[Federal Register Volume 62, Number 152 (Thursday, August 7, 1997)]
[Rules and Regulations]
[Pages 42398-42401]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-20766]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1


Securities Representing Investment of Customer Funds Held in 
Segregated Accounts by Futures Commission Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Final Rules.

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SUMMARY: The Commodity Futures Trading Commission (''Commission'') is 
amending Rules 1.23 and 1.25 to allow futures commission merchants 
(``FCMs'') to make direct transfers into segregated accounts of 
permissible, unencumbered securities of the types set forth in Section 
4d(2) of the Commodity Exchange Act (``Act'') and Rule 1.25 promulgated 
thereunder. This will provide FCMs a more efficient means to increase 
or decrease their residual interest in funds segregated for the benefit 
of commodity customers than heretofore permitted. In addition, the 
revised rules will permit FCMs to deposit the proceeds from the sale or 
maturity of any such investments directly into a nonsegregated bank 
account, provided that the FCM maintains a sufficient residual 
financial interest in the funds segregated for commodity customers to 
assure that all of an FCM's obligations to its customers are covered. 
The Commission's expectation is that these rule changes will reduce the 
number of transactions required to manage an FCM's segregated cash and 
securities balances, thus reducing operating costs for the industry. To 
assure that there will be a clear audit trail for the increased types 
of permitted transactions, Rule 1.27 also is being amended to require 
that the description of the investment securities, required by the 
rule, includes the security identification number developed by the 
Committee on Uniform Security Identification Procedures (``CUSIP 
Number''). Also, Rule 1.25 is being amended to require identification, 
in the record of investments required to be maintained by Rule 1.27, of 
the manner in which the proceeds from the sale or maturity of any 
segregated securities are disposed of.

EFFECTIVE DATE: September 8, 1997.

FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Jr., Chief 
Accountant, or Lawrence B. Patent, Associate Chief Counsel, Division of 
Trading and Markets (``Division''), Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington, 
D.C. 20581. Telephone (202) 418-5430.

SUPPLEMENTARY INFORMATION:

I. Investment of Customers' Segregated Funds

    At all times, an FCM is required to have sufficient funds in 
segregation to meet its obligations to customers. As a consequence, to 
protect against a customer account going into deficit, an FCM must 
deposit funds of its own to cover any customer account deficits, and 
such funds must remain in segregation until more funds are remitted to 
the FCM by the customers who hold such deficit accounts. Thus, 
maintaining an adequate cushion of its own in segregation is a part of 
routine FCM funds management operations. FCM operational funding needs 
often dictate that any unneeded excess funds in segregation be moved so 
that they can be used in other aspects of the firm's operations. 
Therefore, prudent and efficient funds management typically requires an 
FCM to make frequent transfers of funds into and out of segregation.
    Prior to these rule changes, FCMs were only allowed to increase or 
decrease their interest in customers' segregated funds by direct 
transfers of cash. That is, securities owned by the FCM and held in a 
non-segregated account could not be transferred to a segregated 
account. Moreover, to assure an audit trail, if an FCM wished to move 
funds represented by securities into segregation, the securities had to 
be sold and the cash proceeds transferred into a segregated account. 
The FCM could, then, use the segregated cash to purchase more 
securities that would be held in segregation. The effect of these 
requirements was that any segregated securities, except for securities 
purchased and specifically owned and deposited by individual customers, 
always had to be purchased with cash from a segregated cash account. 
Likewise, the proceeds from any sale of segregated securities always 
had to be deposited into a segregated account, even if there was no 
longer a need for the funds to be in segregation. That is, such funds 
could only be moved to a non-segregated account after the securities 
were converted to cash and the cash had been deposited into a 
segregated account.
    On March 21, 1997, the Commission published for comment proposed 
amendments to Rules 1.23, 1.25, and 1.27.\1\ The proposed changes would 
permit FCMs to transfer their own unencumbered securities from a non-
segregated account directly into a customer segregated safekeeping 
account. This would enable an FCM to increase the amount of funds 
segregated for the benefit of commodity customers more quickly and 
economically. To be eligible for direct transfer, such securities were 
required to be unencumbered and to qualify as permitted investments of 
customer funds under Rule 1.25. The proposed rule amendments also would 
permit an FCM to transfer such securities from a segregated customer 
safekeeping account directly to the FCM's own non-segregated account, 
to the extent the FCM had excess funds available in segregation. The 
30-day public comment period on the proposed rule changes expired on 
April 21, 1997. The Commission received one written comment letter on 
this proposal from the Joint Audit Committee (``JAC'').\2\ The JAC 
raised two issues.
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    \1\ See 62 FR 13564 (March 21, 1997).
    \2\ JAC is comprised of representatives from each commodity 
exchange and National Futures Association which coordinate the 
industry's audit and ongoing surveillance activities to promote a 
uniform framework of self-regulation.
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    First, JAC suggested that Rule 1.25 be amended by removing the 
requirement contained in the rule that the proceeds from any sale of 
segregated securities be redeposited into a segregated account. JAC 
indicated that by eliminating this restriction, FCMs would be able to 
sell segregated securities directly out of the segregated account and 
deposit the funds to a non-segregated account. Since it was the 
Commission's aim to permit cash and securities to be treated the same 
way, thus reducing the number of transactions required to administer 
segregated funds and reduce transaction costs, the Commission agrees 
with this suggestion. Therefore, to adopt the JAC's suggestion, Rule 
1.25 is further amended in two respects: 1) the requirement to deposit 
the proceeds from the sale of segregated securities to a segregated 
account is eliminated; and 2) a requirement to identify, in the record 
of investments required to be maintained by Rule 1.27, the manner in 
which the proceeds from the sale or maturity of any segregated 
securities are disposed of, is added to the rule. That is, if proceeds 
are not redeposited in a segregated account, the record must

[[Page 42399]]

reflect that the proceeds were deposited to an identified non-
segregated account.
    These changes to the rules are achieved without any sacrifice of 
the audit trail related to segregated funds transfers. Also, the rules 
do not impose any significant costs or other undue burdens upon FCMs, 
because the additional information required to be maintained by the 
rule should be available to FCMs in the internal records they already 
maintain.
    The Commission's proposed amendment to Rule 1.23 would have 
modified the restrictions to allow the transfer of the types of 
securities set forth in Rule 1.25 between segregated and nonsegregated 
accounts. These proposed changes would permit transfers between 
segregated and non-segregated accounts, whether made in cash or 
securities, to be treated the same way. Therefore, the Commission has 
determined to adopt the amendment to Rule 1.23 as originally proposed, 
but to add the amendment to Rule 1.25 to assure that the Rule 1.23 rule 
changes achieve the desired result.
    In its second comment, JAC pointed out that the proposed amendments 
to Rules 1.23 and 1.25 would restrict the transfer of securities to 
those held in a segregated safekeeping account with a bank or trust 
company. JAC's original request for the proposed rule change was to 
allow FCMs the ability to transfer segregated securities held by any 
permitted segregation depository, including contract market clearing 
organizations and other FCMs. The Commission agrees. Therefore, the 
final amendments to Rules 1.23 and 1.25, as adopted, refer to 
securities held in segregated safekeeping at any permitted custodian of 
segregated funds, that is a bank, trust company, contract market 
clearing organization, or another FCM. It should be noted that clearing 
organizations and FCMs ultimately deposit customer funds in a 
segregated safekeeping account with a bank or trust company.\3\ In this 
connection the Commission notes that to be considered properly 
segregated, pursuant to the Act and the rules promulgated thereunder, 
securities must be held in safekeeping.
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    \3\ In proposing these rule amendments, the Commission noted 
that their adoption would also require the Division to revise 
Financial and Segregation Interpretation No. 7, which includes the 
following statement:
    Under Regulations 1.23 and 1.25 such obligations must be: (1) 
purchased with money deposited in an account used for the deposit of 
customers' funds; (2) made through such an account; and (3) the 
proceeds from any sale of such obligations must be redeposited in 
such an account. Thus, all additions to and withdrawals from 
customer segregated funds which represent topping up by the FCM to 
cover actual or expected customer deficits must be in the form of 
cash.
    1 Comm. Fut. L. Rep. (CCH) para. 7117, at 7124 (July 23, 1980).
    The Division will delete this text from the interpretation 
shortly and will publish an amended interpretation on its Internet 
web site (http://www.cftc.gov) and request Commerce Clearing Housng 
to publish the revised interpretation in the Commodity Futures Law 
Reporter.
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    For purposes of Rules 1.26, 1.27, 1.28 and 1.29, all permissible 
investments, when deposited into segregated accounts, will be deemed to 
be securities and obligations which represent investments of customers' 
funds until such time as the FCM withdraws or otherwise disposes of 
such investments.
    Also, the Commission is adopting as proposed amendments to Rule 
1.27, which require FCMs to maintain records of permissible investments 
held in segregated accounts. Rule 1.27 now will require the record to 
include the CUSIP number of such securities as a part of the 
description of such investments, and Rule 1.25 will require the FCM's 
record to indicate if securities were liquidated and the non-segregated 
account where the proceeds were transferred. The Commission is not 
adopting any other changes to Rule 1.27, but wants to remind FCMs that 
Rule 1.27 requires them to include in the investments record, among 
other information, the name of the person through whom such investments 
were made and the name of the person to or through whom such 
investments were disposed of. Therefore, this record should identify 
permissible investments owned by the FCM which were deposited into 
segregation and any investments withdrawn from segregation and 
deposited in the FCM's own account. Securities owned by the FCM, used 
to meet its segregation requirements, must be identified as customer 
securities and properly segregated, whether physically deposited or 
deposited by book entry.
    The Commission also invited comments on whether custodians for 
these purposes should be limited to banks and trust companies not 
affiliated with the FCM. The Commission asked this question, in part, 
as a follow-up to issues raised during the Barings crisis. Many firms 
had deposited their cash with affiliates of the Barings bank, which in 
turn used the Barings bank as a depository for those assets. During the 
Barings crisis, these firms found that their assets, notwithstanding 
some interpretations that the segregation laws in the United Kingdom 
impose a complete trust on customer funds, would not necessarily be 
considered segregated for their benefit in any impending liquidation in 
bankruptcy of the Barings group. In this connection, the Commission 
notes that the International Organisation of Securities Commissions 
issued guidance on client asset protection, which is contained in a 
report published in August 1996, that recommends to regulatory 
authorities that they should: ``. . . carefully consider the 
circumstances in which authorised firms may be permitted to meet the 
requirements of a client asset protection regime by holding client 
assets with a related custodian.''
    In this connection, the only commenter, the JAC, stated that such a 
limitation on affiliated depositories would not seem warranted. In most 
jurisdictions, funds in securities held in safekeeping can be separated 
from funds amenable to the claims of a creditor of the custodian, as 
well as a creditor of the FCM. Amendments added to the Act in 1968, to 
impose the requirement to segregate directly on the custodian, are 
intended to achieve that effect.\4\ The adoption of the rules in this 
release is intended to facilitate maintaining segregated funds in the 
form of securities. The Commission, therefore, believes that there is 
no compelling reason to impose a condition, at this time, that such 
funds be held at non-affiliated custodians. The Commission notes that 
it intends to keep this conclusion under review. This is because 
legislative and regulatory changes in the U.S. or in other countries, 
developments in risk assessment systems or cooperative arrangements 
with domestic and/or international regulators and encountering new 
types of custodianship problems in connection with a failed firm could 
at some future time suggest that the Commission consider a change in 
its current rules and policies in this connection.
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    \4\ Pub. L. No. 90-258, Sec. 6, 82 Stat. 26, 28 (1968), now 
codified as the concluding paragraph of Sec. 4d(2) of the Act, 7 
U.S.C. 6d(2) (1994).
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    Under the Act, an FCM may segregate commodity customers' funds at a 
bank or trust company, another registered FCM, or a clearing 
organization of a contract market. Each of these depositories is, 
itself, required by the Act to treat and deal with such funds as 
belonging to the FCM's customers and not as the FCM's own funds. Each 
of these persons is also liable under the Act for any misuse of, or 
failure to segregate, such funds. Such liability accrues whether or not 
the depository is related to the FCM. When customer funds are deposited 
with another FCM or contract market clearing organization, the funds, 
ultimately, are deposited

[[Page 42400]]

with a bank or trust company by such FCM or clearing organization.
    With respect to net capital compliance issues, the Commission's 
staff has previously informally advised the Joint Audit Committee and 
individual registrants that deposits of funds with affiliates would be 
deemed by staff to be returns of capital by an FCM and, therefore, such 
deposits could not be treated as regulatory capital by an FCM, unless 
such funds represented either: (1) Funds segregated or set aside in 
safekeeping under the Commission's rules for commodity or foreign 
futures or foreign options customers; (2) funds held pursuant to the 
Securities and Exchange Commission's customer protection rules (17 CFR 
240.15c3-3); or (3) amounts to be used for normal operating expenses. 
The Commission is in agreement with that policy and does not believe 
any additional limitation needs to be imposed at this time. Unusually 
large amounts of cash held in segregation will be reviewed as part of 
Commission and SRO audit programs.

II. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601-611 (1988), 
requires that agencies, in proposing rules, consider the impact of 
those rules on small businesses. The rule amendments discussed herein 
would affect registered FCMs. The Commission has previously established 
certain definitions of ``small entities'' to be used by the Commission 
in evaluating the impact of its rules on such entities in accordance 
with RFA.\5\ The Commission previously determined that registered FCMs 
are not small entities for the purpose of the RFA.\6\
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    \5\ 47 FR 18618-18621 (April 30, 1982).
    \6\ 47 FR 18619-18620.
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    Further, the amendments discussed herein do not impose any 
significant new burdens upon FCMs. These amendments facilitate the use 
of firm-owned obligations to enhance funds segregated for commodity 
customers by allowing the direct transfer of said obligations into and 
out of segregated accounts. As a result, the Commission anticipates 
that adoption of the amendments will reduce the burden of compliance 
with segregation requirements by FCMs. Accordingly, when these rule 
amendments were proposed, the Chairperson, on behalf of the Commission, 
certified, pursuant to 5 U.S.C. 605(b), that the rule amendments would 
not have a significant economic impact on a substantial number of small 
entities. The Commission, nonetheless, invited comment from any 
registered FCM that believed these rules would have a significant 
impact on its operations, but none was received.

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (Pub. L. No. 104-13, May 13, 
1995) (``PRAct'') imposes certain requirements on federal agencies 
(including the Commission) in connection with their conducting or 
sponsoring any collection of information, as defined by the PRAct. 
While these rule amendments have no burden, the group of rules (3038-
0024) of which the rules proposed to be amended are a part has the 
following burden:

Average burden hours per response.................................18.00
Number of Respondents..........................................1,662.00
Frequency of response.............................................19.00
    Copies of the OMB approved information collection package 
associated with these rules may be obtained from the Desk Officer, 
CFTC, Office of Management and Budget, Room 10202, NEOB, Washington, DC 
20503, (202) 395-7340.

List of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and 
Recordkeeping requirements, Segregation requirements.
    In consideration of the foregoing and pursuant to the authority 
contained in the Act and, in particular, Sections 4d, 4g and 8a (5) 
thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission hereby amends 
Chapter I of Title 17 of the Code of Federal Regulations as follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f, 
6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 
12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24.

    2. Section 1.23 is revised to read as follows:


Sec. 1.23  Interest of futures commission merchant in segregated funds; 
additions and withdrawals.

    The provision in section 4d(2) of the Act and the provision in 
Sec. 1.20(c), which prohibit the commingling of customer funds with the 
funds of a futures commission merchant, shall not be construed to 
prevent a futures commission merchant from having a residual financial 
interest in the customer funds, segregated as required by the Act and 
the rules in this part and set apart for the benefit of commodity or 
option customers; nor shall such provisions be construed to prevent a 
futures commission merchant from adding to such segregated customer 
funds such amount or amounts of money, from its own funds or 
unencumbered securities from its own inventory, of the type set forth 
in Sec. 1.25, as it may deem necessary to ensure any and all commodity 
or option customers' accounts from becoming undersegregated at any 
time. The books and records of a futures commission merchant shall at 
all times accurately reflect its interest in the segregated funds. A 
futures commission merchant may draw upon such segregated funds to its 
own order, to the extent of its actual interest therein, including the 
withdrawal of securities held in segregated safekeeping accounts held 
by a bank, trust company, contract market clearing organization or 
other futures commission merchant. Such withdrawal shall not result in 
the funds of one commodity and/or option customer being used to 
purchase, margin or carry the trades, contracts or commodity options, 
or extend the credit of any other commodity customer, option customer 
or other person.
    3. Section 1.25 is revised to read as follows:


Sec. 1.25  Investment of customer funds.

    No futures commission merchant and no clearing organization shall 
invest customer funds, except in obligations of the United States, in 
general obligations of any State or of any political subdivision 
thereof, or in obligations fully guaranteed as to principal and 
interest by the United States. This shall not prohibit a futures 
commission merchant 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, clearing organization of a 
contract market, or other registered futures commission merchant. 
Furthermore, for purposes of Secs. 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

[[Page 42401]]

customer funds until such investments are withdrawn from segregation.
    4. Section 1.27 is amended by revising paragraphs (a)(4) and (b)(2) 
to read as follows:


Sec. 1.27  Record of investments.

    (a) * * *
    (4) A description of the obligations in which such investments were 
made, including the CUSIP numbers;
* * * * *
    (b) * * *
    (2) A description of such documents, including the CUSIP numbers; 
and
* * * * *
    Issued in Washington D.C. on July 28, 1997, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-20766 Filed 8-6-97; 8:45 am]
BILLING CODE 6351-01-P