Introduction

On December 5, 2011, the US Commodity Futures Trading Commission (the CFTC or Commission) held an open meeting where it approved two final rules and one proposed rule promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). This was the first meeting in nearly two months after the CFTC had canceled its last 2 scheduled meetings due to the retirement of Commissioner Michael Dunn and appointment of new Commissioner Mark Wetjen, as well as the intervening investigation and unwinding of customer positions related to the bankruptcy of a futures commission merchant (FCM).

Summary

The final rules adopted on December 5 will (i) amend CFTC Rule 1.25, which regulates the manner in which FCMs and derivatives clearing organizations (DCOs) may invest customer collateral (Rule 1.25)1 and (ii) create a registration regime for foreign boards of trade (the FBOT Rule).2 The proposed rule would create a process by which swap execution facilities (SEFs) and designated contract markets (DCMs) can determine that a swap is "made available to trade" (the MAT Rule).3 This determination triggers the trade execution requirement for swaps that are already subject to mandatory clearing. The Commission was also scheduled to vote on an interpretation regarding the meaning of the term "actual delivery" as it relates to retail commodity transactions, but the Commissioners voted on that proposal via seriatim on December 2, 2011.4 The rules have not yet been published in the Federal Register but are available on the Commission's website.5 Below is a description of the views expressed in the Commissioners' opening statements and each of the above-mentioned rules.

Opening Statements by Commissioners

At the meeting, Chairman Gary Gensler announced that he had directed staff to hold two roundtables on the mandatory clearing of swaps and the process by which SEFs and DCMs determine that swaps are made available to trade.

Commissioner Jill Sommers argued that the MAT Rule is deeply flawed for several reasons. First, she stated that it would allow a single SEF or DCM to bind the entire marketplace because, once a SEF or DCM determines that a given swap is made available to trade, all market participants engaging in such a swap must do so through regulated platforms instead of over-the-counter. Some have argued that this will create a race for SEFs and DCMs to determine that all conceivable swaps are made available to trade even though they may not be suitable for SEF or DCM trading. Second, once a single SEF or DCM determines that a given swap is made available to trade, all "economically equivalent" swaps must also trade on a SEF or DCM. According to Sommers, the term "economically equivalent" is ill-defined and confusing. Third, she stated that there was no reason why the Commission itself should not make this determination, noting that Dodd-Frank does not prohibit the CFTC from doing so. Separately, Sommers stated that she generally supports Rule 1.25 because it clarifies the scope of the ban on in-house transactions and distinguishes in-house transactions from (i) in-house sales of permitted investments and (ii) certain in-house exchanges of collateral. She also called for the Commission to gather more information on how FCMs and DCOs actually invest customer funds.

Commissioner Bart Chilton stressed that the penalties imposed on FCMs for misuse of customer segregated funds must be an appropriate deterrent to such misconduct, and suggested that the current penalties may not do so. Further, Chilton suggested that the CFTC should establish a retail futures customer protection regime similar to that established with respect to securities.

Commissioner Scott O'Malia largely agreed with Commissioner Sommers' criticisms of the MAT Rule, arguing that the rule would vest those with the greatest financial interest in forcing all trading onto platforms with the power to determine which swaps must be executed on such platforms. Although O'Malia stated that this would create an inherent conflict of interest, he voted in favor of the proposed rule. O'Malia also stated that he is pleased with Rule 1.25 because it clarifies the rules surrounding in-house transactions, permits greater utilization of money market mutual funds (MMMFs), and regulates investments in Fannie Mae and Freddie Mac.

The December 5 meeting was Commissioner Mark Wetjen's first appearance at a public meeting. With regard to Rule 1.25, he argued that the Commission should address the following issues which are not addressed in the final rule: (1) the sufficiency of penalties for misuse of customer funds, (2) how examinations of FCMs are conducted, and (3) rules requiring FCMs to provide their customers with information regarding their investments.

Final Rule 1.25: Investment of Customer Funds

This final rule will narrow the scope of instruments in which FCMs and DCOs may invest customer funds and will raise the standards imposed on certain permitted investments. This rule is also made to comply with the Dodd-Frank mandate to remove references to credit ratings. Notably, it will generally eliminate the ability of FCMs and DCOs to invest in foreign sovereign debt, but will permit them to petition the Commission for exemptive relief from this prohibition. The Commissioners voted unanimously in favor of the final rule.

Permitted Investments. Under amended Rule 1.25, FCMs and DCOs will be permitted to invest customer money in the following instruments: (i) US government securities that are fully guaranteed as to principal and interest; (ii) general obligations of any State or political subdivision thereof; (iii) obligations of any US government corporation or enterprise sponsored by the US government; (iv) certificates of deposit issued by a bank that carries deposits insured by the FDIC; (v) commercial paper fully guaranteed as to principal and interest by the US under the Temporary Liquidity Guarantee Program; (vi) corporate notes or bonds fully guaranteed by the US under the Temporary Liquidity Guarantee Program; and (vii) interests in MMMFs, subject to certain requirements. Notably, investments in obligations issued by Fannie Mae or Freddie Mac are only permitted while those entities are operating under the conservatorship of the FHFA with capital support from the US government.6

Repurchase Agreements. The final rule will permit FCMs and DCOs to buy and sell any of the above instruments pursuant to repurchase agreements subject to several conditions. First, FCMs and DCOs cannot enter into repurchase agreements with affiliates. Instead, FCMs and DCOs can only enter into such agreements with a bank, a domestic branch of a foreign bank that is insured by FDIC, a securities broker or dealer, or a government securities broker or dealer registered with the SEC. Additionally, among other requirements, the securities must be "highly liquid," the securities cannot be "specifically identifiable property" (as defined in Part 190 of CFTC regulations), and the term of the agreement can be no more than one business day.7

Foreign Sovereign Debt. The amendments to Rule 1.25 will generally prohibit FCMs and DCOs from investing in foreign sovereign debt. However, as described above, FCMs and DCOs may petition the Commission for exemptive relief pursuant to Section 4(c) of the Commodity Exchange Act (CEA) in order to invest in such instruments. FCMs and DCOs wishing to invest in foreign sovereign debt must explain why doing so will preserve principal and maintain liquidity, which is the general standard applicable to all permitted investments. Although Dodd-Frank restricts the Commission from considering credit ratings in rulemakings, CFTC staff stated that the Commission may be able to consider the creditworthiness of foreign sovereigns when deciding whether or not to grant such exemptive relief.

Investments in MMMFs. The final rule will expand the ability of FCMs and DCOs to invest in MMMFs. Under the final rule, FCMs and DCOs may generally invest any and all of their funds in MMMFs comprising only US government securities, but are limited in the amount they can invest in other MMMFs. Specifically, FCMs and DCOs may invest up to 50 percent of the total assets held in segregation in MMMFs with (i) more than $1 billion in assets and (ii) a management company with more than $25 billion in assets under management, but only up to 10 percent of the total assets held in segregation in MMMFs not meeting both of these size requirements. Investment in MMMF is further limited by several concentration limitations based on the issuer. Specifically, the final rule limits, to varying degrees, the concentration that FCMs and DCOs may have in securities of any single issuer of US agency obligations, municipal securities, certificates of deposit, commercial paper, corporate notes, single families of non-Treasury-only MMMFs, and individual non-Treasury-only MMMFs. For purposes of these issuer-based concentration limits, securities issued by certain affiliates must be aggregated.8

The 30.7 Funds. An FCM must keep funds held to secure customers' foreign futures and options accounts in an account separate from customers' US futures and options positions. Even though these accounts are separate, and may be held outside of the US, the investment guidelines applicable to such accounts will be identical to those applicable to Rule 1.25 accounts (i.e., relating to customers' US futures and options positions).9

Proposed MAT Rule: Process for Making a Swap Available to Trade

Instead of re-proposing the SEF rule, the CFTC chose to propose a separate SEF-related rule on the process by which SEFs and DCMs determine which swaps are "made available to trade." Dodd-Frank refers to some contracts as "listed" and some as "made available to trade." The CFTC chose to propose this rule in response to several comment letters filed with the CFTC after the SEF rule was proposed earlier in 2011.

Under Section 2(h)(8) of the CEA, swaps which are subject to the clearing mandate must also be executed on a SEF or DCM unless no SEF or DCM "makes the swap available to trade" or another exception or exemption applies. This proposed rule would define the process for determining when a swap is "made available to trade" (as opposed to merely being "listed" on the DCM or SEF). Specifically, it would require SEFs and/or DCMs to determine which swaps they believe are "made available to trade" and to submit such determination for approval under Rule 40.5 or self-certification under Rule 40.6. Commissioner Sommers voted against the proposed rule. All other commissioners voted in favor.

Submission Process. Under Rule 40.5, a SEF or DCM can request approval of a made available to trade determination just as registered entities request approval of other proposed rules. The SEF or DCM would be required to explain the basis for its belief that the swap meets certain enumerated factors (outlined below). Under Rule 40.5, such a request will be deemed approved by the Commission 45 days after receipt unless the Commission notifies the SEF or DCM otherwise. Similarly, under Rule 40.6, a SEF or DCM would submit a determination to the Commission as a self-certification. Such submission would be deemed approved if the Commission does not issue a stay within 10 days of submission. In either case, the Commission may only deny the rule approval if it determines that the filing is contrary to the Commission's regulations. Commissioners Sommers and O'Malia objected to the fact that the MAT Rule permits and requires SEFs and DCMs, instead of the Commission, to make these determinations. They also objected to the Commission's limited ability to deny such applications. Chairman Gensler explained that the CFTC does not have the resources to make these determinations instead of SEFs or DCMs, but indicated that it might be possible to delay compliance with mandatory trading requirements in order to grant all SEFs a level playing field once a made available to trade determination has been submitted.10

Factors to Consider. The MAT Rule lists 8 factors for SEFs and DCMs to consider when determining whether or not a swap is made available to trade. SEFs and DCMs may base a determination on any number of these factors and therefore have great flexibility in making these determinations. The factors to consider are: (1) whether there are ready and willing buyers and sellers; (2) the frequency or size of transactions on SEFs, DCMs, or of bilateral transactions; (3) the trading volume on SEFs, DCMs, or of bilateral transactions; (4) the number and types of market participants; (5) the bid/ask spread; (6) the usual number of resting firm or indicative bids and offers; (7) whether a SEF's trading system or platform or a DCM's trading facility will support trading in the swap; or (8) any other factor that the SEF or DCM may consider relevant.11

Economically Equivalent Swaps. As mentioned above, once a single SEF or DCM determines that a swap is made available to trade, all economically equivalent swaps can only be transacted on a SEF or DCM, unless another exception or exemption applies. The MAT Rule defines "economically equivalent" as a swap that the SEF or DCM determines to be economically equivalent with another swap after consideration of each swap's material pricing terms.12 Commissioner O'Malia criticized this aspect of the rule because buy-side participants might be required to determine whether their bilateral swaps are economically equivalent to other swaps. Chairman Gensler suggested that the Commission may define "economically equivalent" in the final rule to mean the same tenor and the same underlying as another swap, and the proposing release asks whether this would be an appropriate definition.13

Public Notice. The preamble to the MAT Rule states that the Commission will post DCM and SEF rule submission filings on its website and that SEFs and DCMs submitting rule submissions will be required to post such rule submissions on their websites. However, Rule 40.5 does not require the Commission to provide an opportunity for public comment, and the Commission must only do so under Rule 40.6 if it decides to issue a stay on the self-certification filing.

Final Rule on Registration of Foreign Boards of Trade (FBOTs)

This final rule creates a registration process for FBOTs, which will replace the existing staff-issued no-action letters traditionally relied upon by FBOTs providing direct access to the US. Under this final rule, any FBOT wishing to provide its members or other participants located in the US with direct access to its platform will be required to register with the CFTC as an FBOT. According to CFTC staff, this rule is not intended to impose dual regulations on FBOTs in that the home regulator will continue to be the FBOT's primary regulator. The Commissioners voted unanimously in favor of the final rule.

Prior No-Action Regime. Since 1996, there has been no formal application process for FBOTs to satisfy before permitting direct access to participants from within the US. Instead, an FBOT wishing to grant access to US market participants would request a "no-action" letter from the CFTC, whereby the CFTC would declare that it would not take enforcement action against the FBOT for failure to register with the CFTC as a DCM or derivatives transaction execution facility (DTEF).14 FBOTs that were granted no-action relief could access US persons trading for their own accounts, registered FCMs trading on behalf of US persons, non-US persons exempt from FCM registration pursuant to Rule 30.10 submitting orders and trading for US customers, and commodity pool operators (CPOs) or commodity trading advisors (CTAs), or entities exempt from such registration, submitting orders on behalf of US pools they operate or US customer accounts for which they have discretionary authority.15 When requesting no-action relief, an FBOT would have to establish that it was subject to a domestic regulatory regime that provides oversight of the FBOT in a manner comparable to the CFTC's oversight. However, according to the final rule, staff's standard of review under the no-action process varied from determining that the FBOT was regulated by a legitimate regulatory authority to determining that the FBOT and its regulatory authority supported and enforced equivalent standards for trading and customer and market protection.16 Nonetheless, the Commission had developed seven factors it generally considered when determining whether or not to grant no-action relief.17

FBOT Registration Required. Under the final rule, any FBOT wishing to provide its members and other participants with "direct access" to its electronic trading and order matching system from within the US must register with the CFTC.

"Direct access" is defined 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 trade matching system of the [FBOT]."18 The final rule would permit registered FBOTs to provide direct access to the same entities approved under no-action relief.19

Criteria for Registration. An FBOT's application for registration must (i) provide the CFTC with general information about the FBOT and (ii) establish that the FBOT satisfies seven specific requirements. These requirements are set forth in Rule 48.7. One notable change from the proposed rule is that the appendix to the final rule consists of two application forms (one for the FBOT and one for its clearing organization). The proposed rule did not have either application form and did not require FBOTs to file any application specifically on behalf of their clearing organizations. Instead, the proposed rule would have only required an FBOT to demonstrate that its clearing organization satisfied certain requirements set forth in the proposed rule. Generally, under the final rule, an FBOT applicant will be required to establish that its clearing organization is either registered with the CFTC as a DCO or that it complies with international standards.

Linked and Related Contracts. FBOTs offering contracts that are linked to a contract listed for trading on a US SEF or DCM must identify such contracts in the application process and will be subject to additional conditions. The Commission may also impose additional conditions on FBOTs which list contracts that do not meet the definition of a linked contract but which share some other commonality with a contract listed for trading on a SEF or DCM (e.g., a contract that settles against the same third-party index). These conditions include: (1) disseminating public trading data; (2) adopting position limits for the linked contracts that are comparable to US position limits; (3) having certain authority over market participants; (4) agreeing to promptly notify the Commission of certain changes; (5) providing large trader information to the Commission; and (6) providing the Commission with certain information regarding aggregate trader positions.20

Grandfather Relief. Despite many comments requesting that FBOTs operating under existing no-action relief only be required to include in their applications information which has materially changed, was not previously filed, or which relates to newly imposed requirements, the Commission determined to require such FBOTs to essentially file a complete application. However, FBOTs which submitted their no-action requests electronically and whose application remains on file will be permitted to refer to previously-submitted information and documentation and explain which provisions they satisfy and how. Further modifying the proposed rule, the final rule will grant FBOTs currently operating under no-action relief (and certain FBOTs with no-action requests pending) with 180 days from the effective date of the FBOT Rule to submit their application, instead of 120 days as proposed.21

Interpretation and Request for Comment: "Actual Delivery" for Retail Commodity Transactions

As mentioned above, the Commission approved an Interpretation of the term "actual delivery" as it relates to retail commodity transactions by seriatim vote on December 2, 2011. This Interpretation will form part of the so-called "Broad Zelener Fix," intended to close a gap in CFTC regulations permitting certain futures-like and retail swap-like contracts from being unregulated.

Background. In CFTC v. Zelener,22 the Seventh Circuit narrowly interpreted the statutory term for a futures contract, excluding certain futures-like contracts from CFTC regulations. Zelener involved rolling spot contracts, which were written as spot transactions but which, in practice, were held open indefinitely and never resulted in actual delivery (i.e., they were functionally similar to futures contracts). In Zelener, the court held that these contracts were spot transactions (and therefore outside of the CFTC's jurisdiction) because of the terms of the contract without looking to the functional reality of the agreements.23

Congress first addressed this issue in the 2008 Farm Bill24 by providing the CFTC with additional authority over retail foreign currency transactions (which were at issue in Zelener). However, the CFTC still did not have authority over Zelener-like contracts based on other commodities. In Dodd-Frank, Congress therefore sought to close this gap yet again by mandating that transactions with retail customers25 entered into on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty be executed on a regulated exchange and be subject to the CFTC's anti-fraud authority.26 This short provision in Dodd-Frank effectively shut down retail commodity foreign exchange and precious metals trading and leverage transaction shops.27 One statutory exception to this prohibition, however, is for a contract that "results in actual delivery within 28 days or such other longer period as the Commission may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved."28 The recent CFTC Interpretation relates to what it means for a contract to result in "actual delivery." Note that, as amended by Dodd-Frank, the CEA now effectively has three different provisions defining "forwards": the traditional forward exclusion in CEA Section 1a(27), the forward exclusion in the definition of "swap," and the "actual delivery" exclusion in the Broad Zelener Fix provision of Dodd-Frank. However, the CFTC specifically stated that this Interpretation does not change its long-standing interpretation of what type of contract constitutes a "forward."

Interpretation. The Interpretation states that the Commission will employ a functional approach when determining whether a contract results in actual delivery and will examine how the agreement, contract, or transaction is marketed, managed, and performed. The Commission notes that it will not rely solely on language used by the parties to the agreement, thereby distancing itself from the Seventh Circuit's rationale in Zelener. The Commission also explained that it will consider the following factors when determining whether a contract results in actual delivery: 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. To further clarify how the CFTC will conduct its analysis, the Interpretation provides several examples of transactions that will and will not qualify for this exemption.

Going Forward. While this Interpretation is not a proposal and, instead, becomes effective 60 days after publication in the Federal Register, the Commission is soliciting comments on the Interpretation and stated that it will take appropriate action if the comments demonstrate a need to modify the Interpretation.

Footnotes

1 See Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions (not yet published).

2 See Registration of Foreign Boards of Trade (not yet published).

3 See 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 (not yet published).

4 See Retail Commodity Transactions Under Commodity Exchange Act Section 2(c)(2)(D) (not yet published).

5 Available at http://www.cftc.gov/PressRoom/Events/opaevent_cftcdoddfrank120511 (last visited Dec. 5, 2011).

6 See Rule 1.25 (to be codified at 17 C.F.R. §§ 1.25(a)(1)-(3)).

7 See id. (to be codified at 17 C.F.R. § 1.25(d)).

8 See id.

9 See id. (to be codified at 17 C.F.R. § 30.7(g)).

10 See MAT Rule (to be codified at 17 C.F.R. §§ 37.10(a), 38.12(a)).

11 See id. (to be codified at 17 C.F.R. §§ 37.10(b), 38.12(b)).

12 See id. (to be codified at 17 C.F.R. §§ 37.10(c), 38.12(c)).

13 See id. at 20.

14 See Registration of Foreign Boards of Trade, 75 Fed. Reg. 70974, 70974 (Nov. 19, 2010) (describing the former no-action process); see generally CEA § 4(a), 7 U.S.C. 6(a). Note that Dodd-Frank eliminated DTEFs as a category of regulated trading facilities.

15 See, e.g., http://www.cftc.gov/international/foreignmarketsandproducts/foreignmkts (last visited Dec. 5, 2011).

16 See FBOT Rule at 24.

17 See Boards of Trade Located Outside of the United States and the Requirement to Become a Designated Contract Market of Derivatives Transaction Execution Facility, 71 Fed. Reg. 34070, 34071-72 (June 13, 2001); see also http://www.cftc.gov/international/foreignmarketsandproducts/foreignmkts (last visited Dec. 5, 2011).

18 FBOT Rule (to be codified at 17 C.F.R. § 48.2(c)).

19 This rule does not cover circumstances where FBOTs provide US participants with access through a non-US person exempt under Rule 30.10 because that does not entail "direct access." Part 30 of that CFTC's regulations address such intermediated access to FBOTs.

20 See FBOT Rule (to be codified at 17 C.F.R. §§ 48.2(d), 48.8(c)).

21 See id. (to be codified at 17 C.F.R. § 48.6).

22 373 F.3d 861 (7th Cir. 2004).

23 See id.

24 Food, Conservation and Energy Act of 2008, Pub. L. 110-246, 122 Stat. 1651 (2008).

25 For purposes of this section, retail customers are persons other than eligible contract participants (ECPs) and eligible commercial entities (ECEs).

26 Dodd-Frank § 742(a) (adding CEA § 2(c)(2)(D)).

27 The CFTC adopted this Interpretation in response to several requests from retail foreign exchange and precious metals trading firms for interpretation of the application of this section of Dodd-Frank. Note that Dodd-Frank did not amend CEA Section 19 which relates, in part, to leverage transactions, and the CFTC has not proposed to amend Part 31 to its regulations which similarly deal with leverage transactions. Also, note that several arguments have been made that new CEA Section 2(c)(2)(d) leaves room for market participants to engage in retail commodity transactions if they are entered into on a non-leveraged and non-margined basis and if they are not financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty. See CEA § 2(c)(2)(D)(i)(II). However, it has also been noted that CEA Section 2(c)(2)(B) prohibits non-ECPs from entering into foreign exchange futures or options unless their counterparty is one of several enumerated types of entities. Further, new CEA Section 2(e) (as added by Dodd-Frank) generally prohibits any person from engaging in a swap outside of a DCM unless that person is an ECP, thereby effectively limiting off-exchange retail swaps. See Dodd-Frank § 723(a)(2) (adding CEA § 2(e)).

28 Dodd-Frank § 742(a) (adding CEA § 2(c)(2)(D)(ii)(III)(aa)) (emphasis added).

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