United States: CFTC Proposed Rules Implementing CFMA

Co-written by David Mitchell

On March 9, 2001 the Commodity Futures Trading Commission ("CFTC") published a notice in the Federal Register, 66 F.R. 14262 (the "F.R. Notice"), containing proposed new rules and rule amendments (the "Proposed Rules") intended to implement those provisions of the Commodity Futures Modernization Act of 2000 (the "CFMA") dealing with trading facilities. The comment period for the Proposed Rules expires April 9, 2001, but the Commission has urged commenters to submit their comments as early as possible.

At the same time, the Commission announced that rules relating to clearing organizations and intermediaries will be proposed shortly.

The Proposed Rules are to a large extent based upon provisions contained in the comprehensive regulatory framework which had been published by the Commission on December 13, 2000 (65 F.R. 77962), but were subsequently withdrawn on December 28, 2000 (65 F.R. 82272) in light of the unexpected passage of the CFMA. Those provisions have been modified, to reflect the CFMA, the comments received by the Commission with respect to the comprehensive regulatory framework that had been published and reconsideration by the Commission of various matters.

In brief outline, the Proposed Rules would:

• Adopt a new Section 1.1, which would be an antifraud rule for foreign exchange products traded over-the-counter between retail customers and certain unregulated persons.
• Amend Section 15.05 of the existing Commission Regulations to require that certain foreign brokers and foreign traders have agents for service of process in the U.S. unless their transactions are executed through or maintained in accounts carried by a registered futures commission merchant ("FCM") or introduced by a registered introducing broker.
• Completely revise Part 36 of the Commission Regulations (dealing with what were colloquially referred to as "pro-markets," which were markets limited to certain sophisticated participants), to apply to markets exempt from regulation under Sections 5d and 2(h)(iii) through (v) of the Commodity Exchange Act as amended by the CFMA (the "Act").
• Add a new Part 37 to the Commission Regulations, dealing with derivatives transaction execution facilities ("DTEFs").
• Add a new Part 38 to the Commission Regulations, setting forth a new regulatory regime for designated contract markets and superseding many of the regulations presently applicable to such markets.
• Add a new Part 40 to the Commission Regulations, containing provisions common to contract markets, DTEFs and derivatives clearing organizations.
• Adopt a new Regulation 166.5, which would require contract markets to provide for dispute resolution procedures covering claims or grievances by customers against members, superseding the existing Part 180 of the Commission’s Regulations.
• Make certain technical amendments to the rules applicable to registered futures associations (i.e., the National Futures Association or "NFA").

While the Proposed Rules go a long way to reducing the regulatory burden on contract markets and providing guidance for them and for the other markets provided for in the CFMA, they are lengthy (occupying 27 3-column pages in the Federal Register) and detailed, and they raise a host of interpretive questions which undoubtedly will be the subject of comment from the existing exchanges, those contemplating forming new markets and others.

One point of particular interest is that Section 15 of the Act, as amended by Section 119 of the CFMA, requires the Commission to consider the cost and benefits of its action before issuing new regulations. This is the first time that the Commission has had to apply the cost-benefit provisions of Section 15, and what it does here is likely to serve as a precedent for how it addresses the cost/benefit issue in all future rule-makings. On page 14267 of the F.R. Notice, the Commission expresses its understanding that Section 15 does not require the Commission "to quantify the cost and benefits of a new regulation or to determine whether the benefits of the proposed regulation outweigh its cost." The Commission merely views the statutory provision as requiring it to "consider" the cost and benefits of its action. It is not clear how the Commission could "consider" costs and benefits if it has not in any way quantified them.

On March 13, 2001 the Commission also proposed new Rule 1.68 and related rule amendments that would permit an FCM to offer customers who are "eligible contract participants" (each, an "ECP") the right to elect to opt out of segregation with respect to their funds which are held by the FCM for purposes of margining their transactions on a DTEF. 66 F.R. 14507 (March 13, 2001). An ECP is defined in Section 1a(12) of the Act generally as a commercial or institutional entity or an individual who meets a substantial asset test. Comments on this proposal must be received by April 12, 2001.

This proposal implements Section 5a(f) of the Act, which provides that a registered DTEF may authorize an FCM to offer its customers that are ECPs the right to opt out of segregation with respect to their funds that are carried by the FCM for the purpose of trading on the DTEF. Under proposed Rule 1.68, a customer who is an ECP must sign a written agreement in which it elects to opt out of segregation and acknowledges that it is aware of the consequences of not having those funds segregated, to-wit: in the event of the FCM’s bankruptcy, the customer would not be entitled to the customer priority in available assets of the FCM pursuant to the Commission’s Part 190 Regulations. The FCM would be required to keep this agreement on file and open to inspection. Under the proposal, if a customer opts out of segregation, the FCM may provide a single monthly account statement with a notation of trades for which segregation is not applicable. Similarly, the FCM’s records would have to distinguish those positions subject to the opt-out agreement and those that remain subject to segregation. In the same vein, customer funds related to DTEF opt-out trades could not be commingled with segregated commodity customer funds. The customer could cancel its election to opt out of segregation upon written notice to the FCM with respect to trades entered into after the FCM received such notice from the customer.

The Commission is proposing to prohibit a customer who opts out of segregation from establishing a third party safekeeping account to hold funds related to DTEF opt-out trades. Because such an account could be deemed to be a separate segregated account, the Commission believes that it would be inconsistent for a customer who elects to opt out of segregation to be able to use such an account for funds related to such trades.

A DTEF that wishes to adopt a rule permitting FCMs to offer ECPs the right to opt out of segregation would be required to notify the CFTC of its intent to institute such a rule at least one day before its implementation. The Commission is also proposing certain conforming amendments to various provisions of its rules, including the net capital rule and the bankruptcy rules in Part 190 of its regulations.

This proposal presents a number of interesting issues. Among other things, the proposal does not distinguish in treatment between opt-out trades effected on domestic DTEFs and opt-out trades effected on foreign DTEFs and does not address whether funds related to DTEF opt-out trades may be commingled for convenience with secured amount funds required to be set aside for foreign futures and options transactions pursuant to Rule 30.7. An FCM which elects to permit ECP customers to opt-out of segregation for DTEF trades undoubtedly will encounter significant back office and operational issues in implementation.