to enter customer information into severaldatabases maintained by the U.S. government. Accounts of persons who areresidents of countries that have been identified as “noncooperative” by U.S. lawenforcement officials must now, by law, be rejected outright. Persons whosenames appear in databases identifying suspected money launderers must alsobe rejected as customers.
SINGLE-STOCK FUTURESAdditional paperwork may be required for customers who express an interest intrading single-stock futures, which are regulated by both the CFTC and the Securities and Exchange Commission. Rules that were implemented when this newproduct first began trading in November 2002 required additional information andadditional risk disclosures not contained in most FCMs’ original account openingdocuments. Although some FCMs may now have incorporated all of this required
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information into their account forms, the more extensive risk disclosures for single-stock futures will usually be contained in a separate document.
ACCOUNT FUNDING REQUIREMENTSOnce the account has been approved, it must be funded. Customer funds mustoriginate from a bank account with the same title as that of the trading account.Funds delivered by wire are considered “good funds,” and customers can tradeas soon as these funds are credited to their accounts. If the account is fundedwith a personal check, many FCMs will not allow a customer to trade untilthe check clears the bank. FCMs will usually not accept third-party checks,funds originating from a source different than the account owner, or fundsdrawn on credit.Although customers’ funds are not insured, FCMs are required to segregatecustomer funds from the rest of the firm’s money and are limited in how they mayinvest those funds to earn interest when they are not being used by the customer.
MARGIN CALLSFinancial integrity is vital to the futures market. Under the current system, alltrades executed on a U.S. exchange are cleared through an exchange clearinghouse. Instead of a specific trader on the other side of a customer’s trade, theclearinghouse actually becomes the buyer to every seller and the seller to everybuyer. Because of this arrangement, a customer need not be concerned aboutthe financial condition of the person on the other side of his trade. Rather, theclearinghouse stands in the middle of the transaction and looks to each individual customer’s FCM to be financially responsible for their respective side ofthe trade.Because futures trading is highly leveraged (i.e., the margin deposit that acustomer makes is very small relative to the value of the underlying contract), asmall price movement may result in the FCM being required to send additionalfunds to the clearinghouse. Consequently, the FCM must be able to receivethese funds from its customers quickly in order to satisfy its obligation to theclearinghouse. If a margin call cannot be met on a timely basis, the FCM may beforced to liquidate a customer’s position. This protects the customer from incurring a debit balance, and protects the FCM from having to send its ownmoney to the clearinghouse when a customer has no intention of sending additional money to the FCM.Customers should be aware that FCMs are very serious about margin callsand the preservation of their right to liquidate. The customer account agreement
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gives the FCM the right to liquidate a customer’s positions for various reasons,including but not limited to a customer’s failure to maintain adequate margin ora customer’s unavailability to receive a margin call. Should your FCM notify youof a margin call, you have a limited time to meet this request for additionalfunds. Should you fail to send the funds in a timely basis, you may discover yourposition has been closed out. Foreign customers may wish to use the services ofa U.S. bank to ensure that money can be wired on a timely basis. Margin calls aregenerally initiated during normal market hours in the United States, which mayrequire foreign customers to meet a margin call in the middle of the night in theirtime zone.The rules regarding margins and margin calls are very strict and rigidly enforced, but, to the credit of the futures industry, no customer has ever lost moneydue to the failure of an FCM.
RESOLVING DISPUTESUnlike the securities industry, FCMs cannot require customers to agree to arbitrate disputes. Customers may bring claims to the CFTC through its reparationsprogram or to NFA arbitration. Customers can also choose to arbitrate their disputes at the exchange on which the trade was executed or at an organization suchas the American Arbitration Association. Both FCMs and customers may commence actions in state or federal court, although customers may have waived theirright to a jury trial in their customer agreement, and may also have agreed to litigate in a jurisdiction selected by the FCM.A customer who is seeking restitution for alleged violations of the CommodityExchange Act may file a reparation claim with the CFTC within two years of thetime the claim arose. The customer can file pro se (without an attorney) and thecost is minimal. Reparations decisions are often appealable, but this may increasethe costs and the time it takes to finalize the decision. Although a customer cancontractually agree to a one-year limitation on bringing a claim in any other forum,this does not alter his or her right to commence a reparation claim for two yearsfrom the date of the alleged violation.NFA offers an arbitration program. Should a customer commence an actionagainst a member of the NFA (and all FCMs and introducing brokers are requiredto be members of NFA), the member is obligated to respond. Again, a customercan file an arbitration demand pro se; however, the filing fees are higher than inreparations. The various exchanges also offer arbitration programs for disputes involving contracts traded on that exchange.Both reparations and arbitration matters are usually decided faster than theywould be in court. Depending on the amount of the claim, the matter may be decided within a year. Large claims normally require oral hearings, and a customer
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may want an attorney to represent him or her if the claim is for a substantialamount of money. Both the CFTC and the NFA will usually schedule a hearing in alocation selected by the customer. The aforementioned forums may allow testimony by telephone with prior approval.Customers should be aware that FCMs routinely file actions in state or federalcourt to collect on debit balances that a customer may incur. Due to provisions inthe customer agreement, a customer may be forced to defend a claim in the statewhere the FCM is located. This could involve the cost of travel, as well as the costto hire an attorney to represent the customer’s interests.
CHAPTER 13
The Tax Factorfor Traders
W
hen newcomers begin to trade futures, taxes probably are not at the topof their list of concerns. But there are tax advantages with futures trading, in addition to the benefits of leverage, short selling, and the like thatfutures offer.Several caveats should be mentioned before getting into a discussion on thetax treatment of futures and currency transactions:• Tax laws are subject to change by Congress at any time and are constantlyevolving. For current-year tax regulations, you should consult an accountantor tax adviser.• This chapter covers only federal income tax provisions. Various states mayhave applicable rules that could affect your total tax picture as it relates totrading.• This chapter covers only the general rules for taxing the results of futures andcurrency trading by the typical individual trader and does not get into othertax issues such as achieving trader status or complex trading arrangements.You should definitely find an accountant or tax specialist to advise you onthose matters.
SECTION 1256 CONTRACTSFor tax purposes, it is important to determine whether a contract comes underSection 1256 of the Internal Revenue Code (IRC) because gains or losses fromthese contracts are treated differently than those from stocks or interest-bearinginstruments.197
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Section 1256 includes any regulated futures contracts, foreign currency contracts, nonequity options, and dealer equity options. A regulated futures contractis a futures contract that is traded subject to the rules of a qualified domestic commodities exchange. Regulated futures contracts can also include futures contractstraded on a foreign exchange if the foreign exchange employs a cash flow systemsimilar to the variation margin system used in the Unites States and if the foreignexchange has been designated by the U.S. Secretary of the Treasury as a “qualifiedboard or exchange,” as stated in IRC Section 1245(g).The key features of Section 1256 status include:• The mark-to-market rule. All Section 1256 contracts held at the end of a taxyear are marked to market at year-end and deemed to have been sold at themarket’s year-end closing price. The actual gains and losses on dispositionsof the Section 1256 contracts throughout the year are aggregated with thedeemed gains and losses on the year-end positions. The mark-to-market ruleapplies to all Section 1256 contracts, whether they have been held for minutes or months and is similar to the daily mark-to-market practices in the futures industry.• The 60/40 tax treatment. All gains and losses on Section 1256 contracts, regardless of time held, receive 60/40 treatment—60 percent of the net gain (orloss) is considered long-term capital and 40 percent is considered short-termcapital gain (or loss).Example: On May 5, 2005, you buy a regulated futures contract with a value of$50,000. On December 30, 2005 (the last day of business of your tax year), the fairmarket value of the contract was $60,000. Because you are deemed to have soldthe contract at the market’s year-end closing price, you recognize a $10,000 gain onyour 2005 tax return, treated as 60 percent long-term and 40 percent short-termcapital gain. On February 14, 2006, you sell the contract for $65,000. Because yourecognized a $10,000 gain on your 2005 tax return, your tax basis in the contract isincreased to $60,000 and you recognize only the additional $5,000 gain ($65,000 –$60,000) on your 2006 tax return, which is also treated as 60 percent long-term and40 percent short-term capital gain.How much difference does this tax treatment make for the investor? Using thesame example, let us assume you had a net gain of $10,000 to report for Section1256 contracts and were in the 35 percent tax bracket in 2005. If the total weretaxed at short-term ordinary income rates, your tax liability for futures profitswould be $3,500.With the 60/40 tax treatment, your tax liability would break down as follows:60% × $10,000 = $6,000$6,000 × 15% maximum long-term capital gains rate = $900 tax due40% × $10,000 = $4,000
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$4,000 × 35% short-term capital gains rate = $1,400 tax dueTotal tax due $900 + $1,400 = $2,300In this scenario, the maximum blended tax rate is 23 percent instead of 35 percent, the top tax rate on profits from similar investment gains from securities orother instruments. You save more than $1,000 on taxes with the 60/40 treatmentfor futures profits compared to what you would have to pay on profits from otherinvestments taxed at the short-term capital gains or ordinary income rates.One other point should be noted about the marked-to-market provision. It ispossible that you could pay tax on the $10,000 gain as of the end of the year andthen have an adverse market move after the first of the year reduce those profits—in other words, you have paid taxes on profits that no longer exist. You can factorthe loss into the new year’s net result calculations, of course, but if your overallcapital loss for the year is greater than $3,000, the excess could not be recognizedthat year and would have to be rolled forward another year; it may take severalyears to deduct the total loss.Note: The mark-to-market and 60/40 rules do not apply to Section 1256 contract transactions that are made for the purposes of hedging. A hedging transaction is entered into in the normal course of a trade or business primarily to reducean investor’s amount of risk or exposure. Any gain or loss from hedging transactions involving Section 1256 contracts will result in ordinary income or loss.Cash forex transactions that are part of a taxpayer’s international business operations are not covered by Section 1256 treatment, either, but rather by Section988 of the IRC. However, an individual cash forex trader can elect Section 1256treatment instead, just as the futures trader can.
HOW TO REPORT GAINS OR LOSSESAnyone who bought or sold a regulated futures or foreign currency contract during the tax year or is holding such a contract at the end of the year has to reportthis activity to the Internal Revenue Service (IRS). You should receive a Form1099-B or an equivalent statement from your broker with your trading results (Box9 on Form 1099-B). See Figure 13.1.The net gain or loss from Section 1256 regulated futures contracts is reportedon Form 6781, Part I, line 1. See Figure 13.2.The net gain or loss amount on Form 6781 is then reported on Schedule D(Form 1040). No special election needs to be made to have marked-to-market60/40 treatment. See Figure 13.3.If trading in Section 1256 contracts results in a net loss for the year, a noncorporate taxpayer can use up to $3,000 of net capital losses to offset ordinary income ($1,500 if the taxpayer is married and filing separately). Any unused netcapital loss can be carried forward into subsequent tax years until it is used up.
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FIGURE 13.1 Form 1099-B: Proceeds from Broker and Barter Exchange Transactions.(Source: IRS)
FIGURE 13.2 Form 6781: Gains and Losses from Section 1256 Contracts and Straddles.(Source: IRS)
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FIGURE 13.3 Schedule D (Form 1040): Capital Gains and Losses. (Source: IRS)
SPECIAL CONSIDERATIONSThere are other types of futures transactions that are reported differently thanSection 1256 contracts.
Securities Futures ContractsSecurities futures contracts, also known as single-stock futures, are contracts forthe sale for future delivery of a single security or of a narrow-based securities index. These are not Section 1256 contracts (unless they are dealer securities futures contracts, a separate issue not covered here) and receive different taxtreatment than other futures contracts.Gains (or losses) from offsetting or terminating a single-stock futures contractare taxed under Section 1234B and have the same character as the gain or lossfrom transactions in the underlying security (stock, options, and narrow-based indexes). As a result, there is no 60/40 tax treatment for these futures contracts.
StraddlesA straddle is any set of offsetting positions on personal property. These offsettingpositions substantially reduce the investor’s risk of loss from holding another
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position. A straddle may be in the form of a physical commodity, a commodity futures or options contract, or a financial futures or options contract.Losses are subject to the loss deferral rule. That is, losses on the dispositionof property can be deducted only to the extent that the loss is greater than theoffsetting unrecognized gain position. Any unused losses are carried over to thenext period.The net gains or losses from straddle positions are also reported on Form 6781but in Part II, Section A, line 10, for losses or Section B, line 12, for gains as seenearlier. The gain or loss amount on Form 6781 is then reported on Schedule D(Form 1040), “Capital Gains and Losses.”
Mixed StraddlesA mixed straddle is a straddle in which some, but not all, of the positions in thestraddle are Section 1256 contracts. There are two methods to account for mixedstraddles: You can open a mixed straddle account or you can make an election forstraddle-by-straddle identification.In both instances, the net gain or loss from the mixed straddle attributed tothe Section 1256 contract is treated as 60 percent long-term, 40 percent shortterm, the same 60/40 treatment as futures contracts. If the net gain or loss from thestraddle is attributed to the non-1256 position, the gain or loss is treated as shortterm. In addition, there are annual limitations that apply in the case of a mixedstraddle account. You should consult your tax adviser if you are trading mixedstraddles, as the analysis of whether a mixed straddle account would be beneficialto you is complex and beyond the scope of this discussion.
CHAPTER 14
The Businessof FuturesWho Does What
P
ublic confidence is the cornerstone of the financial services industry. We’veall seen what can happen to markets when the public loses its confidence inthem or when the public loses confidence in analysts making recommendations or in corporate accounting or management practices.The best way to create and preserve public confidence is to ensure that thehighest levels of integrity are demanded of each and every market professional.Customers need to know that the firms and individuals with whom they aretransacting business are properly licensed, are sufficiently knowledgeableabout the products and services they offer, and have the best interests of theircustomers at heart.The futures industry attempts to preserve the integrity of trading with severallevels of participants: Regulators, exchanges, brokerage firms and, finally, the individual brokers and advisors who deal directly with customers.
REGULATORY STRUCTURERegulation is the single most effective way to ensure the public’s confidence in theintegrity of the marketplace. In the United States, regulation is provided by a combination of federal oversight agencies and self-regulatory organizations. Unlikemost other countries throughout Europe, Asia, and the rest of the Americas,where there is a single regulatory authority with responsibility for the entire financial services community, the United States currently has similar, but distinct, regulatory structures for the securities and commodity futures industries.This dual approach evolved, in part, because of the inherently different purposes203
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of the marketplaces. The securities market serves to enable capital formation;the futures market facilitates price discovery and risk transfer, as explained inChapter 1.Timing is another key reason for the structure. During the Depression that followed the stock market crash of 1929, Congress held hearings that resulted in thepassage of the Securities Act of 1933 and the Securities Exchange Act of 1934. Asan outgrowth of this legislation, the Securities and Exchange Commission (SEC)was created in 1934 and given a mandate to enforce new securities laws, promotestability in the markets, and protect investors.Although U.S. futures markets trace their origins to 1848 when the ChicagoBoard of Trade was founded, the first piece of comprehensive federal futureslegislation was not enacted until 1936. At that time, only agricultural productswere being traded on the futures exchanges, so regulatory oversight was placedwith the U.S. Department of Agriculture. As futures markets expanded, Congresscreated the Commodity Futures Trading Commission (CFTC) as a separateagency in 1974.The U.S. regulatory structure has four components:1. At the federal level are the SEC and the CFTC. These agencies are charged
with protecting investors and ensuring the integrity of the securities and commodity futures industries, respectively. Their operations are funded by federalappropriations. The SEC and the CFTC, in turn, report to Congressional oversight committees.2. Industrywide self-regulatory organizations (SROs) are the second component.The National Association of Securities Dealers (NASD) and National FuturesAssociation (NFA) deliver private-sector regulation at no cost to the taxpayer.NASD and NFA have similar duties. They’re responsible for registering industry professionals, writing rules to govern their behavior, examining them forcompliance, bringing enforcement actions when appropriate, and operatingdispute resolution forums. These self-regulatory programs are funded, for themost part, by assessment fees paid by the users of the marketplace. Additionalrevenues come from various fees paid by members. The activities of theseSROs are overseen by their respective federal agencies. The NASD came intoexistence in 1938; NFA, in 1982.3. Securities and futures exchanges also are SROs and are the third componentof the regulatory structure. They are responsible for ensuring that their respective member communities follow prescribed exchange rules and relevantfederal regulations. Exchange activities are also subject to review by federaloversight agencies.4. The fourth level is the futures commission merchant (FCM) or broker/dealer.FCMs and broker/dealers both hold customers’ funds. Consequently, they areresponsible for ensuring that their employees and agents are properly licensedto do business with the public and for monitoring that business.
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These are all important participants in the business of regulation. Their involvement ensures that there is no point in the order process that is not subjectto scrutiny.
FUTURES EXCHANGESFutures exchanges, or boards of trade, are officially designated by the CFTC ascontract markets. The CFTC currently identifies 14 exchanges as “active” and another half-dozen or so that it classifies as “dormant” because their contractshaven’t traded for at least six months. Most of the active exchanges are traditionalbricks-and-mortar exchanges, but some are electronic.Historically, futures exchanges have been structured as not-for-profit organizations that are owned and governed by their members. Most exchanges are stillmember organizations, but the Chicago Mercantile Exchange (CME) became thefirst financial exchange to demutualize into a shareholder-owned corporation inDecember 2002.In the traditional not-for-profit model, membership on an exchange is limitedto a specific number of individuals, although some exchanges permit members tohold multiple memberships. Each membership carries with it a percentage of ownership and trading rights.In the publicly held model, members of the public purchase shares in the exchange, just as they do in any other publicly held enterprise. At the CME, traderswho satisfy certain requirements can either purchase shares of Class B commonstock, which gives them rights to trade at the CME, or lease rights to trade at theCME from other Class B shareholders.Although futures and securities exchanges are both auction markets, the waybusiness is conducted on the floors of futures exchanges can differ from how it isconducted on the floors of securities exchanges. For example, the New York StockExchange currently uses a specialist system to maintain an orderly order flow andto guarantee that public customers receive a fair price. However, futures exchanges typically rely on independent floor brokers to represent customer ordersand “locals” to make a market for those orders.
CLEARINGHOUSESThe purpose of clearing trades is to guarantee all contracts traded on the exchanges. In effect, the clearinghouse becomes the seller to every buyer and thebuyer to every seller.The clearinghouse ensures that trading is conducted in an orderly fashion bymatching and recording trades, collecting and maintaining margins according tothe positions of the clearing member firms, matching open short with open long
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positions for delivery, allocating delivery notices, and generating trading and delivery statistics. The clearinghouse also acts as a fiscal transfer agent, transferringmoney from the margin funds of traders who have incurred a loss in the market onany given day to the margin funds of traders who have generated a gain.Here’s how the typical order process works:1. A customer places an order through a brokerage firm.2. The brokerage firm sends the order to an exchange.3. The order is filled at an exchange.4. The order is then transmitted to the clearinghouse. If the brokerage firm isn’t a
member of a clearinghouse, it clears through another firm that is a clearinghouse member.5. The clearinghouse confirms the order, guarantees the trade, and adjuststhe clearing firm’s account based on the gain or loss that results from thetransaction.6. The FCM then credits or debits its customer accounts accordingly.This cash flow allows for the daily settlement of accounts, which is known asmarking to the market. Marking to the market is one of the single most distinguishing features of futures markets and the most vital procedure for maintainingthe financial integrity of the markets. Daily settlement prior to the market’s opening the next morning serves to confirm that each clearing member firm is solventand can continue to conduct business.This process also reduces the risk of defaults by FCMs. In fact, no clearingmember of the Clearing Corp., formerly known as the Board of Trade ClearingCorporation, nor the CME’s clearinghouse has ever experienced such a default.Settling transactions in the securities industry is handled differently. The current standard is T+3, which means that stock transactions must be settled withinthree days of transaction. The SEC is working on a plan to move to T+1 and to automate every step in the settlement process, creating what is commonly referredto as straight-through processing (STP). The implementation of STP would actually bring the settlement process in the securities industry closer to the norm inthe futures industry.The clearing process itself is also handled differently in the securities and futures industries. Although securities take three days to settle, all trades arecleared in one place, as are securities options trades. Until recently, futures exchanges steadfastly maintained their own closed and proprietary clearing systems,which was cumbersome and expensive for FCMs. However, the threat of competition from new exchanges finally drove the CBOT and CME, who between themclear upwards of 85 percent of all futures contracts in the United States, to createa Common Clearing Link. Implementation of the Common Clearing Link began inNovember 2003 and was completed successfully in January 2004.
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In addition to U.S. clearinghouses, international organizations—or CentralCounterparty Clearing Houses, as they are known in Europe—perform similarfunctions. One example is the LCH.Clearnet Group, which serves major international exchanges and platforms, equity markets, derivatives markets, energy markets, international swaps markets, and the majority of the euro-denominatedmarkets. LCH.Clearnet Group is overseen by the Financial Services Authority, theagency with responsibility for regulating the financial services industry in theUnited Kingdom.
FUTURES INDUSTRY PROFESSIONALSWith a few exceptions, any individual or firm that conducts futures business withthe public is required by the Commodity Exchange Act to become registered withthe federal government. Registration is intended to serve two purposes: (1) toscreen for the applicant’s fitness to engage in business as a futures professional,and (2) to identify those individuals and organizations whose business activitiesare truly subject to federal regulation. There are nine official registration categories (many of which we’ve already referenced), but we’ll describe only the onesyou’re most likely to encounter as a trader. Details about the registration exemptions can be found in Part 4 of the regulations of the Commodity Exchange Act.
Futures Commission MerchantA futures commission merchant (FCM) is an individual or organization that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support these orders. An FCM isfrequently referred to as a brokerage firm. As of December 2004, approximately200 firms are registered as FCMs.
Introducing BrokerAn introducing broker (IB) is an individual or organization that solicits or acceptsorders to buy or sell futures contracts or options on futures but does not acceptmoney or other assets from customers to support the orders. Instead, the IB introduces the accounts to an FCM, which handles the customer’s funds. Approximately 1,500 IBs are registered and operate much like an FCM branch office or afull-service brokerage firm.
Commodity Pool OperatorA commodity pool operator (CPO) is an individual or organization that operatesa commodity pool or solicits funds for a commodity pool—that is, an enterprise
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in which funds contributed by a number of persons are combined for the purpose of trading futures contracts or options on futures or to invest in anothercommodity pool. There are approximately 1,800 CPOs. If you decide to putmoney into futures but would prefer to have it traded by professionals ratherthan trade it yourself, you may use the services of a CPO to help you find theright pool for you.
Commodity Trading AdvisorA commodity trading advisor (CTA) is an individual or organization that forcompensation, or profit, advises others as to the value of, or the advisability of,buying or selling futures contracts or options on futures. These can be brokersor, most often, those who trade commodity pools. Today there are approximately 800 CTAs. As with the CPO, if you decide to put money into futures butwould rather have it traded by a professional, you may want to have a CTAtrade it for you or want to trade the CTA’s recommendations yourself. Brokerage firms can often help you find a CTA whose trading philosophy matches yourinvestment goals.
Associated PersonAn associated person (AP) is an individual who solicits orders, customers, or customer funds (or who supervises persons so engaged) on behalf of an FCM, IB,CPO, or CTA. An AP is anyone who is a salesperson or who supervises salespersons for any of these categories of individuals or firms. The registration requirements apply to any person in the supervisory chain of command and not just topersons who directly supervise the solicitations of orders, customers, or funds.There are approximately 53,000 registered APs.
National Futures Association Members and YouAny registered FCM, IB, CPO, and those registered CTAs who manage or exercisediscretion over customer accounts must also become members of the NFA to conduct futures business with the public. The futures exchanges also are voluntarymembers of the NFA.These are the primary categories of futures professionals. It’s a large and diverse community, and sometimes it’s difficult to know what type of business relationship might make the most sense for you. However, one thing is certain: Ifyou’re going to participate in the futures markets, you need to work with a professional who is properly licensed, is registered in one of these categories, and is anNFA member. The reason is simple: As an NFA member, the firm or individual issubject to a set of consistent financial requirements and sales-practice rules designed to protect your best interests as an investor.
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Certain types of futures-related activities do not require registration and NFAmembership. For example, authors, newsletter providers, and professionals whodevelop courses, teach seminars, and create web sites but who don’t otherwise directly solicit customers typically aren’t required to register. Although registrationisn’t required, in some instances these professionals register anyway.
Background Affiliation Status Information Center (BASIC)If you’re new to futures and you don’t already have a business relationship, theBackground Affiliation Status Information Center (BASIC) system offered by the
FIGURE 14.1 NFA BASIC home page. (Source: National Futures Association)
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