Structured-Product Shops Face CFTC Regime

Fund operators suddenly have a new regulatory wrinkle to worry about.

At issue is whether managers that invest in asset-backed securities, collateralized loan obligations and other types of structured products should be regulated as commodity-pool operators under new CFTC rules set to take effect Jan. 1. If so, then scores of firms might have to register with the futures regulator and submit to a slew of disclosure requirements — though a letter issued by the commission late last week appears to offer some relief.

Under rules the CFTC adopted in February, managers that trade more than a minimal amount of futures and swaps for hedging purposes must register with the commission by yearend. Indeed, industry lawyers have spent much of the past year trying to figure out which hedge funds can claim exemption under the so-called de minimis trading rule, and what alternative hedging strategies might be employed to avoid registration.

But only in recent weeks have industry insiders come to realize that structured products present a special case. That’s because under the Dodd-Frank Act, vehicles that hold non-security-based swaps are subject to regulation as commodity pools — potentially including many asset-backed bond deals that encompass interest-rate swaps. Thus, in calculating their derivatives exposures, structured-product fund operators may need to account not only for swap contracts they entered directly, but also for those supporting the securitizations they invested in. The mandate apparently applies only to funds that buy the first-loss or equity pieces of structured-product transactions.

“This goes into the category of unintended consequences,” said Dechert lawyer George Mazin. “You’d never think a hedge fund would have some problem because of indirect exposure.”

In a last-minute plea for relief, the Managed Funds Association and other industry groups wrote to the CFTC on Nov. 30 requesting a nine-month extension of the yearend registration deadline for firms that invest in asset-backed bonds. The trade associations also asked the commission to develop guidance to help structured-product investors interpret and apply the rules.

That same day, however, the commission issued a no-action letter granting funds of funds a six-month extension for determining their obligations under the new regime. Funds of funds whose portfolios include commodity pool operators may themselves have to register with the CFTC.

Industry leaders now think the no-action letter also may apply to structured-product hedge funds. Depending on how the rules are interpreted, a fund that invests in asset-backed bonds could be viewed as a multi-manager operation whose “underlying vehicles” are the securitization trusts.

“The MFA believes that the CFTC no-action relief for funds of funds may be applicable to investment funds that invest in securitization vehicles,” said MFA communications director Steve Hinkson.

Even if the MFA is right, structured-product fund operators uncertain of their status have until Dec. 31 to seek a temporary exemption from CFTC registration. Managers are supposed to e-mail such requests to dsionoaction@cftc.gov.

In their letter to the CFTC, the trade groups highlighted a number of practical considerations that could make it difficult, if not impossible, for hedge funds to comply with the new rules. For starters, issuers of asset-backed securities don’t disclose details about the swaps used to structure their deals, leaving investors in the dark about their exposure to the underlying derivatives. “Furthermore,” the industry groups noted in their letter to the CFTC, “certain issuers of securitization vehicles grant discretion to a trustee or manager to invest in and divest of swaps, which further complicates an investor’s analysis of whether a particular securitization vehicle is or could be a commodity pool.”

Industry professionals are keeping their fingers crossed that structured-product fund operators ultimately will be let off the hook by the CFTC. That’s because securitization specialists already have convinced the commission to issue an order temporarily relieving a swath of structured products from regulation as commodity pools — a directive they’re now trying to make permanent. Asset-backed bond players also are pressing the agency for exemptions for a broader range of deals, including CLOs. Such exemptions, in turn, would extend to investors in those deals.

Some 50 fund operators pursue investment strategies focused on structured products, according to Hedge Fund Alert’s Manager Database, and many more dedicate portions of their portfolios to asset-backed securities, CLOs, commercial mortgage bonds and the like. What’s more, investors and managers both have been pouring increasing amounts of money into the strategy. That’s because structured-product vehicles have been the most profitable of all funds this year, posting an average return of 14.6% through Oct. 31, according to Hedge Fund Research, compared to 4.5% for hedge funds as a whole.

Meanwhile, many other hedge funds face a Dec. 31 deadline for registering with the CFTC. The requirement applies to any fund that has posted more than 5% of its net-asset value as margin for futures or non-security-based swaps. The mandate also applies if the total notional value of those contracts exceeds the fund’s net asset value.

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