodity pools. We work closely with the U.S. Commodity Futures Trading Commission (CFTC) to provide effective and efficient regulation that protects customers without imposing undue burdens on the futures industry.

The U.S. Futures Industry Regulatory Scheme for Collective Investment Vehicles

One of NFA's responsibilities is to oversee the regulatory requirements for registered commodity pool operators (CPOs) and their regulated commodity pools. The CEA and CFTC rules reach collective investment vehicles indirectly by imposing registration and other requirements on the entities operating those vehicles. Since the operator/manager makes legal and operational decisions and has the authority to act on the pool's behalf, this is an effective regulatory scheme.

Theoretically, any collective investment vehicle that trades one futures contract is a commodity pool and its operator is a CPO governed by the CEA. The CFTC, has, however, created a number of exclusions and exemptions by rule. CFTC Regulation 4.5 excludes certain otherwise regulated entities (e.g., registered investment companies) from the very definition of commodity pool operator, taking them outside of the CEA's reach. Since other regulators supervise both the sale and the operation of these vehicles, the exclusion ensures that they are not subject to duplicative or inconsistent requirements.

CFTC Regulation 4.13 exempts CPOs who operate pools meeting various criteria (e.g., sophisticated investors, limited futures activity) from the CEA's registration requirements, which means that the entities operating these pools are subject to the CEA's antifraud provisions for their conduct relating to those pools but are not subject to specific regulatory requirements. The 4.13 pools are, of course, subject to reporting requirements (e.g., large trader reports and special calls for information) that apply to them as market participants.

CFTC Regulation 4.7 exempts registered CPOs from certain disclosure, record-keeping, and reporting requirements for pools offered only to sophisticated investors. The CPO must still be registered, however, and it must ensure that the pool provides its participants with quarterly net asset information and with an annual report containing financial information about the pool. Furthermore, although 4.7 pools are not required to prepare a written disclosure document or private placement memorandum, we have noted during the course of our examinations that most of them use a private placement memorandum that includes the full list of disclosures required for pools offered to less sophisticated investors.

Those investments that are offered to retail customers are subject to extensive regulation. The sale of public commodity pools-those registered under the Securities Act of 1933-is regulated by both the securities regulators (as a public distribution of securities) and the futures regulators. These pools are subject to a wide range of regulatory requirements, including the preparation of a written disclosure document that must contain specified information and must be submitted to NFA for review before it is used.

Over 1,300 CPOs are registered with the CFTC, and the vast majority are NFA Members. Approximately 650 of these CPOs are currently operating pools with assets on their balance sheets.

NFA has a number of programs to monitor CPOs' compliance with applicable rules and regulations. NFA's on-site examinations provide the most comprehensive review. During these examinations, NFA staff looks for and reviews transactions between the CPO and its pools, transfers between the CPO's pools, and the CPO's banking relationships. Staff performs basic testing on all the commodity pools operated by the CPO, including reviewing the pools' participant lists, solicitation materials, additions, and withdrawals. In addition, NFA uses a risk-based approach to select and test one pool in detail. In choosing this pool, NFA considers a number of factors, including the number of participants in the pool, the pool's total net asset value, exemptions held by the pool, and whether NFA conducted detailed testing on the pool in a prior exam. NFA reviews the pool's financial records, including its assets and liabilities (with an emphasis on the pool's futures transactions) and confirms the existence of non-futures assets-including securities, cash, swaps, and other financial instruments-that have a material effect on the pool. NFA also reviews the pool's trading activity for consistency with its disclosure document or offering memorandum.

NFA examines an average of 275 CPOs a year. These firms are selected using a risk-based approach that assigns a higher priority to those CPOs with pools that pose greater risk and to those CPOs that have not been examined recently.

Each of the approximately 1,800 active pools covered by CFTC and NFA requirements must provide participants with year-end financial statements and must file those statements with NFA. NFA analyzes each statement and completes most reviews within 30 days after receipt. This review examines whether the financial statement adequately reflects the pool's assets and liabilities and is consistent with any disclosure document on file, and it focuses special attention on unusual balances and significant changes in the pool's net asset value. NFA looks at the pool's entire financial statement, with the greatest emphasis on the pool's futures activities.

NFA reviews each disclosure document filed with NFA, including those voluntarily prepared and filed by 4.7 pools. In 2008, NFA reviewed disclosure documents for almost 400 pools.1

General Comments on Consultation Report

IOSCO's recommendations regarding hedge fund regulation should be formulated to meet several goals:

  • to protect financial markets against systemic risk;

  • to protect hedge fund investors without imposing undue burdens on hedge funds and other players in the financial markets; and

  • to avoid duplication of effort and conserve regulators' valuable resources so that they can be used where they are needed most.

As the report recognizes, hedge funds provide benefits to financial markets by adding liquidity, to investors by providing opportunities for diversification, and to financial institutions and large corporations by accepting the risks those entities are attempting to mitigate. As the report also recognizes, hedge fund activities are not a major cause of the current financial crisis. Therefore, those of us who regulate these activities must be careful that we do not overreact and stifle innovation in the process.

The U.S. experience shows that the use of self-regulation, subject to government oversight, is an efficient and effective means of regulation that frees up government resources, saves taxpayers money, and allows rules to be adopted more quickly than may be the case with government regulations. Self-regulatory organizations can, and do, provide these same benefits to hedge fund regulation.

With these general principles in mind, our answers to selected questions follow.

Specific Responses to Selected Questions

Paragraphs 114-118. NFA agrees that counterparties and lenders should have strong risk management controls and conduct substantial due diligence before entering into transactions with hedge funds. If a hedge fund refuses to provide the necessary information, then the counterparty or lender should walk away. In order to protect hedge fund investment strategies, however, regulators should ensure that governing laws and regulations protect against disclosure of confidential information in a counterparty's or lender's possession.

Paragraph 119. As discussed further in response to Paragraph 128, NFA prefers direct regulation of hedge fund managers over direct regulation of the funds. The regulatory scheme should not, however, substitute the judgment of regulators for the judgment of the managers when it comes to making trading decisions. Rather, laws and regulations should be carefully crafted so that they do not prevent hedge fund managers from providing those services and trading strategies that the investors in the funds expect. The regulatory scheme should also ensure that it does not over-allocate valuable resources to hedge fund regulation when those resources could be better utilized elsewhere.

Paragraph 121. A consistent regulatory approach would be helpful for hedge fund managers with global funds, but IOSCO and regulators from other jurisdictions should be mindful of local regulatory approaches.

Paragraph 122. NFA agrees that regulatory oversight should be risk-based. We believe the relevant factors for determining whether a fund is systemically important include the fund's size and the concentration and liquidity of its investments.

Paragraphs 123-126. There is no question that hedge fund managers should provide certain information at registration/authorization. NFA notes, however, that obtaining information during the registration process has some limitations as it provides only a one-time snapshot. Therefore, as we discuss in response to Paragraph 128, regulators should require registered managers to provide certain operating information for their funds at regular intervals.

During the registration process, regulators should, at a minimum, obtain the following information about the hedge fund manager: ownership, legal form (type of entity and where organized), location of books and records, and background of key personnel (including any criminal or enforcement actions against them). For each fund covered by the regulator's rules, regulators should also obtain information such as: legal form, type of instruments the fund may invest in, investment strategy (in general terms), fees, potential conflicts of interest, redemption policy, financial affiliates, entities providing professional services to the firm (e.g., accounting, legal, and investment management services), and any special risks associated with the fund and its trading strategies. For each fund, the manager should also identify whether the fund has begun accepting investors and, if so, the number of investors, the net asset value of the fund, whether it has begun trading, and the fund's performance history (if it has one). The information about individual funds could be provided as part of a prospectus or private placement memorandum that is then distributed to investors.

While regulators should have access to information regarding the investments in a fund's portfolio and how they affect the fund's leverage and risk, we note that registration/authorization is not necessarily a pre-requisite for obtaining this information. In the U.S. futures markets, for example, the CFTC can obtain relevant information by issuing a special call that is customized for the circumstances.

Paragraph 127. Given the significant differences between hedge funds, ongoing requirements must be broadly written to provide hedge fund managers with sufficient flexibility to tailor compliance programs to their funds' characteristics. For example, a fund that invests solely in interest-bearing securities would not have the same need for a comprehensive and independent risk management function as a diversified fund that enters into swaps and other more exotic transactions. Similarly, a fund that limits its trading activities to transparent exchange markets with daily settlement prices would not need the same type of "robust" verification of fund valuations as a fund that trades in illiquid OTC instruments.

Paragraph 128. NFA does not see any need for direct regulation of the underlying hedge funds. In the U.S. futures regulatory scheme, the CPO-equivalent to a manager-is registered, but the commodity pool, or fund, is not. Similarly, the CPO is a Member of NFA, but the pool is not. Nevertheless, CFTC and NFA rules affect the administration of and disclosures by pools through restrictions on how the CPOs can operate them. Through this regulatory scheme, we can, and do, obtain the information mentioned in the bullets to Paragraph 128. Direct regulation of the funds would add an extra layer of complication to our regulatory function without any corresponding benefit.

NFA is currently considering and will shortly be requesting comment on a proposal to require CPOs to provide quarterly information on their non-exempt funds. In particular, we are considering asking for the following:

  • The identity of third parties with whom the CPO has a relationship, such as carrying brokers, trading managers, and solicitors;

  • Changes to each fund's net asset value;

  • The monthly performance of each fund; and

  • Each fund's current Schedule of Investments.

We believe that this information will help us identify funds that may be at risk either systemically or due to fraud by the fund or its manager.

Another crucial aspect of ongoing supervision is the regulator's ability to review books and records relating to the fund manager and its funds. In particular, regulators must have access to corporate and trading records, bank records, and written procedures. While this information need not be provided on a regular basis, it must be available quickly when requested.

Paragraphs 129-131. NFA agrees that IOSCO should support a set of globally consistent best practice standards. While the standards can be universally applicable, however, the means of complying with them must be flexible enough to respond to different business models and trading strategies as well as to characteristics such as size and sophistication of investors. If these conditions are met, then compliance should be mandatory.

If you have any questions concerning this letter, please contact me at kwuertz@nfa.futures.org.

Respectfully submitted,

Karen K. Wuertz
Senior Vice President,
Strategic Planning & Communications


1 This number is significantly lower than the number of active pools since many 4.7 pools do not file disclosure documents and existing pools that are closed to new investors are not required to update their disclosure documents (although they must provide participants with notice of material changes).

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