[Federal Register: May 17, 2005 (Volume 70, Number 94)]
[Rules and Regulations]
[Page 28190-28204]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr17my05-7]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 1
RIN 3038-AC15
Investment of Customer Funds and Record of Investments
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (``Commission'') is
amending its regulations regarding investment of customer funds and
related recordkeeping requirements. The amendments address standards
for investing in instruments with certain features, requirements for
adjustable rate securities, concentration limits on reverse repurchase
agreements (``reverse repos''), transactions by futures commission
merchants (``FCMs'') that are also registered as securities broker-
dealers (``FCM/BDs''), rating standards and registration requirement
for money market mutual funds (``MMMFs''), the auditability standard
for investment records, and certain technical changes. Among those
technical changes is an amendment to the Commission's recordkeeping
rules in connection with repurchase agreements (``repos'') and proposed
transactions by FCM/BDs.
DATES: Effective Date: June 16, 2005.
FOR FURTHER INFORMATION CONTACT: Phyllis P. Dietz, Special Counsel,
Division of Clearing and Intermediary Oversight, Commodity Futures
Trading Commission, Three Lafayette Centre, 1155 21st Street, NW.,
Washington, DC 20581. Telephone (202) 418-5430.
Table of Contents
I. Background
II. Discussion of the Final Rules
A. Instruments With Certain Features
B. Adjustable Rate Securities
1. Revised Terminology
2. Permitted Benchmarks
3. Supplemental Requirements
C. Reverse Repos--Concentration Limits
D. Transactions by FCM/BDs
E. Rating Standards for MMMFs
F. Registration Requirement for MMMFs
G. Auditability Standard for Investment Records
H. Additional Technical Amendments
1. Clarifying and Codifying MMMF Redemption Requirements
(a) Next-day Redemption Requirement
(b) Exceptions to the Next-day Redemption Requirement
2. Clarifying Rating Standards for Certificates of Deposit
3. Clarifying Corporate Bonds as Permitted Investments
4. Clarifying References to Transferred Securities
5. Clarifying Payment and Delivery Procedures for Reverse Repos
and Repos
6. Changing Paragraph (a)(1) ``Customer Funds'' to ``Customer
Money''
7. Conforming Reference to ``Marketability'' Requirement
8. Conforming Terminology for ``Derivatives Clearing
Organizations''
9. Conforming Terminology for ``Government Sponsored
Enterprise''
10. Conforming Terminology for ``Futures Commission Merchant''
11. Clarifying the Meaning of ``NRSRO''
III. Section 4(c)
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Costs and Benefits of the Proposed Rules
Text of Rules
SUPPLEMENTARY INFORMATION:
I. Background
Commission Rule 1.25 (17 CFR 1.25) sets forth the types of
instruments in which FCMs and derivatives clearing organizations
(``DCOs'') are permitted to invest customer assets that are required to
be segregated under the Commodity Exchange Act (``Act'').\1\ Rule 1.25
was substantially amended in December 2000 to expand the list of
permitted investments beyond the Treasury and municipal securities that
are expressly permitted by the Act.\2\ In connection with that
expansion, the Commission added several provisions intended to control
exposure to credit, liquidity, and market risks associated with the
additional investments.
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\1\ Section 4d(a)(2) of the Act, 7 U.S.C. 6d(a)(2), requires
segregation of customer funds. It provides, in relevant part, that
customer-deposited ``money, securities, and property shall be
separately accounted for and shall not be commingled with the funds
of [the FCM] or be used to margin or guarantee the trades or
contracts, or to secure or extend the credit, of any customer or
person other than the one for whom the same are held.''
\2\ See 65 FR 77993 (Dec. 13, 2000) (publishing final rules);
and 65 FR 82270 (Dec. 28, 2000) (making technical corrections and
accelerating effective date of final rules from February 12, 2001 to
December 28, 2000).
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On June 30, 2003, the Commission published for public comment
proposed amendments to two provisions of Rule 1.25, and it further
requested comment (without proposing specific amendments) on several
other provisions of the rule.\3\ In February 2004, the Commission
adopted final rule amendments regarding repos with customer-deposited
securities and modified time-to-maturity requirements for securities
deposited in connection with certain collateral management programs of
DCOs.\4\ The Commission did not, however, take any action on the other
matters raised in its June 30, 2003 release.
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\3\ 68 FR 38654 (June 30, 2003).
\4\ 69 FR 6140 (Feb. 10, 2004).
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On February 3, 2005, the Commission published for public comment
proposed rule amendments related to the remaining issues raised in its
June 30, 2003 request for comment. The Commission also solicited
comment on additional proposed amendments to Rule 1.25 and Rule 1.27,
including certain technical amendments.\5\
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\5\ The proposed amendments to Rule 1.27 dealt with issues
related to changes in Rule 1.25.
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The Commission received comment letters from the Chicago Mercantile
Exchange (``CME''), Joint Audit Committee (``JAC''), Futures Industry
Association (``FIA''), National Futures Association (``NFA''), and
Goodwin Proctor LLC, on behalf of Federated Investors, Inc.
(``Federated'').\6\ In general, the comments supported the Commission's
efforts to expand the list of permitted investments for customer funds.
In addition, each comment letter specifically addressed one or more of
the following four topics: instruments with certain features, permitted
benchmarks for adjustable rate securities, the auditability standard
for investment records, and elimination of rating requirements for
money market mutual funds. These comments will be discussed below in
connection with each topic.
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\6\ These letters are available in the comment file accompanying
the February 3, 2005 release, at href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov.
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Taking into consideration the comments received, the Commission has
determined to adopt amendments to Rule 1.25 and Rule 1.27, as proposed,
with two exceptions. First, the Commission is modifying its revisions
to Rule 1.25(b)(3)(iv) regarding permitted benchmarks for adjustable
rate securities.\7\ Second, the Commission is modifying the language of
the new auditability standard established under Rule 1.27(a)(8).\8\
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\7\ See section II.B.2. of this release.
\8\ See section II.G. of this release.
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The final rules, discussed in section II.A. through G. of this
release, relate to standards for investing in instruments with certain
features, permitted
[[Page 28191]]
benchmarks for adjustable rate securities, concentration limits on
reverse repos, permitted transactions (``in-house transactions'') by
FCM/BDs,\9\ elimination of the rating requirement for MMMFs, required
registration for MMMFs under Securities and Exchange Commission
(``SEC'') Rule 2a-7, and an auditability standard for investment
records.
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\9\ In connection with this amendment, the Commission is also
adopting technical amendments to Rule 1.27 to clarify the
recordkeeping requirements applicable to repos and in-house
transactions by FCM/BDs.
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Certain technical amendments to Rule 1.25 and Rule 1.27 are
discussed in Section II.H. of this release. Those amendments clarify
the following: (1) The next-day redemption requirement for MMMFs (also
codifying previously published exceptions to that requirement); (2) the
rating standards for certificates of deposit; (3) the permissibility of
investing in corporate bonds; (4) the inapplicability of segregation
rules to securities transferred pursuant to a repo; (5) payment and
delivery procedures for repos and reverse repos; and (6) the
distinction between investment of customer money and investment of
customer-deposited securities. The Commission is also adopting
technical amendments to conform references to applicable marketability
standards, update and conform the terminology referring to a DCO,
conform the terminology referring to a government sponsored enterprise
(``GSE''), conform the terminology referring to an FCM, and clarify the
meaning of the term ``NRSRO.''
II. Discussion of the Final Rules
A. Instruments With Certain Features
As originally adopted in 2000, Rule 1.25(b)(3)(i) expressly
prohibited investment of customer funds in instruments with any
embedded derivatives. At the request of market participants, in June
2003, the Commission requested comment on whether instruments with
certain features should be permitted, notwithstanding the general
prohibition of Rule 1.25(b)(3)(i). After considering the formal
comments submitted by the FIA, as well as additional information
provided during discussions with FIA representatives, the Commission
proposed to amend Rule 1.25(b)(3)(i) to permit FCMs and DCOs to invest
customer money in instruments with certain features, subject to certain
express standards.
Proposed paragraph (b)(3)(i)(A) would permit an instrument to have
a call feature, in whole or in part, at par, on the principal amount of
the instrument before its stated maturity date. Proposed paragraph
(b)(3)(i)(B) would permit caps, floors, or collars on the interest paid
pursuant to the terms of an adjustable rate instrument. Proposed
paragraph (b)(3)(i) would further provide that the terms of the
instrument must obligate the issuer to fully repay the principal amount
of the instrument at not less than par value, upon maturity.
The Commission received three comment letters discussing these
proposed amendments. In its comment letter, the CME stated that, as a
clearinghouse, it would have to determine whether to accept as
performance bond permitted instruments that ``are illiquid or pose
operational or risk management challenges to the clearing
organization,'' listing as possible examples securities with embedded
derivatives, variable rate securities, auction rate securities, and
reverse repos.\10\ The CME did not specifically identify any
operational or risk management challenges presented by instruments with
the two types of features described in the request for comment.
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\10\ See letter from Craig S. Donohue, Chief Executive Officer,
CME, dated March 7, 2005 (``CME Letter'') at 2.
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In addition, the CME expressed concern about the ability of certain
FCMs to adequately evaluate and manage investments in instruments with
embedded derivatives generally, noting certain ``complexities
associated with evaluating [such] instruments.'' \11\ The CME did not,
however, identify any particular complexities associated with
instruments with the two types of features described in the request for
comment. The CME also noted that ``if [it] is to accept instruments
with embedded derivatives or auction rate securities, CME will continue
to exercise its discretion and judgment to design a program that
accepts and values these instruments in a manner that CME believes will
ensure the safety and soundness of the customers and firms that use our
markets.'' \12\
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\11\ Id.
\12\ Id.
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The JAC agreed with the CME, stating ``we share the concern
expressed by the [CME] in its comment letter that certain FCMs may not
have the tools and systems needed to understand the risks and
implications of the instruments they will be permitted to invest in.''
\13\ As with the CME, however, the JAC comments appeared to refer to
instruments with embedded derivatives generally and did not identify
any particular risks or challenges presented by instruments with call
features or adjustable rate instruments with caps, floors, or collars
on their interest payments.
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\13\ See letter from Joseph D. Sanguedolce, Chairman, JAC, dated
March 7, 2005 (``JAC Letter'') at 2.
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The FIA, in its comment letter, specifically responded to the CME's
comment letter. It disagreed with the CME, stating that ``we do not
believe that the instruments authorized under the proposed rule will
pose particular operational or risk management challenges.'' \14\ In
support of its view, the FIA pointed to the Commission's requirements
for instruments with embedded derivatives, adding that ``securities
with embedded derivatives often have similar or lower levels of risk
than fixed-rate securities in which FCMs are currently authorized to
invest under rule 1.25.'' \15\
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\14\ See letter from John M. Damgard, President, FIA, dated
March 7, 2005 (``FIA Letter'') at 3.
\15\ Id.
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With respect to the CME's concern that instruments with embedded
derivatives might not be appropriate investments for all FCMs, the FIA
stated that it did not anticipate that every FCM would want to take
advantage of the added investment opportunities provided by the
proposed amendments. The FIA further noted that ``FCMs can obtain the
necessary tools and systems to monitor compliance with rule 1.25 from
third party providers and, therefore, will not necessarily have to
incur the significant costs.'' \16\
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\16\ Id. at 4, FN 6.
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The Commission has carefully considered the comment letters and has
decided to adopt the amendments as proposed. The Commission believes
that the final rules establish prudential standards by limiting the
number and scope of acceptable features to call features and caps,
floors, or collars on interest paid, as described above. The
limitations imposed by paragraph (b)(3)(i), in combination with the
other risk-limiting standards imposed by Rule 1.25, create an
appropriate framework for protecting principal and maintaining an
acceptable level of risk. Moreover, the Commission has not received any
data that suggests that the price transparency of an instrument is
reduced when it provides for a call feature or a cap, floor, or collar
on interest paid.
As noted in the Commission's discussion of the proposed rules, the
issuer's right to call an instrument prior to maturity does not
jeopardize the principal amount, but merely
[[Page 28192]]
accelerates the maturity of the instrument. Because the issuer of a
callable instrument typically offers a higher return to investors in
return for the right to call the issue if prevailing interest rates
fall, or for other reasons, a callable instrument can afford its
holders the opportunity to achieve a higher yield without exposing
themselves to greater credit risk by seeking higher yields from other
issuers that may be less creditworthy. Similarly, instruments with a
cap, floor, or collar on the interest paid do not jeopardize the
principal amount payable at maturity. The Commission further notes that
the rules require that the terms of the instrument must obligate the
issuer to fully repay the principal amount of the instrument at not
less than par value, upon maturity.
The Commission agrees with the CME that DCOs have a duty to
exercise discretion in determining what forms of collateral should be
accepted at the clearinghouse level and how that collateral should be
valued. DCOs perform an important risk management function and the
Commission supports their efforts to exercise their judgment in
maintaining high standards for risk management.
The Commission expects that FCMs will carefully evaluate the
appropriateness of each permitted investment in terms of its investment
objectives and compliance with the time-to-maturity, concentration
limits, and other requirements of Rule 1.25.
DSROs also have a role to play in that they are responsible for
seeing that adequate internal controls, risk management policies and
practices, and other compliance procedures are adopted and followed by
FCMs. The Commission considers a DSRO's examination of an FCM's
investments of customer funds to be a critical part of the supervisory
framework and notes that the Joint Audit Program utilized by the DSROs
in examining member FCMs contains a module specifically addressing Rule
1.25 compliance.
The Commission did not receive any comments on its proposed
technical amendment to expressly prohibit investing in any instrument
that, itself, constitutes a derivative instrument. Accordingly, the
Commission is amending paragraph (b)(3)(iii), as proposed, to provide
that ``No instrument may provide payments linked to a commodity,
currency, reference instrument, index, or benchmark except as provided
in paragraph (b)(3)(iv) of this section, and it may not otherwise
constitute a derivative instrument.''
B. Adjustable Rate Securities
Rule 1.25(b)(3)(iv) permits investment in ``variable-rate
securities,'' provided that the interest rates thereon correlate
closely and on an unleveraged basis to a benchmark of either the
Federal Funds target or effective rate, the prime rate, the three-month
Treasury Bill rate, or the one-month or three-month LIBOR rate. In its
June 30, 2003 release, the Commission requested comment on whether the
provision on permitted benchmarks should be amended and, if so, what
the applicable standard should be.
The FIA submitted a comment letter recommending that the Commission
expand the list of permitted benchmarks to include any fixed rate
instrument that is a ``permitted investment'' under the rule. The FIA
reasoned that, if an FCM is authorized to purchase a fixed rate
instrument, e.g., a six-month Treasury bill, and continuously roll that
instrument over, then it should be able to purchase an instrument
benchmarked to that fixed rate security.
After considering the FIA's recommendation, the Commission proposed
several amendments to paragraph (b)(3)(iv) for the purpose of refining
its regulatory approach to variable rate securities, as well as
responding specifically to the FIA's comment.
1. Revised Terminology
As a preliminary matter, the Commission proposed to distinguish
between a ``floating rate security'' and a ``variable rate security.''
A floating rate security, under proposed new paragraph
(b)(3)(iv)(B)(2), would be defined as ``a security, the terms of which
provide for the adjustment of its interest rate whenever a specified
interest rate changes and that, at any time until the final maturity of
the instrument or the period remaining until the principal amount can
be recovered through demand, can reasonably be expected to have a
market value that approximates its amortized cost.'' A variable rate
security, under proposed new paragraph (b)(3)(iv)(B)(3), would be
defined as ``a security, the terms of which provide for the adjustment
of its interest rate on set dates (such as the last day of a month or
calendar quarter) and that, upon each adjustment until the final
maturity of the instrument or the period remaining until the principal
amount can be recovered through demand, can reasonably be expected to
have a market value that approximates its amortized cost.'' The term
``adjustable rate security'' would refer to either or both of the
foregoing, under proposed new paragraph (b)(3)(iv)(B)(1).
The definitions of floating rate security and variable rate
security are the same as those contained in SEC Rule 2a-7,\17\ and
their use is consistent with the Rule 1.25(b)(5) time-to-maturity
provision.\18\ The introduction of these terms is intended to clarify,
not change, the meaning of paragraph (b)(3)(iv).
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\17\ See Rule 2a-7(a)(13), 17 CFR 270.2a-7(a)(13) (floating rate
security); and SEC Rule 2a-7(a)(29),17 CFR 270.2a-7(a)(29) (variable
rate security).
\18\ Under Rule 1.25(b)(5), the portfolio time-to-maturity
calculation is computed pursuant to SEC Rule 2a-7.
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The Commission did not receive any comments on these proposed
changes in terminology and the Commission is adopting new paragraphs
(b)(3)(iv)(B)(1), (2) and (3), as proposed.
2. Permitted Benchmarks
As noted above, the FIA recommended that Rule 1.25(b)(3)(iv) be
amended to provide that permissible benchmarks can include any fixed
rate instrument that is a ``permitted investment'' under the rule. The
Commission agrees that it is appropriate to afford greater latitude in
establishing benchmarks for permitted investments, thereby enabling
FCMs and DCOs to more readily respond to changes in the market. In its
February 3, 2005 release, the Commission proposed new paragraph
(b)(3)(iv)(A)(2) which would provide that, in addition to the
benchmarks already enumerated in the rule, floating rate securities
could be benchmarked to rates on any fixed rate instruments that are
``permitted investments'' under Rule 1.25(a). The Commission did not,
however, expand the list of permitted benchmarks for variable rate
securities.
In its March 2005 comment letter, the FIA requested that the
Commission expand the list of permitted benchmarks for all adjustable
rate securities, stating that ``we see no reason why the permitted
benchmarks for variable rate securities cannot be identical to the
expanded list of permitted benchmarks for floating rate securities.''
\19\
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\19\ See FIA Letter at 2.
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Similarly, the NFA encouraged the Commission to expand the
permitted benchmarks for both floating rate and variable rate
securities.\20\
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\20\ See letter from Thomas W. Sexton, III, Vice President and
General Counsel, NFA, dated March 7, 2005 (``NFA Letter'') at 1.
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The Commission has considered the practical implications of
limiting the permitted benchmarks as originally proposed, and it has
decided to expand the list of permitted benchmarks to include the same
reference instruments
[[Page 28193]]
for both floating rate and variable rate securities. As a result, the
Commission is adopting a revised paragraph (b)(3)(iv)(A)(1) to provide
that ``the interest payments on variable rate securities must correlate
closely and on an unleveraged basis to a benchmark of either the
Federal Funds target or effective rate, the prime rate, the three-month
Treasury Bill rate, the one-month or three-month LIBOR rate, or the
interest rate of any fixed rate instrument that is a permitted
investment listed in paragraph (a)(1) of this section.'' The Commission
is adopting, as proposed, new paragraph (b)(3)(iv)(A)(2), which relates
to permitted benchmarks for floating rate securities.
3. Supplemental Requirements
The Commission proposed to further amend paragraph (b)(3)(iv) by
adding two supplemental requirements that it believes are prudent and
necessary in light of the increasing number and complexity of
adjustable rate securities that could qualify as permitted investments.
Under proposed paragraph (b)(3)(iv)(A)(3), any benchmark rate would
have to be expressed in the same currency as the adjustable rate
security referencing it. This eliminates the need to calculate and
account for changes in applicable currency exchange rates. Under
proposed paragraph (b)(3)(iv)(A)(4), the periodic coupon payments could
not be a negative amount. This is designed to prevent FCMs and DCOs
from investing in instruments that the Commission believes do not
reflect an acceptable level of risk.
The Commission did not receive any comments on these proposed new
provisions and they are being adopted, as proposed.
C. Reverse Repos--Concentration Limits
Rule 1.25(b)(4)(iii) establishes concentration limits for reverse
repos.\21\ These restrictions, which were adopted in response to public
comment, as expressed at that time, take into consideration the
identity of both the issuer of the securities and the counterparty to
the reverse repo. Consideration as to counterparty was based on the
counterparty having direct control over which specific securities would
be supplied in a transaction.\22\ Given industry experience over the
past several years, however, it has been brought to the attention of
the Commission that the ability of FCMs and DCOs to monitor compliance
with this two-prong standard has proven to be operationally unworkable.
As a result, in June 2003, the Commission requested comment on market
participants' experience with the current provisions relating to
reverse repos and suggestions on how best to address the risks of these
transactions.
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\21\ As used in this release, the term ``reverse repo'' means an
agreement under which an FCM or DCO buys a security that is a
permitted investment from a qualified counterparty, with a
commitment to resell that security to the counterparty at a later
date. A ``repo'' is an agreement under which an FCM or DCO sells a
security to a qualified counterparty, with a commitment to
repurchase that security at a later date.
\22\ See 65 FR 77993, 78002 (Dec. 13, 2000).
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In its February 3, 2005 release, the Commission, responding to an
FIA recommendation, proposed to amend paragraph (b)(4)(iii) to make
reverse repos subject to the concentration limits for direct
investments under Rule 1.25(b)(4)(i). The Commission did not receive
any comments addressing this proposed change and it is amending
paragraph (b)(4)(iii), as proposed.
D. Transactions by FCM/BDs
In its letter responding to the Commission's June 30, 2003 request
for public comment, the FIA proposed adding a new provision to Rule
1.25, which would permit an FCM/BD to engage in transactions that
involve the exchange of customer money or customer-deposited securities
for securities that are held by the FCM in its capacity as a securities
broker-dealer (``in-house transactions'').\23\ The FIA proposed
specific requirements for in-house transactions, many of which were
similar to requirements already applicable to repos and reverse repos
under Rule 1.25(d). Lehman Brothers also submitted a comment letter in
support of the FIA's proposal.
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\23\ After the submission of its comment letter, the FIA
requested that the Commission also authorize transactions in which
customer-deposited securities are exchanged for cash.
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In its February 3, 2005 release, the Commission proposed to amend
Rule 1.25 by adding new paragrahs (a)(3) and (e) to permit FCM/BDs to
engage in in-house transactions subject to specified requirements. The
authority granted under paragraph (a)(3) would be subject to the
requirements of paragraph (e), which incorporates many of the same
restrictions currently imposed on repo and reverse repo transactions
under paragraph (d).
In considering issues related to the investment of customer money
or securities by an FCM, the Commission's primary interest is in
preserving the integrity of the customer segregated account. This is
important both for systemic integrity and customer protection reasons.
Not only must there be sufficient value in the account at all times,
but the quality of investments must reflect an acceptable level of
credit, market, and liquidity risk. In this regard, it is important
that non-cash assets can be quickly converted to cash at a predictable
value. As stated in its February 3, 2005 release, the Commission
believes that the in-house transactions, which can provide the economic
equivalent of repos and reverse repos, satisfy these standards.
Moreover, the in-house transactions can assist an FCM both in achieving
greater capital efficiency and in accomplishing important risk
management goals, including internal diversification targets.
The Commission did not receive any comments addressing the proposed
amendments regarding in-house transactions, including related technical
amendments. Accordingly, the Commission is adopting new paragraphs
(a)(3)(i), (a)(3)(ii), (a)(3)(iii), and (e), as proposed, and
redesignating existing paragraph (e) as paragraph (f).
Under paragraph (a)(3)(i), customer money may be exchanged for
securities that are permitted investments and are held by an FCM/BD in
connection with its securities broker or dealer activities. Under
paragraph (a)(3)(ii), securities deposited by customers as margin may
be exchanged for securities that are permitted investments and are held
by an FCM/BD in connection with its securities broker or dealer
activities. Under paragraph (a)(3)(iii), securities deposited by
customers as margin may be exchanged for cash that is held by an FCM/BD
in connection with its securities broker or dealer activities.
Paragraph (e)(1) requires that the FCM, in connection with its
securities broker or dealer activities, must own or have the
unqualified right to pledge the securities that are exchanged for
customer money or securities held in the customer segregated account.
The securities may be held as part of the broker-dealer inventory or
may have been deposited with the broker-dealer by its customers.
Paragraph (e)(2) requires that the transaction can be reversed
within one business day or upon demand. This is the same standard that
currently applies to repos and reverse repos under Rule 1.25(d)(5),
with the goal of establishing investment liquidity.
Paragraph (e)(3) incorporates the Rule 1.25(d)(1) requirement that
the securities transferred from and to the customer segregated account
must be specifically identified by coupon rate, par amount, market
value, maturity date, and CUSIP or ISIN number.
Paragraph (e)(4) establishes two general requirements for the types
of
[[Page 28194]]
customer-deposited securities that may be used in the in-house
transactions. Paragraph (e)(4)(i) requires that the securities be
``readily marketable'' as defined in SEC Rule 15c3-1.\24\ Paragraph
(e)(4)(ii) requires that the securities not be ``specifically
identifiable property'' as defined in Rule 190.01(kk). These same
requirements apply to customer-deposited securities used in repos under
Rule 1.25(a)(2)(ii).
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\24\ 17 CFR 240.15c3-1.
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Paragraph (e)(5) establishes requirements for securities that will
be transferred to the customer segregated account as a result of the
in-house transaction, clarifying the treatment of these securities once
they are held in the customer segregated account. Paragraph (e)(5)(i)
requires that the securities be priced daily based on the current mark-
to-market value. Paragraph (e)(5)(ii) provides that the securities will
be subject to the concentration limit requirements applicable to direct
investments. Paragraph (e)(5)(iii) provides that the securities
transferred to the customer segregated account must be held in a
safekeeping account with a bank, a DCO, or the Depository Trust Company
in an account that complies with the requirements of Rule 1.26.\25\
Paragraph (e)(5)(iv) incorporates the Rule 1.25(d)(7) restrictions on
the subsequent use of the securities. It provides that the securities
may not be used in another similar transaction and may not otherwise be
hypothecated or pledged, except such securities may be pledged on
behalf of customers at another FCM or a DCO. It further specifies
requirements for permitted substitution of securities.
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\25\ Note that the Commission has not included in this paragraph
the FIA's proposed one-day time-to-maturity treatment for securities
transferred to the customer segregated account. Although an in-house
transaction could be reversed within one day, the rule would not
require that it be reversed within that time frame. Effectively,
these instruments would be subject to the same risks associated with
the price sensitivity of direct investments and, accordingly, should
be subject to the same standards in order to maximize the protection
of principal. Special treatment would undermine the purpose of the
time-to-maturity requirement.
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Paragraph (e)(6) sets forth the payment and delivery procedures for
in-house transactions. Adapted from Rule 1.25(d)(8), the provisions are
designed to ensure that in-house transactions are carried out in a
manner that does not jeopardize the adequacy of funds held in the
customer segregated account. Paragraph (e)(6)(i) governs transactions
under paragraph (a)(3)(i), paragraph (e)(6)(ii) governs transactions
under paragraph (a)(3)(ii), and paragraph (e)(6)(iii) governs
transactions under paragraph (a)(3)(iii).
Paragraph (e)(7) provides that the FCM must maintain all books and
records with respect to the in-house transactions in accordance with
Rules 1.25, 1.27, 1.31, and 1.36, as well as the applicable rules and
regulations of the SEC. This clarifies the pre-existing obligations of
the FCM, and it is adapted from Rule 1.25(d)(10).
Paragraph (e)(8) incorporates the requirements of Rule 1.25(d)(11).
It provides that an actual transfer of securities by book entry must be
made consistent with Federal or State commercial law, as applicable.
Moreover, at all times, securities transferred to the customer
segregated account are to be reflected as ``customer property.''
Paragraph (e)(9) provides that, for purposes of Rules 1.25, 1.26,
1.27, 1.28 and 1.29, securities transferred to the customer segregated
account would be considered to be customer funds until the money or
securities for which they were exchanged are transferred back to the
customer segregated account. As a result, in the event of the
bankruptcy of the FCM, any securities transferred to and held in the
customer segregated account as a result of an in-house transaction
could be immediately transferred to another FCM. This provision adapts,
in part, the provisions set forth in Rule 1.25(d)(12).
Paragraph (e)(10) addresses the failure to return customer-
deposited securities to the customer segregated account. Adapted from
Rule 1.25(a)(2)(ii)(D), it provides that, in the event the FCM is
unable to return to the customer any customer-deposited securities used
in an in-house transaction, the FCM must act promptly to ensure that
there is no resulting direct or indirect cost or expense to the
customer.
The Commission is also adopting, as proposed, two amendments
related to in-house transactions. First, the Commission is amending
Rule 1.25(b)(4) by adding a new paragraph (iv) to provide that, for
purposes of determining compliance with applicable concentration
limits, securities transferred to a customer segregated account
pursuant to Rule 1.25(a)(3) will be combined with securities held by
the FCM as direct investments. In adding this new provision, the
Commission is also redesignating existing paragraphs (b)(4)(iv) and (v)
as (b)(4)(v) and (vi), respectively.
Second, the Commission is adopting a technical amendment to Rule
1.27 to clarify the applicability of recordkeeping requirements to
securities transferred to and from the customer custodial account
pursuant to repos and in-house transactions. In this regard, Rule 1.27
provides that each FCM that invests customer funds and each DCO that
invests customer funds of its clearing members' customers or option
customers must keep a record showing specified information. Among the
items to be recorded are the amount of money so invested (paragraph
(a)(3)) and the date on which such investments were liquidated or
otherwise disposed of and the amount of money received of such
disposition, if any (paragraph (a)(6)). The Commission is amending
those provisions by adding, after the reference to ``amount of money,''
the phrase ``or current market value of securities.'' This clarifies
that amounts recorded must include the value of securities, as well as
cash.
E. Rating Standards for MMMFs
Rule 1.25 permits FCMs and DCOs to invest customer funds in MMMFs,
subject to certain standards set forth in the rule. Among those
standards is the requirement that MMMFs that are rated by a nationally
recognized statistical rating organization (``NRSRO'') must be rated at
the highest rating of the NRSRO.\26\ While the rule does not permit
investments in lower rated MMMFs, it does not prohibit investments in
unrated MMMFs. As a result, a rated MMMF that does not have the highest
rating is not acceptable as a permitted investment, but an unrated MMMF
is acceptable.\27\
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\26\ See Rule 1.25(b)(2)(i)(E).
\27\ The Commission notes that a substantial percentage of
customer money invested in MMMFs is invested in unrated funds.
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By letter dated April 8, 2004, Federated Investors, Inc.
(``Federated'') requested that the Commission eliminate the rating
requirement for MMMFs.\28\ Federated expressed the view that the rating
requirement creates a competitive inequity for lower rated MMMFs that
have yield and portfolio characteristics similar to the unrated funds
that are commonly used by FCMs for investment of customer funds.
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\28\ See letter from Melanie L. Fein, Goodwin Proctor LLP, on
behalf of Federated, dated April 8, 2004, available in the comment
file accompanying this rulemaking, at href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov.
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Recognizing the anomalous situation created by the rating
requirement, and in light of the risk-limiting standards imposed by SEC
Rule 2a-7 \29\ as well as Rule 1.25(c), the Commission proposed to
eliminate the rating requirement. Federated submitted a comment letter
in which it reiterated its support for the elimination of the rating
requirement
[[Page 28195]]
and, among other things, emphasized the extensive investor protections
of SEC Rule 2a-7 that it believes make the Commission's existing rating
requirement for MMMFs unnecessary.\30\ In this regard, Federated
observed that SEC Rule 2a-7 imposes strict portfolio quality,
diversification, and maturity standards, which greatly limit the
possibility of significant deviation between the share price of a fund
and its per share net asset value. Additionally, Federated noted that
MMMFs are subject to board oversight regarding credit quality
requirements and investment procedures. The Commission did not receive
any other comments on this topic.
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\29\ As discussed in Section II.F. of this release, the
Commission is amending Rule 1.25(c)(1) to eliminate the possibility
of a fund obtaining an exemption from the SEC Rule 2a-7 registration
requirement.
\30\ See letter from Melanie L. Fein, Goodwin Proctor LLP, on
behalf of Federated, dated February 28, 2005.
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Accordingly, in consideration of the above, the Commission is
eliminating the rating requirement for MMMFs, as proposed, by adopting
two amendments to Rule 1.25(b)(2)(i). First, it is revising paragraph
(b)(2)(i)(A) to read ``U.S. government securities and money market
mutual funds need not be rated.'' Second, it is eliminating the rating
requirement for MMMFs contained in paragraph (b)(2)(i)(E).
F. Registration Requirement for MMMFs
Rule 1.25(c)(1) provides that, generally, an MMMF must be an
investment company that is registered with the SEC under the Investment
Company Act of 1940 and that holds itself out to investors as an MMMF
in accordance with SEC Rule 2a-7. Paragraph (c)(1) further provides
that an MMMF sponsor may petition the Commission for an exemption from
this requirement, and the Commission may grant such an exemption if the
MMMF can demonstrate that it will operate in a manner designed to
preserve principal and to maintain liquidity. The exemption request
must include a description of how the fund's structure, operations and
financial reporting are expected to differ from the requirements in SEC
Rule 2a-7 and applicable risk-limiting provisions contained in Rule
1.25. In addition, the MMMF must specify the information that it would
make available to the Commission on an on-going basis.
As explained in the February 3, 2005 release, the Commission has
received several informal inquiries regarding possible exemption
requests. In evaluating these inquiries, Commission staff have explored
alternative standards that could be used to ascertain whether an MMMF
will operate in a manner designed to preserve principal and to maintain
liquidity and, therefore, could be exempted. As a result of this
exercise, it has become apparent that establishing such standards
presents substantial practical and policy issues.
For example, from a practical standpoint, granting an exemption
would require that the Commission, on a case-by-case basis, review a
particular MMMF's risk-limiting policies and procedures and determine
that, notwithstanding deviations from the Rule 2a-7 requirements, those
policies and procedures will operate to preserve principal and to
maintain liquidity. Moreover, if an exemption were granted, Commission
staff would have to maintain oversight over the exempt MMMF to
ascertain that it continues to operate in accordance with the
Commission's standards. The Commission believes that it would be
inefficient to devote substantial resources to the exemption process.
In addition, the Commission is concerned that this process could
produce inconsistent results and give rise to an uncertain framework
for regulatory oversight.
From a policy standpoint, the Commission is concerned that by
granting an exemption, the Commission may be perceived as expressing a
view about the adequacy of an MMMF's overall risk-limiting policies and
procedures and, ultimately, upon the investment quality of any
particular MMMF. The Commission does not wish to provide, or be
perceived as providing, any such assurances to FCMs or DCOs that might
be interested in investing customer money in an exempt MMMF.
The Commission did not receive any comments on this proposed
action. Accordingly, the Commission is amending paragraph (c)(1) to
eliminate the availability of an exemption for unregistered funds.
While this removes the possibility of adding certain MMMFs to the pool
of qualifying permitted investments, the Commission believes that this
potential loss will be mitigated by the availability of additional MMMF
investments as a result of the Commission's decision to eliminate the
rating requirement for MMMFs.\31\ As a related matter, the Commission
is also adopting a technical amendment that would delete the reference
to ``a fund exempted in accordance with paragraph (c)(1) of this
section'' at the end of paragraph (c)(2).
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\31\ See discussion in Section II.E. of this release.
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G. Auditability Standard for Investment Records
Rule 1.27 sets forth recordkeeping requirements for FCMs and DCOs
in connection with the investment of customer funds under Rule 1.25.
More specifically, the rule lists the types of information that an FCM
or DCO must retain, subject to the further recordkeeping requirements
of Rule 1.31.
The Commission proposed to amend Rule 1.27 by adding a new
provision to establish an auditability standard for pricing information
related to all instruments acquired through the investment of customer
funds. Such a standard is intended to facilitate the maintenance of
reliable and readily available valuation information that can be
properly audited. This is particularly important with respect to
instruments for which historical valuation information may not be
retrievable from third party sources at the time of an audit.
The Commission proposed to amend Rule 1.27 by adding a new
paragraph (a)(8), to require FCMs and DCOs to maintain supporting
documentation of the daily valuation of instruments acquired through
the investment of customer funds, including the valuation methodology
and third party information. Such supporting documentation would have
to be sufficient to enable auditors to verify information to external
sources and recalculate the valuation for a given instrument.
Several commenters provided particularly noteworthy insights on the
issue of auditability standards. While supporting the adoption of a
comprehensive auditability standard ``given the ever-expanding
population of complex investments which may become available'' \32\ the
Joint Audit Committee noted the importance under Generally Accepted
Auditing Standards of an auditor's ability to independently verify
valuation documents from third parties provided by an FCM. The JAC also
requested guidance regarding the evaluation of internal models that
certain FCMs may use to value investments of segregated funds.\33\
Finally, the JAC also recommended that the auditability standard impose
an obligation on FCMs and DCOs to maintain documentation supporting a
particular instrument's compliance with all criteria set forth in Rule
1.25 for permitted investments.\34\
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\32\ See JAC Letter at 2.
\33\ Id. at 1.
\34\ Id. at 2.
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In its comment letter, the FIA requested that the Commission, in
adopting the final rules, confirm certain views expressed by Commission
staff in conversations with FIA representatives.
[[Page 28196]]
More specifically, the FIA sought clarification that (a) FCMs could
rely on their custodian banks to provide valuations for securities that
are held in the customer segregated account, and daily records of these
valuations would be sufficient to comply with the auditability
standard; (b) if an FCM used one or more dealers to value certain
securities, the FCM would be required to maintain a record of the
dealers used and the prices provided; and (c) if an FCM used internal
models to value certain securities, the FCM would be required to
maintain a daily record of the prices obtained from such models and,
separately, be prepared to explain the models when subject to
audit.\35\
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\35\ FIA Letter at 2-3.
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The NFA similarly encouraged the Commission ``to clarify the
proposal's recordkeeping obligations for FCMs to the extent that the
valuation of the investments is performed by custodial banks, dealers
and an FCM's internal models.'' \36\
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\36\ NFA Letter at 1.
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The proposed auditability standard was stated in broad terms to
provide flexibility to FCMs and DSROs in establishing verification
procedures for the valuation of instruments, particularly those for
which historical valuation information may not be readily available
from third party sources at the time of an audit. The Commission
declined to propose prescriptive rules based on its belief that the
broader standard would afford auditors greater latitude in determining
what would be ``sufficient'' for their purposes. The auditability
standard is not intended to be a substitute for properly designed and
executed internal controls or proper oversight thereof by an FCM's
DSRO. Rather, it is envisioned as a meaningful addition to the matrix
of safeguards that are designed to minimize credit, liquidity and
market risk in connection with investments of customer funds.
The Commission has decided to adopt the proposed auditability
standard with revised language that is intended to clarify the
Commission's intent. Accordingly, the Commission will add language to
refer to ``readily available'' documentation to emphasize that the
documentation must be made available to the auditor in a timely and
convenient manner. The standard will provide that ``[s]uch supporting
documentation must be sufficient to enable auditors to verify the
valuations and the accuracy of any information from external sources
used in those valuations.''
In response to the requests of the FIA and NFA, the Commission
confirms that: (a) FCMs may rely on their custodian banks to provide
valuations for securities that are held in the customer segregated
account, and daily records of these valuations will be sufficient to
comply with the auditability standard; (b) if an FCM uses one or more
dealers to value certain securities, the FCM must maintain a record of
the dealers used and the prices provided; and (c) if an FCM uses
internal models to value certain securities, the FCM must maintain a
daily record of the prices obtained from such models and, separately,
be prepared to explain such models, inputs and assumptions thereto, and
internal controls thereover.
The Commission acknowledges the JAC's suggestion that the
Commission impose a separate obligation on FCMs and DCOs to maintain
documentation that would affirmatively demonstrate the compliance of
any investment with the various criteria of Rule 1.25, and it will
consider whether to solicit public comment on this issue.
H. Additional Technical Amendments
1. Clarifying and Codifying MMMF Redemption Requirements
The Commission permits FCMs and DCOs to invest customer money in
MMMFs in accordance with the standards set forth in Rule 1.25(c). Among
those standards is the requirement that the MMMF be able to redeem the
interest of the FCM or DCO by the business day following a redemption
request. The Commission proposed to amend paragraph (c)(5) to clarify
that the MMMF must be legally obligated to redeem the interest and make
payment in satisfaction thereof by the business day following the
redemption request. In addition, the Commission proposed a further
amendment to codify previously articulated exceptions to the next-day
redemption requirement.
(a) Next-Day Redemption Requirement
In response to inquires from participants in the futures and mutual
fund industries, the Commission proposed to amend paragraph (c)(5) to
clarify that next-day redemption and payment is mandatory. To effect
this, the Commission proposed to eliminate the language requiring that
the MMMF ``must be able to redeem an interest by the next business day
following a redemption request'' and to substitute in its place a
provision that requires the fund to ``be legally obligated to redeem an
interest and make payment in satisfaction thereof by the business day
following a redemption request.'' The revised language unambiguously
establishes the mandatory nature of the redemption obligation and also
clarifies the distinction between redemption (valuation) of MMMF
interests and actual payment for those redeemed interests. Thus, the
next-day redemption requirement is not met even if an MMMF, as a matter
of practice, offers same-day or next-day redemption, if there is no
binding obligation to do so.
The second provision of paragraph (c)(5) suggests two ways in which
an FCM or DCO may demonstrate compliance with the next-day redemption
requirement, i.e., an appropriate provision in the fund's offering
memorandum or a separate side agreement between the fund and the FCM or
DCO. In view of the revised articulation of the next-day redemption
requirement, the Commission determined that it is not necessary to
specify ways in which an FCM or DCO can demonstrate that the
requirement has been met. The Commission therefore proposed to
eliminate the second provision and to substitute in its place a
provision that requires the FCM or DCO to retain documentation
demonstrating compliance with the next-day redemption requirement. Such
documentation can then be produced for audit purposes.
The Commission did not receive any comments on these changes and it
is amending paragraph (c)(5), as proposed. This includes the
redesignation of existing paragraph (c)(5), as amended, as paragraph
(c)(5)(i).
(b) Exceptions to the Next-Day Redemption Requirement
In response to an inquiry from the Board of Trade Clearing
Corporation in 2001, the Commission's Division of Trading and Markets
issued a letter stating that it would raise no issue in connection with
MMMFs that provide for certain exceptions to the practice of next-day
redemption.\37\
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\37\ See CFTC Staff Letter No. 01-31, [2000-2002 Transfer
Binder] Comm. Fut. L. Rep. (CCH) ] 28,521 (Apr. 2, 2001).
---------------------------------------------------------------------------
The letter specifically identified circumstances in which next-day
redemption could be excused: (1) Non-routine closure of the Fedwire or
applicable Federal Reserve Banks; (2) non-routine closure of the New
York Stock Exchange or general market conditions leading to a broad
restriction of trading on the New York Stock Exchange, i.e., a
restriction of trading due to market-wide events; or (3) declaration of
a market emergency by
[[Page 28197]]
the SEC. The letter also included a catch-all provision that included
emergency conditions set forth in Section 22(e) of the Investment
Company Act of 1940.\38\
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\38\ 15 U.S.C. 80a-22(e).
---------------------------------------------------------------------------
The Commission proposed to codify these exceptions in new paragraph
(c)(5)(ii). The Commission recognizes that there is some overlap
between the enumerated exceptions and those contained in Section 22(e),
but it believes that this is appropriate given the need to provide for
all relevant circumstances.
The Commission did not receive any comments on this issue and it is
adopting paragraph (c)(5)(ii), as proposed.
2. Clarifying Rating Standards for Certificates of Deposit
Rule 1.25(b)(2)(i)(B) provides that ``[m]unicipal securities,
government sponsored agency securities, certificates of deposit,
commercial paper, and corporate notes, except notes that are asset-
backed, must have the highest short-term rating of an NRSRO or one of
the two highest long-term ratings of an NRSRO.'' The Commission notes
that certificates of deposit, unlike the other instruments listed in
that paragraph, are not directly rated by an NRSRO.
Because NRSRO ratings reflect the financial strength of the issuer
of an instrument, they offer a useful standard, among others, for
determining whether an instrument can be a permitted investment for
customer money. Although certificates of deposit are not rated by
NRSROs, it is possible to apply a rating standard by using, as a proxy,
the ratings of other instruments issued by the issuers of certificates
of deposit. For example, the Commission has previously taken this
approach in establishing standards for foreign depository institutions
that may hold customer funds. In this regard, Rule 1.49(d)(3)(i)
provides that, in order to hold customer funds, a bank or trust company
located outside the United States must satisfy either of the following
requirements: (1) it must have in excess of $1 billion of regulatory
capital; or (2) the bank or trust company's commercial paper or long-
term debt instrument, or if the institution is part of a holding
company system, its holding company's commercial paper or long-term
debt instrument, must be rated in one of the two highest rating
categories by at least one NRSRO.
Consistent with this approach, the Commission believes that it is
appropriate to use, as a proxy for a certificate of deposit rating,
NRSRO ratings for the commercial paper or long-term debt instrument of
the issuer of the certificate of deposit or such issuer's parent
holding company. Accordingly, the Commission proposed to delete the
reference to certificates of deposit in paragraph (b)(2)(i)(B) of Rule
1.25 and revise paragraph (b)(2)(i)(E) to apply the same standard
contained in paragraph (b)(2)(i)(B) to the commercial paper or long-
term debt instrument issued by the certificate of deposit issuer or its
holding company.
The Commission did not receive any comments on this issue.
Accordingly, it is amending paragraph (b)(2)(i)(B) and adding new
paragraph (E), as proposed.\39\
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\39\ Paragraph (b)(2)(i)(E) formerly set forth the rating
requirement for MMMFs. See discussion in Section II.E. of this
release.
---------------------------------------------------------------------------
3. Clarifying Corporate Bonds as Permitted Investments
Paragraph (a)(vi) currently uses the term ``corporate note,'' which
may be interpreted by some market participants to mean obligations
whose original term to maturity does not exceed five years or perhaps
ten years. The Commission proposed to clarify that this terminology
should not be read to limit the duration of an instrument. It therefore
proposed to amend paragraphs (a)(1)(vi), (b)(2)(i)(B) and (C), and
(b)(4)(i)(C) to use the term ``corporate notes or bonds.'' Rather than
constrain the types of permitted investments on the basis of their
original term to maturity, the Commission has addressed the issue of
the greater price sensitivity of longer-term and fixed rate instruments
to changes in prevailing interest rates by adopting the portfolio time-
to-maturity requirements of paragraph (b)(5); thus, it is the remaining
term to maturity that is relevant.
The Commission did not receive any comments on this issue and it is
amending paragraphs (a)(1)(vi), (b)(2)(i)(B) and (C), and (b)(4)(i)(C),
as proposed.
4. Clarifying References to Transferred Securities
Rule 1.25(a)(2) permits FCMs and DCOs to enter into repos using
customer-deposited securities and securities that are permitted
investments purchased with customer money. Such transactions are
subject to the provisions of paragraph (d) of Rule 1.25. Among those
provisions is paragraph (d)(6), which requires that the ``securities
transferred under the agreement'' must be held in a safekeeping account
with a bank, a DCO, or the Depository Trust Company in an account that
complies with the requirements of Rule 1.26.
The Commission has been asked whether the reference to ``securities
transferred under the agreement'' is intended to include not only in-
coming securities, but out-going securities as well. Such an
interpretation would mean that any out-going securities, in addition to
any in-coming cash, would have to be held in a customer segregated
account in accordance with Rule 1.26.\40\ This is not the intended
outcome, and the Commission therefore proposed to amend paragraph
(d)(6) to clarify that Rule 1.26 applies only to securities transferred
to (not from) an FCM or DCO.\41\
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\40\ Rule 1.26 addresses the treatment of instruments purchased
with customer funds, but does not address the treatment of cash
received by an FCM or DCO pursuant to a repo. The Commission
believes that it is not necessary to specify in Rule 1.26 that cash
acquired in exchange for securities under a repo must be held in a
customer segregated cash account because this requirement is clear
from the language of Section 4d(a)(2) of the Act.
\41\ The Commission notes that with respect to the in-house
transactions discussed in Section II.D. of this release, proposed
Rule 1.25(e)(5)(iii) specifically provides that securities
transferred to the customer segregated account as a result of the
transaction must be held in a safekeeping account with a bank, a
DCO, or the Depository Trust Company in an account that complies
with the requirements of Rule 1.26.
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The Commission also proposed technical amendments to paragraphs
(d)(3) and (d)(11) to similarly clarify that the securities referred to
in those provisions are securities transferred to (not from) the
customer segregated custodial account of an FCM or DCO.
The Commission did not receive any comments on this issue and it is
amending paragraphs (d)(3), (d)(6), and (d)(11), as proposed.
5. Clarifying Payment and Delivery Procedures for Reverse Repos and
Repos
The Commission proposed to amend paragraph (d)(8) to clarify
payment and delivery procedures for reverse repos and repos. Paragraph
(d)(8) provides that the ``transfer of securities'' must be made on a
delivery versus payment basis in immediately available funds. The
Commission proposed to amend this provision to clarify that the
delivery versus payment requirement applies to the transfer of
securities to (not from) the customer segregated custodial account, as
would be the case in a reverse repo. The Commission further proposed to
add a sentence clarifying that the transfer of funds to the customer
segregated cash account, as would be the case in a repo, must be made
on a payment versus delivery basis.
[[Page 28198]]
The Commission did not receive any comments on this issue and it is
amending paragraph (d)(8), as proposed.
6. Changing Paragraph (a)(1) ``Customer Funds'' to ``Customer Money''
Rule 1.25(a)(1) authorizes FCMs and DCOs to invest ``customer
funds'' in enumerated permitted investments. Paragraph (a)(1) uses the
term ``customer funds'' to describe customer money deposited with an
FCM or a DCO to margin futures or options positions. Because the term
``customer funds'' is otherwise defined in Rule 1.3(gg) to include more
than customer money, the Commission proposed to amend paragraph (a)(1)
to substitute the term ``customer money'' for the term ``customer
funds.''
The word ``money'' is used in Section 4d(a)(2) of the Act with
reference to permitted investments, and the term ``customer money'' was
originally used in Rule 1.25. The term was changed to ``customer
funds'' in 1968 when the Commission's predecessor agency, the Commodity
Exchange Authority, adopted revisions to conform the rule to amendments
to Section 4d of the Act.\42\ No explanation was given for the change
in terminology.
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\42\ 33 FR 14455 (Sept. 26, 1968).
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Subsequently, in 1981, the Commission adopted a definition of
``customer funds'' in Rule 1.3(gg), when it adopted rules related to
futures options.\43\ That term encompasses more than money, and
includes securities and other property belonging to the customer.
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\43\ 46 FR 33312 (June 29, 1981).
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Substituting the term ``customer money'' for the term ``customer
funds'' in paragraph (a)(1) conforms the language of that paragraph to
the language of Section 4d(a)(2) of the Act and clarifies the meaning
of the term in relation to other provisions of Rule 1.25. The need for
this proposed change in terminology arises in the context of
distinguishing between customer money and customer-deposited
securities, which are the subject of Rule 1.25(a)(2)(ii) (repos with
customer-deposited securities) and new Rule 1.25(a)(3)(ii) and (iii)
(in-house transactions with customer-deposited securities).
The Commission did not receive any comments on this issue and it is
amending paragraph (a)(1), as proposed.
7. Conforming Reference to ``Marketability'' Requirement
Rule 1.25(a)(2)(ii), which permits FCMs and DCOs to sell customer-
deposited securities pursuant to repos, sets forth various requirements
for such transactions. Among them is the requirement, under paragraph
(a)(2)(ii)(A), that securities subject to repurchase must meet the
marketability requirement contained in paragraph (b)(1) of Rule 1.25.
Paragraph (b)(1), in turn, cross-references the marketability
requirement contained in SEC Rule 15c3-1. For purposes of clarity, the
Commission proposed to amend Rule 1.25(a)(2)(ii)(A) to eliminate the
cross-reference to paragraph (b)(1) and substitute that paragraph's
direct cross-reference to SEC Rule 15c3-1.
The Commission did not receive any comments on this issue and it is
amending paragraph (a)(2)(ii)(A), as proposed.
8. Conforming Terminology for ``Derivatives Clearing Organizations''
Rule 1.25 uses the term ``clearing organization'' to describe an
entity that performs clearing functions. The Act, as amended by the
Commodity Futures Modernization Act of 2000,\44\ now provides that a
clearing organization for a contract market must register as a
``derivatives clearing organization'' and must comply with core
principles set forth in the statute.\45\ The Commission proposed
technical amendments to Rule 1.25 to change the term ``clearing
organization'' to ``derivatives clearing organization.'' This conforms
the language of Rule 1.25 to the language of the Act, more accurately
reflecting the current statutory framework.
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\44\ Appendix E of Pub. L. 106-554, 114 Stat. 2763 (2000).
\45\ See Section 5b of the Act, 7 U.S.C. 7a-1. See also Section
1a(9) of the Act, 7 U.S.C. 1a(9) (defining the term ``derivatives
clearing organization'').
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As an additional matter, in connection with its proposed technical
amendments to Rule 1.27,\46\ the Commission also proposed to change the
term ``clearing organization'' to ``derivatives clearing organization''
in that rule.
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\46\ See Section II.D. of this release.
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The Commission did not receive any comments on this issue and it is
amending Rule 1.25 and Rule 1.27, as proposed.
9. Conforming Terminology for ``Government Sponsored Enterprise''
The Commission also proposed a technical amendment to Rule 1.25 to
change terminology referring to government sponsored ``agency''
securities to government sponsored ``enterprise'' securities. This
would conform the language in the rule to the terminology commonly used
in the marketplace. This change would be reflected in the list of
permitted investments (paragraph (a)(1)(iii)), the rating requirements
(paragraph (b)(2)(i)(B)), and the concentration limits (paragraph
(b)(4)(i)(B)).
The Commission did not receive any comments on this issue and it is
amending paragraphs (a)(1)(iii), (b)(2)(i)(B), and (b)(4)(i)(B), as
proposed.
10. Conforming Terminology for ``Futures Commission Merchant''
The Commission proposed a technical amendment to Rule 1.25 to
substitute the term ``futures commission merchant'' for the
abbreviation, ``FCM,'' as used in paragraph (c)(3). This would provide
conformity in the use of the term futures commission merchant
throughout the rule.
The Commission did not receive any comments on this issue and it is
amending paragraph (c)(3), as proposed.
11. Clarifying the Meaning of ``NRSRO''
Rule 1.25(b)(2) sets forth the rating requirements for permitted
investments. The rule refers to ratings by an ``NRSRO,'' the
abbreviation for a ``nationally recognized statistical rating
organization.'' The Commission proposed to amend paragraph (b)(2)(i) to
formally set forth the abbreviation as a defined term and to cross-
reference the definition of that term contained in SEC Rule 2a-7.
Since the Commission issued its proposed technical amendment, the
SEC published for public comment a proposed new rule defining the term
``nationally recognized statistical rating organization.''\47\ The
Commission continues to believe that it is appropriate to utilize the
definition that is the industry standard, as articulated or otherwise
applied by the SEC. Accordingly, the Commission will continue to cross-
reference the SEC's usage. However, the text of paragraph (b)(2)(i)
will be modified to accommodate future changes in SEC rule text or
applicable statutes. Thus, the language will provide that
``[i]nstruments that are required to be rated by this section must be
rated by a nationally recognized statistical rating organization
(NRSRO), as that term is defined in Securities and Exchange Commission
rules or regulations, or in any applicable statute.''
The Commission did not receive any comments on this issue and it is
amending paragraph (b)(2)(i), as described above.
---------------------------------------------------------------------------
\47\ See 70 FR 21306 (Apr. 25, 2005) (proposing new SEC Rule 3b-
10, 17 CFR 240.3b-10).
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[[Page 28199]]
III. Section 4(c)
Section 4(c) of the Act \48\ provides that, in order to promote
responsible economic or financial innovation and fair competition, the
Commission, by rule, regulation or order, after notice and opportunity
for hearing, may exempt any agreement, contract, or transaction, or
class thereof, that is otherwise subject to Section 4(a) of the Act,
including any person or class of persons offering, entering into,
rendering advice or rendering other services with respect to, the
agreement, contract, or transaction, from the contract market
designation requirement of Section 4(a) of the Act, or any other
provision of the Act other than Section 2(a)(1)(C)(ii) or (D), if the
Commission determines that the exemption would be consistent with the
public interest.
---------------------------------------------------------------------------
\48\ 7 U.S.C. 6(c).
---------------------------------------------------------------------------
The final rules are promulgated under Section 4d(a)(2) of the
Act,\49\ which governs investment of customer funds. Section 4d(a)(2)
provides that customer money may be invested in obligations of the
United States, in general obligations of any State or of any political
subdivision thereof, and in obligations fully guaranteed as to
principal and interest by the United States. It further provides that
such investments must be made in accordance with such rules and
regulations and subject to such conditions as the Commission may
prescribe.
---------------------------------------------------------------------------
\49\ 7 U.S.C. 6d(a)(2).
---------------------------------------------------------------------------
The Commission is expanding the range of instruments in which FCMs
may invest customer funds beyond those listed in Section 4d(a)(2) of
the Act (i.e., securities with embedded derivatives and MMMFs rated
below the highest rating of an NRSRO), to enhance the yield available
to FCMs, DCOs, and their customers without compromising the safety of
customer funds. These rules should enable FCMs and DCOs to remain
competitive globally and domestically, while maintaining safeguards
against systemic risk.
The Commission did not receive any comments on the 4(c) exemption
discussion in its February 3, 2005 release. Accordingly, in light of
the foregoing, the Commission finds that the adoption of final rules
that expand the scope of permitted investments of customer funds will
promote responsible economic and financial innovation and fair
competition, and is consistent with the ``public interest,'' as that
term is used in Section 4(c) of the Act.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') \50\ requires federal
agencies, in promulgating rules, to consider the impact of those rules
on small businesses. The rule amendments adopted herein will affect
FCMs and DCOs. The Commission has previously established certain
definitions of ``small entities'' to be used by the Commission in
evaluating the impact of its rules on small entities in accordance with
the RFA.\51\ The Commission has previously determined that registered
FCMs \52\ and DCOs \53\ are not small entities for the purpose of the
RFA. The Commission did not receive any comments on the Regulatory
Flexibility Act in relation to the proposed rulemaking.
---------------------------------------------------------------------------
\50\ 5 U.S.C. 601 et seq.
\51\ 47 FR 18618 (Apr. 30, 1982).
\52\ Id. at 18619.
\53\ 66 FR 45604, 45609 (Aug. 29, 2001).
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B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (``PRA'') imposes certain
requirements on federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of
information as defined by the PRA. The final rules do not require a new
collection of information on the part of any entities subject to them.
Accordingly, for purposes of the PRA, the Commission certified that the
proposed rules did not impose any new reporting or recordkeeping
requirements.
C. Costs and Benefits of the Proposed Rules
Section 15(a) of the Act requires that the Commission, before
promulgating a regulation under the Act or issuing an order, consider
the costs and benefits of its action. By its terms, Section 15(a) does
not require the Commission to quantify the costs and benefits of a new
rule or determine whether the benefits of the rule outweigh its costs.
Rather, Section 15(a) simply requires the Commission to ``consider the
costs and benefits'' of its action.
Section 15(a) further specifies that costs and benefits shall be
evaluated in light of the following considerations: (1) Protection of
market participants and the public; (2) efficiency, competitiveness,
and financial integrity of futures markets; (3) price discovery; (4)
sound risk management practices; and (5) other public interest
considerations. Accordingly, the Commission could, in its discretion,
give greater weight to any one of the five considerations and could, in
its discretion, determine that, notwithstanding its costs, a particular
rule was necessary or appropriate to protect the public interest or to
effectuate any of the provisions or to accomplish any of the purposes
of the Act.
The Commission has evaluated the costs and benefits of the final
rules in light of the specific considerations identified in Section
15(a) of the Act, as follows:
1. Protection of market participants and the public. The final
rules facilitate greater capital efficiency for FCMs and DCOs, while
protecting customers by establishing prudent standards for investment
of customer funds. Several of the rule amendments narrow and refine
earlier standards based on industry and Commission experience since the
December 2000 rulemaking in which Rule 1.25 was substantially revised
and expanded. In this regard, for example, the amendments relating to
the mandatory registration requirement for MMMFs and auditability
standard for investment records establish stricter standards.
Similarly, amendments that expand investment opportunities for FCMs and
DCOs, such as those permitting investment in instruments with embedded
derivatives, carefully circumscribe the activity in order to protect
the customer segregated account.
2. Efficiency, competitiveness, and financial integrity of futures
markets. The final rules will facilitate greater efficiency and
competitiveness for FCMs and DCOs, but they will not affect the
efficiency and competitiveness of futures markets. The amendments will
not affect the financial integrity of futures markets.
3. Price discovery. The amendments will not affect price discovery.
4. Sound risk management practices. The final rules impose sound
risk management practices upon FCMs and DCOs that invest customer funds
under the rules. They balance the need for investment flexibility with
the need to preserve customer funds. For example, while permitting FCM/
BDs to engage in in-house transactions, the Commission sets forth
specific requirements for such transactions. These include standards
relating to the type of securities that may be transferred to the
customer segregated account, treatment of those securities when held in
the account, and procedures for effecting transactions. Such
requirements are designed to ensure that at no time will in-house
transactions cause the customer segregated account to fall below a
sufficient level. Certain other amendments, such as the registration
[[Page 28200]]
requirement for MMMFs and clarification as to mandatory next-day
redemption and payment for MMMF interests, strengthen risk management
standards that are already in place.
5. Other public considerations. The final rules amendments reflect
industry and Commission experience with Rule 1.25 since the rule was
expanded in December 2000. They provide FCMs and DCOs with greater
flexibility in making investments with customer funds, while
strengthening the rules that protect the safety of such funds and
preserve the rights of customers. For example, the amendments governing
in-house transactions provide FCM/BDs with an efficient and cost-
effective method for maximizing investment opportunities within the
confines of strict risk management requirements. Similarly, the
amendments expand the range of investments to include certain
instruments with embedded derivatives and MMMFs of any rating, and
enable FCMs and DCOs to consider a broader range of investment
possibilities within prescribed limitations.
The final rules are expected to enhance the available yield on
customer funds invested by FCMs and DCOs, while maintaining safeguards
against systemic risk. FCMs and DCOs choosing to make such investments
will bear all costs associated with their investments.
Accordingly, after considering the five factors enumerated in the
Act, the Commission has determined to adopt the rules and rule
amendments set forth below.
Lists of Subjects in 17 CFR Part 1
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.
0
In consideration of the foregoing and pursuant to the authority
contained in the Commodity Exchange Act, in particular, Sections 4d,
4(c), and 8a(5) thereof, 7 U.S.C. 6d, 6(c) and 12a(5), respectively,
the Commission hereby amends Chapter I of Title 17 of the Code of
Federal Regulations as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
0
1. The authority citation for part 1 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h,
6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a,
13a-1, 16, 16a, 19, 21, 23, and 24, as amended by the Commodity
Futures Modernization Act of 2000, Appendix E of Pub. L. 106-554,
114 Stat. 2763 (2000).
0
2. Section 1.25 is revised to read as follows:
Sec. 1.25 Investment of customer funds.
(a) Permitted investments. (1) Subject to the terms and conditions
set forth in this section, a futures commission merchant or a
derivatives clearing organization may invest customer money in the
following instruments (permitted investments):
(i) Obligations of the United States and obligations fully
guaranteed as to principal and interest by the United States (U.S.
government securities);
(ii) General obligations of any State or of any political
subdivision thereof (municipal securities);
(iii) General obligations issued by any enterprise sponsored by the
United States (government sponsored enterprise securities);
(iv) Certificates of deposit issued by a bank (certificates of
deposit) as defined in section 3(a)(6) of the Securities Exchange Act
of 1934, or a domestic branch of a foreign bank that carries deposits
insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper;
(vi) Corporate notes or bonds;
(vii) General obligations of a sovereign nation; and
(viii) Interests in money market mutual funds.
(2)(i) In addition, a futures commission merchant or derivatives
clearing organization may buy and sell the permitted investments listed
in paragraphs (a)(1)(i) through (viii) of this section pursuant to
agreements for resale or repurchase of the instruments, in accordance
with the provisions of paragraph (d) of this section.
(ii) A futures commission merchant or a derivatives clearing
organization may sell securities deposited by customers as margin
pursuant to agreements to repurchase subject to the following:
(A) Securities subject to such repurchase agreements must be
``readily marketable'' as defined in Sec. 240.15c3-1 of this title.
(B) Securities subject to such repurchase agreements must not be
``specifically identifiable property'' as defined in Sec. 190.01(kk)
of this chapter.
(C) The terms and conditions of such an agreement to repurchase
must be in accordance with the provisions of paragraph (d) of this
section.
(D) Upon the default by a counterparty to a repurchase agreement,
the futures commission merchant or derivatives clearing organization
shall act promptly to ensure that the default does not result in any
direct or indirect cost or expense to the customer.
(3) In addition, subject to the provisions of paragraph (e) of this
section, a futures commission merchant that is also registered with the
Securities and Exchange Commission as a securities broker or dealer
pursuant to section 15(b)(1) of the Securities Exchange Act of 1934 may
enter into transactions in which:
(i) Customer money is exchanged for securities that are permitted
investments and are held by the futures commission merchant in
connection with its securities broker or dealer activities;
(ii) Securities deposited by customers as margin are exchanged for
securities that are permitted investments and are held by the futures
commission merchant in connection with its securities broker or dealer
activities; or
(iii) Securities deposited by customers as margin are exchanged for
cash that is held by the futures commission merchant in connection with
its securities broker or dealer activities.
(b) General terms and conditions. A futures commission merchant or
a derivatives clearing organization is required to manage the permitted
investments consistent with the objectives of preserving principal and
maintaining liquidity and according to the following specific
requirements:
(1) Marketability. Except for interests in money market mutual
funds, investments must be ``readily marketable'' as defined in Sec.
240.15c3-1 of this title.
(2) Ratings. (i) Initial requirement. Instruments that are required
to be rated by this section must be rated by a nationally recognized
statistical rating organization (NRSRO), as that term is defined in
Securities and Exchange Commission rules or regulations, or in any
applicable statute. For an investment to qualify as a permitted
investment, ratings are required as follows:
(A) U.S. government securities and money market mutual funds need
not be rated;
(B) Municipal securities, government sponsored enterprise
securities, commercial paper, and corporate notes or bonds, except
notes or bonds that are asset-backed, must have the highest short-term
rating of an NRSRO or one of the two highest long-term ratings of an
NRSRO;
(C) Corporate notes or bonds that are asset-backed must have the
highest ratings of an NRSRO;
(D) Sovereign debt must be rated in the highest category by at
least one NRSRO; and
(E) With respect to certificates of deposit, the commercial paper
or long-term debt instrument of the issuer of a certificate of deposit
or, if the issuer is part of a holding company system, its holding
company's commercial paper or
[[Page 28201]]
long-term debt instrument, must have the highest short-term rating of
an NRSRO or one of the two highest long-term ratings of an NRSRO.
(ii) Effect of downgrade. If an NRSRO lowers the rating of an
instrument that was previously a permitted investment on the basis of
that rating to below the minimum rating required under this section,
the value of the instrument recognized for segregation purposes will be
the lesser of:
(A) The current market value of the instrument; or
(B) The market value of the instrument on the business day
preceding the downgrade, reduced by 20 percent of that value for each
business day that has elapsed since the downgrade.
(3) Restrictions on instrument features. (i) With the exception of
money market mutual funds, no permitted investment may contain an
embedded derivative of any kind, except as follows:
(A) The issuer of an instrument otherwise permitted by this section
may have an option to call, in whole or in part, at par, the principal
amount of the instrument before its stated maturity date; or
(B) An instrument that meets the requirements of paragraph
(b)(3)(iv) of this section may provide for a cap, floor, or collar on
the interest paid; provided, however, that the terms of such instrument
obligate the issuer to repay the principal amount of the instrument at
not less than par value upon maturity.
(ii) No instrument may contain interest-only payment features.
(iii) No instrument may provide payments linked to a commodity,
currency, reference instrument, index, or benchmark except as provided
in paragraph (b)(3)(iv) of this section, and it may not otherwise
constitute a derivative instrument.
(iv) (A) Adjustable rate securities are permitted, subject to the
following requirements:
(1) The interest payments on variable rate securities must
correlate closely and on an unleveraged basis to a benchmark of either
the Federal Funds target or effective rate, the prime rate, the three-
month Treasury Bill rate, the one-month or three-month LIBOR rate, or
the interest rate of any fixed rate instrument that is a permitted
investment listed in paragraph (a)(1) of this section.;
(2) The interest payment, in any period, on floating rate
securities must be determined solely by reference, on an unleveraged
basis, to a benchmark of either the Federal Funds target or effective
rate, the prime rate, the three-month Treasury Bill rate, the one-month
or three-month LIBOR rate, or the interest rate of any fixed rate
instrument that is a permitted investment listed in paragraph (a)(1) of
this section;
(3) Benchmark rates must be expressed in the same currency as the
adjustable rate securities that reference them; and
(4) No interest payment on an adjustable rate security, in any
period, can be a negative amount.
(B) For purposes of this paragraph, the following definitions shall
apply:
(1) The term adjustable rate security means, a floating rate
security, a variable rate security, or both.
(2) The term floating rate security means a security, the terms of
which provide for the adjustment of its interest rate whenever a
specified interest rate changes and that, at any time until the final
maturity of the instrument or the period remaining until the principal
amount can be recovered through demand, can reasonably be expected to
have a market value that approximates its amortized cost.
(3) The term variable rate security means a security, the terms of
which provide for the adjustment of its interest rate on set dates
(such as the last day of a month or calendar quarter) and that, upon
each adjustment until the final maturity of the instrument or the
period remaining until the principal amount can be recovered through
demand, can reasonably be expected to have a market value that
approximates its amortized cost.
(v) Certificates of deposit, if negotiable, must be able to be
liquidated within one business day or, if not negotiable, must be
redeemable at the issuing bank within one business day, with any
penalty for early withdrawal limited to any accrued interest earned
according to its written terms.
(4) Concentration. (i) Direct investments. (A) U.S. government
securities and money market mutual funds shall not be subject to a
concentration limit or other limitation.
(B) Securities of any single issuer of government sponsored
enterprise securities held by a futures commission merchant or
derivatives clearing organization may not exceed 25 percent of total
assets held in segregation by the futures commission merchant or
derivatives clearing organization.
(C) Securities of any single issuer of municipal securities,
certificates of deposit, commercial paper, or corporate notes or bonds
held by a futures commission merchant or derivatives clearing
organization may not exceed 5 percent of total assets held in
segregation by the futures commission merchant or derivatives clearing
organization.
(D) Sovereign debt is subject to the following limits: a futures
commission merchant may invest in the sovereign debt of a country to
the extent it has balances in segregated accounts owed to its customers
denominated in that country's currency; a derivatives clearing
organization may invest in the sovereign debt of a country to the
extent it has balances in segregated accounts owed to its clearing
member futures commission merchants denominated in that country's
currency.
(ii) Repurchase agreements. For purposes of determining compliance
with the concentration limits set forth in this section, securities
sold by a futures commission merchant or derivatives clearing
organization subject to agreements to repurchase shall be combined with
securities held by the futures commission merchant or derivatives
clearing organization as direct investments.
(iii) Reverse repurchase agreements. For purposes of determining
compliance with the concentration limits set forth in this section,
securities purchased by a futures commission merchant or derivatives
clearing organization subject to agreements to resell shall be combined
with securities held by the futures commission merchant or derivatives
clearing organization as direct investments.
(iv) Transactions under paragraph (a)(3). For purposes of
determining compliance with the concentration limits set forth in this
section, securities transferred to a customer segregated account
pursuant to paragraphs (a)(3)(i) or (a)(3)(ii) of this section shall be
combined with securities held by the futures commission merchant as
direct investments.
(v) Treatment of securities issued by affiliates. For purposes of
determining compliance with the concentration limits set forth in this
section, securities issued by entities that are affiliated, as defined
in paragraph (b)(6) of this section, shall be aggregated and deemed the
securities of a single issuer. An interest in a permitted money market
mutual fund is not deemed to be a security issued by its sponsoring
entity.
(vi) Treatment of customer-owned securities. For purposes of
determining compliance with the concentration limits set forth in this
section, securities owned by the customers of a futures commission
merchant and posted as margin collateral are not included in total
assets held in segregation by the futures commission merchant, and
securities posted by a futures commission merchant with a derivatives
[[Page 28202]]
clearing organization are not included in total assets held in
segregation by the derivatives clearing organization.
(5) Time-to-maturity. (i) Except for investments in money market
mutual funds, the dollar-weighted average of the time-to-maturity of
the portfolio, as that average is computed pursuant to Sec. 270.2a-7
of this title, may not exceed 24 months.
(ii) For purposes of determining the time-to-maturity of the
portfolio, an instrument that is set forth in paragraphs (a)(1)(i)
through (vii) of this section may be treated as having a one-day time-
to-maturity if the following terms and conditions are satisfied:
(A) The instrument is deposited solely on an overnight basis with a
derivatives clearing organization pursuant to the terms and conditions
of a collateral management program that has become effective in
accordance with Sec. 39.4 of this chapter;
(B) The instrument is one that the futures commission merchant owns
or has an unqualified right to pledge, is not subject to any lien, and
is deposited by the futures commission merchant into a segregated
account at a derivatives clearing organization;
(C) The derivatives clearing organization prices the instrument
each day based on the current mark-to-market value; and
(D) The derivatives clearing organization reduces the assigned
value of the instrument each day by a haircut of at least 2 percent.
(6) Investments in instruments issued by affiliates. (i) A futures
commission merchant shall not invest customer funds in obligations of
an entity affiliated with the futures commission merchant, and a
derivatives clearing organization shall not invest customer funds in
obligations of an entity affiliated with the derivatives clearing
organization. An affiliate includes parent companies, including all
entities through the ultimate holding company, subsidiaries to the
lowest level, and companies under common ownership of such parent
company or affiliates.
(ii) A futures commission merchant or derivatives clearing
organization may invest customer funds in a fund affiliated with that
futures commission merchant or derivatives clearing organization.
(7) Recordkeeping. A futures commission merchant and a derivatives
clearing organization shall prepare and maintain a record that will
show for each business day with respect to each type of investment made
pursuant to this section, the following information:
(i) The type of instruments in which customer funds have been
invested;
(ii) The original cost of the instruments; and
(iii) The current market value of the instruments.
(c) Money market mutual funds. The following provisions will apply
to the investment of customer funds in money market mutual funds (the
fund).
(1) The fund must be an investment company that is registered under
the Investment Company Act of 1940 with the Securities and Exchange
Commission and that holds itself out to investors as a money market
fund, in accordance with Sec. 270.2a-7 of this title.
(2) The fund must be sponsored by a federally-regulated financial
institution, a bank as defined in section 3(a)(6) of the Securities
Exchange Act of 1934, an investment adviser registered under the
Investment Advisers Act of 1940, or a domestic branch of a foreign bank
insured by the Federal Deposit Insurance Corporation.
(3) A futures commission merchant or derivatives clearing
organization shall maintain the confirmation relating to the purchase
in its records in accordance with Sec. 1.31 and note the ownership of
fund shares (by book-entry or otherwise) in a custody account of the
futures commission merchant or derivatives clearing organization in
accordance with Sec. 1.26(a). If the futures commission merchant or
the derivatives clearing organization holds its shares of the fund with
the fund's shareholder servicing agent, the sponsor of the fund and the
fund itself are required to provide the acknowledgment letter required
by Sec. 1.26.
(4) The net asset value of the fund must be computed by 9 a.m. of
the business day following each business day and made available to the
futures commission merchant or derivatives clearing organization by
that time.
(5) (i) General requirement for redemption of interests. A fund
shall be legally obligated to redeem an interest and to make payment in
satisfaction thereof by the business day following a redemption
request, and the futures commission merchant or derivatives clearing
organization shall retain documentation demonstrating compliance with
this requirement.
(ii) Exception. A fund may provide for the postponement of
redemption and payment due to any of the following circumstances:
(A) Non-routine closure of the Fedwire or applicable Federal
Reserve Banks;
(B) Non-routine closure of the New York Stock Exchange or general
market conditions leading to a broad restriction of trading on the New
York Stock Exchange;
(C) Declaration of a market emergency by the Securities and
Exchange Commission; or
(D) Emergency conditions set forth in section 22(e) of the
Investment Company Act of 1940.
(6) The agreement pursuant to which the futures commission merchant
or derivatives clearing organization has acquired and is holding its
interest in a fund must contain no provision that would prevent the
pledging or transferring of shares.
(d) Repurchase and reverse repurchase agreements. A futures
commission merchant or derivatives clearing organization may buy and
sell the permitted investments listed in paragraphs (a)(1)(i) through
(viii) of this section pursuant to agreements for resale or repurchase
of the securities (agreements to repurchase or resell), provided the
agreements to repurchase or resell conform to the following
requirements:
(1) The securities are specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
(2) Counterparties are limited to a bank as defined in section
3(a)(6) of the Securities Exchange Act of 1934, a domestic branch of a
foreign bank insured by the Federal Deposit Insurance Corporation, a
securities broker or dealer, or a government securities broker or
government securities dealer registered with the Securities and
Exchange Commission or which has filed notice pursuant to section
15C(a) of the Government Securities Act of 1986.
(3) The transaction is executed in compliance with the
concentration limit requirements applicable to the securities
transferred to the customer segregated custodial account in connection
with the agreements to repurchase referred to in paragraphs (b)(4)(ii)
and (iii) of this section.
(4) The transaction is made pursuant to a written agreement signed
by the parties to the agreement, which is consistent with the
conditions set forth in paragraphs (d)(1) through (d)(12) of this
section and which states that the parties thereto intend the
transaction to be treated as a purchase and sale of securities.
(5) The term of the agreement is no more than one business day, or
reversal of the transaction is possible on demand.
(6) Securities transferred to the futures commission merchant or
derivatives clearing organization under the agreement are held in a
safekeeping account with a bank as referred to in paragraph (d)(2) of
this section, a
[[Page 28203]]
derivatives clearing organization, or the Depository Trust Company in
an account that complies with the requirements of Sec. 1.26.
(7) The futures commission merchant or the derivatives clearing
organization may not use securities received under the agreement in
another similar transaction and may not otherwise hypothecate or pledge
such securities, except securities may be pledged on behalf of
customers at another futures commission merchant or derivatives
clearing organization. Substitution of securities is allowed, provided,
however, that:
(i) The qualifying securities being substituted and original
securities are specifically identified by date of substitution, market
values substituted, coupon rates, par amounts, maturity dates and CUSIP
or ISIN numbers;
(ii) Substitution is made on a ``delivery versus delivery'' basis;
and
(iii) The market value of the substituted securities is at least
equal to that of the original securities.
(8) The transfer of securities to the customer segregated custodial
account is made on a delivery versus payment basis in immediately
available funds. The transfer of funds to the customer segregated cash
account is made on a payment versus delivery basis. The transfer is not
recognized as accomplished until the funds and/or securities are
actually received by the custodian of the futures commission merchant's
or derivatives clearing organization's customer funds or securities
purchased on behalf of customers. The transfer or credit of securities
covered by the agreement to the futures commission merchant's or
derivatives clearing organization's customer segregated custodial
account is made simultaneously with the disbursement of funds from the
futures commission merchant's or derivatives clearing organization's
customer segregated cash account at the custodian bank. On the sale or
resale of securities, the futures commission merchant's or derivatives
clearing organization's customer segregated cash account at the
custodian bank must receive same-day funds credited to such segregated
account simultaneously with the delivery or transfer of securities from
the customer segregated custodial account.
(9) A written confirmation to the futures commission merchant or
derivatives clearing organization specifying the terms of the agreement
and a safekeeping receipt are issued immediately upon entering into the
transaction and a confirmation to the futures commission merchant or
derivatives clearing organization is issued once the transaction is
reversed.
(10) The transactions effecting the agreement are recorded in the
record required to be maintained under Sec. 1.27 of investments of
customer funds, and the securities subject to such transactions are
specifically identified in such record as described in paragraph (d)(1)
of this section and further identified in such record as being subject
to repurchase and reverse repurchase agreements.
(11) An actual transfer of securities to the customer segregated
custodial account by book entry is made consistent with Federal or
State commercial law, as applicable. At all times, securities received
subject to an agreement are reflected as ``customer property.''
(12) The agreement makes clear that, in the event of the bankruptcy
of the futures commission merchant or derivatives clearing
organization, any securities purchased with customer funds that are
subject to an agreement may be immediately transferred. The agreement
also makes clear that, in the event of a futures commission merchant or
derivatives clearing organization bankruptcy, the counterparty has no
right to compel liquidation of securities subject to an agreement or to
make a priority claim for the difference between current market value
of the securities and the price agreed upon for resale of the
securities to the counterparty, if the former exceeds the latter.
(e) Transactions by futures commission merchants that are also
registered securities brokers or dealers. A futures commission merchant
that is also registered with the Securities and Exchange Commission as
a securities broker or dealer pursuant to section 15(b)(1) of the
Securities Exchange Act of 1934 may enter into transactions pursuant to
paragraph (a)(3) of this section, subject to the following
requirements:
(1) The futures commission merchant, in connection with its
securities broker or dealer activities, owns or has the unqualified
right to pledge the securities that are exchanged for customer money or
securities held in the customer segregated account.
(2) The transaction can be reversed within one business day or upon
demand.
(3) Securities transferred from the customer segregated account and
securities transferred to the customer segregated account as a result
of the transaction are specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
(4) Securities deposited by customers as margin and transferred
from the customer segregated account as a result of the transaction are
subject to the following requirements:
(i) The securities are ``readily marketable'' as defined in Sec.
240.15c3-1 of this title.
(ii) The securities are not ``specifically identifiable property''
as defined in Sec. 190.01(kk) of this chapter.
(5) Securities transferred to the customer segregated account as a
result of the transaction are subject to the following requirements:
(i) The securities are priced each day based on the current mark-
to-market value.
(ii) The securities are subject to the concentration limit
requirements set forth in paragraph (b)(4)(iv) of this section.
(iii) The securities are held in a safekeeping account with a bank,
as referred to in paragraph (d)(2) of this section, a derivatives
clearing organization, or the Depository Trust Company in an account
that complies with the requirements of Sec. 1.26.
(iv) The securities may not be used in another similar transaction
and may not otherwise be hypothecated or pledged, except such
securities may be pledged on behalf of customers at another futures
commission merchant or derivatives clearing organization. Substitution
of securities is allowed, provided, however, that:
(A) The qualifying securities being substituted and original
securities are specifically identified by date of substitution, market
values substituted, coupon rates, par amounts, maturity dates and CUSIP
or ISIN numbers;
(B) Substitution is made on a ``delivery versus delivery'' basis;
and
(C) The market value of the substituted securities is at least
equal to that of the original securities.
(6) The transactions are carried out in accordance with the
following procedures:
(i) With respect to transactions under paragraph (a)(3)(i) of this
section, the transfer of securities to the customer segregated
custodial account shall be made simultaneously with the transfer of
money from the customer segregated cash account. In no event shall
money held in the customer segregated cash account be disbursed prior
to the transfer of securities to the customer segregated custodial
account. Any transfer of securities to the customer segregated
custodial account shall not be recognized as accomplished until the
securities are actually received by the custodian of such account. Upon
unwinding of the transaction, the
[[Page 28204]]
customer segregated cash account shall receive same-day funds credited
to such account simultaneously with the delivery or transfer of
securities from the customer segregated custodial account.
(ii) With respect to transactions under paragraph (a)(3)(ii) of
this section, the transfer of securities to the customer segregated
custodial account shall be made simultaneously with the transfer of
securities from the customer segregated custodial account. In no event
shall securities held in the customer segregated custodial account be
released prior to the transfer of securities to that account. Any
transfer of securities to the customer segregated custodial account
shall not be recognized as accomplished until the securities are
actually received by the custodian of the customer segregated custodial
account. Upon unwinding of the transaction, the customer segregated
custodial account shall receive the securities simultaneously with the
delivery or transfer of securities from the customer segregated
custodial account.
(iii) With respect to transactions under paragraph (a)(3)(iii) of
this section, the transfer of money to the customer segregated cash
account shall be made simultaneously with the transfer of securities
from the customer segregated custodial account. In no event shall
securities held in the customer segregated custodial account be
released prior to the transfer of money to the customer segregated cash
account. Any transfer of money to the customer segregated cash account
shall not be recognized as accomplished until the money is actually
received by the custodian of the customer segregated cash account. Upon
unwinding of the transaction, the customer segregated custodial account
shall receive the securities simultaneously with the disbursement of
money from the customer segregated cash account.
(7) The futures commission merchant maintains all books and records
with respect to the transactions in accordance with Sec. Sec. 1.25,
1.27, 1.31, and 1.36 and the applicable rules and regulations of the
Securities and Exchange Commission.
(8) An actual transfer of securities by book entry is made
consistent with Federal or State commercial law, as applicable. At all
times, securities transferred to the customer segregated account are
reflected as ``customer property.''
(9) For purposes of Sec. Sec. 1.25, 1.26, 1.27, 1.28 and 1.29,
securities transferred to the customer segregated account are
considered to be customer funds until the customer money or securities
for which they were exchanged are transferred back to the customer
segregated account. In the event of the bankruptcy of the futures
commission merchant, any securities exchanged for customer funds and
held in the customer segregated account may be immediately transferred.
(10) In the event the futures commission merchant is unable to
return to the customer any customer-deposited securities exchanged
pursuant to paragraphs (a)(3)(ii) or (a)(3)(iii) of this section, the
futures commission merchant shall act promptly to ensure that such
inability does not result in any direct or indirect cost or expense to
the customer.
(f) Deposit of firm-owned securities into segregation. A futures
commission merchant shall not be prohibited from directly depositing
unencumbered securities of the type specified in this section, which it
owns for its own account, into a segregated safekeeping account or from
transferring any such securities from a segregated account to its own
account, up to the extent of its residual financial interest in
customers' segregated funds; provided, however, that such investments,
transfers of securities, and disposition of proceeds from the sale or
maturity of such securities are recorded in the record of investments
required to be maintained by Sec. 1.27. All such securities may be
segregated in safekeeping only with a bank, trust company, derivatives
clearing organization, or other registered futures commission merchant.
Furthermore, for purposes of Sec. Sec. 1.25, 1.26, 1.27, 1.28 and
1.29, investments permitted by Sec. 1.25 that are owned by the futures
commission merchant and deposited into such a segregated account shall
be considered customer funds until such investments are withdrawn from
segregation.
0
3. Section 1.27 is amended as follows:
0
A. By inserting the word ``derivatives'' before the term ``clearing
organization'' in paragraphs (a) and (b);
0
B. By inserting the phrase ``or current market value of securities''
after the phrase ``The amount of money'' in paragraph (a)(3);
0
C. By inserting the phrase ``or current market value of securities''
after the phrase ``the amount of money'' in paragraph (a)(6);
0
D. By deleting ``and'' at the end of paragraph (a)(6);
0
E. By changing the period to a semi-colon at the end of paragraph
(a)(7) and inserting ``and'' at the end of that paragraph; and
0
F. By adding paragraph (a)(8) to read as follows:
Sec. 1.27 Record of investments.
(a) * * *
(8) Daily valuation for each instrument and readily available
documentation supporting the daily valuation for each instrument. Such
supporting documentation must be sufficient to enable auditors to
verify the valuations and the accuracy of any information from external
sources used in those valuations.
* * * * *
Issued in Washington, DC on May 11, 2005, by the Commission.
Catherine D. Daniels,
Assistant Secretary of the Commission.
[FR Doc. 05-9794 Filed 5-16-05; 8:45 am]
BILLING CODE 6351-01-P