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Doing business with third-party trading system providers: What every NFA Member needs to know

Doing business with a third-party trading system provider can be a profitable business opportunity for an NFA Member. However, Members should understand the responsibilities and risks involved in such a venture.

NFA's Board of Directors recently approved an Interpretive Notice designed to provide guidance to NFA Members who provide execution services to users of computerized trading systems developed by non-Member third-party system developers. The Notice also discusses the factors that may cause a Member to be responsible for promotional material which promotes these trading systems and the Member's supervisory obligations under NFA Compliance Rule 2-9.

"We developed this Interpretive Notice with input from our Executive Committee and our Advisory Committees," says Ron Hirst, an associate general counsel at NFA. "We incorporated many of their suggestions throughout the process."

Futures trading systems that generate signals to traders as to when to buy and sell commodity futures and options contracts have become increasingly popular over the past few years. A number of NFA Member firms offer trade execution services to customers who use these computerized trading systems, and NFA has seen several instances where the promotional material used by the third-party developer is clearly inappropriate.

One of the purposes of the Interpretive Notice is to remind Members of the conditions under which third-party trading system developers are required to register with the Commodity Futures Trading Commission (CFTC). Section 1a(6) of the Commodity Exchange Act defines a Commodity Trading Advisor (CTA) as any person who for compensation or profit, engages in the business of advising others, directly or through publications, writings or electronic media, as to the value of or the advisability of trading commodity futures.

However, in March 2000 the CFTC adopted CFTC Rule 4.14(a)(9) to create an exemption from registration requirements for CTAs that provide standardized advice by means of media, such as newsletters, pre-recorded telephone hotlines, Internet Web sites, and non-customized computer software. Also, the CTA may not direct client accounts.

"Whether a third-party system developer is required to be registered as a CTA depends on the particular facts of each case," says Hirst. "In some cases, the third-party system developer may be required to register as an Introducing Broker (IB) if it refers customers to an NFA Member and receives compensation for the referrals. We encourage anyone who has questions concerning the application of Rule 4.14 to contact the CFTC."

If an NFA Member wants to conduct business with a third-party system developer that is not registered as a CTA, the Member should request that the developer provide a letter from counsel stating the reasons why registration is not required. If the developer cannot or does not provide such a letter, the Member should request that the developer apply for registration and NFA Membership.

It is the Member's responsibility to ensure that it is not violating NFA Bylaw 1101, which states that no Member may carry an account, accept an order or handle a transaction in commodity futures on behalf of any non-Member that is required to be registered as a CTA or in some other capacity.

"Simply put, if a third-party system developer cannot produce a letter from counsel stating why it does not have to be registered and fails or refuses to register, the Member should terminate its business relationship with that entity," says Hirst.

Promotional Material Responsibility

In addition to registration issues, the Interpretive Notice outlines under what conditions NFA Members may be held accountable under Compliance Rules 2-29 and 2-9 for misleading promotional material that promotes third-party trading system developers and their trading systems.

"We have seen several instances, especially in the last few years, of misleading promotional material touting trading systems developed by third-party system developers who are not NFA Members and for which an NFA Member provides trade execution services," says Hirst. "For example, we recently reviewed a promotional piece used by a non-Member third-party system developer to promote its trading system which boasted of hypothetical annual rates of return ranging from 86.4% to 151.7%."

Depending on the business relationship of the Member with the system developer, the Member may be held responsible for the misleading promotional material. The most obvious example would be when the Member or its Associates prepare and distribute the promotional material on behalf of the third-party system developer.

An NFA Member may also be responsible if there is an agency relationship between the NFA Member and the third-party system developer.

"NFA's Business Conduct Committee has always recognized that each Member is responsible for the acts of its agents," says Hirst, "and this certainly applies to the preparation of advertising material."

In determining whether there is an agency relationship, NFA examines the nature of the business relationship between the parties and whether the parties have expressly or implicitly agreed that one may act for the other. If there is an agency relationship between the Member and the third-party system developer, the Member has an affirmative duty, under NFA Compliance Rule 2-9, to supervise the activities of the third-party system developer/agent.

Even where no agency relationship exists, a Member whose Web site links to or otherwise refers customers to a third-party system developer or has a referral agreement with a third-party trading system developer should conduct a due diligence inquiry into the system developer's advertising practices. The Interpretive Notice also reminds Members that their supervisory obligations under Rule 2-9 and Rule 2-29 require them to diligently supervise their employees and agents who are responsible for creating and maintaining hyperlinks to Web sites of third-party system developers or for establishing referral agreements with third-party system developers.

"This guideline echoes the guidelines we set out in 1999 in our Interpretive Notice regarding supervisory procedures for e-mail and the use of Web sites," says Hirst. "The same principles apply. We just want to remind Members that they should not try to circumvent our promotional material requirements by relying upon the unregistered status of the third-party trading system developer."

The Interpretive Notice, entitled "Guidelines Relating to the Registration of Third-Party Trading System Developers and the Responsibility of NFA Members for Promotional Material That Promotes Third-Party Trading System Developers and Their Trading Systems," can be found on NFA's Web site at www.nfa.futures.org. The Notice is currently being reviewed by the CFTC.

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