CFTC Proposed Rule: Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations

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Gavel.png FINAL RULE: This page refers to the proposed rule on enhanced customer protections. The final rule was approved October 30, 2013
Timeline, Enhanced Customer Protections, CFTC
Proposal Date Comment Deadline Final Rule Approved Effective Date
November 14, 2012 February 15, 2012 October 30, 2013 January 13, 2014

On October 22, 2012, the CFTC released a proposal and request for public comment on a list of changes to its rules in order to enhance protections for futures customers. The amendments are designed to strengthen the safeguards surrounding the holding of money, securities and other property deposited by customers with futures commission merchants (FCMs) and derivatives clearing organizations (DCOs).[1]

The 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.

Note: One aspect of the proposed rule that has drawn sharp criticism from FCMs has been the requirement that FCMs retain a residual interest, or additional firm-owned collateral, to pre-fund all margin calls, including those in transit. For more on the story, see the John Lothian Special Report below.

Background

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.

The proposed rule builds upon other rulemakings related to the Dodd-Frank Act:

The proposed improvements are detailed below. [2]

The Proposal

Part 30: Foreign Futures Markets

  • FCMs would be required to hold sufficient funds in secured accounts, using the net liquidating equity method;
  • FCMs would 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.

Improved Oversight

  • 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.

Additional Disclosures

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.

John Lothian News Special Report: Residual Interest, February 2013

A rule proposed by the Commodity Futures Trading Commission (CFTC) designed to strengthen safeguards for customer deposits at futures commission merchants (FCMs) is threatening to overhaul the futures brokerage system.

The proposed “residual interest” provision introduced last fall, and discussed in a CFTC roundtable on February 5, would require substantial increases in margin buffers by FCMs.

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 has put together a special report on this critical issue. The deadline for comments on this proposed rule was February 15, 2013.

Related Documents:Federal Register Entry; Q&A

References

  1. CFTC Proposes New Regulations and to Amend Existing Regulations to Enhance Protections for Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations. CFTC. Retrieved on October 23, 2012.
  2. Q & A – Proposed Amendments to Enhance Customer Protection. CFTC. Retrieved on October 23, 2012.

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