Reframing Commodity Pools in the Wake of Dodd-Frank and the Volcker Rule by Jenny Liu, Cornell Law Review, Volume 99 Issue 1. 2013.
“The massive financial disaster of 2008 and the international credit catastrophe that subsequently developed was a “historic economic crisis” that led to a near collapse of the U.S. and global economic systems. In its aftermath, widespread demands for regulatory reform reverberated through the financial world. In the United States, authorities responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or Dodd-Frank), which spanned an impressive 2,319 pages and provided sea changes unprecedented in scope since the Great Depression. Within this sprawling legislation is the oft-cited Volcker Rule, which, in a nutshell, bans proprietary trading by banks whose deposits are federally insured by the Federal Deposit and Insurance Corporation and restricts their relationships with hedge funds and private equity funds.3 Yet among all of this discussion about market integrity and the need to protect the American investor, the public eye has overlooked a business entity operating in the derivatives markets that represents more than $600 billion in net assets in the U.S. economy: commodity pools. Moreover, much of the scope of the Dodd-Frank Act and the Volcker Rule hinges on the definitions of “commodity pool” and “commodity pool operator” (CPO). Given this fact, it is perhaps surprising that commodity pools have garnered little public attention and remain in relative obscurity when compared to other financial instruments. In their broadest sense, commodity pools are popular investment entities that collect funds from participants to then trade in commodities, other commodity pools, and commodity derivatives. A derivative is a financial contract whose value is determined by the underlying asset; therefore, a commodity derivative is a financial contract whose value is derived by the underlying commodity, such as wheat, oil, or other products.7 Commodity pools are attractive to investors because they enable investors to gain access to investment opportunities while simultaneously allowing these investors to diversify their portfolios to prevent risk. CPOs, on the other hand, are organizations or individuals that manage commodity pools. CPOs must register with the CommodityFutures Trading Commission (CFTC or the Commission), the administrative agency that generally oversees the derivatives and commodities markets. The Commodity Exchange Act (CEA) regulates,among other things, commodity futures trading. In amending the CEA, the Dodd-Frank Act became the first piece of legislation to add a definition of the term “commodity pool.” This is a profound change given that commodity pools historically have been in the background in the formal rulemaking and legislation of financial instruments. Dodd-Frank reversed course and added a plethora of new mandates and oversight techniques for the CFTC. For example, Dodd-Frank expanded the definition of commodity pools to include investment vehicles that not only trade in futures but also in swaps—bilateral contracts in which parties agree to exchange cash flows at some predetermined schedule. In addition, Dodd-Frank required the CFTC to narrow the circumstances that would exempt a CPO from registration. Dodd-Frank’s addition of a definition of commodity pools presents two major concerns for the financial industry. First, because “commodity pool” is now a defined term, the categorization of a business entity as a commodity pool becomes significant because it can subject the entity to certain clearing requirements. Clearing requirements mandate an institution or person to act as a central counter party to the original participants in a contract to mitigate the risk of nonperformance.15 Because the definition of commodity pools is subsumed under categories of entities that are subject to clearing requirements, it is important to interpret the definition of commodity pools in a sufficiently narrow fashion. This avoids the unintended consequence of encompassing business entities that fall under the technical definition of a commodity pool but functionally are not the types of collective-investment vehicles that the regulators envisioned. Secondly, the Dodd-Frank Act’s expansion of the definition of a commodity pool and the CFTC’s narrowing of the exemptions for CPOs have the effect of increasing regulatory burdens. Imposing these regulatory burdens may effectively prevent some investors from hedging or managing their risks, thereby undermining the CEA’s dual purpose of market integrity and investor protection. These considerations bring to light the importance of the definitions of a commodity pool and a CPO. How these terms are defined ultimately direct the scope of some of the major provisions of the Volcker Rule and the Dodd-Frank Act. In functional terms, the definitions will also provide participants with sufficient information to allow them to effectively manage their investment risk, which ultimately promotes a more efficient market. This Note will demonstrate that the CFTC has traditionally declined to adopt a bright-line rule for determining whether a business entity is a commodity pool and whether an institution or a person is a CPO. This Note will argue that the current ad hoc approach should be further refined and that the CFTC should provide more concrete definitions by using the Investment Company Act of 1940 (1940 Act) and its treatment of investment companies as a model…”