This is the next installment of our multi-part series on the February 20 proposal by the U.S. Commodity Futures Trading Commission (the “CFTC”) in respect of proposed CFTC Regulation §1.44 (the “Proposed Rule”).

The previous post provided general information about the nature of the relationship between institutional investors and their investment managers. Indeed, that relationship was one of the primary reasons for the Proposed Rule.

This post considers different views of the relationship between an investment manager and its clients, as background to a discussion of the Proposed Rule.

Some market participants and commenters view the Proposed Rule as creating risk, while others view the Proposed Rule as a necessary nuisance. In short, different market participants have different views of the same situation.

Different Views of the Same Situation

Some market participants and commenters view the Proposed Rule as creating risk. Consider, for example, CFTC Commissioner Johnson’s statement about the Proposed Rule:

The separate account treatment permits margin to be withdrawn from one account of a customer while another account of that same customer faces a margin call, it creates the risk that a customer will withdraw funds from the account in surplus and then later default on the margin call, leaving the [futures commission merchant] (“FCM”)] with fewer resources to cover the resulting losses.

This statement implicates two of the primary policy reasons underlying the Proposed Rule: the avoidance of systemic risk and the protection of market participants from the misuses of customer assets.

Other market participants, like institutional investors and their investment managers believe that the Proposed Rule is necessary to prevent the distortion of the economic realities of a relationship between an institutional investor and its investment managers. Some of these market participants may even view the Proposed Rule as a necessary nuisance.

Consider, for example, two investment funds managed by a single investment manager:

• Fund A—Invests in Treasury securities and, as part of its investment strategy, uses Treasury futures contracts; and

• Fund B—Invests in equity securities and, as part of its investment strategy, uses stock index futures contracts.

If the two funds are legally separate entities, then the futures contracts in Fund A and the futures contracts in Fund B would certainly be separate from one another for most purposes, including initial margin requirements. (One notable exception for these particular types of futures contracts is the CFTC’s large trader reporting program, which is beyond the scope of this post.)

To combine the two fund’s futures positions would create an artificial net risk position that effectively distorts the efficient allocation of each fund’s capital.

The same concept applies when two funds are owned by a single entity but managed independently of one another (even if by a single investment manager)—in such an instance, each fund is frequently referred to as an account of the institutional investor.

Each account is separate and distinct from the other account in terms of its risk and return profile and its efficient use of capital. To disregard the reality of the separateness of risk at the account level could present an FCM with a distorted risk profile of a single investor with multiple accounts, at best, and increase the amount of leverage available to the investor or its managers, at worst.

Such an approach could (ironically) increase systemic risk by making more derivatives trading capacity available to an investment manager on behalf of a single client in the aggregate than would be available if assets and liabilities are appropriately “ringfenced” at the account level.

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