[Federal Register Volume 75, Number 212 (Wednesday, November 3, 2010)]
[Proposed Rules]
[Pages 67642-67657]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-27657]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1 and 30
RIN 3038-AC15
Investment of Customer Funds and Funds Held in an Account for
Foreign Futures and Foreign Options Transactions
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is proposing to amend its regulations regarding the investment of
customer segregated funds and funds held in an account subject to
Commission Regulation 30.7 (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
proposed rules address: Certain changes to the list of permitted
investments, a clarification of the liquidity requirement, the removal
of rating requirements, an expansion of concentration limits including
asset-based, issuer-based, and counterparty concentration restrictions.
It also addresses 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 application of customer segregated funds investment limitations to
30.7 funds, the removal of ratings requirements for depositories of
30.7 funds, and the elimination of the option to designate a depository
for 30.7 funds.
DATES: Comments must be received on or before December 3, 2010.
ADDRESSES: You may submit comments, identified by RIN number, by any of
the following methods:
Agency Web site, via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments
through the Web site.
Mail: David A. Stawick, Secretary of the Commission,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, NW., Washington, DC 20581.
Hand Delivery/Courier: Same as mail above.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the Commission to consider
information that may be exempt from disclosure under the Freedom of
Information Act, a petition for confidential treatment of the exempt
information may be submitted according to the established procedures in
CFTC Regulation 145.9.\1\
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\1\ Commission regulations referred to herein are found at 17
CFR Ch. 1.
FOR FURTHER INFORMATION CONTACT: Phyllis P. Dietz, Associate Director,
202-418-5449, [email protected], or Jon DeBord, Attorney-Advisor, 202-
418-5478, [email protected], or Division of Clearing and Intermediary
Oversight, Commodity Futures Trading Commission, Three Lafayette
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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
II. Discussion of the Proposed Rules
A. Permitted Investments
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
III. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Costs and Benefits of the Proposed Rules
Text of Rules
I. Background
A. Regulation 1.25
Under Section 4d(a)(2) of the Commodity Exchange Act (Act),\2\ the
investment of customer segregated funds is limited 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). Pursuant to authority under Section 4(c) of the
Act,\3\ the Commission substantially expanded the list of permitted
investments by amending Commission 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
securities or GSE securities), bank certificates of deposit (CDs),
commercial paper, corporate notes,\5\ general obligations of a
sovereign nation, and interests in MMMFs.\6\ In connection
[[Page 67643]]
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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\2\ 7 U.S.C. 6d(a)(2).
\3\ 7 U.S.C. 6(c).
\4\ 17 CFR 1.25.
\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 customer segregated funds and 30.7 funds (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, much of that data remains useful as an indication of how
Regulation 1.25 was implemented in a more stable financial environment,
and 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.
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 has 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 (Crane), 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.
(TSI). Two letters were received from Federated: A July 10, 2009
letter (Federated letter I) 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
[[Page 67644]]
Dodd-Frank Act \17\ was promulgated 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, Public Law 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\ The Commission is proposing amendments to
Regulations 1.25 and 30.7 that include removal of provisions setting
forth credit rating requirements. Separate rulemakings proposed today
address the elimination of credit ratings from Regulations 1.49 and
4.24 and the removal of Appendix A to Part 40 (which contains a
reference to credit ratings).
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\18\ See Section 939A(a) of the Dodd-Frank Act.
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The Commission is now proposing amendments to Regulations 1.25 and
30.7 and requests comment on all aspects of the proposed rules, as well
as comment on the specific provisions and issues highlighted in the
discussion below. In addition, commenters are welcome to offer their
views regarding any other related matters that are raised by the
proposed amendments.
II. Discussion of the Proposed Rules
A. Permitted Investments
In proposing amendments to Regulation 1.25, the Commission seeks to
simplify the regulation and impose requirements that can better ensure
the preservation of principal and maintenance of liquidity. The
Commission has endeavored to tailor its proposal 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.
The Commission seeks to simplify Regulation 1.25 by narrowing the
scope of investment choices in order to eliminate the potential use of
instruments that may pose an unacceptable level of risk. In their July
2009 comment letters, both NFA and CME suggested contracting the scope
of permitted investments by eliminating asset classes used negligibly
as investment vehicles.
The Commission seeks to increase the safety of Regulation 1.25
investments by promoting diversification. For example, issuer-specific
concentration limits control how much exposure an FCM or DCO has to the
credit risk of any one investment. The Commission believes that greater
diversification can be achieved through instituting two additional
types of concentration limits. First, asset-based concentration limits,
suggested by the FIA, MF Global and Newedge in their comment letters,
reduce market risk by limiting how much of any one class of instrument
an FCM or DCO can have in its portfolio at any one time. Second,
repurchase agreement counterparty concentration limits serve to cap an
FCM or DCO's exposure to the credit risk of a counterparty.
Below, the Commission details its proposal to remove government
sponsored enterprise (GSE) securities that are not backed by the full
faith and credit of the United States, corporate debt obligations not
guaranteed by the United States, general obligations of a sovereign
nation (foreign sovereign debt), and in-house transactions from the
list of permitted investments. These proposed changes reflect the
position of the Commission that the safety of a particular instrument
or transaction must be viewed through the lens of its likely
performance during a period of market volatility and financial
instability.
1. Government Sponsored Enterprise Securities
The Commission proposes to amend paragraph (a)(1)(iii) to expressly
add U.S. government corporation obligations \19\ to GSE securities
(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. 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.\20\
Obligations of U.S. government corporations, such as the Government
National Mortgage Association (known as 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, it believes that GSE securities should remain on the
list of permitted investments in the event this status changes in the
future.
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\19\ See 31 U.S.C. 9101 (defining ``government corporation'').
\20\ Frank J. Fabozzi with Steven V. Mann, The Handbook of Fixed
Income Securities, 242-245 (McGraw Hill 7th ed. 2005).
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The failure of two GSEs during the financial crisis has moved the
Commission to view the securities of such GSEs as inappropriate for
investments of customer funds. In 2008, the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac) failed due to problems in the subprime mortgage market.
While Fannie Mae and Freddie Mac were bailed out in 2008, the U.S.
government had no obligation to do so and investors cannot rely on
another bailout should a GSE fail in the future.
In consideration of the above, the Commission proposes to amend
paragraph (a)(1)(iii) of Regulation 1.25 by permitting investments in
only those U.S. agency obligations that are fully guaranteed as to
principal and interest by the United States.\21\ The Commission
requests comment on whether GSE securities should remain as permitted
investments under Regulation 1.25, either subject to a Federal
guarantee requirement or not.
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\21\ Although U.S. Government corporation obligations backed by
the full faith and credit of the United States could also be
categorized as U.S. Government securities under Regulation
1.25(a)(1)(i), the Commission is distinguishing them from other
government securities, such as Treasury securities, because they
cannot be expected to have the same liquidity even if they satisfy
the ``highly liquid'' requirement under proposed. Regulation
1.25(b)(1). See also discussion of concentration limits in Section
II.B.4. of this notice.
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2. Commercial Paper and Corporate Notes or Bonds
In order to simplify the regulation by eliminating rarely-used
instruments, and in light of the credit, liquidity, and market risks
posed by corporate debt securities, the Commission proposes to limit
investments in ``commercial paper'' \22\ and ``corporate notes or
bonds'' \23\ 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.\24\
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\22\ Regulation 1.25(a)(1)(v).
\23\ Regulation 1.25(a)(1)(vi).
\24\ 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. Additionally, it should be noted that two commenters
suggested expanding the list of permitted investments to include
commercial paper and corporate notes or bonds guaranteed by foreign
sovereign governments. However, as the Commission has determined
that foreign sovereign debt is itself unsuitable as a permitted
investment, going forward (explained in more detail below), it
follows that corporate debt guaranteed by a foreign sovereign
government would also not be permissible.
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[[Page 67645]]
Information obtained during the 2007 Review indicated that
commercial paper and corporate notes or bonds were not widely used by
FCMs or DCOs.\25\ Consistent with this, the NFA states in its comment
letter that most firms invest about 33 percent of their customer funds
in government securities, 10 percent in MMMFs, and the balance
maintained in bank accounts or on deposit with a carrying broker.
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\25\ 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. Further, 26 FCM respondents engaged in reverse repurchase
agreements as of December 1, 2007 and none received commercial paper
or corporate notes or bonds in those transactions.
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In the fall of 2008, the Federal Deposit Insurance Corporation
(FDIC) created the TLGP, which guarantees principal and interest on
certain types of corporate debt. Although the TLGP debt securities are
backed by the full faith and credit of the U.S. Government and
therefore pose minimal credit risk to the buyer for the period during
which the guarantee is effective, initially there was concern as to
whether the securities were readily marketable and sufficiently liquid
so that the holders of such securities would be able to liquidate them
quickly and easily without having to incur a substantial discount.
In February 2010, having evaluated the growing market for TLGP debt
securities, the Division issued an interpretative letter concluding
that TLGP debt securities are sufficiently liquid, and might therefore
qualify as permitted investments under Regulation 1.25 if they meet the
following criteria in addition to satisfying the pre-existing
requirements imposed by Regulation 1.25: (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.\26\
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\26\ Letter from Ananda Radhakrishnan, Director, Division of
Clearing and Intermediary Oversight, CFTC, to Debra Kokal, Chairman
of the Joint Audit Committee (Jan. 15, 2010) (TLGP Letter).
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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 because this would permit continuing
investment in TLGP debt securities, even though the Commission has
proposed to otherwise eliminate commercial paper and corporate notes or
bonds. Therefore, the Commission proposes to 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.
As a result of this limitation, paragraph (b)(3)(iv), which relates to
adjustable rate securities, is no longer necessary.\27\ The Commission
proposes to delete current paragraph (b)(3)(iv) and replace it with
language codifying the criteria for federally backed commercial paper
and corporate notes or bonds. Accordingly, the Commission proposes to
delete paragraph (b)(3)(i)(B) and amend paragraph (b)(3)(iii) to remove
references to paragraph (b)(3)(iv). The Commission requests comment on
the proscription of commercial paper and corporate notes or bonds that
are not federally guaranteed under the TLGP, the liquidity of TLGP
debt, and whether the removal of the requirements for adjustable rate
securities will have any unintended or detrimental effects on
Regulation 1.25 investments.
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\27\ The original purpose of this paragraph was to set
parameters for adjustable rate securities issued by corporations
and, to a lesser extent, GSEs. As proposed, Regulation 1.25 would
only permit corporate and GSE securities that had explicit U.S.
Government guarantees. Therefore, the mechanics of an adjustable
rate component for these instruments would no longer require
oversight for Regulation 1.25 purposes.
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3. Foreign Sovereign Debt
The Commission proposes to remove foreign sovereign debt as a
permitted investment in the interests of both simplifying the
regulation and safeguarding customer funds. The 2007 Review revealed
negligible investment in foreign sovereign debt \28\ and that fact, in
combination with recent events undermining confidence in the solvency
of a number of foreign countries, supports the Commission's proposed
action. Removal of foreign sovereign debt from the list of permitted
investments is not expected to significantly impact FCM and DCO
investment strategies for customer funds. The Commission notes that,
aside from general appeals to maintain the current list of permitted
investments, only one commenter specifically addressed foreign
sovereign debt.\29\
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\28\ The 2007 Review indicated that out of 87 FCM respondents,
only three held an investment in foreign sovereign debt at any time
during that year. It should also be noted that only one FCM invested
in such debt under Regulation 30.7.
\29\ FIA, in its comment letter, recommended expanding
investment in foreign sovereign debt beyond the current rule, which
limits an FCM's investment in foreign sovereign debt to the amount
of its liabilities to its clients in that foreign country's currency
(FIA letter at 5). As the Commission is prepared to remove foreign
sovereign debt entirely, a more detailed analysis of this
recommendation is unnecessary.
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Currently, an FCM or DCO can invest customer funds in foreign
sovereign debt subject to two limitations: (1) The debt must be rated
in the highest category by at least one nationally recognized
statistical rating organization (NRSRO) and (2) the FCM or DCO may
invest in such debt only to the extent it has balances in segregated
accounts owed to its customers or its clearing member FCMs,
respectively, denominated in that country's currency. The purpose of
permitting investments in foreign sovereign debt is to facilitate
investments of customer funds in the form of foreign currency without
the need to convert that foreign currency to a U.S. dollar denominated
asset, which would increase the FCM or DCO's exposure to currency risk.
An investment in the sovereign debt of the same country that issues the
foreign currency would limit the FCM or DCO's exposure to sovereign
risk, i.e., the risk of the sovereign's default.
Both the lack of investment in foreign sovereign debt and the
recent global financial volatility have caused the Commission to
reevaluate this provision. First, as noted above, it appears that
foreign sovereign debt is rarely used as an investment tool by FCMs.
Second, the financial crisis has highlighted the fact that certain
countries' debt can exceed an acceptable level of risk.
In consideration of the above, the Commission proposes to remove
foreign sovereign debt as a permitted investment under Regulation 1.25
and renumber paragraph (a)(1) accordingly. The Commission requests
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.
4. In-House Transactions
The Commission proposes to eliminate in-house transactions
permitted under paragraph (a)(3) and subject to the requirements of
paragraph (e) of Regulation 1.25. This proposal is consistent with the
Commission's proposed prohibition on an FCM or DCO entering into a
repurchase or reverse repurchase agreement with a counterparty that is
an affiliate of the FCM or DCO.\30\
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\30\ See discussion infra at Section II.D, regarding proposed
Regulation 1.25(d)(3).
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In 2005, two commenters recommended that the Commission permit FCMs
that are dually registered as securities brokers or dealers to engage
[[Page 67646]]
in in-house transactions.\31\ At the time, the Commission concluded
that in-house transactions would allow FCMs to realize ``greater
capital efficiency'' and further reasoned that ``the substitution of
one permitted investment for another in an in-house transaction [would]
not present an unacceptable level of risk to the customer segregated
account.'' \32\ The Commission therefore amended Regulation 1.25 to
allow an FCM/broker-dealer to enter into transactions that are the
economic equivalent of a repurchase or reverse repurchase agreement,
subject to certain requirements.\33\ More specifically, an FCM may
exchange customer money for permitted investments held in its capacity
as a broker-dealer, it may exchange customer securities for permitted
investments held in its capacity as a broker-dealer, and it may
exchange customer securities for cash held in its capacity as a broker-
dealer.\34\
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\31\ See 70 FR at 28193 (FIA and Lehman Brothers supporting in-
house transactions).
\32\ 70 FR 5577, 5581 (Feb. 3, 2005).
\33\ See Regulation 1.25(a)(3) and (e).
\34\ Regulation 1.25(a)(3)(i)-(iii).
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Recent market events have, however, increased concerns about the
concentration of credit risk within the FCM/broker-dealer corporate
entity in connection with in-house transactions. Therefore, consistent
with the Commission's proposal to prohibit FCMs from entering into
repurchase and reverse repurchase agreements with affiliates, the
Commission is proposing to eliminate in-house transactions as permitted
investments for customer funds under paragraph (a)(3) of Regulation
1.25 and rescind paragraph (e), which sets forth the requirements for
in-house transactions. Accordingly, paragraph (f) will be redesignated
as new paragraph (e).
The Commission requests comment on the impact of this proposal on
the business practices of FCMs and DCOs. Specifically, the Commission
requests 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.
The Commission requests comment on any other aspect of the proposed
changes to paragraph (a) of Regulation 1.25. In particular, the
Commission solicits comment on whether MMMFs should be eliminated as a
permitted investment.\35\ In discussing whether MMMF investments
satisfy the overall objective of preserving principal and maintaining
liquidity, the Commission specifically requests comment on whether
changes in the settlement mechanisms for the tri-party repo market
might impact a MMMF's ability to meet the requirements of Regulation
1.25.\36\
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\35\ MMMFs are discussed in greater detail infra, in Sections
II.B.4 and II.C of this notice.
\36\ An industry task force recently concluded an extensive
review of the tri-party repo market to identify ways in which it
could be improved. See Payments Risk Committee, Task Force on Tri-
Party Repo Infrastructure, http://www.newyorkfed.org/tripartyrepo/task_force_report.html (May 17, 2010). In contrast to current
practice, under which funds from maturing repos are available early
in the day, modifications to the settlement arrangements for tri-
party repo transactions may result in payments occurring later in
the day. To the extent that MMMFs invest in tri-party repos, this
change could impact their ability to pay out large amounts of cash
early in the day.
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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 * * *.'' \37\ 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 a requirement that the investment be
``readily marketable,'' that it meet specified rating requirements, and
that it not exceed specified issuer concentration limits. The
Commission is proposing 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. 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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\37\ Regulation 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.'' \38\ The Commission
proposes to remove the ``readily marketable'' requirement from
paragraph (b)(1) and substitute in its place a ``highly liquid''
standard.\39\ The Commission did not receive any comment letters
specifically discussing the meaning and application of the ``readily
marketable'' requirement.\40\
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\38\ See 17 CFR 240.15c3-1(c)(11)(i) (SEC regulation defining
``ready market'').
\39\ Related to this proposed new standard, the provision in
paragraph (a)(2)(ii)(A) that requires securities subject to
repurchase agreements to be `` `readily marketable' as defined in
Sec. 240.15c-1 of this title'' also would be amended to provide
that securities subject to repurchase agreements must be `` `highly
liquid' as defined in paragraph (b)(2) of this section.''
\40\ FIA, MF Global and Newedge mentioned marketability in their
letters but no significant changes were recommended.
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The term ``ready market'' is borrowed from the Securities and
Exchange Commission (SEC) capital rules and is interpreted by the
SEC.\41\ That standard is used in setting appropriate haircuts for the
purpose of calculating capital. Although its inclusion in Regulation
1.25 was intended to be a proxy for the concept of liquidity, it is not
a concept that is otherwise easily applied as a prudential standard in
determining the appropriateness of a debt instrument for investment of
customer funds.
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\41\ The term ``ready market'' is defined, in relevant part, to
``include a recognized established securities market in which there
exists independent bona fide offers to buy and sell so that a price
reasonably related to the last sales price or current bona fide
competitive bid and offer quotations can be determined for a
particular security almost instantaneously and where payment will be
received in settlement of a sale at such price within a relatively
short time conforming to trade custom.'' 17 CFR 240.15c3-
1(c)(11)(i).
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It is the Commission's view that the ``readily marketable''
language should be eliminated 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. As noted above, the SEC's ``ready market'' standard is
intended for a different purpose and is easier to apply to exchange
traded equity securities than debt securities.
Although Regulation 1.25 requires that investments be consistent
with the objective of maintaining liquidity, the Commission has not
articulated an explanation or a definition of the concept of
``liquidity.'' The Commission therefore proposes to define ``highly
liquid'' functionally, as having the ability to be converted into cash
within one business day, without a material discount in value. This
approach focuses on outcome rather than process, and the Commission
believes it will be easier to apply to debt securities than the current
``readily marketable'' standard.
An alternative to using a materiality standard in the definition of
highly liquid is to employ a more formulaic and measurable approach. An
example of a calculable standard would be one that provides that an
instrument is
[[Page 67647]]
highly liquid if there is 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 1
percent haircut off of its book value.
The Commission proposes to amend paragraph (b)(1) to eliminate the
marketability standard and in its place establish a requirement that
permitted investments be highly liquid. The Commission requests comment
on whether the proposed definition of ``highly liquid'' accurately
reflects 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 welcomes comment on the ease
or difficulty in applying the proposed or alternative ``highly liquid''
standards.
2. Ratings
The Commission proposes to remove all rating requirements from
Regulation 1.25. This proposal is mandated by Section 939A of the Dodd-
Frank Act. Further, the proposal reflects the Commission's views that
ratings are not sufficiently reliable as currently administered, that
there is reduced need for a measure of credit risk given the proposed
elimination of certain permitted investments, and that FCMs and DCOs
should bear greater responsibility for understanding and evaluating
their investments.\42\
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\42\ The Commission received three letters regarding rating
requirements, but none focused on the question of whether or not to
retain ratings.
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The original purpose of imposing rating requirements was to
mitigate credit risk associated with permitted investments which
included commercial paper and corporate notes. Recent events in the
financial markets, however, revealed significant weaknesses in the
ratings industry.
Eliminating or restricting rating requirements has been considered
by Congress and regulators with some frequency during the past two
years. This has been motivated, at least in part, by public sentiment
that credit rating agencies did not accurately rate debt in the months
and years leading up to the financial crisis, worsening the financial
crisis and increasing investors' losses. The SEC, in September 2009,
adopted rule amendments that removed references to NRSROs from a
variety of SEC rules and forms promulgated under the Securities
Exchange Act of 1934 and from certain rules promulgated under the
Investment Company Act of 1940 (Investment Company Act).\43\ In
November 2009, the SEC adopted rules imposing enhanced disclosure and
conflict of interest requirements for NRSROs.\44\ The SEC also has
opened comment periods on other proposed amendments, including one that
would remove references to NRSROs from its net capital rule.\45\
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\43\ See 74 FR 52358 (Oct. 9, 2009) (publishing final rules and
proposing additional rule amendments).
\44\ See 74 FR 63832 (Dec. 4, 2009) (publishing final rules and
proposing additional rule amendments).
\45\ 74 FR at 52377-78 (proposing removal of certain references
to NRSROs in the SEC's net capital rules for broker-dealers).
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The Dodd-Frank Act contains several measures that focus both on
decreasing reliance on NRSROs and improving the performance of NRSROs
when they must be relied upon. Section 939 of the Dodd-Frank Act
mandates the removal of certain references to NRSROs in several
statutes,\46\ and Section 939A requires all Federal agencies to review
references to NRSROs in their regulations, to remove reliance on credit
ratings and, if appropriate, to replace such reliance with other
standards of credit-worthiness.
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\46\ Sections 7(b)(1)(E)(i), 28(d) and 28(e) of the Federal
Deposit Insurance Act (12 U.S.C. 1811 et seq.), Section 1319 of the
Federal Housing Enterprises Financial Safety and Soundness Act of
1992 (12 U.S.C. 4519), Section 6(a)(5)(A)(iv)(I) of the Investment
Company Act of 1940 (15 U.S.C. 80a-6(a)(5)(A)(iv)(I)), Section 5136A
of title LXII of the Revised Statutes of the United States (12
U.S.C. 24a), and Section 3(a) of the Securities Exchange Act of 1934
(15 U.S.C. 78a(3)(a)).
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The Commission, therefore, intends to remove credit rating
requirements from Regulation 1.25.\47\ Alternative standards of credit-
worthiness are not being proposed. Evidence that rating agencies have
not reliably gauged the safety of debt instruments in the past and the
fact that other Regulation 1.25 proposed amendments published in this
notice obviate much of the need for credit ratings, have helped to
shape the Commission's decision.
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\47\ See infra Section II.E.2 regarding the corresponding change
in Regulation 30.7.
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While some might argue that imperfect information is better than
none at all, several factors outweigh the possible risks associated
with removing rating requirements. First, eliminating commercial paper
and corporate notes or bonds as permitted investments would take away a
large class of potentially risky investments for which ratings would be
relevant. Second, the issuer concentration limits and proposed asset-
based concentration limits should reduce the likelihood that one
problem investment would destabilize an entire investment portfolio.
Finally, removing rating requirements would not absolve FCMs and DCOs
from investing in safe, highly liquid investments; rather it would
shift to FCMs and DCOs more of the responsibility to diligently
research their investments.
In light of the above analysis, the Commission proposes to
eliminate paragraph (b)(2) of Regulation 1.25 and renumber the
subsequent provisions of paragraph (b) accordingly.
3. Restrictions on Instrument Features
Currently, both non-negotiable and negotiable CDs are permitted
under Regulation 1.25. Paragraph (b)(3)(v) details the required
redemption features of both types of CDs.
Non-negotiable CDs represent a direct obligation of the issuing
bank to the purchaser. The CD is wholly owned by the purchaser until
early redemption or the final maturity of the CD. To be permitted under
Regulation 1.25, the terms of the CD must allow the purchaser to redeem
the CD at the issuing bank within one business day, with any penalty
for early withdrawal limited to any accrued interest earned. Therefore,
other than in the event of a bank default, an investor is assured of
the return of its principal.
Negotiable CDs are considerably different than non-negotiable CDs
in that they are typically purchased by a broker on behalf of a large
number of investors. The large size of the purchase by the broker
results in a more favorable interest rate for the purchasers, who
essentially own shares of the negotiable CD. Unlike a non-negotiable
CD, the purchaser of a negotiable CD cannot 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 negotiated CD terms (interest rate and duration) and
the current economic conditions, the market for a given CD can be
illiquid and can result in the inability to redeem within one business
day and/or a significant loss of principal.
Therefore, the Commission proposes to amend paragraph (b)(3)(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.\48\
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\48\ While it proposes to eliminate negotiable CDs as an
interest bearing vehicle for purposes of Regulation 1.25, the
Commission notes that Section 627 of the Dodd-Frank Act removes the
prohibition on payments of interest on demand deposits. Demand
deposits which meet Regulation 1.25 standards of liquidity may,
therefore, be a source of interest income to DCOs and FCMs.
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[[Page 67648]]
4. Concentration Limits
Paragraph (b)(4) of Regulation 1.25 currently sets forth issuer-
based concentration limits for direct investments, securities subject
to repurchase or reverse repurchase agreements, and in-house
transactions. The Commission proposes 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.\49\
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\49\ The Commission is aware that other diversification methods
exist or could be devised (such as the diversification requirements
for MMMF investments in CME's IEF2 collateral management program)
and believes that such methods can coexist with the proposed
concentration limits.
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(a) Asset-based concentration limits. Asset-based concentration
limits would dictate the amount of funds an FCM or DCO could hold in
any one class of investments, expressed as a percentage of total assets
held in segregation. In their comment letters, the FIA, MF Global and
Newedge specifically suggested the incorporation of asset-based
concentration limits. The Commission agrees that such limits could
increase the safety of customer funds by promoting diversification.
Specifically, the Commission proposes the following asset-based
limits in light of its evaluation of credit, liquidity, and market
risk:
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.
Asset-based concentration limits are consistent with the
Commission's historical view that not all permitted investments have
identical risk profiles.\50\ In its efforts to increase the safety of
permitted investments on a portfolio basis, the Commission has decided
to assign to each permitted investment an asset-based concentration
limit that correlates to its level of risk and liquidity relative to
other permitted investments.\51\
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\50\ See 70 FR at 5581 (discussing the relative risk profiles of
permitted investments in the context of repurchase agreements).
\51\ The Commission notes that paragraphs (b)(4)(ii)-(iii) of
Regulation 1.25 would apply to both asset-based and issuer-based
concentration limits. Therefore, for the purpose of calculating
asset-based concentration limits, instruments purchased by an FCM or
DCO as a result of a reverse repurchase agreement under paragraph
(b)(4)(iii) would be combined with instruments held by the FCM or
DCO as direct investments.
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U.S. government securities are backed by the full faith and credit
of the U.S. government, are highly liquid, and are the safest of the
permitted investments. As such, the Commission proposes a 100 percent
concentration limit, allowing an FCM or DCO to invest all of its
segregated funds in U.S. government securities.\52\
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\52\ FIA, MF Global and Newedge each assigned a 100 percent
concentration limit to U.S. government securities. See FIA letter at
3, MF Global letter at 2, and Newedge letter at 5.
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U.S. agency obligations, as proposed, must be fully guaranteed as
to principal and interest by the United States. The Commission views
these as sufficiently safe but potentially not as liquid as a Treasury
security. Because of this concern, and in the interest of promoting
diversification, the Commission proposes a 50 percent concentration
limit.\53\
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\53\ FIA, MF Global and Newedge each assigned a 75 percent
concentration limit to GSE securities. See FIA letter at 3, MF
Global letter at 2, and Newedge letter at 5.
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The Commission categorizes TLGP debt securities as corporate
securities,\54\ which are riskier than U.S. government securities.
While TLGP debt securities have an explicit FDIC guarantee, which
provides confidence for TLGP debt investors that they will receive the
full amount of principal and interest in the event of an issuer
default, the timing of such a payment is uncertain. Additionally, while
TLGP debt securities that meet the Commission's requirements have a
liquid secondary market, that might not always be the case. The
Commission therefore proposes to apply a 25 percent concentration limit
for TLGP debt securities as well.
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\54\ See TLGP Letter.
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CDs are safe for relatively small amounts, but the risk increases
for larger sums. The rise in bank failures since 2008 is a cause for
concern with regard to CDs because they are FDIC insured to a maximum
of only $250,000. As a result, the Commission proposes to apply a 25
percent concentration limit to CDs.
In evaluating possible asset-based concentration limits for TLGP
debt securities and CDs, the Commission determined that the same
concentration limit should apply to both, even though the risk profiles
of the asset classes are different. The Commission recognizes that TLGP
debt securities pose no risk to principal, unlike bank CDs which are
subject to the possible default of the issuing bank. However, a CD
which must be redeemable within one business day under Regulation
1.25(b)(3)(v) could prove to be more liquid than TLGP debt securities
during a time of market stress. The Commission requests comment on
whether there should be differentiation between asset-based
concentration limits for TLGP debt securities and CDs and, if so, what
those different concentration limits should be.
Municipal securities are backed by the state or local government
that issues them, and they have traditionally been viewed as a safe
investment. However, municipal securities have been volatile and, in
some cases, increasingly illiquid over the past two years. Therefore,
the Commission proposes to apply a 10 percent concentration limit to
municipal securities.\55\
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\55\ FIA, MF Global and Newedge each assigned a 25 percent
concentration limit to all assets that were not U.S. government
securities, GSE securities or MMMFs. See FIA letter at 3, MF Global
letter at 2, and Newedge letter at 5.
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MMMFs have been widely used as an investment for customer
segregated funds.\56\ As discussed in the next section, their portfolio
diversification, administrative ease, and heightened prudential
standards recently imposed by the SEC, continue to make MMMFs 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.\57\ To mitigate
these risks, the Commission proposes to assign a 10 percent
concentration limit for MMMFs.\58\ The Commission believes that this
concentration limit is commensurate with the risks posed by MMMFs. The
Commission solicits comment regarding whether 10 percent is an
appropriate asset-based concentration limit for MMMFs. The Commission
welcomes opinions on what alternative asset-based concentration limit
might be appropriate for MMMFs and, if such
[[Page 67649]]
asset-based concentration limit is higher than 10 percent, what
corresponding issuer-based concentration limit should be adopted.
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\56\ The 2007 Review indicated that out of 87 FCM respondents,
46 had invested customer funds in MMMFs at some point during the
November 30, 2006-December 1, 2007 period.
\57\ See 75 FR 10060, 10078 n.234 (Mar. 4, 2010).
\58\ FIA recommended a 100 percent concentration limit, Newedge
recommended a 50 percent concentration limit, and MF Global
recommended a 25 percent concentration limit for MMMFs. See FIA
letter at 3, Newedge letter at 5, and MF Global letter at 2.
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(b) Issuer-based concentration limits. The Commission has
considered the current concentration limits and proposes 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 and the Commission believes that it is prudent to require FCMs
and DCOs to diversify their MMMF portfolios. The 25 percent issuer-
based limitation for GSEs (now U.S. agency obligations) and the 5
percent issuer-based limitation for municipal securities, commercial
paper, corporate notes or bonds, and CDs will remain in place.
(c) Counterparty concentration limits. Finally, the Commission
proposes a counterparty concentration limit of 5 percent of total
assets held in segregation for securities subject to reverse repurchase
agreements. Under Regulation 1.25(b)(4)(iii), concentration limits for
reverse repurchase agreements are derived from the concentration limits
that would have been assigned to the underlying securities had the FCM
or DCO made a direct investment. Therefore, 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-permissible
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.
In accordance with the above discussion, the Commission proposes to
amend paragraph (b)(4) to add a new paragraph (i) setting forth asset-
based concentration limits for direct investments; amend and renumber
as new paragraph (ii) issuer-based concentration limits for direct
investments; amend and renumber as new paragraph (iii) concentration
limits for reverse repurchase agreements; delete the existing paragraph
(iv) due to the Commission's proposed elimination of in-house
transactions; renumber as a new paragraph (iv) the provision regarding
treatment of customer-owned securities; and add a new paragraph (v)
setting forth counterparty concentration limits for reverse repurchase
agreements.
The Commission requests comment on any and all aspects of the
proposed concentration limits, including whether asset-based
concentration limits are an effective means for facilitating investment
portfolio diversification and whether there are other methods that
should be considered. In addition, the Commission requests comment on
whether the proposed concentration levels are appropriate for the
categories of investments to which they are assigned and whether there
should be different standards for FCMs and DCOs.
C. Money Market Mutual Funds
The continued use of MMMFs was the sole focus of five comment
letters,\59\ a substantial focus of one,\60\ and referenced positively
by an additional four.\61\ Taken together, the letters conveyed a
consensus that MMMFs are both safe and administratively efficient. In
their respective comment letters, Federated noted that MMMFs are
subject to the overlapping regulatory regimes overseen by the SEC, and
ICI highlighted the quality, liquidity and diversity of an MMMF's
holdings. Further, TSI noted that out of 700-800 MMMFs, only one failed
during the September 2008 financial turmoil, a crisis which Dreyfus
likened to a ``1,000 year flood.''
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\59\ See Crane letter, Dreyfus letter, Federated letter I, ICI
letter, and TSI letter.
\60\ See CME letter at 5-6.
\61\ See FCStone letter at 2, MF Global letter at 2, Newedge
letter at 5, and NFA letter at 1.
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While the Commission appreciates the benefits of MMMFs, it also is
cognizant of their risks. Reserve Primary Fund, the September 2008
failure referenced by TSI, was an MMMF that satisfied the enumerated
requirements of Regulation 1.25 and at one point was a $63 billion
fund. The Reserve Primary Fund's breaking the buck called attention to
the risk to principal and potential lack of sufficient liquidity of any
MMMF investment. In the wake of the Reserve Primary Fund problem, the
Commission has been forced to consider the possibility that any number
of MMMFs that meet the technical requirements of Regulation 1.25(c)
might not meet the Regulation 1.25 objective of preserving principal
and maintaining liquidity, particularly during volatile market
conditions.\62\ Lending credence to such concerns, the SEC has
estimated that, in order to avoid breaking the buck, nearly 20 percent
of all MMMFs received financial support from their money managers or
affiliates from mid-2007 through the end of 2008.\63\
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\62\ See 75 FR at 10078 n.234 (SEC final rulemaking adopting
amendments to regulations governing MMMFs, describing the September
2008 run on MMMFs: ``On September 17, 2008, approximately 25% of
prime institutional money market funds experienced outflows greater
than 5% of total assets; on September 18, 2008, approximately 30% of
prime institutional money market funds experienced outflows greater
than 5%; and on September 19, 2008, approximately 22% of prime
institutional money market funds experienced outflows greater than
5%'').
\63\ See 74 FR 32688, 32693 (July 8, 2009).
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In response to the potential risks posed by investments in MMMFs,
the Commission is proposing to institute the concentration limits
discussed above. However, the Commission has decided to refrain from
further restricting investments in MMMFs at this time. The Commission
is hopeful that the combination of its asset-based limitations, issuer-
based limitations applied to a single family of funds, and the SEC's
recent MMMF reforms will adequately address the risks associated with
MMMFs.\64\
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\64\ See 75 FR 10060 (SEC final rulemaking decreasing the
percentage of second tier securities (which are securities that do
not receive the highest rating from an NRSRO or, if unrated,
securities that are comparable in quality to securities that do not
receive the highest rating from an NRSRO) from 5 percent to 3
percent, reducing the dollar-weighted average portfolio maturity
from 90 days to 60 days, introducing a dollar-weighted average life
to maturity of 120 days, and imposing new daily and weekly liquidity
requirements, among others).
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The Commission requests comment on whether MMMF investments should
be limited to Treasury MMMFs,\65\ or to those MMMFs that have
portfolios consisting only of permitted investments under Regulation
1.25.
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\65\ A ``Treasuries fund'' must have at least 80 percent of its
assets invested in U.S. treasuries at all times, as required by 17
CFR 270.35d-1.
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The Commission is proposing two technical amendments to paragraph
(c) of Regulation 1.25. First, the Commission is proposing to clarify
the acknowledgment letter requirement under paragraph (c)(3); and
second, the Commission is proposing to revise and clarify the
exceptions to the next-day redemption requirement under paragraph
(c)(5)(ii).
1. Acknowledgment Letters
The Commission is proposing to amend Regulation 1.25(c)(3) to
clarify
[[Page 67650]]
the appropriate party to provide an acknowledgment letter where
customer funds are invested in MMMFs. Regulation 1.26 requires an FCM
or DCO which invests customer funds in instruments permitted under
Regulation 1.25 to create a segregated account at a depository for such
instruments and to obtain an acknowledgment letter from the depository.
Because interests in MMMFs generally are not held at a depository in
the first instance, like other permitted investments, Regulation
1.25(c)(3) currently provides an exception to the Regulation 1.26
requirement that an acknowledgment letter be provided by a depository.
Regulation 1.25(c)(3) requires the ``sponsor of the fund and the fund
itself'' to provide an acknowledgment letter when the MMMF shares are
held by a fund's shareholder servicing agent.
The Commission has received a number of inquiries regarding the
meaning of this provision and the definition of ``sponsor,'' a term
that is not defined in the Investment Company Act. While the term is
not defined, it is nonetheless used throughout the Investment Company
Act and is generally understood to refer to the entity that organizes
the fund. Such an entity typically provides seed capital to the
investment company and may be an affiliated investment adviser or
underwriter to the investment company.
The Commission seeks to clarify that the intent of Regulation
1.25(c)(3) is to require an acknowledgment letter from a party that has
substantial control over the 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 an MMMF. The Commission
has concluded that in many circumstances, the fund sponsor, the
investment adviser, or fund manager would satisfy this requirement. To
the extent there are circumstances where an entity such as the
Administrator would be in this position, proposed Regulation 1.25(c)(3)
encompasses such an entity. The Commission requests comment on whether
the proposed standard is appropriate and whether there are other
entities that could serve as examples.
The Commission is also proposing 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 is 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 requests comment on whether removal of this
language helps clarify the intent of Regulation 1.25(c)(3).
The Commission is accordingly proposing to amend Regulation
1.25(c)(3) to set forth a functional definition accompanied by specific
examples. The proposed amendment would require an FCM or DCO to obtain
the acknowledgment letter required by Regulation 1.26 \66\ from an
entity that has substantial control over the fund's assets and has the
knowledge and authority to facilitate redemption and payment or
transfer of the customer segregated funds. The proposed language would
specify that such an entity may include the fund sponsor or investment
adviser.\67\
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\66\ In a related proposed rulemaking, the Commission has
proposed to add a new paragraph (c) to Regulation 1.26 which would
specifically govern acknowledgment letters for MMMFs. The Commission
also has proposed a mandatory form of acknowledgment letter in
proposed Appendix A to Regulation 1.26. See 75 FR 47738 (Aug. 9,
2010).
\67\ A fund sponsor or investment adviser would be identified as
appropriate entities to provide an acknowledgment letter, because
they would typically be expected to satisfy the proposed standard.
However, in any circumstance where the fund sponsor or investment
adviser does not meet that standard, the acknowledgment letter would
have to be obtained from another entity that can meet the regulatory
requirement.
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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.'' \68\ This
``next-day redemption'' requirement is a significant feature of
Regulation 1.25 and is meant to ensure adequate liquidity.\69\
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)).\70\ The Commission has received 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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\68\ Regulation 1.25(c)(5)(i).
\69\ 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.'').
\70\ 15 U.S.C. 80a-22(e).
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Recently, as part of its MMMF reform initiative, the SEC adopted a
rule that provides the basis for another exception to the next-day
redemption requirement.\71\ Promulgated under Section 22(e), Rule 22e-3
\72\ permits MMMFs to suspend redemptions and postpone payment of
redemption proceeds in order to facilitate an orderly liquidation of
the fund.\73\ Before Rule 22e-3 may be invoked, the fund's board,
including a majority of its disinterested directors, must determine
that the extent of the deviation between the fund's amortized cost per
share and its current net asset value per share may result in material
dilution or other unfair results,\74\ and the board, including a
majority of its disinterested directors, must irrevocably approve the
liquidation of the fund.\75\ In addition, prior to suspending
redemption, the fund must notify the SEC of its decision.\76\
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\71\ See Letter from Ananda Radhakrishnan, Director, Division of
Clearing and Intermediary Oversight, CFTC, to Debra Kokal, Chairman
of the Joint Audit Committee (June 3, 2010) (stating that Rule 22e-3
falls within the exceptions to the next-day redemption requirement
under Regulation 1.25).
\72\ 17 CFR 270.22e-3.
\73\ See 75 FR at 10088.
\74\ 17 CFR 270.22e-3(a)(1).
\75\ 17 CFR 270.22e-3(a)(2).
\76\ 17 CFT 270.22e-3(a)(3).
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In order to expressly incorporate 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 has decided 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 Rule 22e-3.
Section 22(e) will, however, continue to be incorporated by reference
so as to provide for any future amendment or regulatory actions by the
SEC.
The Commission will include, as Appendix A to the rule text, safe
harbor language that can be used by MMMFs to ensure that their
prospectuses comply with Regulation 1.25(c)(5). The proposed language
tracks the proposed paragraph (c)(5).
The Commission requests comment on all aspects of its proposed
amendments to paragraph (c). The Commission seeks comment specifically
on any proposed regulatory language that commenters believe requires
further clarification. In addition, commenters are invited to submit
views on the usefulness and substance of the proposed safe harbor
language contained in proposed Appendix A.
D. Repurchase and Reverse Repurchase Agreements
The Commission proposes to eliminate repurchase and reverse
repurchase transactions with affiliate counterparties. This amendment
forwards the interests of both protecting
[[Page 67651]]
customer funds as well as establishing consistency within the
regulation, which would no longer permit in-house transactions and
currently prohibits investments in instruments issued by affiliates.
Repurchase and reverse repurchase transactions were originally
included as permitted investments to increase the liquidity in the
portfolio of segregated funds.\77\ By entering into repurchase
agreements with unaffiliated counterparties, FCMs can convert
securities holdings into cash or alternatively supply cash to market
participants in exchange for liquid securities. In the event that a
counterparty receiving cash defaults, the other party is protected due
to its holding of the counterparty's securities. Reverse repurchase and
repurchase agreements contribute generally to increased market
liquidity and are not inconsistent with the required safety of customer
funds.
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\77\ 65 FR 39008, 39015 (June 22, 2000).
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The benefits of such an arrangement are diminished, however, when
repurchase agreements are between affiliates. In particular, 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. While such a scenario would be unexpected in calm
markets, during periods of financial turbulence such problems are
considerably more likely to occur. It should be noted that the actions
of market participants suggest that even possession and control of
liquid securities may be insufficient to alleviate concerns relating to
transactions with financially troubled counterparties.\78\
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\78\ 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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Further, the interests of consistency of the regulation weigh in
favor of disallowing repurchase agreements between affiliates.
Currently, a repurchase agreement between affiliates is allowed under
Regulation 1.25(d), while investments in debt instruments issued by an
affiliate--effectively a collateralized loan between affiliates--is
prohibited by paragraph (b)(6). A repurchase agreement is functionally
equivalent to a short-term collateralized loan. In both transactions,
one party provides cash to another party, secured by assets owned by
the other party, and, in return, the other party repays the cash, plus
interest, and its assets are returned. The similarity of the two
transactions would seem to require similar treatment under Regulation
1.25.
Therefore, the Commission proposes to amend paragraph (d) by adding
new paragraph (3) prohibiting repurchase and reverse repurchase
agreements with affiliates. Current paragraphs (3) through (12) will be
renumbered as (4) through (13), accordingly. The Commission seeks
comment on its proposal to eliminate repurchase and reverse repurchase
transactions with affiliate counterparties.
E. Regulation 30.7
1. Harmonization
The Commission proposes to harmonize Regulation 30.7 with the
investment limitations of Regulation 1.25. As noted above, the
Commission has 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.\79\
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.
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\79\ 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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The Commission anticipates that the impact of this amendment will
be slight, as it appears that using Regulation 1.25 standards in 30.7
investments is a common industry practice. For example, Newedge
commented that the harmonization of Regulations 1.25 and 30.7 ``would
reflect current market practice * * *'' since, in its opinion, ``* * *
many if not most FCMs currently invest Part 30.7 funds in the same
products and transactions in which they invest Rule 1.25 funds.'' \80\
FIA also noted that its ``member firms generally follow the Rule 1.25
investment guidelines'' when investing 30.7 funds.\81\ In addition to
adding new paragraph (g) to Regulation 30.7 to reflect this amendment,
the Form 1-FR-FCM instruction manual would be revised accordingly.\82\
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\80\ Newedge letter at 4.
\81\ FIA letter at 5.
\82\ Pending adoption of final amendments to Regulation 30.7,
the Commission will revise the section headed ``Permissible
Investments of Part 30 Set-Aside Funds'' on page 12-9 to align with,
and refer back to, the discussion of Regulation 1.25 investments on
pages 10-7 and 10-8.
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The Commission solicits comment on applying the requirements of
Regulation 1.25 to 30.7 funds. In this regard, the Commission seeks
comment on any differences between customer segregated funds and 30.7
funds that would warrant the continuing application of different
standards.
2. Ratings
The Commission proposes to remove all rating requirements from
Regulation 30.7. This proposal 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.\83\
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\83\ See discussion supra Section II.B.2 regarding the
Commission's policy decision to remove references to credit ratings
from Regulation 1.25 and other regulations.
---------------------------------------------------------------------------
The only reference to credit ratings in Regulation 30.7 is in
paragraph (c)(1)(ii)(B). Paragraph (c)(1)(ii) permits 30.7 funds to be
kept in an account with a depository outside the United States if the
depository meets any of three alternative standards: (1) The depository
has in excess of $1 billion of regulatory capital, (2) the depository
or its parent's ``commercial paper or long-term debt instrument * * *
is rated in one of the two highest rating categories by at least one''
NRSRO, or (3) if it does not meet either of the first two criteria, the
depository has been permitted to hold 30.7 funds upon the request of a
customer.
The use of the credit rating of the commercial paper or long-term
debt of the depository institution is comparable to the standard used
to gauge the safety of an issuer of a CD.\84\ The Commission has viewed
credit ratings as unreliable to gauge the safety of an issuer of a CD
and proposed, in Section II.B.2 of this notice, to remove this
requirement from Regulation 1.25. The Commission now proposes to remove
paragraph (c)(1)(ii)(B) in Regulation 30.7 as it views an NRSRO rating
as similarly unreliable to gauge the safety of a depository institution
for 30.7 funds. This proposal also serves to align
[[Page 67652]]
Regulation 30.7 with Regulation 1.25 on the topic of NRSROs.
---------------------------------------------------------------------------
\84\ See Regulation 1.25(b)(2)(i)(E).
---------------------------------------------------------------------------
The Commission requests comment on whether there is a standard or
measure of solvency and credit-worthiness that can be used as an
additional test of a bank's safety. Specifically, the Commission seeks
comment on whether a leverage ratio or a capital adequacy ratio
requirement consistent with or similar to those in the Basel III
accords \85\ would be an appropriate additional safeguard for a bank or
trust company located outside the United States.
---------------------------------------------------------------------------
\85\ See Press Release, Basel Committee on Banking Supervision,
Group of Governors and Heads of Supervision Announces Higher Global
Minimum Capital Standards (Sept. 12, 2010), http://bis.org/press/p100912.pdf.
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3. Designation as a Depository for 30.7 Funds
Under Regulation 30.7(c)(1)(ii)(C), a bank or trust company that
does not otherwise meet the requirements of paragraph (c)(1)(ii) may
still be designated as an acceptable depository by request of its
customer and with the approval of the Commission. The Commission
proposes to 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. The Commission has never allowed a bank or trust
company located outside the United States to be a depository through
these means, and believes that it is appropriate to require that all
depositories meet the regulatory capital requirement under paragraph
(c)(1)(ii)(A).
Therefore, the Commission proposes to amend Regulation 30.7 by
deleting paragraph (c)(1)(ii)(C). The Commission requests comment on
whether an exception of any kind to Regulation 30.7(c)(1)(ii) is
appropriate.
III. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) \86\ requires federal
agencies, in promulgating rules, to consider the impact of those rules
on small businesses. The rule amendments proposed 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.\87\ The Commission has previously determined that registered
FCMs \88\ and DCOs \89\ 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 proposed rules will not have a
significant economic impact on a substantial number of small entities.
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\86\ 5 U.S.C. 601 et seq.
\87\ 47 FR 18618 (Apr. 30, 1982).
\88\ Id. at 18619.
\89\ 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 proposed rule amendments do not
require a new collection of information on the part of any entities
subject to the proposed rule amendments. Accordingly, for purposes of
the PRA, the Commission certifies that these proposed rule amendments,
if promulgated in final form, would not impose any new reporting or
recordkeeping requirements.
C. Costs and Benefits of the Proposed Rules
Section 15(a) of the CEA \90\ requires the Commission to consider
the costs and benefits of its actions before issuing a rulemaking under
the Act. By its terms, section 15(a) does not require the Commission to
quantify the costs and benefits of a rule or to determine whether the
benefits of the rulemaking outweigh its costs; rather, it requires that
the Commission ``consider'' the costs and benefits of its actions.
Section 15(a) further specifies that the costs and benefits shall 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 and could in its
discretion determine that, notwithstanding its costs, a particular rule
is necessary or appropriate to protect the public interest or to
effectuate any of the provisions or accomplish any of the purposes of
the Act.
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\90\ 7 U.S.C. 19(a).
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Summary of proposed requirements. The proposed rules would
facilitate greater protection of customer funds and 30.7 funds and
reduction of systemic risk by establishing stricter prudential
standards for investment of such funds. The proposed amendments
restrict the scope of permitted investments to reflect the current
economic environment. During the prior ten-year period, starting with
the December 2000 rulemaking, Regulation 1.25 was substantially revised
and expanded. The more restrictive proposals contained herein are based
on the Commission's experience over the course of the past decade and,
in particular, since September 2008, during which certain permitted
investments under Regulation 1.25 were shown to present potentially
unacceptable levels of risk. In narrowing the scope of Regulation 1.25
(as to both type and characteristics of permitted investments), the
Commission's primary purpose is to safeguard the funds of customers
and, in so doing, to help ease the chain reaction of negative effects
that can come about during a financial crisis in the broader financial
marketplace.
Costs. With respect to costs, the Commission has determined that
any costs associated with the proposal are outweighed by its benefits.
The Commission recognizes that scaling back on the type and form of
permitted investments could result in certain FCMs and DCOs earning
less income from their investments of customer funds. This, in turn,
could reduce an FCM or DCO's overall profits and create an incentive
for them to charge higher fees to customers. The Commission believes,
however, that the potential loss of income for those FCMs and DCOs
whose investment strategies will be materially affected by the proposed
amendments will be outweighed by the reduction in potential risk
associated with the current regulatory standards for permitted
investments. To the extent that customers may bear the cost of the
proposed changes, the customers will nonetheless benefit from greater
protection of their funds. Eliminating the option of a customer to
designate, with the Commission's permission, a foreign depository for
30.7 funds would potentially limit the choices of suitable
depositories. However, the presence of alternative depositories would
mitigate any adverse impact. The proposed amendments would not affect
the efficiency or competitiveness of futures markets, and the proposed
amendments will not affect price discovery.
Benefits. With respect to benefits, the Commission has determined
that the proposal will result in several benefits. First, the risk-
reducing nature of the proposed amendments would facilitate greater
financial integrity of FCMs and DCOs and, as a result, futures markets
more generally. Essential to the proper functioning of futures markets
is the financial integrity of the clearing
[[Page 67653]]
process, which is dependent upon the immediate availability of
sufficient funds for daily pays and collects and default management.
The proposed amendments would also raise the standards for risk
management practices of FCMs and DCOs that invest customer funds. They
balance the need for investment flexibility and capital efficiency with
the need to preserve principal and maintain liquidity. In particular,
the proposal both narrows the scope of permitted investments to only
those that the Commission considers the safest, and mandates
diversification well beyond previous requirements. The Commission
believes that these structural safeguards will decrease the credit,
market, and liquidity risk exposures of FCMs and DCOs. Moreover, the
revised requirements will more closely align with the investment
restrictions contained in Section 4d of the Act.
Also, the Commission recognizes that many, if not most, FCMs and
DCOs are already engaging in sound risk management practices and are
pursuing responsible investment strategies under the existing
regulatory regime. However, the Commission believes that in an
environment where many of its previous economic assumptions are called
into question, it becomes necessary to establish new bright line
requirements to better ensure proper risk management in connection with
the investment of customer segregated and 30.7 funds.
The proposed amendments retain an appropriate degree of flexibility
in making investments with customer segregated and 30.7 funds, while
significantly strengthening the rules that protect the safety of such
funds. In addition, eliminating the option of a customer to designate,
with the Commission's permission, a foreign depository for 30.7 funds
that otherwise would not meet the requirements of Regulation 30.7 both
closes a loophole that might have allowed for a less financially sound
depository to hold 30.7 funds and eliminates the need for the
Commission to individually review the safety and soundness of foreign
depositories.
Public Comment. The Commission invites public comment on its cost-
benefit considerations. Commenters are also are invited to submit any
data or other information that they may have quantifying or qualifying
the costs and benefits of the Proposal with their comment letters.
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 proposes to amend Chapter I of Title 17 of the
Code of Federal Regulations as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 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).
2. Revise Sec. 1.25 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 and fully
guaranteed as to principal and interest by the United States (U.S.
agency obligations);
(iv) Certificates of deposit issued by a bank (certificates of
deposit) as defined in section 3(a)(6) of the Securities Exchange Act
of 1934, or a domestic branch of a foreign bank that carries deposits
insured by the Federal Deposit Insurance Corporation;
(v) Commercial paper 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.
(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 that 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; provided, however, that the
terms of such instrument obligate the issuer to
[[Page 67654]]
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, and it may not
otherwise constitute a derivative instrument.
(iv) 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.
(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.
(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 each of municipal securities and money market
mutual funds 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 of 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 may
not exceed 2 percent of total assets held in segregation by the futures
commission merchant or derivatives clearing organization.
(D) 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 5 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.
[[Page 67655]]
(c) Money market mutual funds. The following provisions will apply
to the investment of customer funds in money market mutual funds (the
fund).
(1) The fund must be an investment company that is registered under
the Investment Company Act of 1940 with the Securities and Exchange
Commission and that holds itself out to investors as a money market
fund, in accordance with Sec. 270.2a-7 of this title.
(2) The fund must be sponsored by a federally-regulated financial
institution, a bank as defined in section 3(a)(6) of the Securities
Exchange Act of 1934, an investment adviser registered under the
Investment Advisers Act of 1940, or a domestic branch of a foreign bank
insured by the Federal Deposit Insurance Corporation.
(3) A futures commission merchant or derivatives clearing
organization shall maintain the confirmation relating to the purchase
in its records in accordance with Sec. 1.31 and note the ownership of
fund shares (by book-entry or otherwise) in a custody account of the
futures commission merchant or derivatives clearing organization in
accordance with Sec. 1.26(c). The futures commission merchant or the
derivatives clearing organization shall obtain the acknowledgment
letter required by Sec. 1.26(c) from an entity that has substantial
control over the fund's assets 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
investment adviser.
(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) Appendix A 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
[[Page 67656]]
securities are actually received by the custodian of the futures
commission merchant's or derivatives clearing organization's customer
funds or securities purchased on behalf of customers. The transfer or
credit of securities covered by the agreement to the futures commission
merchant's or derivatives clearing organization's customer segregated
custodial account is made simultaneously with the disbursement of funds
from the futures commission merchant's or derivatives clearing
organization's customer segregated cash account at the custodian bank.
On the sale or resale of securities, the futures commission merchant's
or derivatives clearing organization's customer segregated cash account
at the custodian bank must receive same-day funds credited to such
segregated account simultaneously with the delivery or transfer of
securities from the customer segregated custodial account.
(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 Paragraph (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
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.
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 derivates clearing organization;
(v) A member of any foreign board of trade; or
(vi) 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 October 26, 2010, by the
Commission.
David A. Stawick,
Secretary of the Commission.
Note: The following statement will not appear in the Code of
Federal Regulations.
[[Page 67657]]
Statement of Chairman Gary Gensler
Investment of Customer Funds and Funds Held in an Account for Foreign
Futures and Foreign Options Transactions
October 26, 2010
I support today's Commission vote on the proposed rulemaking
regarding the investment of customer segregated and secured amount
funds. This rulemaking fulfills part of the Dodd-Frank Act's
requirement that the Commission remove all reliance on credit ratings
from its regulations. In addition, the rule enhances protections
regarding where derivatives clearing organizations (DCOs) and futures
commission merchants (FCMs) can invest customer funds. The market
events of the last two years have underscored the importance of prudent
investment standards to ensure the financial integrity of DCOs and FCMs
and of maximizing protection of customer funds.
[FR Doc. 2010-27657 Filed 11-2-10; 8:45 am]
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