Divisions of the U.S. Commodity Futures Trading Commission (CFTC) on August 8, 2016 issued letters restricting futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) from investing in money market funds that have the authority to impose redemption restrictions under 2014 amendments to Rule 2a-7 under the Investment Company Act of 1940 (Amended Rule 2a-7). FCMs and DCOs will nonetheless continue to be permitted to make certain investments in other money market funds, as discussed below.
The no-action letter issued by the staff of the Division of Swap Dealer and Intermediary Oversight (DSIO)1 and the interpretative letter issued by the staff of the Division of Clearing and Risk (DCR)2 were issued in anticipation of the October 14, 2016 compliance date for Amended Rule 2a‑7 – after which a money market fund that is not a “government money market fund” (Non-Government MMF) or a government money market fund that elects to retain the authority to impose redemption restrictions (Electing Government MMF) will be required to impose redemption restrictions in the event its liquidity level falls below certain thresholds. A government money market fund is a money market fund that invests at least 99.5% of its total assets in cash, U.S. government securities and/or certain repurchase agreements.
Specifically, in light of the letters, FCM and DCO investments of customer funds in Non-Government MMFs and Electing Government MMFs will be prohibited as of October 14, 2016. However, the DSIO letter states that DSIO will not recommend an enforcement action against an FCM that:
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Invests customer funds in a government money market fund that is not an Electing Government MMF (Non-Electing Government MMF);
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Treats investments of customer funds in a Non-Electing Government MMF as not subject to any CFTC concentration limit (provided the Non-Electing Government MMF satisfies a new, heightened minimum asset requirement); or
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Invests amounts of its own funds held in customer accounts in a Non-Government MMF or Electing Government MMF, to the extent such amounts are in excess of the FCM’s “targeted residual interest” (discussed below).
This OnPoint describes key issues arising under applicable CFTC rules in light of the authority to impose redemption restrictions under Amended Rule 2a-7, and provides an overview of the guidance and relief set forth in the letters.
Background: Redemption Restrictions under Amended Rule 2a-7
The Securities and Exchange Commission (SEC) adopted a series of amendments to Rule 2a-7 in 2010, 2014 and 2015 to address perceived weaknesses in money market funds that arose during the financial crisis.3 Among the 2014 reforms, Amended Rule 2a-7 provides money market funds with the ability – and, under certain circumstances, requires money market funds – to impose redemption restrictions to curb shareholders’ incentives to redeem their shares of the funds during times of extraordinary market stress.
Under Amended Rule 2a-7, any Non-Government MMF must have the ability to impose redemption restrictions. Although a government money market fund is not required to have the ability to impose redemption restrictions, such a fund may voluntarily choose to retain the authority to impose redemption restrictions – by electing to become an Electing Government MMF, which election must be disclosed in the fund’s prospectus.4
The redemption restrictions under Amended Rule 2a-7 include the ability to impose:
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A “liquidity fee” (of up to 2%) on redemptions and/or
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A “redemption gate” that temporarily suspends redemptions for up to 10 business days during any 90-day period.
A Non-Government MMF or Electing Government MMF may impose either of the above redemption restrictions once its “weekly liquid assets” (cash, certain government securities, and securities that generally convert into cash within one week) have fallen below 30% of its total assets, provided that the fund’s board determines that imposing the restriction will be in the best interests of the fund.5 In the event that the fund’s weekly liquid assets fall below 10% of its total assets, the Non-Government MMF or Electing Government MMF must impose a 1% liquidity fee on all redemptions, unless the fund’s board determines that imposing a fee would not be in the best interests of the fund or determines that a lower or higher liquidity fee (of up to 2%) would be appropriate.6
In anticipation of the upcoming compliance date for Amended Rule 2a-7, many industry participants raised questions to DSIO regarding whether customer funds could be invested in money market funds once the revisions take effect. In particular, there was a concern that, as a result of the potential ability to impose redemption restrictions, some or all money market funds could be deemed ineligible investments for FCMs and DCOs for the purposes described below.
DSIO Letter: CFTC Regulation 1.25’s Next-Day Redemption and Liquidity Requirements
Restriction on FCM Investment of Customer Funds in Non-Government MMFs and Electing Government MMFs
CFTC regulations provide that customer collateral posted for transactions in futures, futures and commodity options, cleared swaps and uncleared swaps may only be invested by FCMs and DCOs as specifically permitted in CFTC Regulation 1.25.7
Money market funds are listed as permitted investments in CFTC Regulation 1.25.8 However, to qualify as a permitted investment under CFTC Regulation 1.25:
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Any investment must be “‘highly liquid’ such that [it has] the ability to be converted into cash within one business day without material discount in value” (Highly Liquid Requirement);9 and
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A money market fund also must be “legally obligated to redeem an interest and to make payment in satisfaction thereof by the business day following a redemption request” (Next-Day Redemption Requirement).10
CFTC Regulation 1.25(c) enumerates certain exceptions to the Next-Day Redemption Requirement,11 and generally permits FCMs to invest customer assets in money market funds that could postpone or suspend redemptions, as long as the funds could do so only in certain circumstances specified in the regulation (Enumerated Redemption Requirement Exemptions).
The DSIO letter identifies conflicts with each of the Highly Liquid and Next-Day Redemption Requirements relating to Non-Government and Electing Government MMFs.
Conflict with the Highly Liquid Requirement
The DSIO letter states that the imposition of a liquidity fee would conflict with the Highly Liquid Requirement, as the prospect of the imposition of a liquidity fee by a Non-Government or Electing Government MMF would prevent an FCM from being able to redeem its interests without a material discount in value. Accordingly, the DSIO letter states that investment of customer funds in Non-Government and Electing Government MMFs is prohibited.
Conflict with the Next-Day Redemption Requirement
The DSIO letter states that since the redemption gates that a Non-Government or Electing Government MMF may impose under Amended Rule 2a-7 do not fall within the Enumerated Redemption Requirement Exemptions, investment of customer funds in a Non-Government or Electing Government MMF would conflict with the Next-Day Redemption Requirement and is prohibited.
Relief for Investment in Non-Electing Government MMFs without regard to CFTC Concentration Limits
While not directly stated in the DSIO letter, the DSIO letter has the effect of clarifying that Non-Electing Government MMFs are permissible investments for purposes of CFTC Regulation 1.25. Further, the DSIO letter indicates that CFTC Regulation 1.25(b) imposes concentration limits on certain categories of permitted investments, but does not impose a concentration limit on the investment of customer funds in (i) a money market fund “comprising only U.S. government securities” where (ii) the money market fund has at least $1 billion in assets and the management company of such fund has at least $25 billion in assets under management.12 The DSIO letter acknowledges that this condition is different from Amended Rule 2a-7’s definition of a government money market fund.
The DSIO letter states that, “to provide consistency in the definition of Government MMF” between Amended Rule 2a-7 and Regulation 1.25(b), DSIO will not recommend an enforcement action if an FCM invests customer funds in Non-Electing Government MMFs and the FCM treats such investments as not subject to the Regulation 1.25 concentration limits. The DSIO letter further states that this relief is subject to a new condition that the Non-Electing Government MMF have at least $5 billion in assets.
Relief for Investment of FCM Assets in Excess of Targeted Residual Interest Amount
Under regulations adopted in October 2013, an FCM must maintain proprietary funds (referred to as residual interest) in its futures and options customer accounts to cover any undermargined customer accounts on a daily basis.13 In addition, an FCM must maintain a targeted amount of excess residual interest in such accounts to reasonably ensure that the FCM will remain in compliance with the segregated fund requirements at all times (by having sufficient funds in its customer accounts to cover all obligations due to customers).14 Such residual interest amounts must be invested in compliance with Regulation 1.25. However, FCMs often deposit proprietary funds in excess of the required targeted amount (and such excess can be withdrawn at any time).15
The DSIO letter states that the DSIO will not recommend enforcement against an FCM that invests its own assets held in customer segregated accounts in Non-Government or Electing Government MMFs, so long as the amount invested represents only the FCM’s assets in excess of the targeted residual interest. This position is intended to avoid creating an incentive for FCMs to withdraw their assets from customer segregated accounts.16 However, it should be noted that, in a statement published concurrently with the DSIO letter, CFTC Commissioner Sharon Y. Bowen suggested that the CFTC would “reexamine this subject in the near future,” calling DSIO’s no-action position “window-dressing” that gave “the impression of greater security than there actually is.”17
DCR Letter: DCO Core Principles in CFTC’s Part 39 Regulations
CFTC Regulatory Restrictions on the Types of Assets in which a DCO May Hold Margin and on Clearing Member FCM and Customer Funds
CFTC’s Part 39 regulations under Section 5b(c)(2) of the Commodity Exchange Act set forth and implement core principles with which an organization must comply in order to register, and maintain registration, as a DCO.18 In relevant part, these regulations restrict the types of assets and manner in which a DCO may choose to hold initial margin, as well as funds belonging to clearing members and their customers, as follows:
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CFTC Regulation 39.11(e)(1) requires a DCO to (i) “effectively measure, monitor and manage its liquidity risks, maintaining sufficient liquid resources such that it can, at a minimum, fulfill its cash obligations when due” and (ii) hold assets belonging to the DCO, its clearing members or their customers “in a manner where the risk of loss or delay in the access of such assets is minimized.”
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CFTC Regulation 39.15(c) similarly requires a DCO to “hold funds and assets belonging to clearing members and their customers in a manner which minimizes the risk of loss or of delay in the access by the DCO to such funds and assets.”
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CFTC Regulation 39.13(g)(10) requires a DCO to limit the assets it accepts as initial margin to assets that have “minimal credit, market, and liquidity risks.”
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CFTC Regulation 39.15(e) limits a DCO to investing funds and assets belonging to clearing members and their customers in instruments with “minimal credit, market, and liquidity risks,” and also cross-references CFTC Regulation 1.25’s restrictions on investment of customer funds by DCOs and FCMs.
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CFTC Regulation 39.36(f) provides that systemically important DCOs (SIDCOs) and DCOs that opt into the SIDCO regulatory requirements (Subpart C SIDCOs) are subject to Regulations 39.15(c) and (e).19
DCR Interpretative Position
The DCR letter notes that each of the above requirements obligates a DCO to maintain liquid resources sufficient to make prompt payments to members with gains opposite a defaulting member.
The DCR letter notes that redemption gates would not serve to minimize, and could instead substantiate, the risk of delayed access to assets belonging to the DCO, its clearing members or their customers, contrary to Regulations 39.11(e)(1) and 39.15(c). Similarly, redemption gates would conflict with the requirements under Regulations 39.13(g)(10) and 39.15(e) that DCOs maintain initial margin and invest funds belonging to clearing members or their customers in assets with minimal liquidity risks. Any assets subject to a redemption gate would not be available for prompt liquidation to ensure that a DCO is able to make on-time payments to its customers; as such, the DCR letter notes that these assets do not present minimal liquidity risks for purposes of the DCO core principles. Accordingly, the DCR letter states that DCR interprets these requirements as incompatible with the prospect of the redemption gates that may be imposed by Non-Government and Electing Government MMFs.
For these reasons, the DCR letter states that DCR interprets the CFTC’s Part 39 regulations to prohibit DCOs from accepting or holding initial margin, or investing in Non-Government or Electing Government MMFs any assets belonging to the DCO, its clearing member FCMs or clearing members’ customers. However, while the DCR letter does not address Non-Electing Government MMFs, it appears that DCOs may continue to invest in such funds.
Conclusion
The DSIO and DCR letters substantially restrict FCM and DCO investments in Non-Government MMFs and Electing Government MMFs. Importantly, under the letters, Non-Electing Government MMFs that do not choose to participate in the ability to impose redemption restrictions would remain permissible investments for customer funds. Accordingly, prior to the October 14, 2016 compliance date for Amended Rule 2a-7, money market fund sponsors may need to modify their arrangements with FCMs and DCOs so that the FCMs and DCOs invest in Non-Electing Government MMFs to the extent required under the letters.
