CFTC Final Rule: Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations
|FINAL RULE: Appeared in the Federal Register November 15, 2013; Effective Date January 14, 2014|
|Proposal Date||Comment Deadline||Final Rule Approved||Effective Date|
|November 14, 2012||February 15, 2012||October 30, 2013||January 13, 2014|
On October 30, 2013, the CFTC approved a final set of rules on customer protection. The rules cover FCM risk management, record keeping and disclosure, and the treatment of customer segregated funds secured funds in foreign futures and options accounts. Of particular note is the requirement that FCMs hold a "residual interest" in customer accounts in an amount least equal to its customers’ aggregate undermargined amounts for the prior trade date, in order to protect the funds of customers with excess margin.
The rule appeared in the Federal Register on November 14, 2013, and its effective date is January 13, 2014. There will be a phase in of the residual interest rule. One year after the rule appears in the Federal Register, any margin deficit will be required to be topped up by 6pm Eastern time on the day after settlement (“T+1”). If the customer has not met such deficit, the FCM must take a capital charge on the amount of the deficit. After five years, the requirement moves from 6pm to the "first daily settlement", which will likely be between 7 and 9am.
After failures at two futures commission merchants within one year - MF Global and Peregrine Financial - the safety of customer segregated funds has come into question by market participants. In developing the proposed rule:
- The commission held meetings with FCMs, DCOs, securities regulators, foreign clearing organizations and academics to explore ideas for enhancing customer protection.
- The commission has held two roundtables on customer protection issues, covering such issues as modifying segregation models, collateral, transparency, and oversight of self-regulatory organization (SRO) examinations.
- The CFTC Technology Advisory Committee (TAC) held a public meeting on potential technological solutions directed at enhancing the protection of customers funds on July 26, 2012.
- The National Futures Association (NFA) issued a proposed rule on the protection of customer funds in August 2012.
On October 22, 2012, the CFTC issued its proposed rule. he rulemaking appeared in the Federal Register on November 14, 2012. The original deadline for public comments was January 14, 2013. However, on January 11, 2013, the deadline was extended until February 15, 2013. Because of the substantial number of items in the proposal, several market participants, including DCOs, FCMs DCMs had requested additional time to address the issues in the proposal. Comments on this proposed rule can be found here.
The final rule builds upon other rulemakings related to the Dodd-Frank Act:
- CFTC Final Rule: Derivatives Clearing Organization General Provisions and Core Principles, October 2011
- CFTC Final Rule: Investment of Customer Funds by Futures Commission Merchants and Derivatives Clearing Organizations, December 2011
- CFTC Final Rule: Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions (the "LSOC" rule), January 2012
- CFTC Final Rule: Core Principles and Other Requirements for Designated Contract Markets, May 2012
The Final Rules
Part 30: Foreign Futures Markets
- FCMs must hold sufficient funds in secured accounts, using the net liquidating equity method;
- FCMs will be prohibited from holding any positions in a Part 30 secured account other than customers’ foreign futures and option positions and associated margin collateral;
- FCMs must hold sufficient proprietary funds in segregated accounts and Part 30 secured accounts to reasonably ensure that the firms are properly segregated and secured at all times, and to cover margin deficiencies in customers’ trading accounts;
- FCMs must maintain written policies and procedures governing the maintenance of excess funds in customer segregated and Part 30 secured accounts, and obtain the pre-approval of management prior to the withdrawal of 25 percent or more of the excess funds held in segregated or secured accounts if the withdrawals were not for the benefit of the FCMs’ customers;
FCMs should provide daily reporting of the segregation and Part 30 secured amount computations, and semi-monthly reporting of the location of customer funds and how such funds are invested under Regulation 1.25;
FCM Risk Management
- FCMs must develop written procedures for segregation risk, which must include processes for:
- evaluation of depositories;
- establishing residual interest targets;
- internal controls for withdrawal of cash and securities from segregated funds;
- assessing the appropriateness of Regulation 1.25 investments; and
- separation of duties among financial personnel, as well as for annual training programs.
- FCMs must address operational risks, including controls to prevent the placing of erroneous orders, including those that exceed pre-set capital, credit, or volume thresholds, and policies and procedures that govern the use, supervision, maintenance, testing, and inspection of such programs.
- The proposal would raise the minimum standard which certified public accountants that audit FCMs must meet, and change the orientation of the FCM examination programs administered by the SROs, to require more attention to quality control over examination program contents, administration, and oversight.
- FCMs would need to file all financial and regulatory notices electronically via the WinJammer electronic system.
- Regulation 1.12 would be revise to implement a more effective early warning system by requiring submission of all material changes to an FCM's risk profile.
- Regulations 1.20 and 1.26 would be revised to require FCMs and DCOs to provide the commission and DSROs, as applicable, with read-only direct electronic access to accounts holding customer funds in depositories.
The additional general risk disclosures would include:
- A statement that customer funds are not covered by insurance in the event of an FCM bankruptcy;
- A statement that DCOs do not insure or guarantee customer funds held by an FCM in the event of an FCM bankruptcy;
- A statement that a customer’s funds may be commingled by an FCM with the funds of other customers, and that there is fellow customer risk;
- A statement that an FCM may invest customer funds in Regulation 1.25 permitted investments; and
- A statement that an FCM may deposit customer funds with affiliated depositories.
Additional Firm-specific disclosures to include:
- The significant types of business activities and product lines engaged in by the FCM, and the approximate percentage of the FCM’s assets and capital devoted to each business activity;
- The FCM’s business on behalf of its customers, including types of accounts, markets traded, international businesses, and clearinghouses and carrying brokers used, and the FCM’s policies and procedures concerning the choice of bank depositories, custodians, and other counterparties;
- The material risks, accompanied by an explanation of how such risks may be material to the FCM’s customers; and
- Any material administrative, civil, enforcement, or criminal action then pending, and any enforcement actions taken in last three years.
Financial Information Available to the Public
- Daily statement of segregated funds and secured amounts and funds held in both U.S. and foreign accounts;
- Statement of cleared swaps customer collateral
- A summary schedule of the futures commission merchant’s adjusted net capital, net capital, excess net capital and reflecting balances as of the month-end for the 12 most recent months; and
- The Statement of Financial Condition, the Statement of Segregation Requirements and Funds in Segregation for Customers Trading on U.S. Exchanges, the Statement of Secured Amounts and Funds Held in Separate Accounts for 30.7 Customers Pursuant to Commission Regulation 30.7, the Statement of Cleared Swaps Customer Segregation Requirements and Funds in Cleared Swaps Customer Accounts Under Section 4d(f) of the Act, and all related footnotes to the above schedules that are part of the futures commission merchant’s most current certified annual report pursuant to Regulation 1.16.
A Correction in the Final Rules, May 2014
On May 13, 2014, a correction to this rule was published in the Federal Register that changes a phrase that had caused confusion among futures commission merchants. Appendix B to Reg. 1.20 and the seventh full paragraph of the body of the Acknowledgment Letter in Appendix B to Reg. 1.26 refer to a depository’s or money market mutual fund’s obligations in the event of the bankruptcy of the derivatives clearing organization's account holder. The provisions are intended to relate exclusively to the bankruptcy of the account holder and should not additionally refer to the bankruptcy of ‘‘any of our futures commission merchant clearing members’’ as was printed in the final rules. The correction can be found HERE.
John Lothian News Special Report: Residual Interest, February 2013
After the rule was proposed by the CFTC the proposed “residual interest” provision introduced last fall was discussed in a CFTC roundtable on February 5. The meeting led by Robert Wasserman, chief counsel of the CFTC’s Division of Clearing and Risk, included panelists Mike Dawley of Goldman Sachs and FIA chairman and Kim Taylor, CME Clearing president who argued that the increased margin requirements under the proposal are substantial. Dawley said the rule, if passed in its current form, would be “one of the most monumental events” in his 30 years in the industry.
John Lothian News put together a special report on the issue.
Related Documents:Fact Sheet, Q&A, Federal Register Entry, FIA Statement