Ep. #5: Notional Funding Restrictions

Some CTAs won’t allow their customers to use notional funding, or they set restrictions on which customers may use it. These restrictions inhibit CTA profitability and make it more difficult for CTAs to attract customers. Listen to this episode to find out why profitable CTAs don’t set restrictions on their customers’ use of notional funding.

TRANSCRIPT:

Welcome to The Profitable CTA, the only podcast that helps commodity trading advisors grow their businesses and boost their bottom lines. I’m Kelly Hollingsworth and I’m happy you’re here because CTA profitability is suffering, and in this show we talk about how to fix that.

In every episode, we discuss a common problem that undermines CTA profitability, and the problem for today is setting restrictions on notional funding.

What is notional funding?

First, very briefly, what is notional funding? If you’re trading a $100,000 account and your customer withdraws $80,000 of his cash and tells you to maintain the same position size that you were trading before the withdrawal, you have a notionally funded account. This is because you’re trading the account as if it has $100k in it but $80k is now a notion in your mind. The cash isn’t really there.

And this kind of thing happens all the time, by the way, because CTAs typically use 20% or less of an account’s value as margin, so the rest of the customer’s cash is sitting there unused, and eventually almost every customer decides to withdraw the excess cash.

In the last episode, we talked about the importance of having a written agreement with every customer to protect your track record in these situations. If you haven’t listened to that, it’s Episode 4, you might want to go back, but as a refresher, CTAs basically have two choices in how they calculate their rates of return.

If you have an agreement with your customer that says the account is traded as if it’s $100k no matter how much cash is in it, you get to calculate your returns based on $100k, even if your customer withdraws money. If you don’t have this agreement, you must calculate your returns based on the cash in the account. This means that a cash withdrawal in the absence of an agreement, but keeping the position size the same, will magnify your % returns, often in very scary ways.  A $6,000 loss with an agreement for a $100k trading level is a 6% down month in your track record. That’s not great, but it’s not a disaster. If you don’t have an agreement, and you have a $6,000 loss when the customer withdraws $80k of his $100,000, there’s only $20k left in the account, that loss shows up as a 30% down month, not because you lost more money, but just because your customer withdrew cash, you didn’t have an agreement, and now you must calculate the percentage loss based on the $20k that remained in the account.

So you definitely want an agreement that allows your customer to withdraw cash without it affecting how you calculate your percentage rates of return. This protects your track record from things that customers can do to affect the returns but which have nothing to do with your trading skill.

What happens when you have this protection? Your rates of return are less volatile. The track record reflects your trading skill, and only your trading skill, because the returns aren’t whipsawed this way and that by the whims of your customers cash management decisions. And this is key because track record is the most important consideration in your business. You want to protect it in every way you can.

Yet, as we discussed at the end of Episode 4, many CTAs are reluctant to use this protective mechanism because it involves notional funding. Some CTAs won’t allow any of their customers to use notional funding, and many others will allow only the most sophisticated customers to use it. This approach is based out of concern for the customer, but what I’d like to discuss today with you is why that concern is misplaced, and why, in my mind, it is harmful to both customer and CTA alike, for CTAs to set restrictions on their customers’ use of notional funding. Today I’d like to discuss a few reasons why I think that.

Why CTAs are reluctant to use notional funding (and why they shouldn’t be)

CTAs who set restrictions on their customers’ use of notional funding, or don’t allow it at all, usually are very concerned for their customer. These restrictions start with concern for the customer because notional funding is a form of leverage. If you can get an account that’s managed as if it’s $100k, but you only put up $20k, that’s leverage. There’s no cost for using this leverage, by the way, it’s free, but many CTAs worry about it for their customers for a few reasons. The first is because of the “risk” that a debit balance will occur.

The “risk” of a debit balance

In an account that’s funded with $20,000, if there are trading losses that go beyond the $20,000, the account will have a negative or debit balance, and the customer will be called upon to deposit cash to cover that shortfall.

Two things to notice here. The first is that the risk of a debit balance is present in all accounts. If an account is traded as if it has $100,000 in it, and that’s how much cash is in the account, the losses can still go beyond the funding level, they can go beyond the $100,000 and take the account below zero. In other words, the trading level of the account, the $100,000 in this example, is not a ceiling on the potential losses. So there is always debit risk, whether the account is fully funded with the whole $100k, or nationally with some amount less than that.

True, it’s more likely that a debit balance will occur with a notionally funded account, and this is why regulators require CTAs to disclose the “risk” of a debit balance being more likely to customers who use notional funding. But the question I’d like you to consider today is this: Is covering a debit balance in a notional funding situation really a risk? I don’t see it.

A risk is something that can happen in the future that you’re trying to avoid in the present so you take action to avoid the bad thing. For example, you drive carefully now, because you don’t want to crash your car later. But you wouldn’t crash your car now to avoid the risk of crashing your car later. That makes no sense at all, and it’s just as nonsensical to deposit cash in an account now to avoid the “risk” of having to deposit cash later. If the only way you avoid something happening is to do it in advance, that illustrates that you’re not really talking about a real risk. Rather, you’re just talking about a timing difference. And this is one reason that in my mind it’s not an especially logical idea for CTAs to restrict their customers use of notional funding, because they’re trying to protect them from the risk of depositing cash in their accounts. If you make your customer deposit cash now to avoid the risk of depositing cash later, you haven’t protected him from a risk at all.

The “risk” of a margin call

CTAs who are tempted to restrict their customers use of notional funding also worry about the “risk” of a margin call. They never want their customers to experience a margin call.

Why do they worry about this? I once read in a publication for CTAs, prepared I think by CME Group, that said that no professional CTA should ever have an account that gets a margin call. I think this idea has an inherent appeal for CTAs who are very concerned about their customers, because when do margin calls happen? When things aren’t going well. And every CTA wants to trade well for their customers, so of course they would also want to avoid margin calls for their customers.

But here’s something I’d like you to think about. A margin call is a time-out. It’s an opportunity for your customer to take a look at what’s happening in his account and decide if he wants to put more cash into your trading program when things aren’t going well, or cut his losses and go home. In this respect, it’s more than a little perverse that the least sophisticated customers with the smaller accounts are those that most CTAs are most reluctant to allow to use notional funding. If anyone needs a time-out during a period of trading losses, it’s the smaller customers who are probably less inclined and less able to tolerate large losses. So there’s nothing wrong with a margin call. There’s nothing wrong with a customer taking a moment to consider if he wants to keep going when things aren’t going well. At that point, he can make a decision to deposit additional cash if he decides that he wants to keep going, or to stop trading if that is what makes sense for him.

So in my mind, margin calls don’t hurt customers. They aren’t a risk. If anything, they could be considered protective. They’re like stop-loss orders. If you put a limited amount of cash in your account, that’s the stop. We all know that the market can blow past a stop, just as trading losses can blow past a funding level in a managed account, but at least the stop is there. Without it, losses can continue on a lot longer than the customer might be comfortable with.

And these are only a couple of the reasons that notional funding might be safer for customers, even or particularly smaller or less sophisticated customers, rather than dangerous. Regulators don’t like to talk about this at all, but there are many good reasons for customers to use notional funding, and therefore there are many good reasons for well-meaning CTAs who are very concerned about their customers, and their customers’ well-being, not to restrict their customers’ use of notional funding. I’m not saying you should require your customers to use notional funding. All I’m saying is you should leave the decision up to them.

And the great news for this episode is that this is one of those instances where what is beneficial for the customer is actually beneficial for business. We have to remember that as of September 2018, when I’m recording this episode, managed futures and forex accounts are still uninsured. In the wake of MF Global and PFG, it makes no sense to force your customers to keep excess cash in an uninsured account if they don’t want to do it. And we can’t argue with the idea that it’s a lot easier to raise $100,000 in AUM if your customers are only required to put up a percentage of that amount.

CTA Liability for Debit Risk

Now, if you’re connected with an IB or an FCM that clears your customers’ accounts, or you’ve signed something that puts debit risk on you, you’re going to be concerned about notional funding because then it’s not just your customers who may be called upon to cover a debit balance. It could be you.

But remember this: exchange-minimum margins still apply. If your customer could put $20k in a self-directed account and trade whatever you would trade for him, and everyone would be fine with that, does it really make sense to require an additional $80,000 if you are doing the trading?

How you answer that question is up to you, but a big thing I’d like you to consider is that insistence on customers keeping a lot of excess cash in an uninsured account when a CTA is doing the trading, but that wouldn’t need to be there if the customer were doing the trading, is one reason that the managed futures/forex industry is suffering.

Every situation is different, but after 25 years in this business, I have yet to see a situation where anyone was served by a requirement for the customer to keep more than exchange-minimum margin on deposit at the customer’s FCM. Some CTAs worry that notionally funded accounts are more likely to close when there are losses, but the truth is that all accounts close when there are losses. I don’t see any relationship between how long a customer is willing to stick with a CTA and the funding level of the account.

And if you take nothing else from this episode, please remember this: Your largest and most sophisticated customers are going to notionally fund their accounts. They’re probably going to notionally fund their accounts by 100%. In other words, you will get an account from them with zero cash in it, and they will ask you to trade it at a certain level, maybe it’s $1 million, maybe it’s $5 million, maybe it’s $200 million. You will have notionally funded accounts as a CTA if you are going to have any kind of business at all, because customers like notional funding, and those who are in a position to demand to use it will do so. If you set restrictions on your customers’ use of notional funding, you will only get accounts from very unsophisticated customers who don’t know why notional funding might be a good choice for them.

So what I encourage every CTA who is tempted to set restrictions on notional funding to do is get really clear on why you are uncomfortable with it, because if the reasons you’re uncomfortable don’t really stand up to logic and scrutiny, and they don’t really make sense when you scratch the surface of them, there’s simply no reason to limit the size of your business and potentially put your more vulnerable customers at risk by limiting the amount of notional funding that your customers are allowed to use.

Before I close for today I’d like to say that if you have questions about any of this, I’m happy to discuss. Email me at kelly@profitablecta.com, or go to my website profitablecta.com where you can access my calendar to set yourself up with an appointment. Also, I’d like to tell you I’m an attorney so this podcast may constitute attorney advertising, and you shouldn’t take anything I say here as legal advice that’s applicable to your situation unless you actually hire me as your attorney and I know exactly what your situation is. To talk to me about legal services or other ways that I can help you with your business, I’m happy to speak with you. Again, go to profitable CTA.com or send me an email at kelly@profitablecta.com.

Thanks for joining me today. I look forward to speaking with you if you’d like some help with your CTA, and I look forward to connecting with you in the next episode.

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