In a ruling that would affect primarily the US managed account Forex market, the National Futures Association (NFA) has proposed a new amendment to the Commodities Futures Trading Commission (CFTC). The amendment is in regards to NFA Compliance Rule 2-10: The Allocation of Bunched Orders for Multiple Accounts.
According to the proposed amendment, Introducing Brokers, Futures Commission Merchants (FCM), and Commodity Trading Advisors (CTA) and referred to as Eligible Account Managers (EAM), will be required to issue information to the NFA on allocation practices of bunched orders. According to the NFA, the purpose of the regulation is to “prevent various forms of customer abuse, such as fraudulent allocation of trades, by providing an adequate audit trail that allows customer orders to be tracked at every step of the order processing system.”
Background
Using the NFA’s terminology, managed funds in the retail forex industry have experienced “explosive growth” in recent years. Typically, they are structured through the use of a Percentage Allocation Management Module (PAMM) which allows money managers to control and send bunched orders for multiple accounts. With the PAMM, a ‘Master Account’ is selected which the manager uses to enter trades. Every managed account becomes a Sub-Account of the master account. When trading, the manager uses the master account which shows aggregated equity and positions of each sub-account, but not their individual details. This is available on the PAMM platform. Using the PAMM, the manager controls how orders are allocated among sub-accounts, such as by percentage of overall equity or fixed lot sizes.
Example:
Account 1: $1.000
Account 2: $3,000
Account 3: $6,000
Using the percentage of equity allocation system, 1 lot order to buy the EURUSD the allocation would be as such:
Account 1: 0.10 Lot EURUSD
Account 2: 0.30 Lot EURUSD
Account 3: 0.60 Lot EURUSD
When trading the master account platform, the trader sees a $10,000 balance and a 1 lot EURUSD buy.
NFA’s Worries
According to NFA, the regulator believes that the percentage allocation method is problematic as it “causes these individual accounts to be treated similar to a commodity pool's participant units—without the Master Account being legally structured as a commodity pool.” In addition, they noted several other problems with PAMMs, notably;
1) PAMMs often restrict the ability of managers to close individual positions of accounts without affecting other sub-accounts.
2) FCMs may apply restrictions on how clients can withdraw or add funds to their account. In this regard the NFA stated that, “In the extreme situation, individual client withdrawal requests are held up indefinitely because the customer's percentage lot open forex position may not be offset until the regularly offered and tradable sized position is offset for all customers at the Master Account level."
3) When removing a sub-account, some PAMMs simply reallocate the open positions to the other sub-accounts. In this process, the removed account doesn’t incur the profit or loss of the positions held in their account at the time of the removal.
In terms of PAMMs, the NFA concluded by stating that they are concerned that managed account holders may not be able to “close their accounts and have timely access to their funds, and customers are not being treated fairly as a result of this trade allocation method. ”
In summary, the NFA in its proposed amendment to the CFTC stated that it continues to allow CTAs to use bunched orders. However, they require that CTAs also apply policies to ensure that allocation of lots are conducted based on the specific needs of each sub-account (author’s note: lumping accounts that only authorize Leverage of 5:1 with others of 50:1 could lead to excessive risk taking if the master account holds positions greater than 5:1 using the percentage allocation function). In addition, before placing trades, they require that CTAs inform their FCM or Retail Foreign Exchange Dealer (RFED) how they are allocating orders to sub-accounts. On this, FCMs and RFEDs are responsible to ensure that they receive this information from the money managers as well as ensuring that such allocations are being performed. CTAs will also be responsible for maintaining their allocation and order execution report records which are subject to review of NFA examinations.
For PAMMs, the proposed amendments, which if the CFTC does not conduct would become approved on December 22nd, the overall initial affects may be minimal. CTAs will still be able to use PAMMs to manage forex accounts. However, dependent on their existing allocation types, they may need to be more ‘hands on’ in managing proportions of bunched order distribution. In addition, the new amendments bring new responsibilities to brokers who will now need to ensure that CTAs are in fact following their preset allocation rules. Over the longer term, the greatest effects of the new rule may be the application of NFA examinations to ensure that reporting is being conducted. Firms with a lack of structured forms to handle their reporting may have a hard time keeping up with requirements, and may find doing so is too expensive or time intensive.
Overall, while a major change is not forthcoming to the world of PAMM accounts in the US. The NFA’s amendment, specifically that they mention how it can be used as a method to resemble a pool operator, does represent that the regulator is increasing its focus on managed accounts. With the PAMM regulation being updated, it won’t be surprising if the NFA also conducts investigations into other pseudo-managed products such as EAs, social trading, and copy trading.
