[Federal Register: May 11, 2005 (Volume 70, Number 90)]
[Notices]
[Page 24768-24771]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr11my05-25]
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COMMODITY FUTURES TRADING COMMISSION
Amendment of Interpretation
SUMMARY: Section 4d(a)(2) of the Commodity Exchange Act (``CEA'') and
related Commission regulations (hereinafter collectively referred to as
``segregation requirements'') require that all funds received by a
futures commission merchant (``FCM'') from a customer to margin,
guarantee, or secure futures or commodity options transactions and all
accruals thereon be accounted for separately, and not be commingled
with the FCM's own funds or used to margin the trades of or two extend
credit to any other person.\1\ Further, Section 4d(a)(2) has been
construed to require that customer funds, when deposited with any bank,
trust company, clearing organization or another FCM, be available to
the FCM carrying the customer account upon demand.\2\
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\1\ See note 7, infra.
\2\ See note 8, infra.
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In Financial and Segregation Interpretation No. 10, the Division of
Trading and Markets (predecessor to the Division of Clearing and
Intermediary Oversight (``Division'')) first addressed the issue of
whether customer funds may be deposited at a bank in a safekeeping or
custodial account (otherwise known as ``safekeeping account'' or
``third-party custodial account''), in lieu of posting such funds
directly with an FCM, without being deemed to violate the segregation
requirements.\3\ Because Section 17(f) of the Investment Company Act of
1940,\4\ at the time, was interpreted by Securities and Exchange
Commission (``SEC'') staff to generally bar registered investment
companies (``RICs'') from using FCMs and futures clearinghouses as
custodians of fund assets, it was decided that the use of third-party
custodial accounts should not be banned altogether and that Section
4d(a)(2) should be interpreted to permit customer funds to be held in
such accounts, subject to standards designed to ensure the carrying
FCM's right of immediate access to customer funds. Since the issuance
of Interpretation No. 10, a change in the law governing the custody of
fund assets now allows RICs, with a limited exception, to post customer
funds with an FCM.\5\ Because it is no longer necessary for most RICs
to use third-party custodial accounts to engage in futures
transactions, coupled with evidence of significant risks that may
impair immediate and unfettered access by FCMs, the use of third-party
custodial accounts is no longer justified or appropriate, except in the
limited case where the FCM is precluded from holding RIC assets.\6\
Accordingly, Interpretation No. 10 is being amended and FCMs will not
be viewed as being in compliance with the requirements of Section
4d(a)(2) if they deposit, hold, or maintain margin funds for customer
accounts in third-party custodial accounts, except that those FCMs not
eligible to hold the assets of their RIC customers (i.e., due to their
affiliation with the RIC or its adviser) may use such accounts under
conditions specified herein.
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\3\ Financial and Segregation Interpretation No. 10, Treatment
of Funds Deposited in Safekeeping Accounts, Comm. Fut. L. Rep. (CCH)
] 7120 (May 23, 1984) (``Interpretation No. 10''). While
specifically directed to third-party accounts of pension plans and
registered investment companies, the views expressed in the
interpretation applied equally to any other customer of an FCM
(e.g., an insurance company).
\4\ See note 12, infra.
\5\ SEC Rule 17f-6, adopted 1996, permits RICs to deposit
customer margin directly with FCMs and futures clearing houses. See
Rule 17f-6, 17 CFR 270.17f-6, under the Investment Company Act, 15
U.S.C. 80a.
\6\ In February 2005, a notice was published in the Federal
Register soliciting comments on a withdrawal of Interpretation No.
10 (``Notice of Proposed Withdrawal''). See 70 FR 5417 (February 2,
2005). In response thereto, the Commission received comments from
the following entities: Investment Company Institute (``ICI'');
National Futures Association (``NFA''); The Joint Audit Committee
(``JAC''); Futures Industry Association (``FIA''); and AIG Series
Trust (``AIG''). ICI and AIG opposed a withdrawal of Interpretation
No. 10; NFA, JAC, and FIA supported a withdrawal of Interpretation
No. 10 and an outright prohibition of third-party custodial
accounts. The comment letters are available on the Internet at
href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/files/foia/comments05" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/files/foia/comments05.
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DATES: Effective Date: February 13, 2006.
FOR FURTHER INFORMATION CONTACT: Carlene S. Kim, Senior Special
Counsel, Division of Clearing and Intermediary Oversight, Commodity
Futures Trading Commission, 1155 21st Street, NW., Washington, DC
20581, telephone: (202) 418-5613.
SUPPLEMENTARY INFORMATION:
I. Background: Section 4d and Interpretation No. 10
Section 4d(a)(2) of the CEA and related Commission regulations
require that all funds received by an FCM from
[[Page 24769]]
a customer to margin, guarantee, or secure futures or commodity options
transactions and all accruals thereon be accounted for separately, and
not be commingled with the FCM's own funds or used to margin the trades
of or to extend credit to any other person.\7\ Further, Section
4d(a)(2) has been generally construed to require that customer funds,
when deposited at a bank or other depository (i.e., trust company,
clearing organization, another FCM), be placed in an account subject to
withdrawal upon demand by the FCM carrying the customer account.\8\
Thus, any impediments or restrictions on the FCM's ability to obtain
immediate and unfettered access to customer funds are not permitted.
The immediate and unfettered access requirements is intended to prevent
potential delay or interruption in securing required margin payments
that, in times of significant market disruption, could magnify the
impact of such market disruption and impair the liquidity of other FCMS
and clearinghouses.\9\
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\7\ U.S.C. 6d(a)(2). The Commission segregation requirements are
set forth in Regulations 1.20-1.30, 1.32 and 1.36, 17 CFR 1.20-1.30,
1.32 and 1.36.
\8\ E.g., Administrative Determination No. 29 of the Commodity
Exchange Authority (Sept. 28, 1937) deposit of customers' funds
``under conditions whereby such funds would not be subject to
withdrawal upon demand would be repugnant to the spirit and purpose
of the Commodity Exchange Act''); Financial and Segregation
Interpretation No. 9--Money Market Deposit Accounts and NOW
Accounts,'' 1 Comm. Fut. L. Rep. (CCH) ] 7119 (November 23, 1983)
(at 7091-3) (``it has always been the Division's [Division of
Trading and Markets] position that customer funds deposited in a
bank cannot be restricted in any way, that such funds must be held
for the benefit of customers and must be available to the customer
and the FCM immediately upon demand'').
\9\ See, e.g., Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ]
7120, at 7133 (``[t]he free flow of required margin payments and the
required deposits is absolutely essential to the proper functioning
of the commodity exchanges. No customer, especially one who may
maintain relatively large positions, can be permitted to interrupt
that flow, or there will be the potential for serious adverse
consequences to other market participants and the marketplace
itself'').
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Interpretation No. 10 addressed the issue of whether customer funds
may be deposited at a bank in a third-party safekeeping account, in
lieu of posting such funds directly with an FCM, without being deemed
in violation of Section 4d(a)(2).\10\ As was stated in Interpretation
No. 10, the segregated customer funds account system, whereby customer
funds are posted directly with the carrying FCM and held by the FCM on
behalf of its customers, satisfies the essential requirements of
Section 4d(a)(2) and is ``administratively the most efficient way to
treat such funds.'' \11\ At the time, however, RICs were generally
precluded from using FCMs and futures clearinghouses as custodians of
fund assets and third-party custodial accounts were the only
permissible means available to RJCs to participate in the futures
market.\12\ In view of this legal restriction on RICs' custodial
arrangements, the decision was made to permit the use of third-party
custodial accounts to hold margin funds, without being deemed to
violate Section 4d(a)(2), subject to standards designed to ensure FCMs'
immediate and unfettered access to the funds in such accounts.\13\
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\10\ See Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ] 7120.
\11\ See Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ] 7120,
at 7135.
\12\ See Section 17(f) of the Investment Company Act, 15 U.S.C.
80a-17(f). At that time (but no longer), under Section 17(f) and
related rules RICs were generally permitted to maintain their assets
only in the custody of a bank, a member of a national securities
exchange, or a national securities depository. FCMs and futures
clearinghouses did not come within one of these categories.
\13\ Specifically, it was explained that ``[i]n view of the
embryonic state of the law and regulatory requirements which may
affect the ability of other institutions to participate in the
commodity markets, [it] does not now wish to ban altogether the use
of safekeeping accounts.'' See Interpretation No. 10, Comm. Fut. L.
Rep. (CCH) ] 7120, at 7131.
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II. Basis for Amended Interpretation
Developments since the issuance of Interpretation No. 10 require
reconsideration of the permissibility of third-party accounts by FCMs
to deposit or hold margin funds for customer accounts. First, in 1996,
the SEC adopted Rule 17f-6, which permitted RJCs, with limited
exception, to deposit, hold, and maintain their assets with FCMs and
certain other entities in connection with futures transactions effected
on U.S. and foreign exchanges.\14\ With the elimination of the
requirement that fund assets be held in a bank custodial account, the
new rule allowed RJCs to participate in futures trading generally in
the same manner as other futures customers by depositing margin funds
with FCMs and clearing organizations.
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\14\ Investment Company Act Rule 17f-6(b)(3), 17 CFR 270.17f-
6(b)(3). Under the rule, a RJC is not permitted to deposit fund
assets with an FCM that is an affiliate of the RJC or its adviser.
Other conditions in the rule provide that the manner in which the
FCM maintains fund assets must be governed by a written contract and
any gains on fund transactions must be maintained with the FCM only
in de minimis amounts.
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Second, the practical and operational factors that may impair the
carrying FCM's right of immediate and unfettered access to customer
funds, notwithstanding any terms and conditions stipulated in a third-
party custodial agreement, have come to light. According to the comment
letter of the FIA, under the tripartite agreements, customers rather
than FCMs have the client relationship with custodian banks. As a
result, customer funds held in third-party accounts are not as readily
accessible to FCMs as they would be in a segregated customer account
context and in fact, these arguments have failed to prevent the release
or customer funds held in third-party accounts, without the knowledge
or awareness of the carrying FCMs.\15\
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\15\ FIA states that ``[d]ue to the tripartite nature of these
arrangements, commodity customer funds held in third-party accounts
are not accessible to the FCMs in the same manner as commodity
customer funds deposited in ordinary segregated bank accounts * * *
In this regard, a third party account typically is maintained at the
registered investment company's regular custodian, so that the
registered investment company rather than the FCM has the client
relationship with the custodian bank. Similarly, the FCM's back
office personnel do not have the same regular, ongoing
communications and interface with custodian bank personnel, as they
do with bank personnel * * *'' See Comment Letter of FIA (April 4,
2005), supra, note 6.
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Regulatory examinations also have found instances of releases of
customer funds from third-party custodial accounts. Specifically,
Commission audit staff have discovered instances of significant amounts
being released from third-party custodial accounts without the
knowledge or permission of the FCMs. The Joint Audit Committee, which
includes the key self-regulatory organizations that perform front-line
supervision of the FCMs, has reported similar instances of unauthorized
withdrawals, noting that is such cases, the FCMs may not become aware
of the asset release until reconciliation is performed.\16\ These
findings demonstrate a real and significant risk associated with third-
party safekeeping arrangements that are at odds with the immediate and
unfettered access standards of Section 4d(a)(2).
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\16\ See Comment Letter of JAC (April 4, 2005), supra, note 6.
As a result, FCMs may be unaware of market exposure assumed on the
undermargined customers' positions. Similarly, FIA noted that the
release of customer funds without the knowledge of the FCM could
lead to erroneous daily computation of the total amount of customer
funds on deposit in segregated accounts, which could then lead to
errors in financial reporting statements filed by the FCM with the
Commission and self-regulatory organizations (``SROs''). See Id.
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Third, third-party custodial accounts pose potential systemic
liquidity risks by diverting FCM capital to cover customer margin
obligations which would otherwise be available to prevent defaults from
affecting the broader marketplace. These risks may be heightened in
times of significant
[[Page 24770]]
market volatility when liquidity is most critical.\17\
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\17\ In addition, initial margin requirements typically rise
during such periods, creating additional stress on FCM resources.
FIA states that the amount of funds in third-party accounts is
substantial and that these accounts are heavily concentrated in a
small number of FCMs and banks, which factors further exacerbate the
systemic liquidity risks. See Comment Letter of FIA, note 6, supra.
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Finally, there remains concern over the parity of treatment between
customers with segregated accounts of Regulation 30.7 accounts\18\ and
customers using third-party custodial accounts in the context of an FCM
bankruptcy proceeding.\19\ The Division's position is that third-party
custodial accounts are subject to the U.S. Bankruptcy Code and
applicable provisions in the CEA, which provide that customer's pro
rata share of the available customer property.\20\ Nevertheless, the
Division is aware that third-party custodial account arrangements may
create unnecessary confusion on the part of the customer and create the
potential risk that third-party custodial accounts might receive
priority or preference over other customers in an FCM's bankruptcy
proceeding, or at least cause additional administrative expenses to be
incurred, in a manner inconsistent with the Commission regulations and
regulatory objectives.\21\
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\18\ 17 CFR 30.7.
\19\ In Interpretation No. 10, the Division voiced the same
concern regarding FCM bankruptcy but concluded that the interest of
facilitating institutional participation in the futures market
supported the use of third-party custodial accounts. See
Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ] 7120, at 7134.
\20\ 11 U.S.C. 766; Commission regulation 190.18, 17 CFR 190.08.
However, this issue has not been judicially determined.
\21\ See Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ] 7120,
at 7134
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Under Interpretation No. 10, FCMs were permitted to hold margin
funds in third-party custodial accounts in order to avoid precluding
participation by RICs in the futures market. The conflicting
restriction concerning the custody of fund assets no longer exists,
with a minor exception. Together with concerns regarding the risks to
the general marketplace and market users, this is persuasive that
third-party custodial accounts are no longer necessary or appropriate,
except in the limited case where an FCM is precluded from holding RIC
assets due to affiliation with a RIC or its adviser. Findings by both
Commission audit staff and the SROs of actual releases of customer
funds, without the required knowledge or approval of the FCMs, further
demonstrate that the risks associated with third-party custodial
accounts are real and material, not merely theoretical, and that the
public policy benefits of ensuring the financial integrity of the
clearing system outweigh any costs or inconvenience to users of third-
party custodial accounts.\22\ Accordingly, Interpretation No. 10 is
being amended to provide that, with the exception noted below, FCMs may
not deposit, hold, or maintain customer margin in a third-party
account, without being deemed to violate Section 4D(a)(2) of the
CEA.\23\
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\22\ Both ICI and AIG noted the operational efficiencies
stemming from the use of a single bank custodian to manage fund
assets. Further, ICI stated that the disruption and financial cost
associated with restructuring of existing custodial relationships
would outweigh any ``theoretical'' benefits. See Comment Letter of
ICI (April 4, 2005) and Comment Letter of AIG (April 12, 2005),
supra, note 6.
\23\ Interpretation No. 10 is hereby withdrawn. Further, the
views relating to third-party custodial accounts, set forth in
related publications are also hereby withdrawn, except that an FCM
that is not eligible to rely on SEC rule 17f-6 may rely on them to
the extent applicable and relevant. See CFTC Advisory No. 37-96
(Responsibilities of Futures Commission Merchants and Relevant
Depositories with Respect to Third Party Custodial Accounts), Comm.
Fut. L. Rep. (CCH) ] 26,765 (July 25, 1996) and Interpretive
Letters, specifically, CFTC Interpretive Letters No. 85-6 (Comm.
Fut. L. Rep. (CCH) ] 22,579), No. 89-1 (Comm. Fut. L. Rep. (CCH) ]
24,404), and No. 90-1 (Comm. Fut. L. Rep. (CCH) ] 24,579).
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The limited case where the use of third-party custodial accounts
will be permitted, described at Section III below, encompasses an FCM
that is affiliated with a RIC or its adviser. This exception is
appropriate because the relief provided by SEC rule 17f-6 from the
restriction against using FCMs as the direct custodians of fund assets
not available to RICs that use affiliate FCMs to clear their futures
transactions. For these RICs, and without SEC action to remedy the
situation, the inability to use third-party custodial accounts would
result in potentially undue disruption and cost. In addition, it
appears that the overwhelming majority of the instances of the current
use of a third-patty custodial accounts would not encompass this
situation.
It should be noted that this amended interpretation regarding the
use of third-party custodial accounts for purposes of Section 4d(a)(2)
extends equally to secured amount funds held for foreign futures and
foreign options customers in third-party accounts pursuant to
Regulation 30.7. As a result, FCMs may not deposit, hold, or maintain
secured amount funds held for foreign futures and foreign options
customers in third-party accounts funds held for foreign futures and
foreign options customers in third-party accounts under Regulation 30.7
III. Conditional Exception for FCMs Not Eligible for SEC Rule 17f-6
An FCM that is not eligible to rely on SEC Rule 17f-6 due to an
affiliation with a RIC or its advisor may use a third-party custodial
account for purposes of holding margin fund for such a customer,
without being deemed to be in violation of Section 4d(a)(2) or
Regulation 30.7, if the following conditions are and continue to be
met.\24\
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\24\ These conditions are generally consistent with those set
forth in Interpretation No. 10.
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First, the account must be maintained in the name of the FCM, for
the benefit of the customer. Examples of acceptable titles are ``[Names
of FCM] Customer Funds for the Benefit of X Investment Company.'' On
the other hand, a third-party custodial account may not be maintained
in the name of the RIC customer or its adviser.\25\
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\25\ The FCM also must comply with all applicable requirements
in Section 4d(a)(2) and related Commission regulations, including
Regulation 1.20(a) which provides that an FCM must obtain and retain
an acknowledgement from the depository that it was informed that the
customer funds deposited therein are those of FCM customers and are
being held on accordance with the provisions of the CEA and
Commission regulations. See 17 CFR 1.20(a)
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Second, the FCM must have the ability to liquidate open positions
in an account which goes into deficit or becomes under margined within
getting clearance from any third-party custodian of the account of the
customer.
Third, the FCM must have the right of withdraw funds from the
third-party custodial account with no right of the customer (or its
fiduciary) to stop, interrupt or otherwise interfere with such
withdrawal. An FCM which is forced to await pre-clearance for margin
withdrawals has neither possession nor control of he funds which may be
needed for margin purposes. Also, the customer (and its fiduciary) may
not withdraw or otherwise have access to the funds in the account
except through the FCM. Although provision in a third-party custodial
account agreement for a notice to the customer (or to its fiduciary)
would not necessarily be inconsistent with the FCM's right of access, a
requirement that a customer pre-approve margin withdrawals by the FCM
would be deemed insistent with the FCM's right of access.\26\ Finally,
[[Page 24771]]
third-party custodial accounts will be considered subject to the
customary provisions in a commodity customer account agreement to the
effect that all money, securities or property in the customer's
account, or held for the customer by the FCM or by any clearing
organization for a contract market upon which trades of the customer
are executed, are pledged with the FCM and the subject to a security.
Interest in the FCM's favor to secure any indebtedness at any time owed
by the customer to the FCM.
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\26\ Similarly, the FCM could agree in a third-party custodial
agreement that before it directs the custodian of a third-party
custodial account to dispose of customer funds held therein, the FCM
will state that all conditions precedent to its right to direct
disposition of customer funds in the account have been met, provided
that the only condition which an FCM must satisfy in order to have
access to the funds in the account is to state that there has been a
default by the customer in making a margin payment or any other
required deposit.
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Fourth, a third-party custodial account may not be located at an
affiliate of the customer or a fiduciary thereof. Thus, for example, a
fund may not maintain a third-party custodial account at a bank with
which the fund has other relationships that make the bank an affiliate
or fiduciary of the fund.
These conditions are designed to ensure, among other things, that
the FCM has free and ready access to margin funds held in a third-party
custodial account, with the customer restricted from access to such
funds except through the FCM. If the conditions are met, and only in
the case of an affiliate FCM for so long as SEC prohibitions exist, a
third-party custodial account for a RIC will be deemed to be a
segregated account of the FCM within the meaning of Section 4d(a)(2) of
the CEA or permissible under Regulation 30.7, as the case may be, and
the FCM may include the funds in such account in the calculation of the
total amount of customer funds on deposit in segregated accounts or
Regulation 30.7 accounts, as the case may be.
IV. Transition Period
In order to ensure that impacted parties, including the FCMs and
RICs, are provided with adequate time to make necessary adjustments to
their existing custodial arrangements, the amendment to Interpretation
No. 10 will not be made effective until nine months following
publication in the Federal Register.\27\
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\27\ ICI requested that in the event that Interpretation No. 10
is withdrawn, such withdrawal should be made effective no less than
nine months following the publication of a final notice. See Comment
Letter of ICI, note 6, supra.
Issued in Washington, DC on May 5, 2005, by the Division of
Clearing and Intermediary Oversight.
James L. Carley,
Director.
[FR Doc. 05-9386 Filed 5-10-05; 8:45 am]
BILLING CODE 6351-01-M