Recently, the Commodity Futures Trading Commission (“CFTC”) issued an interpretive letter regarding new CFTC Regulation 1.73 and its applicability to introducing brokers (“IBs”) that enter into give up arrangements with their customers' clearing futures commission merchants (“FCMs”). In its letter, the CFTC confirmed that the term “executing firm” in Regulation 1.73 refers to both IBs and FCMs that execute orders for customers, requiring IBs who execute give-up orders on behalf of their clients to adopt risk management procedures.
Background on CFTC Regulation 1.73
By way of background, adopted in 2012 as part of the Dodd-Frank Wall Street Reform Act, Regulation 1.73 requires clearing FCMs (and in some instances any “executing firm”) to establish risk-based limits for their proprietary and customer accounts based on position size, order size, margin requirements, or similar factors, and requires FCMs to screen orders for compliance with those risk-based limits. Clearing FCMs are permitted to retain the flexibility to satisfy Regulation 1.73 with “simple numerical limits on order or position size, or through more complex margin- based limit[s],” or “price limits that would reject orders that are too far away from the market, or limits on the number of orders that could be placed in a short time.” Additionally, a clearing FCM that is not serving as the executing firm will be required to enter into an agreement that requires the clearing FCM to establish risk-based limits for the customer and the executing firm to screen orders for compliance with those limits.
CFTC Regulation 1.73 also requires FCMs to, on a weekly basis, assess their ability to meet initial margin and variation margin requirements for their proprietary and customer accounts, while also conducting weekly stress tests under “extreme but plausible” conditions of all positions in the proprietary and customer accounts that could pose a material risk to the FCM. FCMs are also required to evaluate their ability to conduct an orderly liquidation of positions in proprietary and customer accounts and estimate the cost of such liquidation on at least a quarterly basis. Each clearing FCM is obligated to adopt written procedures to comply with the risk management rules, maintain full, complete and systematic records documenting compliance with the risk management obligations, and make the records available to the CFTC and prudential regulators promptly upon request.
These new regulations also have implications for both “give-up” and “bunched” orders. In respect to give-ups, clearing FCMs are required to establish risk-based limits for their customers and executing firms (including IBs) will be required to screen orders for compliance. For bunched orders, clearing FCMs must establish limits for the block account and screen the order, and an FCM that clears the allocated trades must establish and maintain systems of controls that ensure compliance.
Letter No. 13-27 Request for Interpretation of CFTC Regulation 1.73
On June 17, 2013, the CFTC released an interpretive letter regarding the applicability of Regulation 1.73 and its impact on IBs. Regulation 1.73 specifically provides that a firm who “executes an order on behalf of a customer but give it up to another firm for clearing” must enter into an agreement with the clearing firm and screen orders for compliance with limits set by the clearing firm. However, up until the CFTC’s letter, it was not clear who, other than FCMs, fell into the category of an “executing firm.”
This letter, dated April 29, 2013, provided two (2) confirmations from the CFTC: (i) that the term “executing broker” in Regulation 1.73 refers to IBs or FCMs that execute orders for customers; and (ii) that an FCM who provides an executing firm with sponsored access to a market is not obligated under Regulation 1.73 to conduct order screening of the executing firm’s customers.
This interpretation has two (2) important implications for IBs that enter into give up transactions with its customers. First, the IB is required to screen customer orders to ensure that they are in compliance with the risk based limits of the clearing firm. This requires IBs to not only be aware of the risk standards adopted by the clients clearing firm, but to implement policies and procedures for review of orders. Second, IBs that are given market access by clearing FCMs are solely responsible for all customer order screening, with no responsibility falling on the clearing FCM.
Futures Industry Association Template Agreement
In an attempt to assist IBs, the Futures Industry Association (“FIA”) has recently published a free template agreement that IBs and other executing brokers can use to meet the requirements of Regulation 1.73. Additionally, the FIA’s website provides procedural guidance and frequently asked questions for firms impacted by Regulation 1.73.
Firms impacted by CFTC Regulation 1.73 were required to be in full compliance with the new regulations as of June 1, 2013. However, the CFTC recently extended this deadline for FCMs entering into certain bunched orders. If the FCM that initially clears the bunched order establishes risk-based limits for the bunched order and screens the order for compliance with the limit, the CFTC has extended implementation of Regulation 1.73 with regards to bunched orders until September 1, 2013.
This article was written by Mark Ruddy and Jack Delaney of the Ruddy Law Office, PLLC. Any inquiries may be sent to mruddy@ruddylaw.com.
