1. Introduction
Regulation 1.25, promulgated by the United States Commodity Futures Trading Commission (“CFTC”), sets forth the types of products and instruments in which futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) may invest customer funds held in segregated accounts (“Permissible Investments”).[1] Related regulations pertaining to “secured funds” (CFTC regulation 30.7), “cleared swap customer collateral funds–FCMs” (CFTC regulation 22.2), and “cleared swap customer collateral funds–DCOs” (CFTC regulation 22.3) require that investment of those categories of customer funds comply with CFTC regulation 1.25. Most recently, the CFTC amended the scope of Permissible Investments in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and (in part) in response to the issues associated with the bankruptcy of MF Global.[2] In addition to dealing with Permissible Investments, the CFTC recently established regulations applicable to cleared swaps, which also cover the protection of customer collateral for cleared swaps and the investment of such collateral.[3]
2. Permissible Investments
Initially, the Commodity Exchange Act (the “Act”) limited the investment of segregated customer funds to only (1) obligations of the United States and (2) obligations fully guaranteed as to principal and interest by the United States (including general obligations of any state or of any political subdivision thereof).[4] Subsequently, as discussed below, the CFTC amended the list of Permissible Investments in 2000, 2004, and 2005. In 2009, the CFTC considered amending the list of Permissible Investments again, but suspended such consideration because of the financial crisis and the rulemaking mandates of the Dodd-Frank Act.[5]
a. Subsequent Amendments
In the 2000 amendments, the CFTC expanded the list of Permissible Investments, to include “general obligations issued by any enterprise sponsored by the United States (government sponsored enterprise or GSE debt securities), bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interest in [money market mutual funds].”[6] As part of the 2000 amendments, the CFTC also “included several provisions intended to control exposure to credit, liquidity, and market risks associated with the additional investments . . . .”[7]
In the 2004 amendments, the CFTC “adopted amendments regarding repurchase agreements using customer-deposited securities and time-to-maturity requirements for securities deposited in connection with certain collateral management programs of [DCOs].”[8]
In the 2005 amendments, the CFTC “adopted amendments related to standards for investing in instruments with embedded derivatives, requirements for adjustable rate securities, concentration limits on reverse repurchase agreements, transactions by [FCMs] that are also registered as securities brokers or dealers (in-house transactions), rating standards and registration requirements for [money market mutual funds], an auditability standard for investment records, and certain technical changes.”[9]
b. CFTC Amendments Post–2009
Immediately prior to the enactment of Dodd-Frank, the CFTC considered amending CFTC regulations 1.25 and 30.7. The CFTC, however, never issued any proposed amendments, and instead paused its consideration because of Dodd-Frank, which required extensive review of existing rules and new rulemaking by CFTC. On October 26, 2010, the CFTC issued a notice of proposed rulemaking regarding CFTC regulations 1.25 and 30.7.[10] On December 19, 2011, after reviewing the comments received, the CFTC issued final rules amending CFTC regulations 1.25 and 30.7 (“Customer Fund Final Rules”).[11] While the bankruptcy of MF Global was not the stated reason for amending CFTC regulations 1.25 and 30.7, it seems apparent that the bankruptcy and issues associated with the bankruptcy were influential during the CFTC rulemaking process. It brought additional attention to certain transactions - notably, the investment of customer funds in foreign sovereign debt obligations, and transactions with an affiliate of the FCM or DCO. These investments are no longer permitted.
c. Changes to Permissible Investments
In adopting the Customer Fund Final Rules, the CFTC focused on imposing investment requirements “with the goal of enhancing the preservation of principal and the maintenance of liquidity consistent with [the Act].”[12] As a result, the CFTC narrowed the scope of investment choices, raised certain standards imposed on certain investments, and promoted diversification.
Some of the more notable investment categories that are no longer Permissible Investments are (1) foreign sovereign debt obligations, (2) commercial paper and corporate notes or bonds (other than certain instruments that are fully guaranteed by the U.S. government, and (3) inter-affiliate resale and repurchase transactions and certain internal transactions (i.e., “internal repos”).
Subject to the concentration limits established under the Customer Fund Final Rules, FCMs and DCOs may continue to invest customer funds in the following items:
i) U.S. government securities;
ii) State and municipal securities;
iii) Obligations of any U.S. government corporation or enterprise sponsored by the U.S. government (including debt issued by Fannie Mae and/or Freddie Mac, but only so long as the applicable entity is operating under the conservatorship or receivership of the Federal Housing Finance Authority with capital support from the U.S.);
iv) Certificates of deposit;
v) Commercial paper and corporate notes or bonds fully guaranteed as to principal and interest by the U.S. under the “Temporary Liquidity Guarantee Program”;
vi) Interests in money market mutual funds; and
vii) Purchase and repurchase transactions with non-affiliated banks, broker-dealers, or government securities brokers or dealers that involve assets of the type described in (i) through (vi) above.
In addition to amending the list of Permissible Investments, the Customer Fund Final Rules also modify the concentration limits, and include (1) asset-based concentration limits for direct investments, (2) issuer-based concentration limits for direct investments, (3) concentration limits for repurchase agreements, and (4) counterparty concentration limits.[13]
d. Effective and Compliance Date for Customer Fund Final Rules
The Customer Fund Final Rules became effective on February 17, 2012. FCMs and DCOs have until June 18, 2012 to come into compliance with Customer Fund Final Rules.
3. New Cleared Swaps Collateral
The Dodd-Frank Act also requires the CFTC to adopt regulations that establish a comprehensive new regulatory framework for swaps. In complying with its objective, the CFTC proposed five distinct models for the holding of “cleared swap customer collateral.”[14] The five proposed segregation models were (1) “complete legal segregation model,” (2) physical segregation model, (3) futures model, (4) legal segregation with recourse model, and (5) optional approach model.[15]
a. Adoption of “Complete Legal Segregation Model”
After reviewing the five segregation models and considering public comments, the CFTC adopted the “complete legal segregation model” because it found, in part, that this model provides “the best balance between benefits and costs in order to protect market participants and the public.”[16] One of the primary concerns of the CFTC was fellow-customer risk, or “the risk that the collateral of one customer will be used to compensate a [DCO] for market losses resulting from the swaps of another customer.”[17] The CFTC did recognize that this model (as with the other four proposed models) is susceptible to operational risk.[18]
Pursuant to the complete legal segregation model, FCMs and DCOs are required to treat cleared swap customer collateral as belonging to the cleared swaps customer, and not as collateral of the FCM. In addition, FCMs are “prohibited . . . from using one customer’s cleared swap customer collateral as margin or security for another customer’s swaps.”[19]
The cleared swap customer collateral may be held by a covered entity (i.e., FCM and/or DCO) or by a “permitted depository” as defined by the CFTC regulations. If the cleared swap customer collateral is held by a covered entity, then it must be physically separate from the property of the FCM or, for DCOs, physically separate from the property of FCMs, DCOs, or of any other person that is not a cleared swaps customer of an FCM. Subject to certain restrictions, FCMs and DCOs are able to commingle the cleared swaps customer collateral of multiple cleared swaps customers. The investment of cleared swap customer collateral must comply with CFTC Regulation 1.25.[20]
DCOs and FCMs will be required to record on their books and records the amount of such cleared swaps customer collateral (for FCMs) separately from its own funds, and (for DCOs) separately from its own funds, the funds of any FCM, and the funds of any other person that is not a cleared swaps customer of an FCM.
b. Effective and Compliance Date for CFTC Final Rules Regarding Complete Legal Segregation Model[21]
The CFTC Part 22 rules will become effective on April 9, 2012. Parties must comply with Part 22 rules by November 8, 2012.
4. Conclusion
The CFTC amended the list of Permissible Investments (including applicable concentration limits) with the intent of preserving the customer’s principal and maintaining liquidity. While the CFTC began the process of amending the Permissible Investments prior to the Dodd-Frank Act, it was the Dodd-Frank Act and the issues related to the bankruptcy of MF Global that greatly influenced CFTC rulemaking in amending the list of Permissible Investments. After reviewing the comments received regarding Permissible Investments, the CFTC reduced the number of Permissible Investments and modified the applicable concentration limits. Another issue that was left to confront, however, was the treatment of customer collateral used in cleared swap transactions.
During its proposed rulemaking stage, the CFTC considered five possible segregation models. After debate, the CFTC adopted the complete legal segregation model in hopes of reducing fellow-customer risk and protecting the customer funds from FCM or DCO abuse. Identical to its approach in requiring CFTC regulation 30.7 secured customer funds to comply with CFTC regulation 1.25, the CFTC extended the requirements of CFTC regulation 1.25 to the cleared swap customer collateral held by FCMs and DCOs.
Throughout the CFTC rulemaking process for CFTC regulations 1.25, 30.7, and CFTC Part 22, it is clear that the protection of customer assets was a primary concern. In order to protect customer assets and still preserve liquidity, the CFTC removed some of the investments that were previously permissible under prior CFTC regulations. The new restrictions on Permissible Investments and the new regulatory climate will require FCMs and DCOs to find new ways to increase revenue for their business to enhance their bottom line.
[1] CFTC Reg. 1.20 (2012).
[2] 76 Fed. Reg. 78776 (Dec. 9, 2011).
[3] 77 Fed. Reg. 6336 (Feb. 7, 2012). CFTC Regs. 22.2(e)(1) and 22.3(d) (2012).
[4] 7 U.S.C. 6d (2012).
[5] The CFTC issued an advance notice of proposed rulemaking in May of 2009. 74 Fed. Reg. 23962 (May 22, 2009).
[6] 76 Fed. Reg. 78776, 78776 (Dec. 19, 2011) (citing 65 Fed. Reg. 77993 (Dec. 13, 2000) and 65 Fed. Reg. 82270 (Dec. 28, 2000)).
[7] 76 Fed. Reg. 78776, 78776 (Dec. 19, 2011) (citations omitted).
[8] 76 Fed. Reg. 78776, 78776 (Dec. 19, 2011) (citing 69 Fed. Reg. 6140 (Feb. 10, 2004)).
[9] 76 Fed. Reg. 78776, 78776 (Dec. 19, 2011) (citing 70 Fed. Reg. 29190 (May 17, 2005)).
[10] 75 Fed. Reg. 67642 (Nov. 3, 2010).
[11] 76 Fed. Reg. 78776 (Dec. 9, 2011). With respect to CFTC regulation 30.7 secured customer funds, the CFTC did not previously restrict investment of such funds to CFTC regulation 1.25 investments; however, in accordance with the Customer Fund Final Rules, CFTC regulation 30.7 secured customer funds must now be invested in accordance with CFTC regulation 1.25. CFTC Reg. 30.7(g) (2012).
[12] 76 Fed. Reg. 78776, 78778 (Dec. 9, 2011).
[13] CFTC Reg. 1.25(b)(3) (2012); 76 Fed. Reg. 78776, 78779-800 (Dec. 19, 2011).
[14] 77 Fed. Reg. 6336, 6339 (Feb. 7, 2012). The term “cleared swaps customer collateral” is defined as “all money, securities, or other property received by [an FCM] or by a [DCO] from, for, or on behalf of a Cleared Swaps Customer, which money, securities, or other property: (i) Is intended to or does margin, guarantee, or secure a Cleared Swap; or (ii) Constitutes, if a Cleared Swap is in the form or nature of an option, the settlement value of such option.” CFTC Reg. 22.1 (2012). The term also includes “accruals, i.e., all money, securities, or other property that [an FCM] or [DCO] receives, directly or indirectly, which is incident to or results from a Cleared Swap that [an FCM] intermediates for a Cleared Swaps Customer.” CFTC Reg. 22.1 (2012).
[15] 77 Fed. Reg. 6336,6344-47 (Feb. 7, 2012).
[16] 77 Fed. Reg. 6336, 6344 (Feb. 7, 2012). The “Complete Legal Segregation Model” is also referred to as the “Legal Segregation with Operational Commingling Model” or the “LSOC Model.” 77 Fed. Reg. 6336, 6339 (Feb. 7, 2012).
[17] 77 Fed. Reg. 6336, 6347 (Feb. 7, 2012).
[18] The CFTC identified “operational risk” as “the risk that, due to fraud, incompetence, or other mishap, customer funds that are required to be segregated are lost.” 77 Fed. Reg. 6336, 6347 (Feb. 7, 2012).
[19] 77 Fed. Reg. 6336, 6348 (Feb. 7, 2012).
[20] CFTC Reg. 39.13(g)(8)(i)(D) (2012); 76 Fed. Reg. 69334, 69439 (Nov. 8, 2011).
[21] 77 Fed. Reg. 6336, 6336 (Feb. 7, 2012).
About the Authors
Harris L. Kay is a partner in the Financial Services Practice Group at Henderson & Lyman in Chicago. He concentrates his practice on counseling futures and financial services industry clients in connection with a wide variety of compliance, regulatory, litigation and enforcement matters. He has his law degree from the University of Richmond School of Law, and his undergraduate degree from the College of William & Mary.
Christopher H. Mendoza is an associate in the Financial Services Practice Group at Henderson & Lyman. He counsels futures industry clients in connection with a variety of formation, regulatory and compliance matters. He is a graduate of Cornell Law School and Chapman University.
Henderson & Lyman’s attorneys have represented leaders in the financial services industry since the firm's inception. Its clients range from publicly-traded companies to individual traders, and it represents Broker-Dealers, Futures Commission Merchants, Forex Dealer Members, Introducing Brokers, Commodity Pool Operators, Commodity Trading Advisors, Investment Advisers, and proprietary trading groups. The firm has a sophisticated managed funds practice, involved in the formation and representation of public funds, hedge funds, private equity funds, offshore funds, and their respective managers.
The firm counsels its clients in connection with numerous formation, compliance, regulatory, trading-related, and litigation matters, and draws upon its significant industry experience to provide business-minded advice and solutions. The members of the Practice Group include the former general counsel of a publicly-traded Futures Commission Merchant; the former senior counsel of a Futures Commission Merchant; the former general counsel of a broker-dealer; and the general counsel of a nationally-recognized trading firm.
