Federal Register, Volume 76 Issue 243 (Monday, December 19, 2011)[Federal Register Volume 76, Number 243 (Monday, December 19, 2011)]
[Rules and Regulations]
[Pages 78776-78803]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-31689]
[[Page 78775]]
Vol. 76
Monday,
No. 243
December 19, 2011
Part III
Commodity Futures Trading Commission
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17 CFR Parts 1 and 30
Investment of Customer Funds and Funds Held in an Account for Foreign
Futures and Foreign Options Transactions; Final Rule
Federal Register / Vol. 76 , No. 243 / Monday, December 19, 2011 /
Rules and Regulations
[[Page 78776]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1 and 30
RIN 3038-AC79
Investment of Customer Funds and Funds Held in an Account for
Foreign Futures and Foreign Options Transactions
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is amending its regulations regarding the investment of customer
segregated funds subject to Commission Regulation 1.25 (Regulation
1.25) and funds held in an account subject to Commission Regulation
30.7 (Regulation 30.7, and funds subject thereto, 30.7 funds). Certain
amendments reflect the implementation of new statutory provisions
enacted under Title IX of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The amendments address: certain changes to the
list of permitted investments (including the elimination of in-house
transactions), a clarification of the liquidity requirement, the
removal of rating requirements, and an expansion of concentration
limits including asset-based, issuer-based, and counterparty
concentration restrictions. They also address revisions to the
acknowledgment letter requirement for investment in a money market
mutual fund (MMMF), revisions to the list of exceptions to the next-day
redemption requirement for MMMFs, the elimination of repurchase and
reverse repurchase agreements with affiliates, the application of
customer segregated funds investment limitations to 30.7 funds, the
removal of ratings requirements for depositories of 30.7 funds, the
elimination of the option to designate a depository for 30.7 funds, and
certain technical changes.
DATES: This rule is effective February 17, 2012. All persons shall be
in compliance with this rule not later than June 18, 2012.
FOR FURTHER INFORMATION CONTACT: Ananda K. Radhakrishnan, Director,
(202) 418-5188, [email protected], or Jon DeBord, Special
Counsel, (202) 418-5478, [email protected], Division of Clearing and
Risk, Commodity Futures Trading Commission, Three Lafayette Centre,
1151 21st Street NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
A. Regulation 1.25
B. Regulation 30.7
C. Advance Notice of Proposed Rulemaking
D. The Dodd-Frank Act
E. The Notice of Proposed Rulemaking
II. Discussion of the Final Rules
A. Permitted Investments--Regulation 1.25
1. Government Sponsored Enterprise Securities
2. Commercial Paper and Corporate Notes or Bonds
3. Foreign Sovereign Debt
4. In-House Transactions
B. General Terms and Conditions
1. Marketability
2. Ratings
3. Restrictions on Instrument Features
4. Concentration Limits
(a) Asset-Based Concentration Limits
(b) Issuer-based Concentration Limits
(c) Counterparty Concentration Limits
C. Money Market Mutual Funds
1. Acknowledgment Letters
2. Next-day Redemption Requirement
D. Repurchase and Reverse Repurchase Agreements
E. Regulation 30.7
1. Harmonization
2. Ratings
3. Designation as a Depository for 30.7 Funds
4. Technical Amendment
F. Implementation
III. Cost Benefit Considerations
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
Text of Rules
I. Background
A. Regulation 1.25
Under Section 4d \1\ of the Commodity Exchange Act (Act),\2\
customer segregated funds may be invested in obligations of the United
States and obligations fully guaranteed as to principal and interest by
the United States (U.S. government securities) and general obligations
of any State or of any political subdivision thereof (municipal
securities). Pursuant to authority under Section 4(c) of the Act,\3\
the Commission substantially expanded the list of permitted investments
by amending Regulation 1.25 \4\ in December 2000 to permit investments
in general obligations issued by any enterprise sponsored by the United
States (government sponsored enterprise or GSE debt securities), bank
certificates of deposit (CDs), commercial paper, corporate notes,\5\
general obligations of a sovereign nation, and interests in MMMFs.\6\
In connection with that expansion, the Commission included several
provisions intended to control exposure to credit, liquidity, and
market risks associated with the additional investments, e.g.,
requirements that the investments satisfy specified rating standards
and concentration limits, and be readily marketable and subject to
prompt liquidation.\7\
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\1\ 7 U.S.C. 6d.
\2\ 7 U.S.C. 1 et seq. (2006), as amended by the Dodd-Frank Wall
Street Reform and Consumer Protection Act, Pub. L. 111-203, 124
Stat. 1376 (2010).
\3\ 7 U.S.C. 6(c).
\4\ 17 CFR 1.25. Commission regulations may be accessed through
the Commission's Web site, http://www.cftc.gov.
\5\ This category of permitted investment was later amended to
read ``corporate notes or bonds.'' See 70 FR 28190, 28197 (May 17,
2005).
\6\ 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).
\7\ Id.
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The Commission further modified Regulation 1.25 in 2004 and 2005.
In February 2004, the Commission adopted amendments regarding
repurchase agreements using customer-deposited securities and time-to-
maturity requirements for securities deposited in connection with
certain collateral management programs of derivatives clearing
organizations (DCOs).\8\ In May 2005, the Commission adopted amendments
related to standards for investing in instruments with embedded
derivatives, requirements for adjustable rate securities, concentration
limits on reverse repurchase agreements, transactions by futures
commission merchants (FCMs) that are also registered as securities
brokers or dealers (in-house transactions), rating standards and
registration requirements for MMMFs, an auditability standard for
investment records, and certain technical changes.\9\
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\8\ 69 FR 6140 (Feb. 10, 2004).
\9\ 70 FR 28190.
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The Commission has been, and continues to be, mindful that customer
segregated funds must be invested in a manner that minimizes their
exposure to credit, liquidity, and market risks both to preserve their
availability to customers and DCOs and to enable investments to be
quickly converted to cash at a predictable value in order to avoid
systemic risk. Toward these ends, Regulation 1.25 establishes a general
prudential standard by requiring that all permitted investments be
``consistent with the objectives of preserving principal and
maintaining liquidity.'' \10\
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\10\ 17 CFR 1.25(b).
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In 2007, the Commission's Division of Clearing and Intermediary
Oversight (Division) launched a review of the nature and extent of
investments of Regulation 1.25 funds and 30.7 funds
[[Page 78777]]
(2007 Review) in order to further its understanding of investment
strategies and practices and to assess whether any changes to the
Commission's regulations would be appropriate. As part of this review,
all registered DCOs and FCMs carrying customer accounts provided
responses to a series of questions. As the Division was conducting
follow-up interviews with respondents, the market events of September
2008 occurred and changed the financial landscape such that much of the
data previously gathered no longer reflected current market conditions.
However, that data remains useful as an indication of how Regulation
1.25 was implemented in a more stable financial environment.
Additionally, recent events in the economy have underscored the
importance of conducting periodic reassessments and, as necessary,
revising regulatory policies to strengthen safeguards designed to
minimize risk, while retaining an appropriate degree of investment
flexibility and opportunities for capital efficiency for DCOs and FCMs
investing customer segregated funds.
B. Regulation 30.7
Regulation 30.7 \11\ governs an FCM's treatment of customer money,
securities, and property associated with positions in foreign futures
and foreign options. Regulation 30.7 was issued pursuant to the
Commission's plenary authority under Section 4(b) of the Act.\12\
Because Congress did not expressly apply the limitations of Section 4d
of the Act to 30.7 funds, the Commission historically has not subjected
those funds to the investment limitations applicable to customer
segregated funds.
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\11\ 17 CFR 30.7.
\12\ 7 U.S.C. 6(b).
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The investment guidelines for 30.7 funds are general in nature.\13\
Although Regulation 1.25 investments offer a safe harbor, the
Commission does not currently limit investments of 30.7 funds to
permitted investments under Regulation 1.25. Appropriate depositories
for 30.7 funds currently include certain financial institutions in the
United States, financial institutions in a foreign jurisdiction meeting
certain capital and credit rating requirements, and any institution not
otherwise meeting the foregoing criteria, but which is designated as a
depository upon the request of a customer and the approval of the
Commission.
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\13\ See Commission Form 1-FR-FCM Instructions at 12-9 (Mar.
2010) (``In investing funds required to be maintained in separate
section 30.7 account(s), FCMs are bound by their fiduciary
obligations to customers and the requirement that the secured amount
required to be set aside be at all times liquid and sufficient to
cover all obligations to such customers. Regulation 1.25 investments
would be appropriate, as would investments in any other readily
marketable securities.'').
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C. Advance Notice of Proposed Rulemaking
In May 2009, the Commission issued an advance notice of proposed
rulemaking (ANPR) \14\ to solicit public comment prior to proposing
amendments to Regulations 1.25 and 30.7. The Commission stated that it
was considering significantly revising the scope and character of
permitted investments for customer segregated funds and 30.7 funds. In
this regard, the Commission sought comments, information, research, and
data regarding regulatory requirements that might better safeguard
customer segregated funds. It also sought comments, information,
research, and data regarding the impact of applying the requirements of
Regulation 1.25 to investments of 30.7 funds.
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\14\ 74 FR 23962 (May 22, 2009).
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The Commission received twelve comment letters in response to the
ANPR, and it considered those comments in formulating its proposal.\15\
Eleven of the 12 letters supported maintaining the current list of
permitted investments and/or specifically ensuring that MMMFs remain a
permitted investment. Five of the letters were dedicated solely to the
topic of MMMFs, providing detailed discussions of their usefulness to
FCMs. Several letters addressed issues regarding ratings, liquidity,
concentration, and portfolio weighted average time to maturity. The
alignment of Regulation 30.7 with Regulation 1.25 was viewed as non-
controversial.
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\15\ The Commission received comment letters from CME Group Inc.
(CME), Crane Data LLC, The Dreyfus Corporation (Dreyfus), FCStone
Group Inc. (FCStone), Federated Investors, Inc. (Federated), Futures
Industry Association (FIA), Investment Company Institute (ICI), MF
Global Inc. (MF Global), National Futures Association (NFA), Newedge
USA, LLC (Newedge), and Treasury Strategies, Inc.. Two letters were
received from Federated: a July 10, 2009 letter and an August 24,
2009 letter.
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The FIA's comment letter expressed its view that ``all of the
permitted investments described in Rule 1.25(a) are compatible with the
Commission's objectives of preserving principal and maintaining
liquidity.'' This opinion was echoed by MF Global, Newedge and FC
Stone. CME asserted that only ``a small subset of the complete list of
Regulation 1.25 permitted investments are actually used by the
industry.'' NFA also wrote that investments in instruments other than
U.S. government securities and MMMFs are ``negligible,'' and
recommended that the Commission eliminate asset classes not ``utilized
to any material extent.''
D. The Dodd-Frank Act
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank Act).\16\ Title IX of
the Dodd-Frank Act \17\ was enacted in order to increase investor
protection, promote transparency and improve disclosure.
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\16\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the Dodd-
Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
\17\ Pursuant to Section 901 of the Dodd-Frank Act, Title IX may
be cited as the ``Investor Protection and Securities Reform Act of
2010.''
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Section 939A of the Dodd-Frank Act obligates federal agencies to
review their respective regulations and make appropriate amendments in
order to decrease reliance on credit ratings. The Dodd-Frank Act
requires the Commission to conduct this review within one year after
the date of enactment.\18\ Included in these rule amendments are
changes to Regulations 1.25 and 30.7 that remove provisions setting
forth credit rating requirements. Separate rulemakings addressed the
removal of credit ratings from Commission Regulations 1.49 and 4.24
\19\ and the removal of Appendix A to Part 40 (which contains a
reference to credit ratings).\20\
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\18\ See Section 939A(a) of the Dodd-Frank Act.
\19\ See 76 FR 44262 (July 25, 2011).
\20\ See 75 76 FR 44776 (July 27, 2011).
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E. The Notice of Proposed Rulemaking
A Notice of Proposed Rulemaking (NPRM) was issued by the Commission
on October 26, 2010, having been considered in conjunction with the
Dodd-Frank rulemaking regarding credit ratings. The NPRM was published
in the Federal Register on November 3, 2010, and the comment period
closed on December 3, 2010.\21\
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\21\ See 75 FR 67642 (Nov. 3, 2010); see also 76 FR 25274 (May
4, 2011) (reopening the comment period for certain NPRMs until June
3, 2011).
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The Commission invited comments related to topics covered by
Regulations 1.25 and 30.7, including the scope of permitted
investments, liquidity, marketability, ratings, concentration limits,
portfolio weighted average maturity requirements, and the applicability
of Regulation 1.25 standards to foreign futures accounts. The
Commission received 32 comment letters.\22\
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\22\ Comment letters were received from ADM Investor Services,
Inc. (ADM), Bank of New York Mellon (BNYM), BlackRock, Inc.
(BlackRock), Brown Brothers Harriman & Co. (BBH), Business Law
Society of the University of Mississippi (BLS), CME, Committee on
the Investment of Employee Benefit Assets (CIEBA), Dreyfus, Farm
Credit Administration (FCA), Farm Credit Council (Farm Credit
Council), Farr Financial Inc. (Farr Financial), Federal Farm Credit
Banks Funding Corporation (FFCB), Federal Housing Finance Authority
(FHFA), Federated, Futures and Options Association (FOA), FIA and
International Swaps and Derivatives Association, Inc. (FIA/ISDA),
International Assets Holding Corporation and FCStone (INTL/FCStone),
ICI, Joint Audit Committee (JAC), J.P. Morgan Futures Inc. (J.P.
Morgan), LCH.Clearnet Group (LCH), MF Global and Newedge (MF Global/
Newedge), MorganStanley & Co. (MorganStanley), NFA, Natural Gas
Exchange, Inc. (NGX), Office of Finance of the Federal Home Loan
Banks (FHLB), R.J. O'Brien and Associates (RJO), and UBS Global
Asset Management (Americas) Inc. (UBS). Federated sent multiple
letters. Federated's November 30, 2010 letter will be referred to as
``Federated I,'' its December 2, 2010 letter will be referred to as
``Federated II,'' and Arnold & Porter LLP's post-comment period
letter on behalf of Federated, dated March 21, 2011, will be
referred to as ``Federated III.'' Federated also sent a letter dated
November 8, 2010 and a post-comment period letter dated February 28,
2011. The letters from BLS and NGX were received during the reopened
comment period, on May 12, 2011 and May 31, 2011, respectively.
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[[Page 78778]]
II. Discussion of the Final Rules
A. Permitted Investments--Regulation 1.25
In finalizing amendments to Regulation 1.25, the Commission seeks
to impose requirements on the investment of customer segregated funds
with the goal of enhancing the preservation of principal and
maintenance of liquidity consistent with Section 4d of the Act. The
Commission has endeavored to tailor its amendments to achieve these
goals, while retaining an appropriate degree of investment flexibility
and opportunities for attaining capital efficiency for DCOs and FCMs
investing customer segregated funds.
In issuing these final rules, the Commission is narrowing the scope
of investment choices in order to eliminate the potential use of
portfolios of instruments that may pose an unacceptable level of risk
to customer funds. The Commission seeks to increase the safety of
Regulation 1.25 investments by promoting diversification.
Below, the Commission details its decisions regarding the proposals
in the NPRM. The Commission has decided to:
Retain investments in U.S. agency obligations, including
implicitly backed GSE debt securities, and impose limitations on
investments in debt issued by the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac);
Remove corporate debt obligations not guaranteed by the
United States from the list of permitted investments;
Eliminate foreign sovereign debt as a permitted
investment; and
Eliminate in-house and affiliate transactions.
1. Government Sponsored Enterprise Securities
In the NPRM, the Commission proposed to amend Regulation
1.25(a)(1)(iii) to expressly add U.S. government corporation
obligations \23\ to GSE debt securities \24\ (together, U.S. agency
obligations) and to add the requirement that the U.S. agency
obligations must be fully guaranteed as to principal and interest by
the United States. As proposed, all current GSE debt securities,
including that of Fannie Mae and Freddie Mac, would have been
impermissible as Regulation 1.25 investments since no GSE debt
securities have the explicit guarantee of the U.S. government. The
Commission received 14 comment letters discussing GSEs. Thirteen of
those 14 comment letters opposed the proposal.
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\23\ See 31 U.S.C. 9101 (defining ``government corporation'').
\24\ GSEs are chartered by Congress but are privately owned and
operated. Securities issued by GSEs do not have an explicit federal
guarantee, although they are considered by some to have an
``implicit'' guarantee due to their federal affiliation. Obligations
of U.S. government corporations, such as the Government National
Mortgage Association (known as GNMA or Ginnie Mae), are explicitly
backed by the full faith and credit of the United States. Although
the Commission is not aware of any GSE securities that have an
explicit federal guarantee, in the NPRM the Commission concluded
that GSE securities should remain on the list of permitted
investments in the event this status changes in the future.
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Generally, the arguments focused on the safety of GSEs, GSEs'
performance during the financial crisis, and the detrimental,
unintended consequences of the proposal. In addition, there were
several letters from organizations related to the Farm Credit System
GSE (Farm Credit System) and FHLB System GSE (FHLB System) supporting,
at a minimum, the inclusion of their GSE debt as a permitted Regulation
1.25 investment.
In terms of safety, commenters expressed the view that GSE debt
securities are sufficiently liquid and that the U.S. government would
not allow a GSE to fail.\25\ FFCB remarked that the Securities and
Exchange Commission (SEC) has retained GSE debt securities as
investments appropriate under SEC Rule 2a-7 \26\ (which governs
MMMFs).\27\ In addition to GSEs being safe, BlackRock noted that ``any
changes in the viability of such entities should be telegraphed well in
advance resulting in minimal disruption to the credit markets.'' \28\
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\25\ MF Global/Newedge letter at 4.
\26\ 17 CFR 270.2a-7.
\27\ FFCB letter at 3.
\28\ BlackRock letter at 6.
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With respect to Fannie Mae and Freddie Mac, the FHFA's support of
those GSEs effectively amounts to a federal guarantee, according to two
commenters.\29\ As long as the federal government holds exposure of
greater than 50 percent in Fannie Mae and Freddie Mac, RJO wrote that
it believes that the quality of these issuances is better than those of
any bank or corporation.\30\
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\29\ FIA/ISDA letter at 5, J.P. Morgan letter at 1.
\30\ RJO letter at 5.
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Commenters averred that the safety of GSEs is further proven by
their stability during the financial crisis. MF Global/Newedge,
BlackRock and ADM noted that non-Fannie Mae/Freddie Mac GSEs performed
well during the financial crisis.\31\
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\31\ MF Global/Newedge letter at 5, BlackRock letter at 6, ADM
letter at 3. MF Global cited the Student Loan Marketing Association,
FFCB Federal Home Loan Banks and Federal Agricultural Mortgage
Corporation as examples of GSEs that performed well during the
financial crisis.
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Limiting investments to only those agency obligations backed by the
full faith and credit of the U.S. government would be a mistake because
``none'' satisfy the requirement, according to the NFA, or ``only
GNMAs'' satisfy the requirement, according to ADM.\32\ The FHFA wrote
that specific criteria for eligible investments is preferable to
speculation on the actions of third parties (such as whether the
federal government will or will not bail out a GSE).\33\
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\32\ NFA letter at 2, ADM letter at 3.
\33\ FHFA letter at 1.
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Several commenters were concerned that the Commission's proposal
would have the unintended consequence of harming the broader market for
GSEs, as investors would question the safety of such investments.\34\
The Farm Credit Council wrote that ``[u]ntil and unless Congress
signals its intention to erode the federal government's support of
GSEs, we respectfully request that the CFTC not amend Regulation 1.25
with respect to investments in GSEs.'' \35\
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\34\ FCA at 2, Farm Credit Council letter at 3, RJO letter at 4,
FFCB letter at 3.
\35\ Farm Credit Council letter at 1-2.
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Most commenters recommended that GSE debt securities, including
those not explicitly guaranteed by the U.S. government, remain
permitted investments to varying extents. There were a range of
recommendations regarding the debt of Fannie Mae and Freddie Mac. MF
Global/Newedge suggested that GSEs with implicit guarantees should have
a 50 percent asset-based concentration limit along
[[Page 78779]]
with a 10 percent issuer-based limit, or, alternatively, that GSEs
meeting specific outstanding float standards should be allowed. MF
Global/Newedge stated that, at a minimum, the Commission should allow
FCMs to invest in GSEs other than Fannie Mae and Freddie Mac.\36\ CME
wrote that highly liquid GSEs, including those of Fannie Mae and
Freddie Mac, should remain as permitted investments and should have a
25 percent asset-based concentration limit.\37\ RJO recommended that
all GSE securities be permitted, and that, at the very least, the
Commission should permit investments in Fannie Mae and Freddie Mac
until December 31, 2012, when the government guarantee expires.\38\
FIA/ISDA recommended that investments in GSE securities be permitted
subject to the conditions that (i) with the exception of ``agency
discount notes,'' the size of the issuance is at least $1 billion, (ii)
trading in the securities of such agency remains highly liquid, (iii)
the prices at which the securities may be traded are publicly available
(through, for example, Bloomberg or Trace), and (iv) investments in
GSEs are subject to a maximum of 50 percent asset-based and 15 percent
issuer-based concentration limits.\39\ BlackRock recommended a 30
percent issuer limitation on GSEs.\40\
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\36\ MF Global/Newedge letter at 5.
\37\ CME letter at 3.
\38\ RJO letter at 5.
\39\ FIA/ISDA letter at 5.
\40\ BlackRock at 6.
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The Farm Credit Council, FHLB, the FCA, the FFCB and RJO all wrote
letters supporting one or both of the FHLB System \41\ and Farm Credit
System debt securities.\42\ FHLB stated that the prohibition on GSEs
not explicitly backed by the full faith and credit of the federal
government is overly broad. In particular, FHLB noted that FHLB debt
securities performed well throughout the financial crisis. FHLB stated
that it maintained funding capabilities even during the most severe
periods of market stress, due to investors' favorable views of its debt
securities.\43\ Similarly, the Farm Credit Council wrote that Farm
Credit debt securities remained safe during the recent period of market
volatility, and the Farm Credit System was able to supply much-needed
financial support to farmers, rangers, harvesters of aquatic products,
agricultural cooperatives, and rural residents and businesses.\44\ Farm
Credit discount notes, among other Farm Credit debt securities, ``have
been a staple in risk-averse investor portfolios since the [Farm Credit
System's] inception in 1916 and have proven their creditworthiness
across a range of market environments.'' \45\ During the recent crisis,
the Farm Credit System was able to issue and redeem over $400 billion
in discount notes annually, while issuing over $100 billion per year in
longer-maturity debt securities.\46\ RJO concurred regarding both GSEs,
noting that the FHLB System and Farm Credit System experienced minimal,
if any, problems during the crisis.\47\
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\41\ The FHLB System, which is regulated by the FHFA, comprises
an ``Office of Finance'' and 12 independently-chartered, regional
cooperative Federal Home Loan Banks created by Congress to provide
support for housing finance and community development through member
financial institutions. The 12 Federal Home Loan Banks issue debt
securities (FHLB debt securities), the proceeds from which are used
to provide liquidity to the 7,900 FHLB member banks through
collateralized loans. See FHLB letter at 1-3.
\42\ The Farm Credit System comprises five banks and 87
associations which provide credit and financial services to farmers,
ranchers, and similar agricultural enterprises by issuing debt (Farm
Credit debt securities) through the FFCB.
\43\ FHLB letter at 1-3.
\44\ Farm Credit Council letter at 1. Farm Credit debt
securities are regulated by the FCA and insured by an independent
U.S. government-controlled corporation which maintains an insurance
fund of roughly 2 percent of the outstanding loans. The total
outstanding loan amount was over $3 billion as of the end of 2009.
See Farm Credit Council letter at 2.
\45\ FFCB letter at 1.
\46\ Id.
\47\ RJO letter at 4.
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CIEBA, which represents 100 of the country's largest pension funds,
was the only commenter that backed the proposal.\48\
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\48\ CIEBA letter at 3.
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After reviewing the comments, the Commission has concluded that
U.S. agency obligations should remain permitted investments. The
Commission acknowledges the fact, mentioned by several commenters, that
most GSE debt performed well during the most recent financial crisis.
The Commission believes it appropriate to include a limitation for
debt issued by Fannie Mae and Freddie Mac, two GSEs which did not
perform well during the recent financial crisis. Both entities failed
and, as a result, have been operating under the conservatorship of the
FHFA since September of 2008. As conservator of Fannie Mae and Freddie
Mac, FHFA has assumed all powers formerly held by each entity's
officers, directors, and shareholders. In addition, FHFA, as
conservator, is authorized to take such actions as may be necessary to
restore each entity to a sound and solvent condition and that are
appropriate to preserve and conserve the assets and property of each
entity.\49\
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\49\ See 12 U.S.C. 4617(b)(2)(D). The primary goals of the
conservatorships are to help restore confidence in the entities,
enhance their capacity to fulfill their mission, mitigate the
systemic risk that contributed directly to instability in financial
markets, and maintain Fannie Mae and Freddie Mac's secondary
mortgage market role until their future is determined through
legislation. To these ends, FHFA's conservatorship of Fannie Mae and
Freddie Mac is directed toward minimizing losses, limiting risk
exposure, and ensuring that Fannie Mae and Freddie Mac price their
services to adequately address their costs and risk.
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In consideration of the above comments, the Commission is amending
Regulation 1.25(a)(1)(iii) by permitting investments in U.S. agency
obligations. The Commission is adding new paragraph (a)(3) to include
the limitation that debt issued by Fannie Mae and Freddie Mac are
permitted as long as these entities are operating under the
conservatorship or receivership of FHFA.
2. Commercial Paper and Corporate Notes or Bonds
In order to simplify Regulation 1.25 by eliminating rarely-used
instruments, and in light of the credit, liquidity, and market risks
posed by corporate debt securities, the Commission proposed amending
Regulation 1.25(a)(1)(v)-(vi) to limit investments in ``commercial
paper'' \50\ and ``corporate notes or bonds'' \51\ to commercial paper
and corporate notes or bonds that are federally guaranteed as to
principal and interest under the Temporary Liquidity Guarantee Program
(TLGP) and meet certain other prudential standards.\52\
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\50\ 17 CFR 1.25(a)(1)(v).
\51\ 17 CFR 1.25(a)(1)(vi).
\52\ Commercial paper would remain available as a direct
investment for MMMFs and corporate notes or bonds would remain
available as indirect investments for MMMFs by means of a repurchase
agreement.
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The NPRM supported this proposal by noting the credit, liquidity
and market risks associated with corporate notes or bonds and
referenced that information obtained during the 2007 Review indicated
that commercial paper and corporate notes or bonds were not widely used
by FCMs or DCOs.\53\ Second, the NPRM provided background on the TLGP
and explained that TLGP debt would be permissible if: (1) The size of
the issuance is greater than $1 billion; (2) the debt security is
denominated in U.S. dollars; and (3) the debt security is guaranteed
for its entire term.\54\
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\53\ The 2007 Review indicated that out of 87 FCM respondents,
only nine held commercial paper and seven held corporate notes/bonds
as direct investments during the November 30, 2006--December 1, 2007
period.
\54\ Debra Kokal, Joint Audit Committee, CFTC Staff Letter 10-01
[Current Transfer Binder] Comm. Fut. L. Rep. (CCH) ] 31,514 (Jan.
15. 2010) (TLGP Letter).
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Seven comment letters discussed commercial paper and corporate
notes
[[Page 78780]]
or bonds in a substantive manner. Six of the comment letters weighed in
favor of retaining commercial paper and corporate notes or bonds to
some degree. Comments included statements as to the effects of the
proposal, the safety of these instruments, and the lack of reliability
of the 2007 Commission review of customer funds investments.
According to three commenters, limiting commercial paper and
corporate notes or bonds to just those backed by the TLGP is
essentially eliminating the asset class altogether.\55\ BlackRock, ADM
and RJO asserted that TLGP debt is not liquid due to the lack of
available supply and therefore might not be a viable option for
investment.\56\
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\55\ BlackRock letter at 6, RJO letter at 6, ADM letter at 3.
\56\ By contrast, the Commission found that TLGP debt that (1)
has an issuance size of greater than $1 billion, (2) is denominated
in U.S. dollars and (3) is guaranteed for its entire term, is
sufficiently safe and liquid for use as a Regulation 1.25
investment. See TLGP Letter.
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There was general support for maintaining corporate notes or bonds
as Regulation 1.25 permitted investments. FIA/ISDA wrote that as long
as trading in the relevant security remains highly liquid, such
securities should continue to be eligible investments under Regulation
1.25.\57\ RJO noted that commercial paper and corporate notes and bonds
(i) have many high quality names, (ii) have a mature and liquid
secondary market, and (iii) provide greater diversification than merely
``financial sector'' bank CDs.\58\ Further, RJO averred that high
quality corporate notes or bonds are no different than those used by
prime MMMFs.\59\ MF Global/Newedge stated that they were unaware of any
instances of an FCM unable to meet its obligations under Regulation
1.25 as a result of investment losses it suffered involving corporate
notes or commercial paper. They believe that commercial paper and
corporate notes or bonds should continue to be permitted; however, to
the extent that there are limitations, they suggest (a) permitting FCMs
to invest only in corporate notes or commercial paper issued by
entities with a certain minimum capital level or which meet a certain
float size, or (b) limiting FCM investments in such instruments to 25
percent of their portfolio and 5 percent with any one issuer. BlackRock
supports a 25-50 percent asset-based concentration limit for TLGP debt,
but also notes that a lack of creditworthy supply may prevent an FCM
from reaching that limit.\60\
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\57\ FIA/ISDA letter at 5.
\58\ RJO letter at 6.
\59\ RJO letter at 5.
\60\ BlackRock letter at 6.
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Commenters rejected the Commission's contention that the lack of
investment in commercial paper and corporate notes or bonds illustrated
in its 2007 Review was dispositive. MF Global/Newedge suggested that
the investment review is outdated and is inadequate to justify removing
an important source of revenue for FCMs.\61\ RJO noted that commercial
paper and corporate notes likely appear to be used minimally during the
relevant period because investments in such instruments were not as
safe during that time frame.\62\
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\61\ MF Global/Newedge at 8.
\62\ RJO letter at 5.
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The Commission does not find the arguments in favor of retaining
corporate notes and bonds to be persuasive. While the Commission
encourages FCMs and DCOs to increase or decrease their holdings of
certain permitted instruments depending on market conditions, the
Commission is following the language of the statute and its goal of
eliminating instruments that may, during tumultuous markets, tie up or
threaten customer principal. The Commission recognizes that certain
high-quality paper and notes may be sufficiently safe. As discussed in
Section I.B.4.(a) of this rulemaking, an FCM or DCO may invest up to 50
percent of its funds in prime MMMFs, which may invest in high-quality
paper and notes meeting certain standards. To the extent that
commenters suggested that the 2007 Report does not accurately reflect
the volume of investment of customer segregated funds in commercial
paper and corporate notes or bonds, the Commission believes that the
2007 Report contains sufficiently accurate information reflective of
the circumstances at that time.\63\ Further, notwithstanding the
relative paucity of investment in such instruments, the Commission
believes that the investment of customer funds in such instruments runs
counter to the overarching objective of preserving principal and
maintaining liquidity of customer funds.
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\63\ While the Commission does not have similar data reflecting
Regulation 1.25 investments from more recent years, the Commission
believes that investment in commercial paper and corporate notes or
bonds remains minimal. This belief is supported by a July 21, 2009
letter from NFA, in response to the ANPR, which averred that
segregated funds were primarily invested in government securities
and MMMFs, while investments in other instruments were
``negligible.'' Moreover, the Commission has received no evidence to
contradict its position.
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Although the TLGP expires in 2012, the Commission believes it is
useful to include commercial paper and corporate notes or bonds that
are fully guaranteed as to principal and interest by the United States
as permitted investments. This would permit continuing investment in
TLGP debt securities, even though the Commission has otherwise
eliminated commercial paper and corporate notes or bonds from the list
of permitted investments. Therefore, the Commission is adopting the
proposed amendments to Regulation 1.25(a) and (b) that limit the
commercial paper and corporate notes or bonds that can qualify as
permitted investments to only those guaranteed as to principal and
interest under the TLGP and that meet the criteria set forth in the
Division's interpretation.\64\ The Commission is amending Regulation
1.25 by (1) amending paragraphs (a)(1)(v) and (a)(1)(vi) to specify
that commercial paper and corporate notes or bonds must be federally
backed and (2) inserting new paragraph (b)(2)(vi) that describes the
criteria for federally backed commercial paper and corporate notes or
bonds.\65\
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\64\ See TLGP Letter; 75 FR 67642, 67645 (Nov. 3, 2010).
\65\ In the NPRM, the Commission proposed removing paragraph
(b)(3)(iv) (as amended in this rulemaking, paragraph (b)(2)(iv))
which permits adjustable rate securities as limited under that
paragraph. As proposed, Regulation 1.25 would have only permitted
corporate and U.S. agency obligations that had explicit U.S.
government guarantees. However, since the Commission is, for the
most part, retaining the current treatment of U.S. agency
obligations, as described in more detail in section II.A.1 of this
rulemaking, the Commission has decided not to adopt the proposed
removal of paragraph (b)(3)(iv) (now paragraph (b)(2)(iv)).
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3. Foreign Sovereign Debt
Currently, an FCM or DCO may invest in the sovereign debt of a
foreign country to the extent it has balances in segregated accounts
owed to its customers (or, in the case of a DCO, to its clearing member
FCMs) denominated in that country's currency.\66\ In the NPRM, the
Commission proposed to remove foreign sovereign debt as a permitted
investment in the interests of both simplifying the regulation and
safeguarding customer funds in light of
[[Page 78781]]
recent crises experienced by a number of foreign sovereigns. The
Commission requested comment on whether foreign sovereign debt should
remain, to any extent, as a permitted investment and, if so, what
requirements or limitations might be imposed in order to minimize
sovereign risk.
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\66\ The inclusion of foreign sovereign debt as a permitted
investment can be traced to an August 7, 2000 comment letter from
the Federal Reserve Bank of Chicago requesting that the Commission
allow FCMs and DCOs to invest non-dollar customer funds in the
foreign sovereign debt of the currency so denominated. The
Commission agreed in its final rule, explaining that an FCM
investing deposits of foreign currencies would be required to
convert the foreign currencies to a U.S. dollar denominated asset,
and that such conversion would ``increase its exposure to foreign
currency fluctuation risk, unless it incurred the additional expense
of hedging.'' See 65 FR 78003 (Dec. 13, 2000).
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Thirteen comment letters discussed foreign sovereign debt. Twelve
of the 13 suggested retaining foreign sovereign debt to varying
degrees. One comment letter supported the Commission's proposal. As
discussed in more detail below, both the importance of hedging against
foreign currency exposure as well as the unintended consequences of the
proposal were cited frequently by commenters as reasons to retain
foreign sovereign debt as a permitted investment.
Six commenters discussed the need to mitigate the risks associated
with foreign currency exposure. FIA/ISDA, MF Global/Newedge, J.P.
Morgan, LCH, NFA and FOA each noted that when a DCO requires margin
deposited in a foreign currency, an FCM will face a foreign currency
exposure in order to meet that margin requirement. The FCM is able to
mitigate this exposure by investing customer funds in foreign sovereign
debt securities denominated in the relevant currency.\67\
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\67\ FIA/ISDA letter at 6, MF Global/Newedge letter at 5, J.P.
Morgan letter at 1, LCH letter at 2, NFA letter at 3, FOA letter at
4.
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The benefits of increased diversification and liquidity were
mentioned by three commenters. FOA and ADM noted that outside
investment in sovereign debt played a key role, during the recent
financial crisis, in maintaining liquidity and demand in such
instruments, which, in turn, had a beneficial impact on pricing and
spreads.\68\ BlackRock wrote that, notwithstanding the current limited
investment in foreign sovereign debt, there are opportunities to add
diversification and liquidity by allowing such investments.\69\ FIA/
ISDA, FOA and BlackRock suggested that lack of use should not
disqualify an investment as long as permitting it would still serve to
preserve principal and maintain liquidity.\70\
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\68\ FOA letter at 2, ADM letter at 2.
\69\ BlackRock letter at 6.
\70\ FIA/ISDA letter at 6, FOA letter at 3, BlackRock letter at
6.
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Several commenters predicted harmful unintended consequences if the
proposal to remove foreign sovereign debt as a permitted investment
becomes the final rule. CME suggested that the implementation of the
Dodd-Frank Act will result in an increase in the amount of customer
funds held by FCMs and an increase in the number of foreign customers
and foreign-domiciled clearing members.\71\ Removing foreign sovereign
debt would limit diversification, would undermine the role of non-US
sovereign debt, and would have the unintended consequence of increasing
market volatility, according to FOA.\72\ LCH and FOA predicted that
retaliatory action from foreign jurisdictions also could occur.\73\
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\71\ CME letter at 3.
\72\ FOA letter at 3.
\73\ LCH letter at 2, FOA letter at 2-3.
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Most commenters supported retaining foreign sovereign debt to some
degree. CME and FIA/ISDA suggested that foreign sovereign debt be
retained as a permitted investment, adding that all investments must be
highly liquid under the terms of Regulation 1.25, so risky foreign
sovereign debt would not be permitted.\74\ LCH recommended that foreign
sovereign debt remain permitted as an investment, or, at a minimum,
that investments be limited to only high quality sovereign issuers.\75\
LCH also noted that DCOs have conservative investment policies in place
already.\76\ RJO suggested limiting foreign sovereign debt to only G-7
issuers, with limits based upon the margin requirement for all client
positions.\77\ NGX suggested that DCOs domiciled outside of the U.S.,
in G-7 countries, be permitted to invest in their country's sovereign
debt, adding that not allowing such investments may be a ``hardship''
on such DCOs.\78\ ADM suggested that G-7 countries serve as a ``safe
harbor'' for Regulation 1.25 foreign sovereign debt investments.\79\
One commenter, CIEBA, backed the Commission's proposal without further
explanation.\80\
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\74\ CME letter at 3, FIA/ISDA letter at 6.
\75\ LCH letter at 2.
\76\ Id.
\77\ RJO letter at 6.
\78\ NGX letter at 3.
\79\ ADM letter at 2.
\80\ CIEBA letter at 3.
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The Commission has considered the comments and has decided to adopt
the proposed amendment, thereby eliminating foreign sovereign debt from
the list of permitted investments. As discussed in more detail below,
the Commission believes that, in many cases, the potential volatility
of foreign sovereign debt in the current economic environment and the
varying degrees of financial stability of different issuers make
foreign sovereign debt inappropriate for hedging foreign currency risk.
The Commission also is not persuaded that foreign sovereign debt is
used with sufficient frequency to justify the commenters' claims that
foreign sovereign debt assists with diversification of customer fund
investments, and it is not persuaded that the specter of backlash from
other jurisdictions or increased market volatility requires a different
outcome.
First, while it appreciates the risks of foreign currency exposure,
the Commission does not believe that foreign sovereign debt is, in all
situations, a sufficiently safe means for hedging such risk. Recent
global and regional financial crises have illustrated that
circumstances may quickly change, negatively impacting the safety of
sovereign debt held by an FCM or DCO. An FCM or DCO holding troubled
sovereign debt may then be unable to liquidate such instruments in a
timely manner--and, when it does, it may be only after a significant
mark-down. Given the choice between an FCM holding devalued currency,
which can be exchanged for a portion of the customers' margin and
returned to the customer immediately, and an FCM holding illiquid
foreign sovereign debt, which might not be able to be exchanged for any
currency in a timely manner, the Commission believes that the former is
in the customers' best interests. The Commission notes that FCMs can
avoid foreign currency risk by not accepting collateral that is not
accepted at the DCO or foreign board of trade, or by providing in its
customer agreement that the customer will bear any currency
exposure.\81\
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\81\ Additionally, the Commission believes that it is
appropriate to note that Regulation 1.25 does not dictate the
collateral that may be accepted by FCMs from customers or by DCOs
from clearing member FCMs. If FCMs and DCOs so allow, customers and
clearing member FCMs, respectively, may continue to post foreign
currency or foreign sovereign debt as collateral.
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Second, the Commission is not persuaded by commenters' assertions
that investment in foreign sovereign debt has increased the
diversification of customer funds in any meaningful way. The Commission
has noted that investment in foreign sovereign debt was minimal in the
2007 Review.\82\ The Commission has received no data or evidence from
any commenter suggesting that investment in foreign sovereign debt has
materially increased since the 2007 Review.
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\82\ 75 FR 67642, 67645.
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Third, the Commission does not believe that eliminating foreign
sovereign debt as a permitted investment of customer funds will cause
the market or jurisdictional problems claimed by commenters. As
discussed above, no commenter has demonstrated that foreign sovereign
debt is widely used, so its elimination should not
[[Page 78782]]
undermine foreign sovereign debt nor cause a disruption in the market.
The foregoing points notwithstanding, the Commission is aware that
FCMs and DCOs have varying collateral management needs and investment
policies. The Commission also recognizes that the safety of sovereign
debt issuances of one country may vary greatly from those of another,
and that investment in certain sovereign debt might be consistent with
the objectives of preserving principal and maintaining liquidity, as
required by Regulation 1.25.
Therefore, the Commission is amenable to considering applications
for exemptions with respect to investment in foreign sovereign debt by
FCMs or DCOs upon a demonstration that the investment in the sovereign
debt of one or more countries is appropriate in light of the objectives
of Regulation 1.25 and that the issuance of an exemption satisfies the
criteria set forth in Section 4(c) of the Act.\83\ Accordingly, the
Commission invites FCMs and DCOs that seek to invest customer funds in
foreign sovereign debt to petition the Commission pursuant to Section
4(c). The Commission will consider permitting investments (1) to the
extent that the FCM or DCO has balances in segregated accounts owed to
its customers (or clearing member FCMs, as the case may be) in that
country's currency and (2) to the extent that such sovereign debt
serves to preserve principal and maintain liquidity of customer funds
as required for all other investments of customer funds under
Regulation 1.25.
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\83\ See 7 U.S.C. 6(c).
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Finally, in response to NGX, the Commission does not agree that
foreign domiciled FCMs and DCOs should be able to invest in the
sovereign debt of their domicile nation. A compelling argument has not
been presented as to why this constitutes a ``hardship'' to DCOs
domiciled outside of the United States.
4. In-house Transactions
The Commission allowed in-house transactions as a permitted
investment for the first time in 2005.\84\ At that time, the Commission
stated that in-house transactions ``provide the economic equivalent of
repos and reverse repos,'' and, like repurchase agreements with third
parties, preserve the ``integrity of the customer segregated account.''
\85\ The Commission further wrote that in-house transactions should not
disrupt FCMs and DCOs from maintaining ``sufficient value in the
account at all times.'' \86\ In the May 2009 ANPR, the Commission noted
that the recent events in the economy underscored the importance of
conducting periodic reassessments and refocused its review of permitted
investments, including in-house transactions.\87\
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\84\ 70 FR 28190, 28193.
\85\ 70 FR 28193. See also 70 FR 5577, 5581 (February 3, 2005).
\86\ 70 FR 28190, 28193.
\87\ 74 FR 23963, 23964.
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In the NPRM, the Commission proposed to eliminate in-house
transactions permitted under paragraph (a)(3) and subject to the
requirements of paragraph (e) of Regulation 1.25. The Commission noted
that ``[r]ecent market events have * * * increased concerns about the
concentration of credit risk within the FCM/broker-dealer corporate
entity in connection with in-house transactions.'' \88\ The Commission
requested comment on the impact of this proposal on the business
practices of FCMs and DCOs. Specifically, the Commission requested that
commenters present scenarios in which a repurchase or reverse
repurchase agreement with a third party could not be satisfactorily
substituted for an in-house transaction.
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\88\ 75 FR 67642, 67646.
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Six commenters discussed in-house transactions. Four requested that
in-house transactions be retained to some extent, while two supported
the Commission's proposal to eliminate in-house transactions.
FIA/ISDA, CME, MF Global/Newedge and MorganStanley recommended that
the Commission allow FCMs to engage in in-house transactions. FIA/ISDA
and CME suggested that the current terms of Regulation 1.25(e) should
be more than sufficient to assure that the customer segregated account
and the foreign futures and foreign options secured amount are
protected in the event of an FCM bankruptcy.\89\ MorganStanley wrote
that FCM efficiency relies heavily on in-house transactions,
particularly when customer margin is not appropriate for DCO margin. It
further stated that relying entirely on third party repurchase
agreements will materially increase operational risk in an area where
it is negligible today.\90\ According to MorganStanley,
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\89\ CME letter at 3, FIA/ISDA letter at 12.
\90\ MorganStanley letter at 2-3.
Because the in-house transaction can be effected and recorded
through book entries on the FCM/broker-dealer's general ledger, it
can be accomplished through automated internal processes that are
subject to a high level of control. The same is not routinely true
of third-party repurchase arrangements, which often involve greater
time lags than do in-house transactions between execution and
settlement and also typically require more manual processing than
their in-house counterparts.\91\
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\91\ Morgan Stanley letter at 2.
MorganStanley further noted that, as with the FCM of Lehman Brothers
Holdings Inc. (Lehman Brothers) in 2008, a third party custodial
arrangement is not without risk.\92\ MF Global/Newedge wrote that
removing in-house transactions would not reduce FCM risk, ``since FCMs
would be unable to enter into and execute such transactions with and
through entities and personnel with whom they have created an
effective, efficient and liquid settlement framework.'' \93\
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\92\ MorganStanley letter at 3-4.
\93\ MF Global/Newedge letter at 7.
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However, RJO stated that in-house transactions currently do not
provide ``protection to the capital base of the FCM arm of a dually
registered entity.'' \94\ Without ``ring fencing the capital associated
with the separately regulated business lines,'' RJO does not consider
in-house transactions to be satisfactory substitutes for separately
capitalized affiliates or third parties.\95\
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\94\ RJO letter at 3.
\95\ Id.
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CME and FIA/ISDA support retaining in-house transactions as they
currently are permitted under Regulation 1.25. MorganStanley suggested
retaining in-house transactions subject to a concentration limit of 25
percent of total assets held in segregation or secured amount; or if
the Commission is determined to eliminate in-house transactions,
raising the proposed concentration limit for reverse repurchase
agreements to 25 percent of total assets held in segregation or secured
amount.\96\ RJO, for the reasons noted above, and CIEBA, without
explanation, both support the proposal to remove in-house transactions
from the list of permitted investments.\97\
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\96\ MorganStanley letter at 4.
\97\ RJO letter at 3, CIEBA letter at 3.
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Many commenters to the NPRM similarly suggest that the benefits of
repurchase and reverse repurchase agreements can also be realized by
in-house transactions, without any decrease in safety to customer
funds. The Commission rejects this position. The Commission believes
that in-house transactions are fundamentally different than repurchase
or reverse repurchase agreements with third parties. In the case of a
reverse repurchase agreement, the transaction is similar to a
collateralized loan whereby customer cash is exchanged for unencumbered
collateral, both of which are housed in legally separate entities. The
agreement is transacted at arms-length (often by
[[Page 78783]]
means of a tri-party repo mechanism), on a delivery versus payment
basis, and is memorialized by a legally binding contract. By contrast,
in an in-house transaction, cash and securities are under common
control of the same legal entity, which presents the potential for
conflicts of interest in the handling of customer funds that may be
tested in times of crisis. Unlike a repurchase or reverse repurchase
agreement, there is no mechanism to ensure that an in-house transaction
is done on a delivery versus payment basis. Furthermore, an in-house
transaction, by its nature, is transacted within a single entity and
therefore cannot be legally documented, since an entity cannot contract
with itself (the most one could do to document such a transaction would
be to make an entry on a ledger or sub-ledger).
Other advocates of in-house transactions explained that in-house
transactions help them better manage their balance sheets. For example,
if a firm entered into a repurchase or reverse repurchase transaction
with an unaffiliated third party, the accounting of that transaction
may cause the consolidated balance sheet of the firm to appear larger
than if the transaction occurred in-house. In 2005, the Commission
wrote that in-house transactions could ``assist an FCM both in
achieving greater capital efficiency and in accomplishing important
risk management goals, including internal diversification targets.''
\98\ However, the purpose of Regulation 1.25 is not to assist FCMs and
DCOs with their balance sheet maintenance. The purpose of Regulation
1.25 is to permit FCMs and DCOs to invest customer funds in a manner
that preserves principal and maintains liquidity.
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\98\ 70 FR 28193; see also 70 FR 5581.
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The Commission reiterates that customer segregation is the
foundation of customer protection in the commodity, futures and swaps
markets. Segregation must be maintained at all times, pursuant to
Section 4d of the Act and Commission Regulation 1.20,\99\ and customer
segregated funds must be invested in a manner which preserves principal
and maintains liquidity in accordance with Regulation 1.25. As such,
the Commission must be vigilant in narrowing the scope of Regulation
1.25 if transactions that were once considered sufficiently safe later
prove to be unacceptably risky. Based on the concerns outlined above,
the Commission now believes that in-house transactions present an
unacceptable risk to customer segregated funds under Regulation 1.25.
The final regulation deletes paragraph (a)(3), as proposed.\100\
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\99\ 17 CFR 1.20.
\100\ Conversely, transactions that at one point in time are
considered to be unacceptably risky may later prove to be
sufficiently safe. Should any person, in the future, believe that
circumstances warrant reconsideration of the deletion of paragraph
(a)(3) regarding in-house transactions, such person may petition the
Commission for an amendment in accordance with the procedures set
forth in Regulation 13.2, 17 CFR 13.2. Such a petition may include
proposed conditions to the listing of in-house transactions as
permitted investments in order to address the concerns (e.g.,
concentration of credit risk within the FCM/broker-dealer corporate
entity, potential for conflicts of interest in handling customer
funds, etc.) that are the basis for the Commission's determination
to eliminate in-house transactions as permitted investments at this
time.
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For the removal of doubt, the Commission wishes to distinguish in-
house transactions from in-house sales of permitted investments. An in-
house transaction is an exchange of cash or permitted instruments, held
by a dually registered FCM/broker dealer, for customer funds. An in-
house sale is the legal purchase of a permitted investment, which may
be owned by a dually registered FCM/broker-dealer, with customer funds.
Such in-house sales of permitted investments at fair market prices are
acceptable and are unaffected by the elimination of in-house
transactions.
In addition, the Commission wishes to distinguish in-house
transactions from collateral exchanges for the benefit of the customer.
As described above, a dually registered FCM/broker-dealer may not
engage in in-house transactions, which are exchanges made at the
discretion of the dually registered entity. However, a dually
registered FCM/broker-dealer receiving customer collateral not
acceptable at the DCO or foreign board of trade may exchange that
collateral for acceptable collateral held by its dually registered
broker-dealer to the extent necessary to meet margin requirements.\101\
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\101\ FCMs, whether or not dually registered as broker-dealers,
may also engage in collateral exchanges for the benefit of customers
with affiliates or third parties.
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B. General Terms and Conditions
FCMs and DCOs may invest customer funds only in enumerated
permitted investments ``consistent with the objectives of preserving
principal and maintaining liquidity.''\102\ In furtherance of this
general standard, paragraph (b) of Regulation 1.25 establishes various
specific requirements designed to minimize credit, market, and
liquidity risk. Among them are requirements that the investment be
``readily marketable'' (a concept borrowed from SEC regulations), that
it meet specified rating requirements, and that it not exceed specified
issuer concentration limits. The Commission proposed and has decided to
amend these standards to facilitate the preservation of principal and
maintenance of liquidity by establishing clear, prudential standards
that further investment quality and portfolio diversification and to
remove references to credit ratings. The Commission notes that an
investment that meets the technical requirements of Regulation 1.25,
but does not meet the overarching prudential standard, cannot qualify
as a permitted investment.
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\102\ 17 CFR 1.25(b).
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1. Marketability
Regulation 1.25(b)(1) states that ``[e]xcept for interests in money
market mutual funds, investments must be `readily marketable' as
defined in Sec. 240.15c3-1 of this title.'' \103\ In the NPRM, the
Commission proposed to remove the ``readily marketable'' requirement
from paragraph (b)(1) of Regulation 1.25 and substitute in its place a
``highly liquid'' standard. The Commission proposed to define ``highly
liquid'' as having the ability to be converted into cash within one
business day, without a material discount in value. As an alternative,
the Commission offered a calculable standard, in which an instrument
would be considered highly liquid if there was a reasonable basis to
conclude that, under stable financial conditions, the instrument has
the ability to be converted into cash within one business day, without
greater than a one percent haircut off of its book value.
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\103\ See 17 CFR 240.15c3-1(c)(11)(i) (SEC regulation defining
``ready market'').
---------------------------------------------------------------------------
The Commission requested comment on whether the proposed definition
of ``highly liquid'' accurately reflected the industry's understanding
of that term, and whether the term ``material'' might be replaced with
a more precise or, perhaps, even calculable standard. The Commission
welcomed comment on the ease or difficulty in applying the proposed or
alternative ``highly liquid'' standards.
Six commenters mentioned the ``highly liquid'' definition. All six
supported the proposed, but not the alternative, standard.\104\ Several
noted that under the alternative standard, even some Treasuries would
likely fall outside of the scope of permitted investments. No
commenters provided more precise language than ``material'' or any
calculable option.
---------------------------------------------------------------------------
\104\ CME letter at 7, JAC letter at 1-2, FIA/ISDA letter at 3,
Farr Financial letter at 3, RJO letter at 7, BlackRock letter at 6.
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Certain commenters requested additional clarification. FIA/ISDA
wrote
[[Page 78784]]
that some liquid securities do not trade every day and requested that
the Commission confirm that, in determining whether a security is
highly liquid, an FCM may use, as a reference, securities that are
directly comparable, particularly for those issuers with many classes
of securities outstanding.\105\ FIA/ISDA also asked the Commission to
confirm that FCMs may rely on publicly available prices as well as
third party pricing vendors such as Bloomberg, TradeWeb, TRACE, IDCG
and MSRB.\106\ Additionally, JAC requested assurance that the highly
liquid standard will not be substituted for ``ready market'' in other
places in Commission regulations, in the Form 1-FR-FCM instructions, or
for offsets to debit/deficits on 30.7 statements.\107\
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\105\ FIA/ISDA letter at 3.
\106\ Id.
\107\ JAC letter at 2.
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The Commission has considered the comments received and concludes
that the ``readily marketable'' standard is no longer appropriate and
should be removed as it creates an overlapping and confusing standard
when applied in the context of the express objective of ``maintaining
liquidity.'' While ``liquidity'' and ``ready market'' appear to be
interchangeable concepts, they have distinctly different origins and
uses. The objective of ``maintaining liquidity'' is to ensure that
investments can be promptly liquidated in order to meet a margin call,
pay variation settlement, or return funds to the customer upon demand.
Meanwhile, the SEC's ``ready market'' standard is intended for a
different purpose (which is to set appropriate haircuts in order to
calculate capital) and is easier to apply to exchange-traded equity
securities than debt securities. The Commission is therefore adopting
the proposal and amending the text of Regulation 1.25(b)(1) to delete
``readily marketable'' and replace it with ``highly liquid,'' defined
as having the ability to be converted into cash within one business
day, without a material discount in value.
In response to FIA/ISDA's request for clarification, when
determining whether a security which does not trade every day is
sufficiently liquid, the Commission believes that an FCM may use any
data that reasonably provides evidence of liquidity. However, it is the
Commission's position that theoretical pricing data is not enough, on
its own, to establish that a security is highly liquid. FCMs seeking
pricing information should be able to use publicly-available as well as
third party pricing vendors. Finally, in response to JAC, the
Commission confirms that the ``highly liquid'' standard is for
Regulation 1.25 purposes only. This standard will not be substituted
for ``ready market'' elsewhere in Commission regulations at the present
time.
2. Ratings
Consistent with Section 939A of the Dodd-Frank Act, the Commission
is amending Regulation 1.25, as proposed, by removing all references to
ratings requirements.\108\ Only one commenter discussed ratings.
BlackRock cautioned that complete removal of ratings criteria as a risk
filter may place undue responsibility on an FCM or DCO to complete a
thorough risk assessment of an issuer's financial strength.\109\
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\108\ Section 939A(a) directs each Federal agency to review
their regulations for references to or requirements of credit
ratings and assessments of credit-worthiness. Section 939A(b)
states, in part, that ``each such agency shall modify such
regulation * * * to remove any reference to or requirement of
reliance on credit ratings and to substitute in such regulation such
standard of credit-worthiness as each respective agency shall
determine as appropriate for such regulations.'' See 75 FR 67254
(Nov. 2, 2010).
\109\ BlackRock letter at 2.
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The Commission notes that the removal of references to ratings does
not prohibit a DCO or FCM from taking into account credit ratings as
one of many factors to be considered in making an investment decision.
Rather, the presence of high ratings is not required and would not
provide a safe harbor for investments that do not satisfy the
objectives of preserving principal and maintaining liquidity.
3. Restrictions on Instrument Features
In the NPRM, the Commission proposed to amend Regulation
1.25(b)(3)(v) (as amended, Regulation 1.25(b)(2)(v)) by restricting CDs
to only those instruments which can be redeemed at the issuing bank
within one business day, with any penalty for early withdrawal limited
to accrued interest earned according to its written terms. Five
commenters discussed restrictions on the instrument features of CDs.
Four suggested that CDs be retained to varying degrees. One suggested
that CDs be removed from the list of permitted investments entirely.
On the subject of safety, MF Global/Newedge asserted that brokered
CDs are preferable to non-brokered CDs. In support of this conclusion,
MF Global/Newedge pointed out that brokered CDs receive price quotes,
are marked-to-market every day and have numerous buyers, while non-
brokered CDs have only one buyer, ``which creates significant
counterparty risk for FCMs purchasing such products.''\110\
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\110\ MF Global/Newedge letter at 7-8.
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ADM and RJO discussed the liquidity of the market for CDs. ADM
suggested that brokered CDs are liquid despite an inactive secondary
market.\111\ RJO averred that non-negotiable CDs were not intended for
institutional size transactions. RJO also predicted that this proposal
could severely limit the quantity and quality of banks willing to
accept the proposed stringent limitation on breakage fees.\112\
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\111\ ADM letter at 2. According to ADM, the inactivity of the
secondary market for CDs is due to the fact that most buyers hold
CDs to maturity. Id.
\112\ RJO letter at 6. However it should be noted that this
proposal does not alter Regulation 1.25 with regard to penalties;
therefore the Commission views this concern as unwarranted.
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MF Global/Newedge recommended that brokered CDs remain permitted;
however, if limits are to be imposed, they recommended (a) that issuers
of brokered CDs meet certain capital criteria or the CDs meet certain
float size thresholds, or (b) that FCMs be allowed to invest in
brokered CDs up to 50 percent of their portfolio and/or 10 percent with
any one issuer.\113\ MF Global/Newedge also suggested that the
Commission consider allowing brokered CDs with puts. Such an instrument
may be traded in the secondary market, but also may be put back to the
issuer.\114\ Rather than restricting negotiable CDs, ADM suggested that
the Commission restrict the allowable issuers of CDs using guidelines
that the Commission sees fit.\115\ Farr Financial recommended that
brokered CDs be allowed as long as they generally meet the criteria of
``highly liquid.''\116\ Farr Financial also suggested that the portion
of the proposed rule limiting penalties for early withdrawal to ``any
accrued interest earned'' be modified to account for the standard
practices of CD penalties. For example, Farr Financial stated that CDs
with a term of one year or less have an early withdrawal penalty of up
to 90 days of simple interest earned. For CDs with a term of more than
one year, typically the early withdrawal penalty is up to 180 days of
simple interest. CIEBA recommended eliminating investments in both
brokered and non-brokered CDs, without further explanation.\117\
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\113\ MF Global/Newedge letter at 8.
\114\ Id.
\115\ ADM letter at 2.
\116\ Farr Financial letter at 3.
\117\ CIEBA letter at 3.
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The Commission is adopting the proposed amendment to Regulation
1.25(b)(3)(v) (as amended, Regulation 1.25(b)(2)(v)) by restricting CDs
to only
[[Page 78785]]
those instruments which can be redeemed at the issuing bank within one
business day, with any penalty for early withdrawal limited to accrued
interest earned according to its written terms. The preservation of
customer principal and the maintenance of liquidity are the two
overriding determining factors in the permissibility of a CD for
purposes of Regulation 1.25.
Customer principal can be threatened by market fluctuations and
early redemption penalties. Unlike a non-brokered CD, the purchaser of
a brokered CD cannot, in most instances, redeem its interest from the
issuing bank. Rather, an investor seeking redemption prior to a CD's
maturity date must liquidate the CD in the secondary market. Depending
on the brokered CD terms (interest rate and duration) and the current
economic conditions, the market for a given CD can be illiquid and can
result in a significant loss of principal. Penalties for early
redemption may cut into customer principal unless such penalties are
limited, as they are in paragraph (b)(2)(v) of Regulation 1.25, to
accrued interest.\118\
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\118\ 17 CFR 1.25(b)(2)(v).
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The ability of a CD purchaser to redeem a CD at the issuing bank
within one day is the second key factor in determining whether a CD is
acceptable as a Regulation 1.25 investment. As noted above, the
purchaser of a brokered CD cannot, in most instances, redeem its
interest from the issuing bank. If the secondary market for a brokered
CD is illiquid, it can prevent FCMs and DCOs from retrieving customer
funds for the purpose of making margin calls.
In response to MF Global/Newedge's request for clarification, the
Commission notes that a brokered CD with a put option back to the
issuing bank is an acceptable investment, assuming that the issuing
bank obligates itself to redeem within one business day and that the
strike price for the put is not less than the original principal amount
of the CD.
4. Concentration Limits
Regulation 1.25(b)(4) currently sets forth issuer-based
concentration limits for direct investments, other than MMMFs, and
securities subject to repurchase or reverse repurchase agreements and
in-house transactions. In the NPRM, the Commission proposed to adopt
asset-based concentration limits for direct investments and a
counterparty concentration limit for reverse repurchase agreements in
addition to amending its issuer-based concentration limits and
rescinding concentration limits applied to in-house transactions.
(a) Asset-Based Concentration Limits
The Commission's proposed asset-based concentration limits would
restrict the amount of customer funds an FCM or DCO could hold in any
one class of investments, expressed as a percentage of total assets
held in segregation.
In the NPRM, the Commission proposed the following asset-based
limits: No concentration limit (100 percent) for U.S. government
securities; a 50 percent concentration limit for U.S. agency
obligations fully guaranteed as to principal and interest by the United
States; a 25 percent concentration limit for TLGP guaranteed commercial
paper and corporate notes or bonds; a 25 percent concentration limit
for non-negotiable CDs; a 10 percent concentration limit for municipal
securities; and a 10 percent concentration limit for interests in
MMMFs.
The Commission requested comment on whether asset-based
concentration limits are an effective means for facilitating investment
portfolio diversification and whether there are other methods that
should be considered. The Commission, in particular, sought opinions on
what alternative asset-based concentration limit might be appropriate
for MMMFs and, if such asset-based concentration limit is higher than
10 percent, what corresponding issuer-based concentration limit should
be adopted. The Commission also solicited comment on whether MMMFs
should be eliminated as a permitted investment.\119\ In discussing
whether MMMF investments satisfy the overall objective of preserving
principal and maintaining liquidity, the Commission specifically
requested comment on whether changes in the settlement mechanisms for
the tri-party repo market might impact an MMMF's ability to meet the
requirements of Regulation 1.25.\120\ The Commission requested comment
on whether MMMF investments should be limited to Treasury MMMFs, or to
those MMMFs that have portfolios consisting only of permitted
investments under Regulation 1.25.\121\
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\119\ Comment request appears in section II.A of the NPRM. See
75 FR at 67646.
\120\ Id.
\121\ Comment request appears in section II.C of the NPRM. See
75 FR at 67649.
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Eighteen comment letters discussed MMMFs. The overwhelming majority
of comments focused on the proposed limitations on MMMFs, which many in
the industry believed to be ``arbitrary and unduly severe.'' \122\
According to Federated, the Dodd-Frank Act ``represents the collective
effort of Congress and the executive branch to prevent a repetition of
the activities largely confined to the financial services sector that
precipitated the domino effect of the failure of a large systemically
risky company, such as Lehman Brothers, that led to the events at the
Reserve Primary Fund.'' \123\ Federated further asserted that unless
the Commission does not believe that Congress' ``efforts were
successful, the proposed limitations on [MMMFs] are unduly restrictive
and unwarranted.'' \124\ Commenters discussed a variety of topics
including the safety of MMMFs, the recent enhancements to SEC Rule 2a-
7, a comparison of the safety of MMMFs to other permitted investments,
the appropriate concentration limits for MMMFs, and potential problems
that would arise as a result of a 10 percent concentration limit, among
other comments.
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\122\ ICI letter at 2.
\123\ Federated I letter at 6. The Commission notes that the
Reserve Primary Fund (Reserve Primary) was an MMMF that satisfied
the enumerated requirements of Regulation 1.25 and at one point was
a $63 billion fund. Reserve Primary's ``breaking the buck,'' in
September 2008, called attention to the risk to principal and
potential lack of sufficient liquidity of any MMMF investment.
\124\ Federate I letter at 6.
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First, commenters stressed that MMMFs are safe, liquid investments,
comprising roughly $3-4 trillion in assets \125\ and representing
approximately 25 percent of the total assets in registered investment
companies in the United States. Commenters noted that only two funds in
the 40-year history of MMMFs have failed to return $1 per share to
investors (and those funds returned more than 99 cents and 96 cents on
the dollar, respectively).\126\
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\125\ Federated estimated $2.8 trillion. Federated I letter at
2. UBS noted a figure of $3.8 trillion as of May 2009. UBS letter at
6.
\126\ Federated I letter at 1, CME letter at 4-5, J.P. Morgan
letter at 1-2, Farr Financial letter at 1, UBS letter at 2.
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According to many of the comment letters, the recent enhancements
to SEC Rule 2a-7 have made MMMFs even safer and more prepared to
withstand heavy redemption requests during a crisis. In this regard,
heightened credit quality and shortened maturity limits increase
liquidity, \127\ as does a requirement that 10 percent of assets be in
cash, Treasuries or securities that
[[Page 78786]]
convert into cash within one day. The SEC has increased the
transparency of MMMFs by requiring that MMMFs provide portfolio
information, updated monthly, on their Web sites. In addition, MMMFs
are now required to conduct periodic stress tests, which examine an
MMMF's ability to maintain a stable net asset value under hypothetical
market conditions.\128\
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\127\ ICI letter at 4. ICI noted that the weighted average
maturity (WAM) for MMMFs has been reduced from 90 to 60 days. As a
result 60 percent of MMMFs have a WAM of 45 days or less. In
contrast, more than half of all MMMFs had a WAM of greater than 45
days prior to the SEC's amendments to its Rule 2a-7.
\128\ CME letter at 4-5, Federated I letter at 1, FIA/ISDA
letter at 6-8, MF Global/Newedge letter at 6, J.P. Morgan letter at
1-2, UBS letter at 2-4, Dreyfus letter at 2, RJO letter at 7-8,
INTL/FCStone letter at 2, BlackRock letter at 2-4, ADM letter at 1,
BNYM letter at 2-3, BLS letter at 2.
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Second, many commenters compared the safety of MMMFs to that of one
or more other permitted investments. Six commenters averred that MMMFs
are safer than Treasuries.\129\ One commenter argued that municipal
bonds are less liquid than MMMFs.\130\ Two commenters argued that MMMFs
were better investments than TLGP debt.\131\ Five commenters wrote that
MMMFs compared favorably with CDs.\132\
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\129\ CME letter at 6, Farr Financial letter at 2, ICI letter at
7, Dreyfus letter at 4, ADM letter at 3, Federated II letter (Bilson
essay at 8).
\130\ Dreyfus letter at 4.
\131\ UBS letter at 6, Dreyfus letter at 4.
\132\ Federated I letter at 1, CME letter at 4-5, MF Global/
Newedge letter at 6, UBS letter at 5, 7, Dreyfus letter at 4.
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Third, many commenters suggested that a 10 percent MMMF limitation
would cause some inconsonant and unintended results. CME stated that,
in theory, Regulation 1.25 as proposed would permit over 50 percent of
a customer funds portfolio to be invested in TLGP securities, municipal
securities and non-negotiable CDs. In practice, however, FCMs' use of
these investment categories is limited.\133\ ICI wrote that an
incongruity exists where an FCM may invest all of its assets in a self-
managed portfolio of Treasuries, but may only invest 10 percent of its
assets in an MMMF consisting of the same securities.\134\ Federated
expressed views similar to those of ICI, writing that investments in
government funds should not be subject to any concentration limits.
Federated also recommended that the Commission require that MMMFs
maintain certain minimum financial thresholds in order to qualify as a
Regulation 1.25 investment. Federated suggested, as thresholds, that an
MMMF should manage assets of at least $10 billion and that the MMMF's
management company should manage assets of at least $50 billion.\135\
Dreyfus noted that, under the proposal, an FCM may construct a pool of
individual securities outside the constraints of SEC Rule 2a-7 which
would have maturities of longer than those required of MMMFs.
Therefore, greater interest rate risk might be associated with a self-
managed portfolio than with the portfolio in an MMMF.\136\ The decrease
in MMMF investment might lead more funds to be held in cash in banks
(with only $250,000 FDIC insurance).\137\ According to Farr Financial,
another possible result of a 10 percent limitation on MMMFs is that
FCMs and DCOs would hold a large amount of Treasuries, and, in the
event that an FCM or DCO would need to liquidate such Treasuries, would
experience potential loss in the secondary market.\138\ BlackRock wrote
that an overreliance on Treasuries and government securities would
place portfolios in greater danger due to changes to interest rates.
For example, a sudden rise in interest rates may negatively impact the
principal valuation of Treasuries.\139\ If liquidation is required
during such a circumstance, FCMs may experience a loss in
principal.\140\
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\133\ CME letter at 6.
\134\ ICI letter at 8.
\135\ Federated III letter at 2-3.
\136\ Dreyfus letter at 2.
\137\ As pointed out by Farr Financial, FDIC insurance passes
through to an FCM's customers. See Farr Financial letter at 2-3.
\138\ Farr Financial letter at 2.
\139\ BlackRock letter at 2, 5.
\140\ Id.
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Fourth, several commenters highlighted other potential difficulties
that could result from the proposed 10 percent concentration limit,
including issues of diversification, self-management and liquidity. The
NFA warned that by limiting investment in MMMFs and other instruments,
the Commission risks decreasing diversification rather than increasing
it.\141\ Along similar lines, ICI stated that the average MMMF is more
diversified than the portfolio of bank CDs or municipal securities that
FCMs or DCOs would be permitted to hold under the proposed
amendments.\142\
---------------------------------------------------------------------------
\141\ NFA letter at 2.
\142\ ICI letter at 10.
---------------------------------------------------------------------------
Three commenters discussed the problems that arise from self-
managed accounts. ICI, Dreyfus and BNYM suggest that by limiting MMMFs
to 10 percent, the Commission would be forcing FCMs and DCOs to manage
90 percent of their portfolios themselves. Investments in TLGP debt,
CDs and municipals require asset management skills that FCMs and DCOs
might not have without hiring an investment adviser. While some FCMs
and DCOs may be large enough to do this, many are not--and requiring
FCMs to ``go it alone'' will cause customer funds to be at greater
risk.\143\ ADM wrote that because intraday settlements from clearing
organizations are not known until 12 noon CST or later, it would be
difficult to maintain sufficient liquid assets without the use of
MMMFs.\144\
---------------------------------------------------------------------------
\143\ ICI letter at 6-8, Dreyfus letter at 4, BNYM letter at 2-
3.
\144\ ADM letter at 1.
---------------------------------------------------------------------------
In response to the Commission's request for comment on the proposed
changes in the tri-party repo market, which have not been fully
implemented, ICI wrote that the changes would allow sellers in tri-
party repurchase agreements to repurchase the underlying securities
later in the afternoon. Previously, such sellers would repurchase
securities in the morning using funds borrowed from their clearing
banks. The proposed changes should not, according to ICI, adversely
affect an MMMF's ability to pay redemptions by the end of each day.
Because the repurchases would occur while the Fedwire system is open,
MMMFs can transfer the proceeds to their transfer agents to cover daily
redemptions.\145\
---------------------------------------------------------------------------
\145\ ICI letter at 12.
---------------------------------------------------------------------------
The NPRM also requested comment on whether, or to what extent,
MMMFs ought to be limited to Treasury funds. Dreyfus stated that it
would not support such a limitation, as it believes that Government,
prime, and municipal MMMFs are subject to sufficient risk-limiting
constraints that merit their availability to FCMs and DCOs.\146\
Treasury funds are traditionally smaller in size and less liquid than
prime MMMFs, according to FIA/ISDA.\147\ RJO wrote that because
Treasury funds lag interest rate movements for significant periods of
time, they are likely not viable options for FCMs in upward interest
rate environments or over long periods of time.\148\ Taking a different
position, BlackRock suggested that Treasury MMMFs should be exempt from
any asset-based limitations instituted by the Commission.\149\ In
addition, BlackRock recommended that the Commission require investment
decision-makers at FCMs to perform periodic assessments of their MMMF
providers.\150\
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\146\ Dreyfus letter at 2.
\147\ FIA/ISDA letter at 8.
\148\ RJO letter at 8.
\149\ BlackRock letter at 4.
\150\ BlackRock letter at 2, 5.
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CIEBA would support limiting MMMFs to only those funds which invest
in securities that would be permitted investments under Regulation
1.25.\151\ CIEBA did not include further discussion or explanation.
---------------------------------------------------------------------------
\151\ CIEBA letter at 3.
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[[Page 78787]]
As noted above, the Commission proposed a 10 percent asset-based
concentration limit for investments in MMMFs. In response to comments,
the Commission has decided to revise the rule language that was
proposed. Specifically, the Commission will impose different
concentration limits for investments in Treasury-only funds than for
investments in all other MMMFs. The Commission also will distinguish
between funds that do not have both $1 billion in assets and a
management company that has at least $25 billion in MMMF assets under
management (small MMMFs) and those that do (large MMMFs). Federated, as
noted above, recommended that asset thresholds for MMMFs be set at $10
billion and $50 billion, respectively. However, the Commission
believes, at this time, that such thresholds may needlessly constrain
the pool of MMMFs available for investment and result in an unsafe
concentration of customer funds in a limited number of MMMFs. The
modifications to the proposed rule text discussed below reflect the
Commission's consideration of the comments received on the proposed
concentration limit for investments in MMMFs, in light of the
overarching objective of preserving principal and maintaining liquidity
of customer funds.
First, an FCM or DCO may invest all of its customer segregated
funds in Treasury-only MMMFs, subject to the limitation on investment
in small MMMFs discussed below. The Commission agrees with commenters
that since an FCM or DCO may invest all of its funds in Treasuries
directly, an FCM or DCO therefore should be able to make the same
investment indirectly via an MMMF.
Second, for all other MMMFs, the Commission believes that a 50
percent asset-based concentration limit is appropriate, subject to the
limitation on investment in small MMMFs discussed below. After
considering the views presented by market participants, Commission
staff and other regulators, the Commission has determined that a 50
percent asset-based concentration limit strikes the right balance
between providing FCMs and DCOs with sufficient Regulation 1.25
investment options and, at the same time, encouraging adequate
portfolio diversification.
MMMFs' portfolio diversification, administrative ease, and the
heightened prudential standards recently imposed by the SEC, continue
to make them an attractive investment option. However, their volatility
during the 2008 financial crisis, which culminated in one fund
``breaking the buck'' and many more funds requiring infusions of
capital, underscores the fact that investments in MMMFs are not without
risk. The Commission is persuaded to increase the proposed asset-based
concentration limit for MMMFs, other than Treasury-only MMMFs, from 10
percent to 50 percent in part by commenters who noted that MMMFs are
safe and liquid relative to other permitted investments.\152\
Commenters were persistent in reminding the Commission that, aside from
Reserve Primary, no MMMFs had ``broken the buck'' during the 2008
financial crisis and aftermath. The Commission is also cognizant that
decreasing the number of investment options might have the unintended
consequence of over-concentrating customer funds into a small universe
of viable investments. Further, these concentration limits provide FCMs
and DCOs with the ability to delegate investment decisions for their
entire portfolio of customer segregated funds to MMMFs, should the FCMs
and DCOs not wish to make such decisions on their own.
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\152\ Although MMMFs allow FCMs and DCOs to indirectly invest in
instruments which would not be permitted under Regulation 1.25 as
direct investments, the Commission believes that the credit quality,
maturity limitations and liquidity required by the SEC make prime
MMMFs acceptable investments, subject to the concentration limits
imposed by paragraph (b)(3).
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To the extent that an FCM or DCO invests customer segregated funds
in an MMMF, subject to the asset-based concentration limits outlined
above, the FCM or DCO may only invest up to 10 percent of its
segregated funds in small MMMFs. The Commission believes that
distinguishing between small MMMFs and large MMMFs is a necessary
corollary to increasing the concentration limits proposed in the NPRM,
since large MMMFs have capital bases better capable of handling a high
volume of redemption requests in the event of a market event. To the
extent that an FCM or DCO invests customer segregated funds in small
MMMFs, the 10 percent asset-based concentration limit in the final rule
is unchanged from the concentration limit set forth in the NPRM.
However, having considered the comments received on this issue, the
Commission has determined it appropriate to elevate the asset-based
concentration limits from what had been proposed--both for Treasury-
only MMMFs and for all other MMMFs--to the extent that an FCM or DCO
invests in large MMMFs.
Accordingly, the Commission is amending Regulation 1.25 by adding
new paragraphs (b)(3)(i)(E)-(G), which implement the changes described
above. The addition of these paragraphs enables the Commission to
increase the concentration limits originally proposed without
undermining the protection of customer funds and reduction of systemic
risk, while addressing the concerns specifically raised in the
comments.
The Commission has concluded that all other asset-based
concentration limits remain as proposed in the NPRM. The 50 percent
asset-based limitation on U.S. agency obligations \153\ and the 25
percent asset-based limitation on each of TLGP corporate notes or bonds
and TLGP commercial paper,\154\ are consistent with commenter
recommendations. Therefore, the Commission is amending Regulation
1.25(b)(3)(i), as proposed, to reflect the asset-based concentration
limits described above.
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\153\ See Section II.A.1. CME recommended 25 percent, BlackRock
recommended 30 percent, and FIA/ISDA and MF Global/Newedge both
recommended 50 percent.
\154\ See Section II.A.2. MF Global/Newedge recommended 25
percent and BlackRock recommended 25 percent-50 percent. The
Commission is aware that MF Global/Newedge's recommendation was for
all corporate notes or bonds and commercial paper--not merely those
which are TLGP debt. Regardless, such a recommendation is helpful in
establishing a percentage that will allow for ample investment in
instrument categories while still promoting diversification.
---------------------------------------------------------------------------
With respect to the calculation of concentration limits, ADM wrote
that concentration limits should be calculated by aggregating
Regulation 1.25 funds and 30.7 funds.\155\ ADM explained, by way of
example, that if there is a 50 percent concentration limit for
investment X, along with $5 billion in the segregated account and $1
billion in the 30.7 account, that the maximum amount that could be
invested in X would be $3 billion. From this comment, the Commission
concludes that ADM would like the choice of investing up to 60 percent
of its segregated account funds in investment X, as long as that
amount, when combined with the size of the 30.7 account, does not
exceed 50 percent of the cumulative size of the segregated and 30.7
account. However, the Commission has determined that concentration
limits are to be calculated on a fund-by-fund basis. In the example
above, the maximum amount of segregated funds that could be invested in
X would be $2.5 billion, and the maximum amount of 30.7 funds that
could be invested in X would be $0.5 billion. ADM presented no
compelling argument as to why the aggregation of
[[Page 78788]]
funds held in Regulation 1.25 and 30.7 accounts should be permitted.
---------------------------------------------------------------------------
\155\ ADM letter at 2.
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(b) Issuer-Based Concentration Limits
The Commission proposed to amend its issuer-based limits for direct
investments to include a 2 percent limit for an MMMF family of funds,
expressed as a percentage of total assets held in segregation.
Currently, there is no concentration limit applied to MMMFs. Under the
NPRM, the 25 percent issuer-based limitation for GSEs (now proposed to
be encompassed within the term ``U.S. agency obligations'') and the 5
percent issuer-based limitation for municipal securities, commercial
paper, corporate notes or bonds, and CDs would remain in place.
Commenters expressed doubts over whether issuer-based concentration
limits, on individual or families of MMMFs, would have a meaningful,
positive effect on the safety of customer funds. Adverse market
conditions would probably affect all funds, according to ICI, and
therefore issuer concentration limits would do little to mitigate these
risks.\156\
---------------------------------------------------------------------------
\156\ ICI letter at 11.
---------------------------------------------------------------------------
BlackRock, ICI and Dreyfus suggested that limits on family of funds
may not achieve increased safety of customer funds as each MMMF in a
family is managed on an individual basis and will not necessarily share
risks with other MMMFs managed by the same adviser. Dreyfus wrote that
it sees ``no benefit * * * to requiring FCMs to have to potentially
invest in a [prime MMMF] with one provider and a [government or
Treasury MMMF] with another provider, on the basis that such an
arrangement is safer than if the FCM invested in each of these types of
funds with a single provider.'' \157\ BlackRock also noted that MMMF
complexes do not typically aggregate and publish consolidated family
data on a daily basis.\158\
---------------------------------------------------------------------------
\157\ Dreyfus letter at 5. See also ICI letter at 10.
\158\ BlackRock letter at 4.
---------------------------------------------------------------------------
Commenters also questioned the effectiveness of issuer-based
limitations on individual funds. Dreyfus asserted that the operations
and results of one fund do not impact the operation and results of
another fund.\159\ ICI propounded that similar types of MMMFs often
have common holdings. Thus, according to ICI, limiting investments in
individual funds will have a marginal effect on the diversification of
underlying credit risks.\160\
---------------------------------------------------------------------------
\159\ Dreyfus letter at 5.
\160\ ICI letter at 10-11.
---------------------------------------------------------------------------
Taken as a whole, these arguments, that concentration limits will
not increase the safety of customer funds, are untenable. The
commenters assert that neither family-of-funds limits nor issuer-based
limits will increase the diversification and safety of customer funds.
If believed, this leads to the conclusion that it would be safer and
more diverse (or at least as safe and diverse) for an FCM, investing
the maximum amount in MMMFs, to invest all customer cash in one fund
than it would be for that FCM to invest that customer cash among five
funds in three families. As such, the Commission is not persuaded by
the arguments.\161\
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\161\ In response to Dreyfus and ICI's comment regarding limits
on family of funds, the Commission believes that a failure of, or a
run on, an individual fund would likely cause a run on other funds
in the family due to investors' reputational concerns.
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The Commission has considered the comments received on this issue,
and is mindful of the comments and Commission analysis of the asset-
based concentration limits discussed in the preceding section. Having
considered the arguments raised, the Commission has decided to revise
the rule language that was proposed. Specifically, the Commission has
determined that there will be no family-of-funds or issuer-based
concentration limit for MMMFs that consist entirely of Treasuries, and
a 25 percent family of funds issuer-based limitation as well as a 10
percent individual fund issuer-based limitation for all other MMMFs.
Investments in Treasury-only funds are not to be combined with
investments in other MMMFs for purposes of calculating either family-
of-funds or issuer-based concentration limits. The increase in the
family of funds issuer-based concentration limit is related to the
increase in the asset-based concentration limit and addresses the
recommendations of commenters. The introduction of the 10 percent
individual fund issuer-based concentration limit serves to add an
additional layer of diversification and also aligns with
recommendations of commenters.
(c) Counterparty Concentration Limits
In the NPRM, the Commission proposed a counterparty concentration
limit of 5 percent of total assets held in segregation for securities
subject to reverse repurchase agreements. Seven commenters discussed
counterparty concentration limits. All expressed their belief that the
5 percent concentration limit was too low and that such a limit would
greatly increase administrative risks and costs. Most commenters
favored a 25 percent concentration limit, in the event that a
concentration limit was imposed.
FIA/ISDA, LCH, MF Global/Newedge, J.P. Morgan and RJO expressed
similar views that a 5 percent concentration limit might actually
decrease liquidity and increase operational and systemic risk. LCH and
MF Global/Newedge wrote that a counterparty concentration limit would
unnecessarily restrict a very liquid and secure investment that has
provided flexibility and reasonable returns to FCMs and their
customers.\162\ According to FIA/ISDA, because clearing members are
often required to execute and unwind reverse repurchase agreements
intraday and within a brief period of time, and because DCOs strictly
define the securities they will accept as collateral, an FCM must
review the securities received under reverse repurchase transactions to
ensure that they are both eligible for delivery to the DCO and in
compliance with applicable concentration limits.\163\ Several
commenters observed that requiring an FCM to effect reverse repurchase
transactions with multiple counterparties under tight time frames will
substantially increase an FCM's operational risk and invite
errors.\164\ By way of example, INTL/FCStone noted that it currently
has one counterparty and would potentially need to open 20 reverse
repurchase accounts were the proposed rule enacted.\165\ Further, two
commenters wrote that a critical factor to consider is that, in the
event of a counterparty's default, all amounts are collateralized with
permitted investments under Regulation 1.25.\166\
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\162\ LCH letter at 3, MF Global/Newedge letter at 6.
\163\ FIA/ISDA letter at 9-10.
\164\ FIA/ISDA letter at 9-10, MF Global/Newedge letter at 7,
J.P. Morgan letter at 2, LCH letter at 3, RJO letter at 3.
\165\ INTL/FCStone at 2.
\166\ LCH letter at 3, MF Global/Newedge letter at 7.
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INTL/FCStone \167\ and FIA/ISDA \168\ recommended a 25 percent
counterparty concentration limit. RJO wrote that limits are
unnecessary--however if a limit were imposed, RJO recommended 25
percent.\169\ LCH suggested a 10 percent-20 percent limitation.\170\ MF
Global/Newedge recommended having no counterparty limits; however to
the extent that there must be, it recommended (a) limiting FCM
repurchase and reverse repurchase transactions to those external
counterparties maintaining a certain level of capital (such as $50 or
$100
[[Page 78789]]
million) or (b) setting counterparty concentration limits at 25
percent.\171\ ADM wrote that it does not believe any concentration
limit is necessary due to the collateralized nature of the loans.\172\
However, ADM stated that it would support only allowing certain
collateral, such as Treasuries and GSEs, in repurchase
transactions.\173\
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\167\ INTL/FCStone at 2.
\168\ FIA/ISDA letter at 10.
\169\ RJO letter at 3.
\170\ LCH letter at 3.
\171\ MF Global/Newedge letter at 7.
\172\ ADM letter at 2.
\173\ Id.
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As noted above, the Commission proposed a 5 percent counterparty
concentration limit in the NPRM. Having considered the comments
submitted in response to the proposal, the Commission has determined
that a 25 percent counterparty concentration limit is appropriate.
The Commission continues to believe that counterparty concentration
limits are necessary for safeguarding customer funds. Under current
rules, an FCM or DCO could have 100 percent of its segregated funds
subject to one reverse repurchase agreement. The obvious concern in
such a scenario is the credit risk of the counterparty. This credit
risk, while concentrated, is significantly mitigated by the fact that
in exchange for cash, the FCM or DCO is holding Regulation 1.25-
permitted securities of equivalent or greater value. However, a default
by the counterparty would put pressure on the FCM or DCO to convert
such securities into cash immediately and would exacerbate the market
risk to the FCM or DCO, given that a decrease in the value of the
security or an increase in interest rates could result in the FCM or
DCO realizing a loss. Even though the market risk would be mitigated by
asset-based and issuer-based concentration limits, a situation of this
type could seriously jeopardize an FCM or DCO's overall ability to
preserve principal and maintain liquidity with respect to customer
funds.
The Commission is persuaded to increase the limit, from the
proposed level of 5 percent in the NPRM to 25 percent, primarily due to
comments expressing concern about the administrative costs and burdens
of a low counterparty concentration limit. Whereas a 5 percent
limitation would require an FCM reverse-repurchasing all of its
customer cash to have 20 counterparties, a 25 percent limitation
decreases the number of counterparties to four. Further, 25 percent is
in line with commenter recommendations, which ranged from 10 to 25
percent.\174\
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\174\ As noted above, certain commenters wished to have no
counterparty concentration limits, a position with which the
Commission does not agree.
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C. Money Market Mutual Funds
The Commission has decided to make two technical amendments to
paragraph (c) of Regulation 1.25. First, the Commission is clarifying
the acknowledgment letter requirement under paragraph (c)(3); and
second, the Commission is revising and clarifying the exceptions to the
next-day redemption requirement under paragraph (c)(5)(ii).
1. Acknowledgment Letters
In the NPRM, the Commission sought to clarify that the intent of
Regulation 1.25(c)(3) is to require that an FCM or DCO obtain an
acknowledgment letter from a party that has substantial control over a
fund's assets and has the knowledge and authority to facilitate
redemption and payment or transfer of the customer segregated funds
invested in shares of the MMMF. The Commission concluded that in many
circumstances, the fund sponsor, the investment adviser, or fund
manager would satisfy this requirement. The Commission also proposed to
remove the current language in Regulation 1.25(c)(3) relating to the
issuer of the acknowledgment letter when the shares of the fund are
held by the fund's shareholder servicing agent. This revision was
designed to eliminate any confusion as to whether the acknowledgment
letter requirement is applied differently based on the presence or
absence of a shareholder servicing agent.
The Commission requested comment on whether the proposed standard
for entities that may sign an acknowledgment letter is appropriate and
whether there are other entities that could serve as examples. The
Commission requested comment on whether removal of the ``shareholder
servicing agent'' language helps clarify the intent of Regulation
1.25(c)(3).
Three commenters discussed this proposal. CME, BBH and FIA/ISDA
support the proposal, and FIA/ISDA and BBH had additional comments and
suggested changes as well.\175\
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\175\ CME letter at 7, FIA/ISDA letter at 13, BBH letter at 2.
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BBH and FIA/ISDA requested that the Commission confirm that, in
those circumstances in which an FCM deposits customer funds with a bank
or other depository and thereafter instructs the bank to invest such
customer funds in an MMMF, the bank is the appropriate entity from
which the FCM should obtain the acknowledgment letter.\176\ BBH
explained that such settlement banks are ``universally recognized, both
by regulation and standard contractual terms, as an entity that
exercises legitimate control and authority over assets deposited both
directly with it or held in an account at a third party depository or
fund.'' \177\
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\176\ BBH letter at 2, FIA/ISDA letter at 13.
\177\ BBH letter at 2.
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The Commission is amending Regulation 1.25(c)(3) to reflect that an
FCM or DCO must obtain an acknowledgment letter from a party that has
substantial control over MMMF shares purchased with customer segregated
funds and has the knowledge and authority to facilitate redemption and
payment or transfer of the customer segregated funds invested in shares
of the MMMF and is removing the current language in Regulation
1.25(c)(3) relating to the issuer of the acknowledgment letter when the
shares of the fund are held by the fund's shareholder servicing agent.
In response to FIA/ISDA and BBH, the Commission agrees that when an FCM
deposits customer funds in a bank or other depository and thereafter
instructs the depository to invest such customer funds in an MMMF, the
acknowledgment letter may come from the depository if it is acting as a
custodian for the fund shares owned by the FCM or DCO. The Commission
therefore clarifies in the rule text that a ``depository acting as
custodian for fund shares'' is an appropriate entity to issue an
acknowledgment letter.
2. Next-Day Redemption Requirement
Regulation 1.25(c) requires that ``[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.'' \178\
This ``next-day redemption'' requirement is a significant feature of
Regulation 1.25 and is meant to ensure adequate liquidity.\179\
Regulation 1.25(c)(5)(ii) lists four exceptions to the next-day
redemption requirement, and incorporates by reference the emergency
conditions listed in Section 22(e) of the Investment Company Act
(Section 22(e)).\180\ The Commission has, on occasion, fielded
questions from FCMs regarding Regulation 1.25(c)(5), particularly
because the exceptions listed in paragraph (c)(5)(ii) overlap with some
of those appearing in Section 22(e).
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\178\ 17 CFR 1.25(c)(5)(i).
\179\ See 70 FR 5585 (noting that ``[t]he Commission believes
the one-day liquidity requirement for investments in MMMFs is
necessary to ensure that the funding requirements of FCMs will not
be impeded by a long liquidity time frame'').
\180\ 15 U.S.C. 80a-22(e).
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[[Page 78790]]
In order to expressly incorporate SEC Rule 22e-3 into the permitted
exceptions for purposes of clarity, and to otherwise clarify the
existing exceptions to the next-day redemption requirement, the
Commission proposed to amend paragraph (c)(5)(ii) of Regulation 1.25 by
more closely aligning the language of that paragraph with the language
in Section 22(e) and specifically including a reference to Rule 22e-3.
The Commission proposed to include, as an appendix to the rule text
(Regulation 1.25 Appendix), safe harbor language that could be used by
MMMFs to ensure that their prospectuses comply with Regulation
1.25(c)(5).
The Commission requested comment on all aspects of its proposed
amendments to the provisions regarding MMMFs in paragraph (c) of
Regulation 1.25. The Commission sought comment specifically on any
proposed regulatory language that commenters believe requires further
clarification. In addition, commenters were invited to submit views on
the usefulness and substance of the proposed safe harbor language
contained in the proposed Regulation 1.25 Appendix.
Only one commenter, ICI, mentioned this aspect of the NPRM. ICI
supported this proposal to clarify exemptions from next-day redemption
and to include safe harbor language.\181\ Therefore, the Commission
amends paragraph (c)(5)(ii) of Regulation 1.25 by more closely aligning
the language of that paragraph with the language in Section 22(e) and
specifically including a reference to Rule 22e-3. The Commission is
also adding the Regulation 1.25 Appendix to the rule text, in order to
provide MMMFs with safe harbor language to ensure that their
prospectuses comply with Regulation 1.25(c)(5).
---------------------------------------------------------------------------
\181\ ICI letter at 11.
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D. Repurchase and Reverse Repurchase Agreements
The Commission proposed specifically eliminating repurchase and
reverse repurchase transactions with affiliate counterparties.
Repurchase and reverse repurchase transactions are functionally similar
to collateralized loans, whereby cash is exchanged for unencumbered
collateral. In the NPRM, the Commission explained its view that the
concentration of credit risk increases the likelihood that the default
of one party could exacerbate financial strains and lead to the default
of its affiliate. The Commission used the example of Bear Stearns
Companies, Inc. (Bear Stearns) in 2008 \182\ to illustrate that even
possession and control of liquid securities may be insufficient to
alleviate concerns relating to transactions with financially troubled
affiliated counterparties.
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\182\ See SEC Press Release No. 2008-46, ``Answers to Frequently
Asked Investor Questions Regarding the Bear Stearns Companies,
Inc.'' (Mar. 18, 2008), available at http://www.sec.gov/news/press/2008/2008-46.htm (noting that rumors of liquidity problems at Bear
Stearns caused their counterparties to become concerned, creating a
``crisis of confidence'' which led to the counterparties'
``unwilling[ness] to make secured funding available to Bear Stearns
on customary terms'').
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The Commission received four comment letters discussing this topic.
CME and FIA/ISDA both suggested that FCMs have much greater certainty
and are exposed to substantially less counterparty risk to the extent
that they enter into transactions with affiliates.\183\ FIA/ISDA stated
that funds held in affiliate accounts are at no greater risk in the
event of a default than they would be in the event of a default of a
non-affiliate. In both cases, the requirements of Regulation 1.25(d)
are the same. Further, FIA/ISDA wrote that the Bear Stearns example
used by the Commission in the NPRM relates to Bear Stearns' abilities
to enter into agreements with third parties, not its affiliates.\184\
RJO noted that affiliates should be judged as acceptable if the
affiliate meets or exceeds the capital base or some other methodology
deemed satisfactory for adding an arms-length counterparty.\185\ MF
Global/Newedge wrote that removing repurchase agreements with
affiliates would not reduce FCM risk, ``since FCMs would be unable to
enter into and execute such transactions with and through entities and
personnel with whom they have created an effective, efficient and
liquid settlement framework.'' \186\
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\183\ CME letter at 3, FIA/ISDA letter at 9-11.
\184\ FIA/ISDA letter at 10-11.
\185\ RJO letter at 4.
\186\ MF Global/Newedge letter at 7.
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The Commission is not persuaded by these comments. In particular,
while the Commission acknowledges that affiliates have a legal status
that may distinguish such transactions from in-house transactions, the
concentration of credit risk and the potential for conflicts of
interest during times of crisis remain significant concerns. Indeed,
the Commission's reference to Bear Stearns in the preamble was intended
to serve as an illustration of how an elevated concentration of credit
risk may produce broad, unforeseen consequences.
Further, as discussed in the NPRM, the interest of consistency of
the regulation weighs in favor of disallowing repurchase agreements
between affiliates. The Commission finds it incongruous that an
investment in the debt instrument of an affiliate (effectively a
collateralized loan between affiliates) could be prohibited by
paragraph (b)(6) while a repurchase agreement between affiliates (which
is the functional equivalent of a short-term collateralized loan
between affiliates) could be allowed.
Finally, the Commission believes that firms engage in repurchase
agreements with affiliates for purposes of balance sheet maintenance.
Repurchase agreements with affiliates may cause a consolidated balance
sheet to appear smaller than it would if the same transaction occurred
with an unaffiliated third party because such transactions, while they
may appear on sub-ledgers, are typically eliminated on the consolidated
balance sheet. While FCMs and DCOs may prefer to use such transactions
to manage their balance sheets, as mentioned in the context of in-house
transactions in Section II.A.4 of this release, the purpose of
Regulation 1.25 is not to assist FCMs and DCOs with managing their
balance sheets. Rather, the purpose of Regulation 1.25 is to permit
FCMs and DCOs to invest customer funds in a manner that preserves
principal and maintains liquidity. Because of the concerns expressed
above, particularly with respect to the potential for conflicts of
interest, the Commission believes that the interests of protecting
customer funds are best served by eliminating repurchase agreements
with affiliates. Therefore, the Commission is amending paragraph (d) as
proposed.\187\
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\187\ See supra n. 100 (discussing petition procedures set forth
in Regulation 13.2, 17 CFR 13.2).
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E. Regulation 30.7
1. Harmonization
In the NPRM, the Commission proposed to harmonize Regulation 30.7
with the investment limitations of Regulation 1.25 by adding new
paragraph (g) to Regulation 30.7. As noted above, the Commission had
not previously restricted investments of 30.7 funds to the permitted
investments under Regulation 1.25, although Regulation 1.25 limitations
can be used as a safe harbor for such investments.\188\
[[Page 78791]]
The Commission now believes that it is appropriate to align the
investment standards of Regulation 30.7 with those of Regulation 1.25
because many of the same prudential concerns arise with respect to both
segregated customer funds and 30.7 funds. Such a limitation should
increase the safety of 30.7 funds and provide clarity for the FCMs,
DCOs, and designated self-regulatory organizations. Two comment
letters, from JAC and FIA/ISDA discussed this subject and both
supported the amendment.
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\188\ See Commission Form 1-FR-FCM Instructions at 12-9 (Mar.
2010) (``In investing funds required to be maintained in separate
section 30.7 account(s), FCMs are bound by their fiduciary
obligations to customers and the requirement that the secured amount
required to be set aside be at all times liquid and sufficient to
cover all obligations to such customers. Regulation 1.25 investments
would be appropriate, as would investments in any other readily
marketable securities.'').
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2. Ratings
In the NPRM, the Commission proposed to remove all rating
requirements from Regulation 30.7. This amendment is required by
Section 939A of the Dodd-Frank Act and further reflects the
Commission's views on the unreliability of ratings as currently
administered and its interest in aligning Regulation 30.7 with
Regulation 1.25.\189\ The Commission requested comment on this proposal
including whether there existed any sound alternatives to credit
ratings.
---------------------------------------------------------------------------
\189\ See supra Section II.B.2 regarding the Commission's policy
decision to remove references to credit ratings from Regulation 1.25
and other regulations.
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One comment letter, from FIA/ISDA, discussed the topic and
supported the proposal. No comments provided an alternative to credit
ratings. As proposed, the Commission is removing paragraph
(c)(1)(ii)(B) of Regulation 30.7 as it views a nationally recognized
statistical rating organization (NRSRO) rating as unreliable to gauge
the safety of a depository institution for 30.7 funds. This change also
serves to align Regulation 30.7 with Regulation 1.25 on the topic of
NRSROs.
3. Designation as a Depository for 30.7 Funds
As proposed, the Commission will no longer allow a customer to
request that a bank or trust company located outside the United States
be designated as a depository for 30.7 funds. Previously, under
Regulation 30.7(c)(1)(ii)(C), a bank or trust company that did not
otherwise meet the requirements of paragraph (c)(1)(ii) could still be
designated as an acceptable depository by request of its customer and
with the approval of the Commission. However, the Commission never
allowed a bank or trust company located outside the United States to be
a depository through these means, and has decided that it is
appropriate to require that all depositories meet the regulatory
capital requirement under paragraph (c)(1)(ii)(A).
FIA/ISDA and ADM both supported this amendment in their comment
letters. Based on the foregoing, the Commission is amending Regulation
30.7, as proposed, by deleting paragraph (c)(1)(ii)(C).
4. Technical Amendments
JAC recommended reinserting ``foreign board of trade'' in
Regulation 30.7(c)(1), believing it was inadvertently omitted in
February of 2003.\190\ The Commission agrees that the February 2003
Federal Register final rule notice contained a clear administrative
error, and to address that administrative error, the Commission is
reinserting ``[t]he clearing organization of any foreign board of
trade'' in the rule text as new paragraph (c)(1)(v) and renumbering
subsequent paragraphs accordingly.\191\
---------------------------------------------------------------------------
\190\ JAC letter at 2.
\191\ Prior to 2003, Regulation 30.7(c) permitted an FCM to
maintain 30.7 funds in, among other depositories, ``[t]he clearing
organization of any foreign board of trade.'' ``Foreign Futures and
Foreign Options Transactions,'' 52 FR 28980, 29000 (Aug. 5, 1987).
In 2002, the Commission requested comment, in an NPRM, on whether
the list of depositories enumerated in Regulation 30.7(c) should be
expanded. ``Denomination of Customer Funds and Location of
Depositories,'' 67 FR 52641, 52645 (Aug. 13, 2002). The Commission
determined it appropriate to expand the list; however, in publishing
the final rule, the Commission inadvertently failed to include
``[t]he clearing organization of any foreign board of trade'' on the
list. See ``Denomination of Customer Funds and Location of
Depositories,'' 68 FR 5545, 5550 (Feb. 4, 2003) (``Rule 30.7 will be
amended to provide that the funds of foreign futures or options
customers may, in addition to those depositories already enumerated
* * *.'' (emphasis added)). The technical amendment set forth in
this notice corrects that administrative error.
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F. Implementation.
RJO, FIA/ISDA, CME, JAC and NFA suggest a phased implementation
period of 180 days.\192\ The Commission has determined to allow an
implementation period of 180 days following the publication of the
final rules.
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\192\ CME letter at 7, JAC letter at 3, FIA/ISDA letter at 13,
NFA letter at 3, RJO letter at 3.
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III. Cost Benefit Considerations
Section 15(a) of the Act requires the Commission to consider the
costs and benefits of its action before promulgating a regulation.\193\
In particular, costs and benefits must be evaluated in light of five
broad areas of market and public concern: (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. The Commission may in its discretion give greater
weight to any one of the five enumerated areas, depending upon the
nature of the regulatory action.
---------------------------------------------------------------------------
\193\ 7 U.S.C. 19(a).
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Section 4d of the Act \194\ limits the investment of customer
segregated funds to obligations of the United States and obligations
fully guaranteed as to principal and interest by the United States
(U.S. government securities), and general obligations of any State or
of any political subdivision thereof (municipal securities). The
Commission has exercised its authority to grant exempt relief under
Section 4(c) of the Act to permit additional investments beyond those
prescribed in Section 4d. Regulation 1.25 sets out the list of
permissible investments, which the Commission has expanded
substantially over the years.\195\ As detailed in the discussion above,
the final rules narrow the scope of investment choices in order to
reduce risk and to increase the safety of Regulation 1.25 investments,
consistent with the statute. Further, certain changes to the rule
relating to the elimination of credit ratings are mandated by Section
939A of the Dodd-Frank Act.
---------------------------------------------------------------------------
\194\ 7 U.S.C. 6(d).
\195\ 7 U.S.C. 6(c).
---------------------------------------------------------------------------
FCMs currently hold over $170 billion in segregated customer funds
and $40 billion in funds held subject to Regulation 30.7.\196\ The
funds are held as performance bond for the purpose of meeting margin
calls and Commission regulations allow these funds to be invested by
the FCMs and DCOs in enumerated investments subject to various
restrictions. Through this rulemaking, the Commission has determined
that certain investments are no longer permitted as they may not
adequately meet the statute's paramount goal of protecting customer
funds.
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\196\ Based on CFTC data as of April 30, 2011. See CFTC Web
site, Market Reports, Financial Data for FCMs at http://www.cftc.gov/MarketReports/FinancialDataforFCMs/index.htm.
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The Commission recognizes that restricting the type and form of
permitted investments could result in certain FCMs and DCOs earning
less income from their investments of customer funds. The Commission is
unable to determine the magnitude of such income reduction, if any,
because information was not provided to allow the Commission to
estimate any such income reduction. No commenter provided information
about the composition of the portfolio in which customer segregated
funds are invested.
[[Page 78792]]
As noted above, the list of permitted investments under the rules,
notwithstanding the restrictions instituted herein, still represent a
significantly wider selection of investment options than those
permitted by the Act. Further, in most cases, the amended rules allow
for investment in many of the same instruments as previously permitted,
subject to asset-based and issuer-based concentration limits.
In issuing these final rules, the Commission has considered the
costs and benefits of each aspect of the rules, as well as alternatives
to them. In addition, the Commission has evaluated comments received
regarding costs and benefits in response to its proposal.\197\ Where
quantification has not been reasonably estimable due to lack of
necessary underlying information, the Commission has considered the
costs and benefits of the final rules in qualitative terms.\198\
Generally, as discussed more specifically below with respect to the CEA
section 15(a) factors, the Commission believes that the restrictions on
segregated customer funds and Regulation 30.7 fund investments promote
important benefits. These include greater security for customer funds
and enhanced stability for the financial system as a whole.
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\197\ The commenters cost/benefit concerns fall in two
categories, summarized below with the Commission's corresponding
response.
Potentially reduced investment income may cause
increases in customer fee. Some public commenters suggested that a
loss of investment income on customer segregated funds and those
funds held pursuant to Regulation 30.7 potentially attributable to
the rules' investment choice limitations, might incentivize FCMs and
DCOs to raise customer fees to make up for reduced investment
income. No objective evidence was provided to predict the likelihood
of this speculated outcome. The Commission believes that the
corresponding benefit--i.e., substantially reduced risk and greater
protection of customer segregated funds--justifies this speculative
cost, particularly given that the purpose of the segregated funds is
not investment income, but customer fund protection. Moreover, as
discussed herein, two factors mitigate the magnitude of concern for
the significance of any such a potential income reduction. First,
under the final rules, most asset classes are still available to
managers and are only subject to concentration limits. All other
types of investments remain permitted, including Treasuries,
municipals, other U.S. agency obligations, foreign sovereign debt
and MMMFs. Second, the comment letters do not specify how
extensively FCMs and DCOs actually directly invest in those assets
classes the rules will exclude. Rather, comments expressing that
limitations on direct investments in MMMFs would occasion extra cost
and additional investment expertise, suggest that FCMs and DCOs have
eschewed investment in these products, at least to some degree.
Potentially increased portfolio management costs.
Multiple commenters focused on the additional expense FCMs and DCOs
might incur to acquire additional investment staff and expertise
needed to manage portfolios under the new rules. Particular areas of
concern related to the investment process in light of the removal of
credit ratings from that process and portfolio management subject to
the percentage limitations with regard to asset-type, issuer, and
counterparty. Removal of credit ratings is not within Commission
discretion. Moreover, the Commission believes the burden of on-
boarding and risk managing additional counterparties, as well as the
tracking of investments across more issuers, are offset by the
benefit of increased portfolio diversification and more limited
exposure to large credit and counterparty risk profiles.
\198\ In the NPRM, the Commission invited the public ``to submit
any data or other information that may have quantifying or
qualifying the costs and benefits of the Proposal with their comment
letters.'' The Commission received no such quantitative data or
information with respect to these rules.
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A discussion of the costs and benefits of this rule and the
relevant comments is set out immediately below. The remainder of this
Section III considers the costs and benefits of this rule under Section
15(a) of the CEA, organized by (i) impact on each class of permitted
investment, (ii) certain other limitations on permitted investments,
and (iii) Regulation 30.7.
Municipal Securities
Municipal securities are permitted investments pursuant to the Act.
For the reasons discussed above, the final rule restricts the
percentage of total customer segregated funds that may be held by an
FCM or DCO in municipal securities to 10 percent. This is in addition
to the 5 percent limitation of total customer segregated funds that
previously existed for the investment in the municipal securities of
any individual issuer.
The Commission has determined that the overall benefits of the
concentration limitations for municipal securities and the resultant
portfolio risk reductions--as compared to those without such
limitations--are compelling, notwithstanding any related costs.
(1) Protection of Market Participants and the Public
The public has a strong interest in the stability of the nation's
financial system, a goal of the Dodd-Frank Act. The new asset-based
concentration limitation for municipal securities will protect market
participants and the public by limiting losses to customer segregated
funds in the event of a crisis in the municipal bond markets.
The Commission believes that such restrictions are appropriate and
will benefit the public and market participants by safeguarding
customer funds.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes market efficiency,
competitiveness and financial integrity in an important way. Imposing
portfolio concentration limits lowers the risk of FCMs and DCOs
suffering losses and/or being unable to liquidate assets to meet margin
calls. This type of liquidity loss may operate to undermine market
integrity and public confidence in the absence of this rule. While
there may be some potential for ``forced sale'' losses for FCMs and
DCOs on investments that may now be subject to restrictions, the
Commission cannot gauge the magnitude and believes that it has taken
measures appropriate to the circumstances to mitigate any potential
costs. More specifically, the Commission is not in a position to know,
with any precision, the portfolio holdings of FCMs and DCOs with
respect to municipal securities, nor can the Commission predict the
prevailing market conditions if FCMs and DCOs must sell municipal
securities. Consequently, the Commission cannot quantify this cost.
Further, as mentioned above, the Commission does not believe that FCMs
or DCOs invest heavily in municipal securities, so ``forced sales,'' if
necessary, should be of little impact. However, to reduce any potential
impact, slight though it may be, the rules allow for a 180 day phase-in
period, giving FCMs and DCOs ample time to adjust their portfolios to
the extent necessary to comply with the regulations. Since municipal
securities remain eligible investments for FCMs and DCOs and may be
held either directly or indirectly through MMMFs,\199\ the Commission
believes that any potential impact on municipal securities markets
generally also should be mitigated. Accordingly, the Commission
believes that the significant benefits of having portfolios less
concentrated in municipal securities justify any cost, as mitigated
under the rules.
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\199\ These investments, of course, remain subject to the
``highly liquid'' requirement in these rules. To be a permitted
investment, a municipal security must have the ability to be
converted into cash within one business day, without a material
discount in value.
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(3) Price Discovery
The Commission has considered the restrictions on municipal
securities and has determined that the final rules should not have an
impact on price discovery.
(4) Sound Risk Management Practices
As previously noted, the rules enhance risk management practices by
reducing vulnerability to municipal securities defaults by the
introduction of additional investment restrictions in the
[[Page 78793]]
form of asset-based concentration limits. However, given that the list
of permitted investments remains relatively unchanged and that there is
believed to be little investment in municipal securities at this time,
there should be little or no additional resources required to comply
with the final rule and the existing risk management strategies and
systems should be largely unaffected.
(5) Other Public Interest Considerations
The greatest potential impact of this rule on public interest
considerations stem from the increased stability of the financial
system as a whole. The inclusion of asset-based concentration limits
for municipal securities contributes to financial stability by
encouraging sound investment strategies for customer segregated funds.
For FCMs and DCOs, the expenses associated with managing within these
limitations and the potential for reduced investment return
opportunities are costs. As discussed above, municipal securities are
not a widely used investment, however. Further, as a general matter,
FCMs and DCOs still have a great deal of flexibility and the Commission
believes that any added expense associated with a more active
management of the investment portfolios should be minor relative to the
benefits fostered.
U.S. Agency Obligations
U.S. agency obligations will continue to be permitted investments
pursuant to the Commission's authority under Section 4(c), subject to
certain restrictions under the rules. In addition to the existing 25
percent limitation on the securities of any single U.S. agency being
held with customer segregated funds, the new rules limit this asset
class in aggregate to 50 percent of the total customer segregated funds
held by the FCM or DCO. The rules also condition investment in debt
issued by Fannie Mae and Freddie Mac only while these entities are
operating under the conservatorship or receivership of the FHFA.
(1) Protection of Market Participants and the Public
In response to concerns regarding the safety of GSE debt
securities, highlighted by the 2008 failures of both Fannie Mae and
Freddie Mac, these additional restrictions are designed to protect
market participants and the public from the excessive risk that
concentrated investment in these assets might present. The reduction of
credit risk and the portfolio diversification requirements set forth by
the amendment will provide greater security for customer funds, and
ultimately to the FCMs and DCOs that rely on those funds.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes market efficiency,
competitiveness and financial integrity in an important way. Imposing
portfolio concentration limits lowers the risk the risk of FCMs and
DCOs suffering losses and/or being unable to liquidate assets to meet
margin calls. This type of liquidity loss may operate to undermine
market integrity and public confidence in the absence of this rule.
While there may be some potential for ``forced sale'' losses for
FCMs and DCOs on investments that may now be subject to restrictions,
the Commission cannot gauge the magnitude and believes that it has
taken measures appropriate to the circumstances to mitigate any
potential costs. More specifically, the Commission is not in a position
to know, with any precision, the portfolio holdings of FCMs and DCOs
with respect to U.S. agency obligations, nor can the Commission predict
the prevailing market conditions if FCMs and DCOs must sell U.S. agency
obligations. Consequently, the Commission cannot quantify this cost.
However, to reduce any potential cost, the rules contemplate a 180 day
implementation period, giving FCMs and DCOs ample time to liquidate
portfolios to the extent necessary to comply with the regulations.
Since investments in U.S. agency obligations remain available for
indirect investment through MMMFs, the Commission believes any impact
on the markets for U.S. agency obligations generally also should be
mitigated. Accordingly, the Commission believes that the significant
potential benefits of having portfolios less concentrated in U.S.
agency obligations justify any cost, as mitigated under the rules.
(3) Price Discovery
The Commission has considered the restrictions on U.S. agency
obligations and has determined that the final rules should not have an
impact on price discovery.
(4) Sound Risk Management Procedures
The greatest costs relative to sound risk management procedures
have been mentioned previously. The introduction of additional
investment restrictions for U.S. agency obligations in the form of
asset-based and issuer-based concentration limits may require FCMs and
DCOs to enhance their investment management and portfolio monitoring
resources. However, given that investments in U.S. agency obligations--
including GSE debt securities--are currently permitted, the risk
management strategies and systems should largely be in place already.
The Commission continues to believe that the overall benefits of
the restrictions and concentration limits on U.S. agency obligations,
as compared to those based on a regulatory standard without such
limitations, are compelling, notwithstanding attendant costs of the
restrictions and concentration limits. By limiting the concentration of
an FCM's or DCO's investment in U.S. agency obligations, the Commission
is encouraging a diverse portfolio that is more likely to withstand a
crisis in the GSE debt securities market or a failure of one or more
GSEs.
(5) Other Public Interest Considerations
The greatest potential effect of this rule on public interest
considerations stem from the implications of these rules on the overall
stability of the financial system. The inclusion of asset-based and
issuer-based limits on U.S. agency obligations contributes to financial
stability by reducing concentration risk for funds held in customer
segregated accounts. For FCMs and DCOs, the expenses associated with
administration and the potential for lost upside investment
opportunities are costs. However, as discussed above, notwithstanding
the limitations on U.S. agency obligations, FCMs and DCOs still have a
great deal of flexibility to invest in such instruments and the added
expense associated with a more active management of the investment
portfolios should be minor relative to the benefits fostered.
Certificates of Deposit
CDs will continue to be permitted investments pursuant to the
Commission's authority under Section 4(c), subject to certain
restrictions under the rules. In addition to the current issuer-based
limitation of 5 percent, the new rules impose a 25 percent asset-based
limitation. The rules also condition investment in CDs to those that
are redeemable at the issuing bank within one day, or are brokered CDs
that have embedded put options.
(1) Protection of Market Participants and the Public
This rulemaking continues to allow CDs as a permitted investment
for FCMs and DCOs while ensuring that such instruments adequately
preserve the customers' principal and maintain liquidity. The costs of
this rulemaking
[[Page 78794]]
include the administrative costs of moving from non-permitted CDs to
permitted CDs (or other permitted investments) and potential lost
upside investment opportunities from the inability to invest in non-
permitted CDs. The Commission is unable to determine the reduction in
income, if any, because it does not know the composition of the
portfolio in which customer segregated funds are invested. The
Commission believes that there is a strong benefit in creating a
framework for CDs in which such instruments must be able to be
redeemed, within one business day, at the issuing bank, however. The
Commission believes that any cost brought about by this amendment is
justified by a more diversified risk structure as a result of
concentration limits. Further, given the availability of indirect
investment in CDs generally through MMMFs, any income loss resulting
from these limitations should be minor.
Like other asset types, FCMs and DCOs may need additional resources
and expertise, and incur the related expense, to manage a portfolio
subject to the percentage limitations of the rules with regard to
asset-type and issuer. With sizeable allowances for MMMFs, FCMs and
DCOs will be able to continue to leverage the expertise of fund
managers and access indirect investment in otherwise restricted asset
types.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes financial integrity
in an important way. Imposing portfolio concentration limits lowers the
risk of FCMs and DCOs suffering losses and/or being unable to liquidate
assets to meet margin calls. This type of liquidity loss may operate to
undermine market integrity and public confidence in the absence of this
rule.
While there may be some potential for ``forced sale'' losses for
FCMs and DCOs on CDs now subject to restrictions, the Commission cannot
gauge the magnitude and believes that it has taken measures appropriate
to the circumstances to mitigate any potential costs. More
specifically, the Commission is not in a position to know, with any
precision, the portfolio holdings of FCMs and DCOs with respect to CDs,
nor can the Commission predict the prevailing market conditions if FCMs
and DCOs must sell CDs. Consequently, the Commission cannot quantify
this cost. However, to reduce any potential cost, the rules contemplate
a 180 day implementation period, giving FCMs and DCOs ample time to
liquidate portfolios to the extent necessary to comply with the
regulations. Since CDs remain eligible investments for FCMs and DCOs
and may be held either directly or indirectly through MMMFs, the
Commission believes that any potential impact on CD markets generally
also should be mitigated. Accordingly, the Commission believes that the
significant potential benefits of having portfolios less concentrated
in CDs justify any cost, as mitigated under the rules.
(3) Price Discovery
The Commission has reviewed the restrictions on CDs and determined
that the final rules should not have an impact on price discovery.
(4) Sound Risk Management Procedures
The greatest costs relative to sound risk management procedures
have been mentioned previously. The introduction of additional
investment restrictions to CDs in the form of asset-based concentration
limits may require FCMs and DCOs to enhance their investment management
and portfolio monitoring resources. However, the risk management
strategies and systems should largely be in place already.
The Commission believes that the overall benefits of the
concentration limitations and other restrictions on CDs and the
resultant reductions in risk to portfolios, as compared to those based
on a regulatory framework without such limitations, mitigate the costs.
(5) Other Public Interest Considerations
The greatest potential impact of this rule on public interest
considerations stem from the implications of these rules on the
stability of the financial system as a whole. The inclusion of asset-
based limitations on CDs, as well as the restriction that all CDs must
be redeemable at the issuing bank, contributes to financial stability
by reducing concentration risk for funds held in customer segregated
accounts. For FCMs and DCOs, the expenses associated with managing to
these limitations on CDs and the potential for reduced upside
investment return on CD investments are costs. However, as discussed
above, notwithstanding these limitations, FCMs and DCOs may still
invest directly in CDs and may invest indirectly through MMMFs. The
added expense associated with a more active management of the
investment portfolios should be minor relative to the benefits
fostered.
Commercial Paper and Corporate Debt
Some commercial paper and corporate notes or bonds will continue to
be permitted investments pursuant to the Commission's authority under
Section 4(c), subject to certain restrictions under the rules. In
addition to the existing 5 percent limitation on the securities of any
single issuer of such instruments being held with customer segregated
funds, the new rules limit these asset classes in aggregate to 25
percent, respectively, of the total customer segregated assets held by
the FCM or DCO. The rules also restrict investment in commercial paper
and corporate notes or bonds to those that are federally guaranteed as
to principal and interest under the TLGP.
(1) Protection of Market Participants and the Public
The lack of liquidity that impacted these markets during the recent
financial crisis, and which necessitated the federal guarantee under
TLGP, highlights the concerns of permitting FCMs and DCOs unrestricted
investment of customer funds in these assets. The limits imposed by
this rule will protect customer funds from being invested in
concentrated pools of unrated commercial paper and corporate notes or
bonds. While the requirement that these instruments be guaranteed by
TLGP may, in effect, severely limit investment in these instruments by
FCMs and DCOs, the actual costs of this limitation for FCMs and DCOs
are unclear, given that there is little data evidencing the extent of
their use as an investment option, and the fact that indirect
investment is still permitted through the use of MMMFs.
Like other asset types, FCMs and DCOs may need additional resources
and expertise, and incur the related expense, to manage a portfolio of
TLGP corporate notes or bonds and/or commercial paper subject to the
percentage limitations of the rules and the TLGP restrictions. With
sizeable allowances for MMMFs, FCMs and DCOs will be able to continue
to leverage the expertise of fund managers and access indirect
investment in otherwise restricted asset types.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes financial integrity
in an important way. Imposing portfolio concentration limits lowers the
risk of FCMs and DCOs suffering losses and/or being unable to liquidate
assets to meet margin calls. This type of liquidity loss may operate to
undermine market integrity and public confidence in the absence of this
rule.
While there may be some potential for ``forced sale'' losses for
FCMs and DCOs
[[Page 78795]]
on commercial paper and corporate debt now subject to restrictions, the
Commission cannot gauge the magnitude and believes that it has taken
measures appropriate to the circumstances to mitigate any potential
costs. More specifically, the Commission is not in a position to know,
with any precision, the portfolio holdings of FCMs and DCOs with
respect to commercial paper and corporate debt, nor can the Commission
predict the prevailing market conditions if FCMs and DCOs must sell
commercial paper and corporate debt. Consequently, the Commission
cannot quantify this cost. However, to reduce any potential cost, the
rules contemplate a 180 day implementation period, giving FCMs and DCOs
ample time to liquidate portfolios to the extent necessary to comply
with the regulations. Since investments in commercial paper and
corporate debt remain available for indirect investment through MMMFs,
the Commission believes any impact on commercial paper and corporate
debt markets also should be mitigated. Accordingly, the Commission
believes that the significant potential benefits of having portfolios
less concentrated in commercial paper and corporate debt justify any
cost, as mitigated under the rule.
(3) Price Discovery
The Commission has reviewed the restrictions on commercial paper
and corporate notes or bonds and determined that the final rules should
not have an impact on price discovery.
(4) Sound Risk Management Procedures
The greatest costs relative to sound risk management procedures
have been mentioned previously. The introduction of additional
investment restrictions in the form of asset-based concentration limits
and the TLGP restriction may require FCMs and DCOs to enhance their
investment management and portfolio monitoring resources. However, the
risk management strategies and systems should largely be in place
already.
The Commission believes that the overall benefits of the
concentration limits and TLGP restrictions on commercial paper and
corporate notes or bonds, and the resultant reductions in risk to
portfolios, as compared to those based on a regulatory framework
without such limitations, are compelling, notwithstanding attendant
costs of the restrictions and concentration limits. By adding
restrictions and increasing diversification through concentration
limits, customer segregated funds should be better protected in the
event of a crisis in the broader financial market.
(5) Other Public Interest Considerations
The greatest potential impact of this rule on public interest
considerations stem from the implications of these rules for the
stability of the financial system as a whole. The inclusion of asset-
based limits on commercial paper and corporate notes or bonds, as well
as the exclusion of corporate instruments that are not guaranteed by
the TLGP, will contribute to financial stability by increasing the
safety of funds in customer segregated accounts. For FCMs and DCOs, the
expenses associated with managing these limitations and the potential
for reduced upside investment opportunities are costs. However, as
discussed above, notwithstanding the limitations on commercial paper
and corporate notes or bonds, FCMs and DCOs still have a great deal of
flexibility and the added expense associated with a more active
management of the investment portfolios should be minor relative to the
benefits fostered.
Foreign Sovereign Debt
Foreign sovereign debt is eliminated as a permitted investment in
this rulemaking. However, the Commission invites FCMs or DCOs to
request an exemption pursuant to the Commission's authority under
Section 4(c), allowing them to invest in foreign sovereign debt: (1) To
the extent that the FCM or DCO has balances in segregated accounts owed
to its customers (or clearing member FCMs, as the case may be) in that
country's currency; and (2) to the extent that investment in such
foreign sovereign debt would serve to preserve principal and maintain
liquidity of customer funds, as required by Regulation 1.25. Upon an
appropriate demonstration, the Commission has noted that it may be
amenable to granting such an exemption.
(1) Protection of Market Participants and the Public
The recent sovereign debt crises highlight the concerns of
permitting FCMs and DCOs to invest customer funds in foreign sovereign
debt. The restriction of this investment class will protect customer
funds from being invested in risky or illiquid foreign sovereign debt.
While this rule eliminates investment in these instruments by FCMs and
DCOs, the actual costs of this restriction on FCMs and DCOs are
unquantifiable, in large part because the extent to which DCOs invest
in foreign sovereign debt is uncertain.
Certain commenters argued that investment in foreign sovereign debt
is necessary to hedge currency risk, and a prohibition on doing so may
be costly. While the Commission recognizes that the restriction may
impose costs, such costs are mitigated by the ability of an entity to
seek an exemption from the Commission. Further, in a scenario where a
market event has caused a currency devaluation and/or the illiquidity
of a country's sovereign debt, the Commission believes that customers'
best interests are served by an FCM holding a devalued currency, which
(albeit devalued) can be delivered immediately to the customer as
opposed to an illiquid foreign sovereign debt issuance, which may not
be able to be exchanged for any currency in a reasonably short
timeframe.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes financial integrity
in an important way. Eliminating unpredictable and potentially risky
instruments lowers the risk of FCMs and DCOs suffering losses and/or
being unable to liquidate assets to meet margin calls. This type of
liquidity loss may operate to undermine market integrity and public
confidence in the absence of this rule.
While there may be some potential for ``forced sale'' losses for
FCMs and DCOs on foreign sovereign debt now prohibited, the Commission
cannot quantify any such losses and believes that through the exemption
process under Section 4(c), it has mitigated any such potential costs.
Moreover, the Commission is not in a position to know, with any
precision, the portfolio holdings of FCMs and DCOs with respect to
foreign sovereign debt, nor can the Commission predict the prevailing
market conditions if FCMs and DCOs must sell such instruments.
Consequently, the Commission cannot quantify this cost. However, to
mitigate any such potential cost, the rules contemplate a 180-day
implementation period, giving FCMs and DCOs ample time to liquidate
portfolios to the extent necessary to comply with the regulations and/
or allowing FCMs and DCOs the opportunity to request an exemption.
(3) Price Discovery
The Commission does not believe that the restrictions on foreign
sovereign debt will have an impact on price discovery.
[[Page 78796]]
(4) Sound Risk Management Procedures
The restriction on foreign sovereign debt is intended to require an
FCM or DCO to protect against currency exposure in a way that fosters
sound risk management, particularly the protection of customer funds.
(5) Other Public Interest Considerations
The prohibition on investment in foreign sovereign debt will
contribute to financial stability by increasing the safety of funds in
customer segregated accounts. For FCMs and DCOs, any expense associated
with the elimination of foreign sovereign debt is a cost. However, as
discussed above, notwithstanding the elimination of this investment
class, the Commission believes that the benefits to the public and
market participants of this provision of the rule are significant.
Money Market Mutual Funds
MMMF investments will continue to be permitted pursuant to the
Commission's authority under Section 4(c), albeit with some
restrictions. First, an FCM or DCO may invest all of its customer
segregated funds in Treasury-only MMMFs, but for all other MMMFs, as
discussed below, the Commission believes that a 50 percent asset-based
concentration is appropriate. In addition, an FCM or DCO may invest up
to 10 percent of its assets in segregation in funds that do not have
both $1 billion in assets and a management company that has at least
$25 billion in MMMF assets under management (small MMMFs), while,
subject to the caveats described above, an FCM or DCO may invest up to
50 percent of its assets in segregation in funds that do (large MMMFs).
In arriving at these concentration limits, in addition to its own
staff research, the Commission took into consideration information
presented in meetings with the market participants, comment letters and
discussions with other regulators. The Commission decided to allow
investment without asset- or issuer-based limitations for Treasury-only
MMMFs due to the fact that Regulation 1.25 allows direct investments
entirely in Treasuries. Indirect investment in Treasuries via a
Treasury-only MMMF is essentially the risk equivalent of a direct
investment in Treasuries, while allowing an FCM or DCO the
administrative ease of delegating the management of its portfolio to a
MMMF. The Commission decided upon a 50 percent asset-based
concentration limit for large prime MMMFs, as it remains concerned
that, in another crisis, a run on a prime MMMF may threaten both the
liquidity and principal of customer segregated funds. After weighing
the information described above, the Commission determined that a 50
percent asset-based limitation struck the right balance between
providing FCMs and DCOs with sufficient Regulation 1.25 investment
options and, at the same time, encouraging adequate portfolio
diversification. The issuer-based limitation reflects the view that the
Commission seeks to protect FCMs and DCOs from runs on particular funds
and families of funds. As a necessary corollary for increasing the
asset-based concentration limits, the Commission decided to implement
the fund and fund family size requirements in order to ensure that
MMMFs invested in heavily by FCMs and DCOs were large enough to handle
a high volume of redemption requests while still allowing for limited
investment in small MMMFs.
Finally, the Commission notes that these restrictions are such that
an FCM could invest all of its customer funds in MMMFs, by, as
examples, investing entirely in a large Treasury-only MMMF or by
investing 50 percent of its funds in large prime MMMFs (spread out
among five individual funds and three fund families) and 50 percent in
a large Treasury-only MMMF. The Commission believes that this should
alleviate the concerns of FCMs that expressed, in their comment
letters, a reluctance to manage their own portfolios and instead wished
to delegate those responsibilities entirely to fund managers.
(1) Protection of Market Participants and the Public
The recent financial crisis exposed the risks attendant to MMMFs--
in particular, their susceptibility to runs. Though only one fund broke
the buck, many others were supported by their sponsors and/or
affiliates during the crisis. In response, the SEC has made a number of
changes to Rule 2a-7 to address the risks inherent in MMMFs. The
changes are aimed at reducing the perceived credit and liquidity risks
of the MMMFs' underlying portfolios. However, as the President's
Working Group on Financial Markets has noted, systemic risks remain in
the MMMF market, notwithstanding the SEC's recent reforms.\200\ Absent
further changes in the way MMMF shares are valued, redeemed and/or
supported through private or public sector guarantees, future runs on
MMMFs cannot be ruled out.
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\200\ President's Working Group on Financial Markets, Money
Market Fund Reform Options, at 16-18 (2010). The full report may be
accessed at http://www.treasury.gov/press-center/press-releases/Documents/10.21%20PWG%20Report%20Final.pdf.
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The minimum $1 billion asset requirement for individual fund and
$25 billion asset requirement for family of funds of large MMMFs are
designed to ensure that customer funds are typically invested in
sufficiently large funds with diversified portfolios of holdings that
are better positioned to withstand unexpected redemptions requests.
Limited investment in small MMMFs was retained from the NPRM in order
to provide flexibility for FCMs and DCOs and to promote
diversification. The new asset-based concentration limitations for non-
Treasury MMMFs in aggregate, by family and by individual fund will
provide additional protection for customer segregated funds in the
event of both runs on MMMFs generally, and more targeted runs that may
affect a specific family of funds or an individual fund. The portfolio
diversification requirements set forth by the amendment will provide
greater security for customer funds, and ultimately to the FCMs and
DCOs that rely on those funds.
Individual FCMs and DCOs may need additional resources and
expertise, and incur the related expense, to manage a portfolio subject
to the percentage limitations of the rules with regard to asset-type,
issuer and size. However, with sizeable allowances for MMMFs, FCMs and
DCOs will be able to continue to leverage the expertise of fund
managers. The Commission notes that under this rule, an FCM or DCO is
able to invest all of their customer segregated funds in one or more
MMMFs. Therefore, FCMs or DCOs not wishing to manage their portfolios
may delegate entirely to MMMF managers.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that this rule promotes financial integrity
in an important way. Imposing portfolio concentration limits lowers the
risk of FCMs and DCOs suffering losses and/or being unable to liquidate
assets to meet margin calls. This type of liquidity loss may operate to
undermine market integrity and public confidence in the absence of this
rule.
While there may be some potential for ``forced sale'' losses for
FCMs and DCOs on MMMFs that are above the concentration limits or not
meet the asset requirements, the Commission cannot gauge the magnitude
and believes that it has taken measures appropriate to the
circumstances to mitigate any potential costs. More specifically, the
Commission is not in a
[[Page 78797]]
position to know, with any precision, the portfolio holdings of FCMs
and DCOs with respect to MMMFs, nor can the Commission predict the
prevailing market conditions if FCMs and DCOs must sell MMMFs.
Consequently, the Commission cannot quantify this cost. However, to
reduce any potential cost, the rules contemplate a 180 day
implementation period, giving FCMs and DCOs ample time to liquidate
portfolios to the extent necessary to comply with the regulations.
Since investments in MMMFs remain available, the Commission believes
any impact on MMMF markets generally also should be mitigated.
Accordingly, the Commission believes that the significant potential
benefits of having portfolios less concentrated in a small number of
MMMFs justify any cost, as mitigated under the rules.
(3) Price Discovery
The final rules should not have an impact on price discovery.
(4) Sound Risk Management Procedures
The greatest costs relative to sound risk management procedures
have been mentioned previously. The introduction of additional
investment restrictions on MMMFs in the form of asset-based and issuer-
based concentration limits may require FCMs and DCOs to enhance their
investment management and portfolio monitoring resources. However, to
the extent that FCMs and DCOs had invested in MMMFs previously, the
risk management strategies and systems should largely be in place
already.
(5) Other Public Interest Considerations
The greatest potential benefit of this rule on public interest
considerations stem from the implications of these rules on the
stability of the financial system as a whole. The inclusion of asset-
based concentration limitations on non-Treasury MMMFs, placing
limitations on families of funds and on individual funds, and allowing
only limited investment in funds not meeting certain asset limits
contributes to financial stability by promoting the diversification of
investment for funds held in customer segregated accounts. For FCMs and
DCOs, the expenses associated with managing their MMMF investments and
the potential for lost upside investment opportunities are costs.
However, as discussed above, notwithstanding the limitations on the
permitted investments, FCMs and DCOs may still invest all customer
segregated funds in a portfolio of MMMFs, and the added expense
associated with a more active management of the MMMF portfolio should
be minor.
Other Investment Limitations
The final rules also include other limitations and restrictions on
those investments that are permitted for customer segregated funds by
FCMs and DCOs, including the elimination of in-house transactions and
repurchase agreements with affiliates as well as a 25 percent
counterparty concentration limit on repurchase agreements.
(1) Protection of Market Participants and the Public
As stated above, the guiding investment principle for customer
funds is that investments are liquid and preserve principal. The
lessons of the recent financial crisis highlighted the contagion that
can occur in the financial markets from a single failure or default. As
such, the new rules are designed to broadly spread counterparty risk,
such that customer funds are protected and may be liquidated quickly,
notwithstanding select failures in the marketplace. In-house
transactions and repurchase agreements with affiliates have been
eliminated due to the conflicts of interest that can arise during
periods of crisis, the concentration risk associated with engaging in
such transactions within an FCM-broker dealer entity (in the case of an
in-house transaction) and within an affiliate structure (in the case of
a repurchase agreements with affiliates), among other reasons. The 25
percent counterparty-concentration limit has been introduced to ensure
that an FCM or DCO does not have all of its customer funds subject to
the risk profile of a single counterparty.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The Commission believes that these additional limitations promote
financial integrity in an important way. By broadly spreading
counterparty risk and enhancing customer fund protections and
liquidity, the risk of FCMs and DCOs suffering losses and/or being
unable to liquidate assets to meet margin calls is decreased. This type
of liquidity loss may operate to undermine market integrity and public
confidence in the absence of this rule.
Moreover, to the extent there are potential costs noted below,
offsetting benefits justify them. Any decrease in efficiency resulting
from the elimination of in-house transactions and repurchase agreements
with affiliates need be considered in light of the benefits of the
increased certainty of arms-length transactions between two legally
distinct, unaffiliated parties. And, a crucial benefit offsets the
administrative costs associated with having five counterparties rather
than one: Reduced counterparty risk.
(3) Price Discovery
The final rules should not have an impact on price discovery.
(4) Sound Risk Management Procedures
There may be additional expense associated with the on-boarding and
risk managing additional counterparties, but the scale of this
additional burden does not appear large and is justified by the
benefits of improved counterparty concentration limits.
(5) Other Public Interest Considerations
The greatest potential impact of this rule on public interest
considerations stem from the increased stability of the financial
system as a whole. The inclusion of counterparty concentration limits,
in particular, contributes to financial stability by reducing risk for
funds held in customer segregated accounts.
Regulation 30.7
The Commission has decided to harmonize Regulation 30.7 with the
investment limitations of Regulation 1.25. The Commission had not
previously restricted investments of 30.7 funds to the permitted
investments under Regulation 1.25. The Commission now believes that it
is appropriate to align the investment standards given the similar
prudential concerns that arise with respect to both segregated customer
funds and 30.7 funds. The Commission has also removed the credit
ratings requirements for depositories of 30.7 funds and eliminated the
option of customers to designate, with the permission of the
Commission, a depository not otherwise meeting the standards to be a
depository of 30.7 funds.
(1) Protection of Market Participants and the Public
The public has a strong interest in the stability of the nation's
financial system, a goal of the Dodd-Frank Act. Applying Regulation
1.25 standards to 30.7 funds will better insulate them against the
negative shocks of future financial crises, thereby enhancing
protection to market participants and the public. Also, no benefit
justifies applying a different standard for 30.7 funds than for
segregated customer funds. FCMs and DCOs traditionally have used
Regulation 1.25 as a safe harbor for 30.7 funds; accordingly, there is
no basis to anticipate material additional expense
[[Page 78798]]
as a result of extending these requirements to 30.7 funds.
The removal of credit ratings from Regulation 30.7 was necessitated
by Section 939A of the Dodd-Frank Act and is in line with the
Commission's removal of credit ratings under Regulation 1.25. The
removal of the designation option for depositories stemmed from the
fact that the Commission had never entertained such a request and from
the belief that a depository should meet the capital requirements for
depositories in order to hold 30.7 funds.
(2) Efficiency, Competitiveness and Financial Integrity of the Markets
The investments made with 30.7 funds generally have been similar to
those made under Regulation 1.25. Accordingly, the Commission believes
that harmonization of Regulation 30.7 with Regulation 1.25 promotes
financial integrity in the same important ways and relative to less
significant cost as discussed in the above. Specifically, imposition of
the restrictions discussed above with respect to Regulation 1.25 asset
classes lowers the risk of FCMs and DCOs suffering losses and/or being
unable to liquidate assets to meet margin calls. This type of liquidity
loss may operate to undermine market integrity and public confidence in
the absence of this rule.
The Commission does not expect the removal of credit ratings to
have a significant impact on choice of depositories for 30.7 funds. The
Commission expects the elimination of the designation option to have no
impact, since it has never been used.
(3) Price Discovery
The final rules regarding Regulation 30.7 should not have an impact
on price discovery.
(4) Sound Risk Management Procedures
As mentioned above, most FCMs and DCOs have used Regulation 1.25 as
a safe harbor for 30.7 funds. As such, the incremental costs associated
with applying the additional investment restrictions in the form of
asset-based and issuer-based concentration limits should not be
substantial. The risk management strategies and systems should largely
be in place already, and will now be applied to 30.7 funds.
The Commission believes that the overall benefits of applying
Regulation 1.25 standards to 30.7 funds, as compared to those based on
a regulatory framework without such limitations, justify the less
significant costs. By adding restrictions and increasing
diversification through concentration limits, 30.7 funds should be
better protected in the event of a crisis in the broader financial
market. The removal of credit ratings for depositories and the removal
of the designation option should not have a significant impact on risk
management practices because depositories must still meet the capital
requirements in order to qualify under Regulation 30.7 and, as
mentioned, no depositories have ever qualified through designation. The
only cost associated with the former would be the administrative cost
of moving funds from one depository to another, in the event that a
previously qualifying depository now no longer qualifies.
(5) Other Public Interest Considerations
The greatest potential impact of this rule on public interest
considerations stem from the implications of these rules for the
stability of the financial system as a whole. The application of
Regulation 1.25 standards to 30.7 funds will contribute to financial
stability by reducing concentration risk for 30.7 funds. For FCMs and
DCOs, the expenses associated with managing these limitations and the
potential for lost upside investment opportunities are costs. However,
as discussed above, the added expense associated with a more active
management of the investment portfolios should be minor.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) \201\ requires federal
agencies, in promulgating rules, to consider the impact of those rules
on small businesses. The rule amendments contained 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.\202\ The Commission has previously determined that registered
FCMs \203\ and DCOs \204\ are not small entities for the purpose of the
RFA. Accordingly, pursuant to 5 U.S.C. 605(b), the Chairman, on behalf
of the Commission, certifies that the final rules will not have a
significant economic impact on a substantial number of small entities.
---------------------------------------------------------------------------
\201\ 5 U.S.C. 601 et seq.
\202\ 47 FR 18618 (Apr. 30, 1982).
\203\ Id. at 18619.
\204\ 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 the
rule amendments. Accordingly, for purposes of the PRA, the Commission
certifies that these rule amendments, promulgated in final form, do not
impose any new reporting or recordkeeping requirements.
Lists of Subjects
17 CFR Part 1
Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.
17 CFR Part 30
Commodity futures, Consumer protection, Currency, Reporting and
recordkeeping requirements.
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 is revised 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 Dodd-Frank
Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124
Stat. 1376 (2010).
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) Obligations of any United States government corporation or
enterprise sponsored by the United States government (U.S. agency
obligations);
(iv) Certificates of deposit issued by a bank (certificates of
deposit) as defined
[[Page 78799]]
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 fully guaranteed as to principal and interest
by the United States under the Temporary Liquidity Guarantee Program as
administered by the Federal Deposit Insurance Corporation (commercial
paper);
(vi) Corporate notes or bonds fully guaranteed as to principal and
interest by the United States under the Temporary Liquidity Guarantee
Program as administered by the Federal Deposit Insurance Corporation
(corporate notes or bonds); and
(vii) 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 (vii) 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
``highly liquid'' as defined in paragraph (b)(1) of this section.
(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) Obligations issued by the Federal National Mortgage Association
or the Federal Home Loan Mortgage Association are permitted while these
entities operate under the conservatorship or receivership of the
Federal Housing Finance Authority with capital support from the United
States.
(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) Liquidity. Investments must be ``highly liquid'' such that they
have the ability to be converted into cash within one business day
without material discount in value.
(2) 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)(2)(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)(2)(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 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 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.
(vi) Commercial paper and corporate notes or bonds must meet the
following criteria:
(A) The size of the issuance must be greater than $1 billion;
(B) The instrument must be denominated in U.S. dollars; and
(C) The instrument must be fully guaranteed as to principal and
interest by the United States for its entire term.
(3) Concentration--(i) Asset-based concentration limits for direct
investments. (A) Investments in U.S. government securities shall not be
subject to a concentration limit.
(B) Investments in U.S. agency obligations may not exceed 50
percent of the total assets held in segregation by the futures
commission merchant or derivatives clearing organization.
(C) Investments in each of commercial paper, corporate notes or
bonds and certificates of deposit may not exceed 25 percent of the
total assets held in segregation by the futures commission merchant or
derivatives clearing organization.
(D) Investments in municipal securities may not exceed 10 percent
of the total assets held in segregation by the futures commission
merchant or derivatives clearing organization.
(E) Subject to paragraph (b)(3)(i)(G) of this section, investments
in money market mutual funds comprising only
[[Page 78800]]
U.S. government securities shall not be subject to a concentration
limit.
(F) Subject to paragraph (b)(3)(i)(G) of this section, investments
in money market mutual funds, other than those described in paragraph
(b)(3)(i)(E) of this section, may not exceed 50 percent of the total
assets held in segregation by the futures commission merchant or
derivatives clearing organization.
(G) Investments in money market mutual funds comprising less than
$1 billion in assets and/or which have a management company comprising
less than $25 billion in assets, may not exceed 10 percent of the total
assets held in segregation by the futures commission merchant or
derivatives clearing organization.
(ii) Issuer-based concentration limits for direct investments. (A)
Securities of any single issuer of U.S. agency obligations 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.
(B) 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.
(C) Interests in any single family of money market mutual funds
described in paragraph (b)(3)(i)(F) of this section may not exceed 25
percent of total assets held in segregation by the futures commission
merchant or derivatives clearing organization.
(D) Interests in any individual money market mutual fund described
in paragraph (b)(3)(i)(F) of this section may not exceed 10 percent of
total assets held in segregation by the futures commission merchant or
derivatives clearing organization.
(E) For purposes of determining compliance with the issuer-based
concentration limits set forth in this section, securities issued by
entities that are affiliated, as defined in paragraph (b)(5) 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.
(iii) Concentration limits for agreements to repurchase--(A)
Repurchase agreements. For purposes of determining compliance with the
asset-based and issuer-based 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.
(B) Reverse repurchase agreements. For purposes of determining
compliance with the asset-based and issuer-based 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) Treatment of customer-owned securities. For purposes of
determining compliance with the asset-based and issuer-based
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 clearing organization are not
included in total assets held in segregation by the derivatives
clearing organization.
(v) Counterparty concentration limits. Securities purchased by a
futures commission merchant or derivatives clearing organization from a
single counterparty, subject to an agreement to resell to that
counterparty, shall not exceed 25 percent of total assets held in
segregation by the futures commission merchant or derivatives clearing
organization.
(4) 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.
(5) 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.
(6) 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
[[Page 78801]]
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. The futures commission
merchant or the derivatives clearing organization shall obtain the
acknowledgment letter required by Sec. 1.26 from an entity that has
substantial control over the fund shares purchased with customer
segregated funds and has the knowledge and authority to facilitate
redemption and payment or transfer of the customer segregated funds.
Such entity may include the fund sponsor or depository acting as
custodian for fund shares.
(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) For any period during which there is a non-routine closure of
the Fedwire or applicable Federal Reserve Banks;
(B) For any period:
(1) During which the New York Stock Exchange is closed other than
customary week-end and holiday closings; or
(2) During which trading on the New York Stock Exchange is
restricted;
(C) For any period during which an emergency exists as a result of
which:
(1) Disposal by the company of securities owned by it is not
reasonably practicable; or
(2) It is not reasonably practicable for such company fairly to
determine the value of its net assets;
(D) For any period as the Securities and Exchange Commission may by
order permit for the protection of security holders of the company;
(E) For any period during which the Securities and Exchange
Commission has, by rule or regulation, deemed that:
(1) Trading shall be restricted; or
(2) An emergency exists; or
(F) For any period during which each of the conditions of Sec.
270.22e-3(a)(1) through (3) of this title are met.
(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.
(7) The Appendix to this section sets forth language that will
satisfy the requirements of paragraph (c)(5) of this section.
(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
(vii) 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) Permitted 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) A futures commission merchant or derivatives clearing
organization shall not enter into an agreement to repurchase or resell
with a counterparty that is an affiliate of the futures commission
merchant or derivatives clearing organization, respectively. 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.
(4) 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)(3)(iii)(A) and (B) of this section.
(5) 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 (13) of this section
and which states that the parties thereto intend the transaction to be
treated as a purchase and sale of securities.
(6) The term of the agreement is no more than one business day, or
reversal of the transaction is possible on demand.
(7) 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 derivatives clearing organization, or the Depository
Trust Company in an account that complies with the requirements of
Sec. 1.26.
(8) 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.
(9) 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
[[Page 78802]]
account simultaneously with the delivery or transfer of securities from
the customer segregated custodial account.
(10) 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.
(11) 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.
(12) 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.''
(13) 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) 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.
Appendix to Sec. 1.25--Money Market Mutual Fund Prospectus Provisions
Acceptable for Compliance With Section 1.25(c)(5)
Upon receipt of a proper redemption request submitted in a
timely manner and otherwise in accordance with the redemption
procedures set forth in this prospectus, the [Name of Fund] will
redeem the requested shares and make a payment to you in
satisfaction thereof no later than the business day following the
redemption request. The [Name of Fund] may postpone and/or suspend
redemption and payment beyond one business day only as follows:
a. For any period during which there is a non-routine closure of
the Fedwire or applicable Federal Reserve Banks;
b. For any period (1) during which the New York Stock Exchange
is closed other than customary week-end and holiday closings or (2)
during which trading on the New York Stock Exchange is restricted;
c. For any period during which an emergency exists as a result
of which (1) disposal of securities owned by the [Name of Fund] is
not reasonably practicable or (2) it is not reasonably practicable
for the [Name of Fund] to fairly determine the net asset value of
shares of the [Name of Fund];
d. For any period during which the Securities and Exchange
Commission has, by rule or regulation, deemed that (1) trading shall
be restricted or (2) an emergency exists;
e. For any period that the Securities and Exchange Commission,
may by order permit for your protection; or
f. For any period during which the [Name of Fund,] as part of a
necessary liquidation of the fund, has properly postponed and/or
suspended redemption of shares and payment in accordance with
federal securities laws.
PART 30--FOREIGN FUTURES AND FOREIGN OPTIONS TRANSACTIONS
0
3. The authority citation for part 30 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 6, 6c, and 12a, unless otherwise
noted.
0
4. In Sec. 30.7, revise paragraph (c) and add paragraph (g) to read as
follows:
Sec. 30.7 Treatment of foreign futures or foreign options secured
amount.
* * * * *
(c)(1) The separate account or accounts referred to in paragraph
(a) of this section must be maintained under an account name that
clearly identifies them as such, with any of the following
depositories:
(i) A bank or trust company located in the United States;
(ii) A bank or trust company located outside the United States that
has in excess of $1 billion of regulatory capital;
(iii) A futures commission merchant registered as such with the
Commission;
(iv) A derivatives clearing organization;
(v) The clearing organization of any foreign board of trade;
(vi) A member of any foreign board of trade; or
(vii) Such member or clearing organization's designated
depositories.
(2) Each futures commission merchant must obtain and retain in its
files for the period provided in Sec. 1.31 of this chapter an
acknowledgment from such depository that it was informed that such
money, securities or property are held for or on behalf of foreign
futures and foreign options customers and are being held in accordance
with the provisions of these regulations.
* * * * *
(g) Each futures commission merchant that invests customer funds
held in the account or accounts referred to in paragraph (a) of this
section must invest such funds pursuant to the requirements of Sec.
1.25 of this chapter.
Issued in Washington, DC, on December 5, 2011 by the Commission.
David A. Stawick,
Secretary of the Commission.
Appendices to Investment of Customer Funds and Funds Held in an Account
for Foreign Futures and Foreign Options Transactions--Commission Voting
Summary and Statements of Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler, Commissioners Sommers,
Chilton, O'Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rule to enhance customer protections
regarding where derivatives clearing organizations (DCOs) and
futures commission merchants (FCMs) can invest customer funds. I
believe that this rule is critical for the safeguarding of customer
money.
The Commodity Exchange Act in section 4d(a)(2) prescribes that
customer funds can only be placed in a set list of permitted
investments. From 2000 to 2005, the
[[Page 78803]]
Commission granted exemptions to this list, loosening the rules for
the investment of customer funds. These exemptions allowed FCMs to
invest customer funds in AAA-rated sovereign debt, as well as to
lend customer money to another side of the firm through repurchase
agreements.
This rule prevents such in-house lending through repurchase
agreements. I believe there is an inherent conflict of interest
between parts of a firm doing these transactions. The rule also
would limit an FCM's ability to invest customer money in foreign
sovereign debt.
In addition, this rule fulfills a Dodd-Frank requirement that
the CFTC remove all reliance on credit ratings from its regulations.
[FR Doc. 2011-31689 Filed 12-16-11; 8:45 am]
BILLING CODE P
Last Updated: December 19, 2011