[Federal Register Volume 68, Number 125 (Monday, June 30, 2003)]
[Proposed Rules]
[Pages 38654-38657]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-16473]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AC01


Investment of Customer Funds

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rule.

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SUMMARY: The Commodity Futures Trading Commission (Commission) proposes 
to amend its regulations to allow futures commission merchants (FCMs) 
and derivatives clearing organizations (DCO) to engage in repurchase 
agreements with securities

[[Page 38655]]

deposited by customers subject to certain conditions and to modify the 
portfolio time-to-maturity requirements for securities deposited in 
connection with certain collateral management programs of DCOs pursuant 
to certain conditions. The Commission also is requesting comment on 
several other provisions of the rule: Whether the portfolio time-to-
maturity requirement should be modified for portfolios consisting 
exclusively of Treasury securities; whether the restriction on embedded 
derivatives should be modified; whether the list of permitted 
benchmarks for variable rate securities should be expanded; and whether 
the concentration limitations on reverse repurchase agreements should 
be changed. The Commission is proposing these rule amendments and 
requesting comment as part of its continuing efforts to facilitate the 
safe and efficient handling of customer funds, and in response to 
inquiries received as firms gain experience implementing the revisions 
adopted in December 2000.

DATES: Comments must be received on or before July 30, 2003.

ADDRESSES: Comments on the proposed amendments should be sent to Jean 
A. Webb, Secretary, Commodity Futures Trading Commission, Three 
Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. Comments 
may be sent by facsimile transmission to (202) 418-5521, or by e-mail 
to [email protected]. Reference should be made to ``Proposed 
Amendments to Regulation 1.25.''

FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director and 
Chief Counsel, or Lois Gregory, Special Counsel, Division of Clearing 
and Intermediary Oversight, Commodity Futures Trading Commission, Three 
Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. 
Telephone (202) 418-5450.

SUPPLEMENTARY INFORMATION:

I. Background

    Commission Regulation 1.25 (17 CFR 1.25) sets forth the types of 
instruments in which FCMs and DCOs are permitted to invest customer 
segregated funds. Regulation 1.25 was substantially amended in December 
2000 to expand the list of permitted investments.\1\ In connection with 
the expansion, the Commission added several provisions intended to 
minimize the credit, liquidity, and volatility risk associated with the 
additional investments. The Commission is proposing to modify some of 
those provisions. The Commission is also requesting comment on several 
other provisions of the rule.
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    \1\ 65 FR 77993 (December 13, 2000).
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II. Proposed Amendments

A. Repurchase Agreements Involving Collateral Deposited by Customers

    CFTC Interpretative Letter 84-24 (``84-24'') permits FCMs to engage 
in repurchase agreements (``repos'') with collateral deposited by 
customers (``customer collateral'') subject to certain terms and 
conditions.\2\ When the Commission adopted the amendments to Regulation 
1.25 in December 2000, it included provisions governing repos and 
reverse repos involving investments purchased with customer funds 
(``permitted investments'') subject to terms and conditions that differ 
in a number of ways from those in 84-24.\3\ The Commission did not 
address 84-24 at that time.
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    \2\ CFTC Staff Letter No. 84-24, [1984-1986 Transfer Binder] 
Comm. Fut. L. Rep. (CCH) ]22,449 (Dec. 5, 1984).
    \3\ Regulation 1.25(a)(2) and 1.25(d).
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    Various market participants have suggested that repos involving 
customer collateral should be permitted under the terms and conditions 
applicable to permitted investments. They believe that increased use of 
repos could enhance yield. They also note that certain types of 
collateral, while permissible as margin at the FCM level, are not 
acceptable at the clearinghouse level. Permitting repos of such 
collateral could ease cash flow problems that sometimes arise from this 
circumstance.
    The Commission is proposing to amend Regulation 1.25(a)(2) to 
permit FCMs and DCOs to engage in repos of customer-deposited 
securities subject to certain terms and conditions. The proposal would 
eliminate the requirement currently set forth in 84-24 that the FCM 
provide written disclosure of the mechanics of the transaction and 
obtain written authorization from the customer. If the Commission 
adopted the proposal, 84-24 would be superseded.
    Proposed paragraph (a)(2)(ii)(A) would provide that, to be 
eligible, securities must meet the marketability requirements of 
Regulation 1.25(b)(1). This is intended to ensure that, if a repo 
counterparty should default, the FCM or DCO could use the cash proceeds 
from the repo to buy the securities elsewhere.
    Proposed paragraph (a)(2)(ii)(B) would provide that securities 
subject to repurchase agreements must not be ``specifically 
identifiable property'' as defined in section 190.01(kk) of the 
Commission's rules. Such property is generally not eligible for repo.
    Proposed paragraph (a)(2)(ii)(C) would provide that the terms and 
conditions of such a repo must be in accordance with the requirements 
of Rule 1.25(d). The Commission believes that these safeguards, 
currently applicable to repos for permitted investments, are 
appropriate to apply to customer-deposited securities as well.
    Proposed paragraph (a)(2)(ii)(D) would provide that, in the 
unlikely event of a default by a counterparty to a repurchase 
agreement, the FCM must take steps to ensure that the default does not 
result in any cost or expense to the customer. The Commission believes 
that this requirement is appropriate in light of the proposal to 
eliminate the disclosure and consent requirements of 84-24. Given this 
lack of express authorization, any risk of loss created by the 
transaction should be borne by the FCM. The Commission believes that 
although the standards set forth in paragraph (a)(2)(ii)(C) should 
minimize the risk of default, nonetheless, if there is such a default, 
the FCM must make the customer whole.
    The Commission requests comment on all aspects of this proposal. In 
particular, the Commission requests comment on whether it is 
appropriate to permit repos of customer collateral without prior 
written consent, and, if so, whether the limitations set forth in the 
proposal are appropriate. In this regard, the Commission specifically 
requests comment on whether a one-way notice disclosure to the customer 
should be required and whether a mechanism should be provided under 
which a customer could instruct the FCM that repos of its collateral 
would not be permitted. The Commission also requests comment on how an 
FCM may fulfill its obligations to its customer in the event a repo 
counterparty fails to perform. Is it sufficient if the FCM gives the 
customer the cash equivalent of the securities plus any transaction 
costs that might be incurred in replacing the securities? Or, should 
the FCM replace the securities? Would cash compensation be 
insufficient, for example, if a customer needed the particular security 
to maintain the risk profile of its portfolio?
    The Commission further requests comment on whether the terms and 
conditions applicable to DCOs engaging in repos should differ in any 
way from those applicable to FCMs. The Commission also requests comment 
on whether customer collateral that is subject to repo should be 
treated for concentration purposes like permitted investments under 
paragraph (b)(4)(ii) or continue to be treated under paragraph 
(b)(4)(v). Finally, the

[[Page 38656]]

Commission requests comment on whether there are tax implications that 
should be considered in connection with this proposal.

B. Time-to-Maturity Requirements for Certain Collateral

    Rule 1.25(b)(5) establishes a time-to-maturity requirement for the 
portfolio of permitted investments. Certain industry participants have 
requested limited relief from this provision. In particular, a DCO is 
developing a program whereby FCMs could deposit certain collateral on 
an overnight basis to meet certain special margin charges. Absent 
amendment of the rule, the deposit of such collateral could cause the 
FCM's portfolio to exceed the time-to-maturity limits of Rule 
1.25(b)(5).
    In order to encourage development of such innovative collateral 
management programs, and thereby facilitate the efficient use of 
capital, the Commission is proposing to amend Rule 1.25(b)(5). Under 
the proposal, certain instruments may be treated as if they had a time-
to-maturity of one day if certain terms and conditions are satisfied. 
First, the instrument must be deposited with a DCO solely on an 
overnight basis. Second, the instrument must be one that the FCM owns 
or has the unqualified right to pledge, and free of any lien.\4\ Third, 
the instrument must be used for the purpose of meeting concentration 
margin or other similar charges that are in addition to the basic 
margin requirement established by the DCO. Fourth, the DCO must price 
the instrument each day based on a current mark-to-market value. Fifth, 
the DCO must haircut the instrument by at least 2 percent. The 
Commission understands that 2 percent is the standard haircut generally 
used in the repo market.
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    \4\ Instruments that have been given to an FCM by a customer for 
deposit in a segregated account currently are not subject to the 
time-to-maturity provisions of Rule 1.25 and this would remain the 
case under this proposal. Instruments that have been purchased by an 
FCM with customer funds and are being held in a segregated account 
currently are subject to those provisions and this generally would 
remain the case under the proposal. The proposal would provide 
relief with regard to instruments that had been held by an FCM in 
its non-segregated inventory and that were deposited on an overnight 
basis into a segregated account at a DCO. So long as an FCM had an 
unqualified right to pledge the instruments, they could include 
instruments obtained through reverse repurchase transactions, or 
otherwise.
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    The time-to-maturity requirement in 1.25(b)(5) is intended to limit 
the market risk of permitted investments. The Commission believes that 
it is appropriate to provide some additional flexibility under the 
circumstances and with the safeguards described above. That is, when 
instruments are held at a DCO solely on an overnight basis, subject to 
a haircut, and for the purpose of satisfying a margin cushion over and 
above the basic performance bond requirement, a modified treatment is 
appropriate. This treatment could increase capital efficiency at the 
FCM level by permitting additional instruments to be used for margin 
while enhancing systemic security at the DCO level by increasing the 
amount of collateral held to support positions.
    The Commission requests comment on the appropriateness of the 
proposed terms and conditions. In particular, the Commission requests 
comment on whether the haircut is appropriate and whether the relief 
should be limited to instruments deposited to meet concentration and 
similar margin requirements, as proposed or whether the modified 
treatment should be extended to apply to initial margin generally. If 
the latter, should alternative safeguards be developed? For example, 
would it be appropriate to apply the relief to the extent that an FCM 
holds excess funds in segregation?

C. Time to Maturity--Treasury Portfolio

    As noted above, current Rule 1.25(b)(5) limits the dollar weighted 
average of the time-to-maturity for permitted investments to no longer 
than 24 months. In expanding the range of permissible investments in 
December 2000, the Commission added this requirement.
    One FCM has informed a self-regulatory organization that the FCM 
invests exclusively in obligations of the U.S. Treasury. This FCM 
believes that because Treasury instruments do not pose the same risks 
that other permitted investments pose, the time-to-maturity limitation 
should not apply.
    The Commission requests comment on whether an alternate safeguard 
to limit risk, such as appropriate haircuts, would be more appropriate 
than the time-to-maturity requirement of Rule 1.25(b)(5) with respect 
to a portfolio consisting exclusively of U.S. Treasury securities.

D. Embedded Derivatives

    Rule 1.25(b)(3)(i) prohibits instruments with embedded derivatives. 
Some market participants have suggested that there are certain 
instruments containing embedded derivatives that have a lower level of 
risk than some of the other investments permitted under the rule. The 
Commission requests comment on whether Rule 1.25(b)(3)(i) should be 
amended to modify the prohibition on investments in securities that 
contain an embedded derivative. In this regard, commenters are asked to 
describe how the level of risk of such securities could be limited.

E. Variable Rate Securities--Permitted Benchmarks

    Rule 1.25(b)(3)(iv) permits investment in variable rate securities 
provided that they correlate to certain specified benchmarks. Industry 
representatives have noted that the benchmarks used in the marketplace 
evolve over time. They have suggested the rule should provide that the 
interest rate on variable rate securities may be benchmarked to any 
fixed rate instrument that is a permitted investment under the rule. 
The Commission requests comment on whether the provision on permitted 
benchmarks should be amended, and if so, what the applicable standard 
should be.

F. Reverse Repos--Concentration Limits

    Rule 1.25(b)(4)(iii) establishes concentration limits for reverse 
repos. Industry representatives have indicated that because of the need 
to engage in manual processing, this investment alternative has 
generally proved not to be viable. They have expressed a desire to work 
with Commission staff to develop a proposal that would continue to 
address the risks of reverse repos. The Commission requests comment on 
market participants' experience with the current provisions relating to 
reverse repos and suggestions on how best to address the risks of these 
transactions.

III. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601 et seq. 
(1994 & Supp. II 1996), requires federal agencies, in proposing rules, 
to consider the impact of those rules on small businesses. The rule 
amendments discussed herein would affect 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 small 
entities in accordance with the RFA.\5\ The Commission has previously 
determined that registered FCMs are not small entities for the purpose 
of the RFA.\6\ The amendments proposed herein would not require any 
registrant to change its current method of doing business. The proposed 
amendments should reduce, rather than increase, the regulatory 
requirements that apply to registered FCMs. Accordingly, pursuant to 5 
U.S.C. 605(b), the Chairman, on behalf of the Commission, certifies 
that

[[Page 38657]]

these proposed amendments will not have a significant economic impact 
on a substantial number of small entities.
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    \5\ 47 FR 18618-18621 (April 30, 1982).
    \6\ 47 FR 18619-18620.
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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.

Lists of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and 
recordkeeping requirements.

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.

    2. Section 1.25 is proposed to be amended by revising paragraphs 
(a)(2) and (b)(5) to read as follows:


Sec.  1.25  Investment of customer funds.

    (a) * * *
    (2)(i) In addition, a futures commission merchant or clearing 
organization may buy and sell the permitted investments listed in 
paragraphs (a)(1)(i) through (viii) 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 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 meet the 
marketability requirement of 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 clearing organization must take 
steps to ensure that the default does not result in any cost or expense 
to the customer.
    (b) * * *
    (5) 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;
    (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 registered derivatives clearing organization;
    (C) The instrument is used only for the purpose of meeting 
concentration margin or other similar charges assessed by a derivatives 
clearing organization in addition to the basic margin requirement 
established by the derivatives clearing organization;
    (D) The derivatives clearing organization prices the instrument 
each day based on the current mark-to-market value; and
    (E) The derivatives clearing organization reduces the assigned 
value of the instrument each day by a haircut of at least 2 percent.
* * * * *

    Issued in Washington, DC on June 25, 2003, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 03-16473 Filed 6-27-03; 8:45 am]
BILLING CODE 6351-01-U