UK: CFTC Finalizes Amendments To Customer Funds Rule And Addresses Other Dodd-Frank Act Business

The Commodity Futures Trading Commission (CFTC or Commission) held an open meeting on December 5, 2011 to address a diverse set of regulatory initiatives under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).

The Commission:

  • finalized the much-anticipated amendments to its rules governing the investment of customer funds held in accounts for U.S. and foreign futures and options transactions;1
  • finalized a rule on the registration of foreign boards of trade;2
  • announced a further notice of proposed rulemaking regarding technical aspects of making swaps available to trade on designated contract markets and swap execution facilities;3 and
  • approved an interpretation relating to retail commodity transactions.4

Investment of Customer Funds Held in Futures and Options Accounts

Under Section 4d of the Commodity Exchange Act (CEA), the CFTC has long-standing and extensive rules that govern futures commission merchant (FCM) and clearinghouse (also referred to as derivatives clearing organization (DCO)) handling of customer assets (i.e., cash, securities, and other property) deposited and/or pledged as collateral for: exchange-traded commodity futures contracts, options on commodity futures contracts, and commodity options (generally referred to as segregated "customer funds"). Under CFTC Rule 1.25, customer funds may be invested in a limited universe of "permitted investments" subject to various conditions intended to make an investment of customer funds conservative to protect customer principal. Since 2000, the CFTC has expanded the list of permitted investments to include commercial paper, bank certificates of deposit, money market mutual funds, and general obligations of sovereign nations, among others. The CFTC has also permitted FCMs and DCOs to conduct "in-house" transactions that "provide the economic equivalent of [repurchase agreements] and reverse [repurchase agreements]"5 and to engage in certain of these transactions with affiliates. All permitted investments must be highly liquid. In the current interest rate environment, FCMs invest customer funds primarily in money market mutual funds, short-term commercial paper, and certain debt instruments.

CFTC Rule 30.7 governs FCM treatment of customer cash, securities, and other property deposited as collateral for positions in non-U.S. exchange-traded commodity futures contracts and options. The investment limitations on customer funds found in CFTC Rule 1.25 have historically not applied to such foreign transaction customer assets. Instead, FCMs would be considered to have met their general fiduciary obligation to customers under Rule 30.7 if they invest in Rule 1.25 permitted investments.6

As a result of a review the CFTC Division of Clearing and Intermediary Oversight conducted in 2007, the 2008 market crisis, and the CFTC rule review mandated by Title IX of the Dodd-Frank Act, the CFTC determined that CFTC Rules 1.25 and 30.7 should be amended. Following an extensive comment process, the CFTC determined to remove the following investments from the Rule 1.25 list of permitted investments:

  • corporate debt obligations not guaranteed by the United States;
  • foreign sovereign debt; and
  • in-house and affiliate transactions.

The CFTC determined to remove corporate debt obligations after having found in its 2007 study that this asset class was not widely used and also out of concern that, in "tumultuous markets," holding customer funds in these assets could "threaten customer principal."7 The CFTC decided to remove foreign sovereign debt, citing the recent Eurozone crisis. Commenters noted that foreign sovereign debt investments of customer funds are used to mitigate the foreign currency risk that FCMs face when they must convert customer funds into foreign currency to meet foreign exchange margin requirements. The CFTC decided that the potential volatility in foreign sovereign debt and subsequent threat to customer principal outweighed other concerns; however, the CFTC stated that it would consider exemptive applications from individual FCMs and DCOs to permit them to invest customer funds in foreign sovereign debt. With regard to "in-house" transactions, the CFTC had become concerned with these transactions concentrating credit risk within FCMs; instead the CFTC favors the use of repurchase transactions with unaffiliated third parties. The CFTC expressed concern that in-house transactions lack legal documentation and a mechanism to ensure delivery versus payment, both of which would help protect customer funds. The CFTC also eliminated repurchase agreements with FCM affiliates out of concern for conflicts of interest among affiliates. In determining to make each of these changes, the CFTC reiterated that the protection of segregated customer funds is the CFTC's primary concern in any decision it makes as to permitted investments.

In order to meet the over-arching general standard in CFTC Rule 1.25 that permitted investments be "consistent with the objectives of preserving principal and maintaining liquidity," permitted investments have been required to meet certain standards, including minimum credit ratings and marketability. The CFTC amended these conditions in order to set "clear, prudential standards."8 Among the new standards is the removal of credit rating requirements for applicable permitted investments. The CFTC does not want assets with high credit ratings to automatically fall within the safe harbor.

The CFTC also determined to import the permitted investment regime found in CFTC Rule 1.25 (as amended) into CFTC Rule 30.7, rather than leaving those funds only subject to the FCM's general fiduciary obligation. This change is intended to protect customer principal in foreign futures and options accounts.

Registration of Non-U.S. Boards of Trade

Section 738 of the Dodd-Frank Act amended Section 4(b) of the CEA to allow the CFTC to adopt rules that would require any foreign board of trade (FBOT) to register with the CFTC if the FBOT desires to provide its members or other participants located in the United States with direct access9 to the FBOT's electronic trading and order matching system. Pursuant to this statutory provision, the CFTC adopted rules creating uniform application procedures and registration requirements and conditions for FBOTs seeking to provide this direct access to such persons (FBOT Registration Rules).10

The FBOT Registration Rules replace the 20 effective CFTC staff no-action relief letters granted to FBOTs seeking to provide direct access to members and participants in the United States,11 and the CFTC does not believe that it would be prudent to "grandfather" FBOTs operating under such no-action relief without further review. However, any FBOT whose original no-action relief request was submitted electronically and remains on file with the CFTC staff will be permitted in its application under the FBOT Registration Rules simply to refer to the parts of its earlier submission that satisfy a particular registration requirement. An FBOT currently operating under existing no-action relief is required to submit a complete limited registration application within 180 days of the effective date of the FBOT Registration Rules, and may continue to operate pursuant to its no-action relief during such 180-day period. If such FBOT submitted a timely and complete registration application, it may continue to operate under the no-action relief until the CFTC acts upon the registration application.

Entities Eligible to Trade via Direct Access from the United States

An FBOT may apply for registration in order to permit direct access to members and other participants located in the United States to the extent that a member or other participant is:

  • entering orders;
  • registered with the CFTC as an FCM and is submitting customer orders to the trading system for execution; or
  • registered with the CFTC as a commodity pool operator (CPO) or commodity trading advisor (CTA), or is exempt from such registration pursuant to CFTC Rule 4.13 or 4.14 respectively, and is submitting orders for execution on behalf of a U.S. commodity pool or U.S. customer discretionary account; provided that an FCM or a firm exempt from such registration under CFTC Rule 30.10 acts as a clearing firm and guarantees, without limitation, all such trades of the CPO or CTA effected through submission of orders to the trading system.

Registration Criteria

The registration requirements under the FBOT rules are organized around seven general categories:

  • the FBOT and clearing membership criteria;
  • the automated trading system;
  • the terms and conditions of the contracts to be made available in the United States;
  • settlement and clearing;
  • the regulatory regime governing the FBOT and its clearing organization;
  • the FBOT's and its clearing organization's rules and their enforcement; and
  • information sharing.

The FBOT Registration Rules also contain a number of conditions of registration applicable upon initial registration and thereafter on an ongoing basis, including certain specified conditions for maintaining registration, reporting obligations, and conditions applicable to FBOTs with linked contracts.

Proposed Process for Making Swaps Available to Trade

The Dodd-Frank Act amended Section 2(h)(1) of the CEA to make it unlawful for any person to engage in certain swap transactions without first submitting the swap to a registered DCO. Under new CEA Section 2(h)(8), any swap falling within the clearing requirement must be executed on a designated contract market (DCM) or swap execution facility (SEF). However, if a DCM or SEF does not make the swap "available to trade," this execution requirement does not apply. In response to the Dodd-Frank Act mandate, the CFTC has proposed CFTC Rules 37.10 and 38.12 in an effort to establish the process through which registered SEFs and DCMs would make a swap available to trade for the purposes of the execution requirement.

Under the proposed rules, DCMs and SEFs must make an initial determination whether to make a swap available to trade. In order to make this determination, a DCM or SEF must consider a series of factors outlined by the CFTC, including:

  • whether there are ready and willing buyers and sellers;
  • the frequency or size of transactions on DCMs or SEFs, or of bilateral transactions;
  • the trading volume on DCMs or SEFs, or of bi-lateral transactions;
  • the number and type of market participants;
  • the bid/ask spread;
  • the usual number of resting firm or indicative bids and offers;
  • whether a DCM's trading facility or a SEF's trading system or platform will support trading in the swap; and
  • any other factor that the DCM or SEF may consider relevant.12

Following this initial determination, the registered entities must submit the swap to the CFTC for approval or for self-certification.13 In addition, any other DCM or SEF that lists or offers a swap for trading must make that swap available to trade.14 This requirement also applies to any swaps that are "economically equivalent" to the original swap designated as available to trade.15

Finally, any DCM or SEF that makes a swap available to trade must review that decision on an annual basis to determine whether to continue to designate that swap as available to trade. The review must consider the same factors used to make the initial determination. Upon completion of this review, and not more than 30 days after the registered entity's fiscal year end, the DCM or SEF would be required to provide the CFTC with an electronic report of its review.

The CFTC is currently accepting comments on the proposed rules. The deadline for submission is February 13, 2012.

Interpretation of "Actual Delivery" for Purposes of Retail Commodity Transactions

The CFTC Reauthorization Act of 200816 and Section 742(a) of the Dodd-Frank Act have expanded the CFTC's anti-fraud jurisdiction to apply to retail off-exchange commodity transactions, with certain exceptions. In general, the Commission has jurisdiction over a "contract of sale of a commodity for future delivery" (i.e., futures contract), but not "spot market" transactions. This limitation has created controversy where a customer agreement had characterized a transaction as a spot market transaction, but in practice the transaction operated more like a futures contract. Following several court cases in which the definition of "contract of sale of a commodity for future delivery" was interpreted narrowly and against the CFTC's arguments for jurisdiction,17 Congress granted the CFTC limited jurisdiction over, initially, retail foreign exchange contracts that look like spot market transactions but behave like futures contracts, and subsequently through the Dodd-Frank Act, other retail off-exchange commodity contracts with similar characteristics. New CEA Section 2(c)(2)(D) applies the CEA anti-fraud provisions found in Sections 4(a), 4(b), and 4b to these contracts with some exemptions. In particular, CEA Section 2(c)(2)(D)(ii)(III)(aa) excepts from CFTC jurisdiction a contract of sale that ''results in actual delivery within 28 days or such other longer period as the [CFTC] may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved." Congress left it to the CFTC to interpret "actual delivery" in this specific CEA provision, which has now been done in the Interpretive Notice.

Rather than relying only on the "four corners of the agreement" to determine whether actual delivery has taken place, the CFTC has determined to "employ a functional approach and examine how the agreement, contract, or transaction is marketed, managed, and performed." In making its fact-specific determination, the Commission will consider the following factors:

  • the ownership, possession, title, and physical location of the commodity purchased or sold, both before and after execution of the agreement, contract, or transaction;
  • the nature of the relationship between the buyer, seller, and possessor of the commodity purchased or sold; and
  • the manner in which the purchase or sale is recorded and completed.

In general, the CFTC will closely examine whether physical delivery has taken place. One can deduce from the Commission's examples provided in the Interpretive Notice that a book entry showing delivery, a book entry showing that a transaction has been covered or hedged, or a title that does not specify the location of the delivery and other similar information necessary for physical delivery may not be considered actual delivery. In addition, if a position is rolled, offset, or otherwise netted or settled in cash, that too may not be considered actual delivery.

Footnotes

1 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78776 (Dec. 19, 2011) (to be codified at 17 C.F.R. pts. 1 and 30) ["Customer Funds Rules"].

2 Registration of Foreign Boards of Trade, 76 Fed. Reg. __ (__, 2011) (to be codified at 17 C.F.R. pt 48). At the time of publication of this DechertOnPoint, the CFTC's rule on the registration of foreign boards of trade finalized on December 5th has not yet been published in the Federal Register. This OnPoint is based on a copy of this release, available at http://www.cftc.gov/PressRoom/Events/opaevent_cftcdoddfrank120511, and does not reflect any technical amendments that may be made to it before official publication.

3 Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act, 76 Fed. Reg. 77728 (Dec. 14, 2011) ["Proposing Release"].

4 Retail Commodity Transactions under the Commodity Exchange Act, 76 Fed. Reg. 77670 (Dec. 14, 2011) (interpretation; request for comments) ["Interpretative Notice"].

5 Customer Funds Rules, 76 Fed. Reg. at 78782.

6 Commission Form 1-FR-FCM Instructions at 12-9 (Mar. 2010).

7 Customer Funds Rules, 76 Fed. Reg. at 78780.

8 Id. at 78783.

9 "Direct access" is defined in the Dodd-Frank Act as an explicit grant of authority by an FBOT to an identified member or other participant located in the United States to enter trades directly into the FBOT's trade matching system.

10 Registration of Foreign Boards of Trade, 76 Fed. Reg. __ (__, 2011) (to be codified at 17 C.F.R. pt. 48) ["FBOT Rule Release"].

11 The FBOT Rule Release notes that, since 1996, 24 such no-action letters have been issued.

12 Proposing Release, 76 Fed. Reg. at 77732.

13 The registered entities must submit their determination to the CFTC in accordance with Part 40 of the CFTC's Rules. The CFTC will approve the submission, deny it, or otherwise permit the submission to become effective. If the submission becomes effective, the CFTC deems the swap "available to trade." If the swap is subject to the clearing requirement imposed by the Dodd-Frank Act, the swap must be traded on a DCM or SEF. However, until the submission becomes effective, the swap will not be subject to the Dodd-Frank Act's execution requirement.

14 This requirement only applies to DCMs and SEFs that list or offer that swap for trading. These provisions do not require DCMs or SEFs that do not list or offer that swap to make the swap available to trade.

15 The proposed rules define the term "economically equivalent swap" to be "a swap that the SEF or DCM determines to be economically equivalent with another swap after consideration of each swap's material pricing terms."

16 Food, Conservation and Energy Act of 2008, Public Law 110–246, 122 Stat. 1651 (2008).

17 CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), CFTC v. Erskine, 512 F.3d 309 (6th Cir. 2008).

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