[Federal Register: January 14, 1998 (Volume 63, Number 9)]
[Proposed Rules]
[Page 2188-2192]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14ja98-25]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 1
Maintenance of Minimum Financial Requirements by Futures
Commission Merchants and Introducing Brokers
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rules.
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SUMMARY: Rule 1.12 \1\ of the Commodity Futures Trading Commission
("Commission" or "CFTC") sets forth the early warning reporting
requirements for futures commission merchants ("FCMs") and
introducing brokers ("IBs"). These requirements are designed to
afford the Commission and industry self-regulatory organizations
("SROs") sufficient advance notice of a firm's financial or
operational problems to take any protective or remedial action that may
be needed to assure the safety of customer funds and the integrity of
the marketplace. The Commission has determined to propose amendments to
Rule 1.12, applicable to FCMs only, that will require immediate
notification by an FCM to the Commission and its designated self-
regulatory organization ("DSRO") if an FCM knows or should know that
it is in an undersegregated or undersecured condition: i.e., the FCM
has insufficient funds in accounts segregated for the benefit of
customers trading on U.S. contract markets or has insufficient funds
set aside for customers trading on non-U.S. markets to meet the FCM's
obligations to its customers. The term "funds" in this context
includes accrued amounts due to or from the FCM's clearing
organizations and/or carrying brokers in connection with customer-
related activities, typically, the daily or intraday variation
settlement.
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\1\ Commission rules are found at 17 CFR Ch. I (1997).
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The Commission is also proposing to require immediate notification
of certain events pertaining to undercapitalization or failure to
satisfy margin calls, where notice is currently required within 24
hours. The Commission also proposes to codify a previous staff
interpretation that permits notices to be filed by facsimile in
addition to telegraphic means and to require immediate telephonic
notice as well.
DATES: Comments mut be received on or before March 16, 1998.
ADDRESSES: Comments on the proposed amendments should be sent to Jean
A. Webb, Secretary of the Commission, Commodity Futures Trading
[[Page 2189]]
Commission, 1155 21st Street, N.W., Washington, D.C. 20581. In
addition, comments may be sent by facsimile transmission to facsimile
number (202) 418-5221 or by electronic mail to [email protected].
Reference should be made to "Early Warning Amendments".
FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Deputy
Director and Chief Accountant, Lawrence B. Patent, Associate Chief
Counsel, Lawrence T. Eckert, Attorney-Advisor, or Charles T. O'Brien,
Attorney-Advisor, Division of Trading and Markets, Commodity Futures
Trading Commission, 1155 21st Street, N.W., Washington, D.C. 20581;
Telephone (202) 418-5430.
SUPPLEMENTARY INFORMATION:
I. Background
Rule 1.12 requires each FCM \2\ to report to the Commission and to
the FCM's DSRO certain events pertaining to the FCM's: (i) Financial
condition; and (ii) procedures for safeguarding customer and firm
assets; and (iii) ability to monitor its financial condition through an
appropriate system of records and reports. Rule 1.12's purpose is to
notify the Commission and the FCM's DSRO of circumstances that have or
could have a negative impact on the FCM's ability to carry on normal
business operations or that pose a threat to customer funds or the
FCM's financial integrity. Reportable events currently include, among
others, the FCM's adjusted net capital's falling below its "early
warning" level (i.e., 150 percent of the minimum required); \3\
failure to maintain current books and records; the existence of
material inadequacies in the FCM's accounting systems or internal
controls; and the issuance of a margin call exceeding the FCM's
adjusted net capital. Collectively, these are known as the Commission's
"early warning" reporting requirements.
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\2\ Certain portions of Rule 1.12 also apply to IBs. However,
the proposed rule amendments discussed herein relate mostly to
segregated funds and the secured amount, which involves FCM's but
not IBs. Therefore, this release focuses upon Rule 1.12 as it
pertains to FCMs.
\3\ The minimum adjusted net capital requirement for an FCM is
set forth in Rule 1.17(a)(1)(i) and basically requires an FCM to
maintain adjusted net capital equal to the greatest of $250,000,
four percent of the amount of customer funds or the amount required
by an SRO of which the FCM is a member. Therefore, assuming no
higher applicable SRO requirement, the early warning reporting is
triggered if adjusted net capital is less than the greater of
$375,000 or six percent of customer funds.
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The "segregation" requirements of the Commodity Exchange Act
("Act") and Commission rules are the primary safeguard against the
loss of customer funds resulting from the financial failure of an FCM.
Section 4d(2) of the Act \4\ and Rule 1.20 require that an FCM
segregate customer funds from the firm's proprietary funds and that one
customer's funds not be used to margin, guarantee or secure the trades
or contracts, or to secure or extend the credit, of another
customer.\5\ Other important elements of the segregation rules govern
the investment of customer funds \6\ and require a daily record of
segregation requirements and funds in segregation.\7\ Rule 30.7
contains similar protections relating to customers maintaining
positions on non-U.S. exchanges.\8\
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\4\ 7 U.S.C. 6d(2).
\5\ Rule 1.23 states that the prohibition against commingling an
FCM's own funds with the FCM's customer funds does not prevent an
FCM from adding any of its own funds to segregated customer funds as
necessary to prevent any or all customer's accounts from becoming
undermargined. The Commission recently adopted amendments to Rule
1.23 that permit FCMs to use Treasury securities in addition to cash
to increase their interests in customer segregated accounts,
facilitating the use of FCM funds to prevent the undermargining of
customer accounts. See 62 FR 42398 (Aug. 7, 1997).
\6\ Section 4d(2) of the Act and Rules 1.25-1.29.
\7\ Rule 1.32.
\8\ A more detailed presentation concerning these protections
can be found in Chapter 12 of the Form 1-FR-FCM instructions.
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Given the importance of these rules in enabling the Commission to
carry out its customer and market protection functions, it is critical
that the Commission and an FCM's DSRO be made aware at the earliest
possible moment of an FCM's failure to satisfy these requirements.\9\
The proposed CFTC rule would require an FCM to provide immediate
telephonic notice, to be confirmed immediately by facsimile or
telegram,\10\ to the Commission and the FCM's DISRO when the FCM knows
or should know that it has failed to maintain sufficient funds in
segregation or in separate set-aside accounts.\11\
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\9\ The Commission notes that, in the Federal Register release
proposing the Commission's overhaul of minimum financial
requirements over twenty years ago, the Commission stated its
intention to propose an early warning notice for undersegregation of
customer funds. See 42 FR 27166, 27173 (May 26, 1997). However, the
Commission did not subsequently include such a rule as part of its
early warning requirements.
\10\ Telegraphic notification has been the traditional method of
required notice under Rule 1.12, whereby an FCM or an IB sends a
telegram to the Commission and the DSRO concerning a particular
event.
\11\ The Chicago Mercantile Exchange ("CME") currently has a
rule requiring that FCMs for which it acts as the DSRO provide
written notice to it in such circumstances, although the CME's rule
requires such notification within twenty-four hours following such
events. Rules of the Chicago Mercantile Exchange, Rule 971
Segregation and Secured Requirements (1997).
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II. Proposed Rule Amendments
FCMs occasionally have become undersegregated as a result of market
movements which cause deficits in the accounts they carry on behalf of
their customers. Generally, the undersegregated condition is corrected
the following business day with funds available from an FCM's own
proprietary funds or through collection of deficits. However, during
the market downturn on October 27, 1997, the Commission was made aware
that a few FCMs experienced undersegregation to a degree that they were
unable to make up the shortfall from their own internal proprietary
funds. Infusions of external capital were required in those cases to
correct the undersegregated conditions.
An evaluation of the Commission's current early warning
notification rules indicated that these rules, which require notice to
the Commission upon an FCM falling below the net capital early warning
level, may not result in notice to the Commission until as much as a
day or a day and a half after the occurrence of a major market event
which causes an undersegregated condition. In particular, on October
27, some firms knew they had a major problem by noon of that day, but
did not provide notice of these problems to the Commission until on or
about the close of business on October 28.
The Commission believes that it needs to be notified as soon as an
FCM knows that it may have a problem meeting segregation requirements.
The proposed rule is designed to require notice as soon as an FCM
"should know" of an undersegregated condition. Because of the linkage
between segregation and net capital, the proposed rule will also result
in the Commission knowing of a net capital impairment earlier than
under the existing rule and should facilitate a resolution of the
problem with the least harmful impact upon an FCM's customers and other
market participants.
As proposed, new Rule 1.12(h) \12\ would require an FCM to notify
the Commission and its DSRO immediately after it knows or should know
that funds segregated for customers trading on U.S. markets or set
aside for customers trading on non-U.S. markets are less than the
amount required to be segregated or set aside by the Act or Commission
rules. In this context, the term "funds" includes funds on deposit
and funds due to or from the FCM's clearing organizations or carrying
[[Page 2190]]
brokers. The Commission's proposal requires an immediate telephone call
by an FCM, to be followed immediately by telegraphic or facsimile
notice.\13\ The notification to the Commission should be directed to
the Division of Trading and Markets, to the attention of the Director
and the Chief Accountant. Notice to the DSRO should be directed to the
person or unit provided for under the DSRO's rules. For example, the
notice required by CME Rule 971 must be sent to CME's Audit Department.
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\12\ The Commission is proposing to redesignate current
paragraph (h) of Rule 1.12 as paragraph (i) and to include the new
rule in a new paragraph (h).
\13\ The Division of Trading and Markets has stated that any
notice required to be transmitted to the Commission under Rule 1.12
by telegraphic notice may be transmitted by facsimile machine. See
CFTC Advisory No. 90-2, [1990-92 Transfer Binder] Comm. Fut. L. Rep.
(CCH) para. 24,599 (Feb. 6, 1990). The Commission is proposing to
codify this Advisory throughout Rule 1.12 to make clear that any
written notice can be provided either through telegraphic means or
via facsimile transmission.
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In accordance with Rules 1.32 and 30.7(f), each FCM is required to
complete its daily segregation and secured amount computations by noon
of the business day following the day for which the computations are
made.\14\ The time when the Commission would expect an FCM to be aware
of an undersegregated condition or a possible undersegregated condition
would depend upon the circumstances. In this connection, both the net
capital rule and the segregation rules require compliance at all times.
Intra-day changes in the prices of contracts carried by an FCM may
require settlement variation payments. As of the close of trading each
day, there is an accrued settlement amount which is payable to or
receivable from the FCM's clearing organization. A receivable from a
clearing organization is reflected as an asset on the FCM's segregation
calculation, and conversely, a payable to a clearing organization is a
liability. It is important to note that, in the event of a major move
in the market, these amounts could be substantial and, if the move is
against the FCM's customers, it could result in an undersegregated
condition due to a deficit or deficits in the accounts of one or more
customers.
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\14\ Rule 1.32 states that each FCM must compute as of the close
of each business day the total amount of customer funds on deposit
in segregated accounts on behalf of commodity and option customers
and the total amount of such funds required by the Act and
regulations to be on deposit in segregated accounts on behalf of
such customers, as well as the FCM's residual interest in such
funds. Rule 30.7(f) states that each FCM must compute as of the
close of each business day the total amount of money, securities and
property on deposit in separate accounts, the total amount of money,
securities and property required to be on deposit in separate
accounts and the amount of the FCM's residual interest in money,
securities and property on deposit in separate accounts.
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In the event of a major market move, the Commission would expect an
FCM to consider the impact of that move on the values of the positions
it is carrying and how this impact would affect the accrued payable to
its clearing organizations and the deficits in customer accounts. If
the FCM has reason to believe that this impact could be material and
negative in relation to previously computed excess segregation, it
would be advisable to report a possible undersegregated condition to
the Commission.
However, in some cases losses may occur over a large number of
accounts in smaller amounts that, cumulatively, may cause an FCM to
become undersegregated. In such a circumstance, the Commission
recognizes that an FCM may not become aware of an undersegregated
condition until it performs its daily segregation computation the
following day. In any event, an FCM would be expected to notify the
Commission of a deficiency in its segregated accounts by noon of the
following business day.
Proposed new Rule 1.12(h), like the other provisions of the early
warning system, is intended to allow protective action to be taken. The
Commission wishes to emphasize that the triggering event is when an FCM
knows or should know that the FCM has a deficiency, as discussed above.
An FCM should not attempt to circumvent the rule simply by delaying
making the computations until noon of the next business day when it is
clear from market events or other factors that a deficiency likely
exists.
The Commission also wishes to note that, while Rule 1.12(h) would
require only that an FCM notify the Commission and its DSRO of a
segregation or secured amount deficiency immediately, a firm with a
notification obligation under Rule 1.12(h) may incur additional
requirements under other early warning rules or Commission regulations.
For example, a firm that is undersegregated may also be
undercapitalized and thus be required (in addition to notifying the
Commission) to comply with various filing requirements under Rule
1.12(a)(2).\15\ Although the Commission is not proposing any specific
further reporting by an FCM that files notice of a segregation or
secured amount deficiency, under Rule 1.10(b)(4) the Commission may
request in writing that an FCM also file a Form 1-FR-FCM or provide
such other additional financial information as the Commission may
require. This could include, for example, a request that the FCM file
daily segregation or secured account computations with the Commission
for a specified period, rather than simply making such records
available for inspection.\16\
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\15\ Rule 1.12(a)(2) requires that an FCM whose adjusted net
capital is below the amount required under Rule 1.17 or under the
capital rule of any applicable SRO, within twenty-four hours of
giving notice of such occurrence to the Commission, file for the
period "as of" the date of the adjusted net capital deficiency, a
statement of financial condition, a statement of the computation of
the minimum capital requirements, the statements of segregation
requirements and funds in segregation, and the statement of secured
amounts and funds held in separate accounts for foreign futures and
foreign options customers.
\16\ Rule 1.31 requires that all records required by the Act or
Commission rules be maintained for five years under specified
conditions and be available for inspection by any representative of
the Commission or the United States Department of Justice.
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Although the Commission's early warning rules already require an
FCM to notify the Commission if the FCM is undercapitalized, large
market moves such as those which occurred on October 19, 1987, and more
recently on October 27, 1997, can cause a firm to be undersegregated
even though it is not undercapitalized. A large market move can create
unsecured "debit/deficit" accounts, which present greater risk for an
FCM than undermargined accounts since the customer now owes the FCM
money. Accounts of this kind would generally be subject to a margin
call. In that case, absent the FCM being aware of doubts regarding its
customer's ability to pay the deficit or debit, the FCM carrying the
account has one business day from the date on which the deficit or
debit ledger balance originated before it must reclassify the account
as a "non-current asset" in computing its adjusted net capital.\17\
Likewise, the FCM must put sufficient funds from its own capital into
the segregated account to cover the deficit amount or debit ledger
balance, thus ensuring that there are sufficient segregated funds to
cover all customers with liquidating equities in their accounts. Should
the FCM not have sufficient funds to cover the debit or deficit amount,
the FCM would be undersegregated, although not necessarily
undercapitalized. The proposed rule is intended to require that notice
to the CFTC and the DSRO be provided immediately in such
circumstances.\18\
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\17\ Rule 1.17(c)(2) (i) and (vi).
\18\ The Commission also proposes to correct the cross-reference
in Sec. 1.12(g)(2) concerning consolidation that now refers to
`'Sec. 1.10(f)" to read "Sec. 1.17(f)".
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The Commission believes that notice that an FCM is undersegregated
or undersecured should be provided immediately. In reviewing other
provisions of the early warning requirements, the Commission has
[[Page 2191]]
determined to propose that notices of events now required within 24
hours, which must be provided when an FCM or IB is undercapitalized or
when an account must be liquidated, transferred or allowed to trade for
liquidation only, now be provided immediately. Such notifications would
be required by telephone immediately, to be confirmed in writing by
telegraph or facsimile. See Rule 1.12 (a)(1), (f)(1), and (f)(2).\19\
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\19\ Certain other provisions of Rule 1.12 currently require
immediate notifications. See paragraphs (e), (f)(3), (f)(4) and
(f)(5) of Rule 1.12. The Commission is also proposing that these
notifications be made by telephone as well as by telegraph or
facsimile.
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III. Related Matters
A. Regulatory Flexibility Act
Regulatory Flexibility Act ("RFA"), 5 U.S.C. 601-611 (1994),
requires that agencies, in proposing rules, consider the impact of
those rules on small businesses. The rule amendments discussed herein
would affect primarily FCMs. The amendment of one provision,
Sec. 1.12(f)(1), would affect clearing organizations, and the amendment
of another provision, Sec. 1.12(a)(1), would affect IBs. The Commission
has previously determined that, based upon the fiduciary nature of the
FCM/customer relationships, as well as the requirement that FCMs meet
minimum financial requirements, FCMs should be excluded from the
definition of small entity.\20\ Contract markets and their clearing
organizations have also been excluded from the definition of small
entity.\21\
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\20\ 47 FR 18618-18621 (April 30, 1982).
\21\ Id.
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The proposed amendment to Sec. 1.12(a)(1) concerning notice of
undercapitalization would affect the minority of IBs that rely upon
their own capital to meet net capital rules, "independent" IBs, as
well as FCMs. The Commission is proposing to require that this notice
be provided immediately rather than within 24 hours as currently
required. The notification requirement will remain essential the same,
but the timing would be shortened by 24 hours. The Commission believes
that this rule amendment is necessary for the Commission and DSROs to
be able to carry our their overishgt and monitoring functions
concerning the financial condition of futures industry intermediaries
and to protect the customers of those firms and the markets. Therefore,
any slight increase in the burden on an independent IB caused by the
proposed amendment to Rule 1.12(a)(1) is necessary for the Commission
to fulfill its regulatory obligation.\22\
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\22\ The Commission evaluates within the context of a particular
rule proposal whether all or some IBs should be considered small
entities and, if so, analyzes the impact on IBs of the proposal 48
FR 35248, 35276 (Aug. 3, 1983).
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Accordingly, on behalf of the Commission, the Chairperson certifies
that these proposed rule amendments will not have a significant
economic impact on a substantial number of small entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1980 ("PRA"), 44 U.S.C. 3501 et
seq. (1994), imposes certain requirement on federal agencies (including
the Commission) in connection with their conducting or sponsoring any
collection of information as defined by the PRA. The Commission
anticipates that fewer than 10 FCMs per year would be filing reports
under the proposed rule and thus the new rule would not constitute a
collection of information under the PRA.\23\ The group of rules (3038-
0024) of which this is a part has the following burden:
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\23\ 44 U.S.C. 3502(4) 1994)
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Average Burden Hours Per Response: 128.
Number of Respondents: 1366.
Frequency of Response: On occasion.
Persons wishing to comment on the estimated paperwork burden
associated with this proposed rule amendment should contact Jeff Hill,
Office of Management and Budget, Room 3228, NEOB Washington, DC 20503,
(202) 395-7340. Copies of the information collection submission to OMB
are available from the CFTC Clearance Officer, 1155 21st Street N.W.,
Washington, DC 20581, (202) 418.5160.
List of Subjects in 17 CFR Part 1
Commodity futures; minimum financial and relating reporting
require.
In consideration of the foregoing, and pursuant to the authority
contained in the Commodity Exchange Act, and in particular, Sections
4f, fg and 8a(5) therof, 7 U.S.C. 6f, 6g and 12a(5), the Commission
hereby proposes to amend Part 1 of chapter I of title 17 of the Code of
Federal Regulations as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 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.
2. Section 1.12 is amended by revising paragraph (a)(1), by
revising the first sentence of paragraph (b)(4), by adding the phrase
"or facsimile" after the word "telegraphic" in paragraphs (c) and
(d), by revising paragraph (e), by adding the phrase "telephonic,
confirmed in writing by" before the word "telegraphic," by adding
the phrase "or facsimile," after the word "telegraphic," and by
revising the phrase at the end which reads "within 24 hours" to read
"immediately" in paragraphs (f)(1) and (f)(2), by adding the phrase
"telephonic, confirmed in writing by" before the word "telegraphic"
and by adding the phrase "or facsimile," after the word
"telegraphic" in paragraph (f)(3), by adding the phrase "by
telephone, confirmed in writing immediately by telegraphic or facsimile
notice," after the word "immediately" in paragraphs (f)(4) and
(f)(5), by revising the phrase in paragraph (g)(2) which reads
"Sec. 1.10(f)" to read "Sec. 1.17(f)", by redesignating paragraphs
(h)(1) and (h)(2) as paragraphs (i)(1) and (i)(2), respectively, by
revising the last sentence of newly redesignated paragraph (i)(2), and
by adding a new paragraph (h). The additions and revisions follow:
Sec. 1.12 Maintenance of minimum financial requirements by futures
commission merchants and introducing brokers.
* * * * *
(a) * * *
(1) Give telephonic notice, to be confirmed in writing by
telegraphic or facsimile notice, as set forth in paragraph (i) of this
section that the applicant's or registrant's adjusted net capital is
less than required by Sec. 1.17 or by other capital rule, identifying
the applicable capital rule. This notice must be given immediately
after the applicant or registrant knows or should know that its
adjusted net capital is less than is required by any of the aforesaid
rules to which the applicant or registrant is subject; and
* * * * *
(b) * * *
(4) For securities brokers or dealers, the amount of net capital
specified in Rule 17a-11(b) of the Securities and Exchange Commission
(17 CFR 240.17a-11(b)), must file written notice to that effect as set
forth in paragraph (i) of this section within five (5) business days of
such event. * * *
* * * * *
(e) Whenever any self-regulatory organization learns that a member
registrant has failed to file a notice or written report as required by
this Sec. 1.12, that self-regulatory organization must immediately
report this failure by
[[Page 2192]]
telephone, confirmed in writing immediately by telegraphic or facsimile
notice, as provided in paragraph (i) of this section.
* * * * *
(h) Whenever a person registered as a futures commission merchant
knows or should know that the total amount of its funds on deposit in
segregated accounts on behalf of customers, or that the total amount
set aside on behalf of customers trading on non-United States markets,
is less than the total amount of such funds required by the Act and the
Commission's rules to be on deposit in segregated or secured amount
accounts on behalf of such customers, the registrant must report
immediately by telephone, confirmed in writing immediately by
telegraphic or facsimile notice, such deficiency to the registrant's
designated self-regulatory organization and the principal office of the
Commission in Washington, DC, to the attention of the Director and the
Chief Accountant of the Division of Trading and Markets.
(i) * * *
(2) * * * Any notice or report filed with the National Futures
Association pursuant to this paragraph shall be deemed for all purposes
to be filed with, and to be the official record of, the Commission.
Issued in Washington, D.C. on January 6, 1998 by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 98-665 Filed 1-13-98; 8:45 am]
BILLING CODE 6351-01-P
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