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The Commodity Futures Trading Commission (the CFTC) long has restricted how derivatives clearing organizations (DCOs) and futures commission merchants (FCMs) may invest customer funds through its Rule 1.25. By law for decades, customer funds must be kept separate from any other funds of FCMs and DCOs. Rule 1.25 does not address or affect segregation; it simply limits how FCMs and DCOs may invest segregated customer funds. On December 5, the CFTC voted unanimously to amend Rule 1.25 to place additional restrictions on permissible investments of customer funds deposited to support both futures and swap positions.1 The rules are effective on February 17, 2012.
The additional restrictions adopted by the CFTC now will prohibit investment of customer funds in:
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Corporate obligations not guaranteed by the U.S.;
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Foreign sovereign securities; and
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Transactions with an affiliate of the FCM or DCO.
The amendments also make changes to investment requirements, such as requiring investments to be highly liquid, removing conditions in the rule that depended on credit ratings, imposing additional restrictions to certificates of deposit (CDs), tightening concentration limits and making technical changes for investments in money market mutual funds (MMMFs).
Regulatory Background
CFTC Rule 1.25 prescribes rules for investing customer funds and applies equally to DCOs and FCMs.2 As originally promulgated, Rule 1.25 restricted investments of customer funds to obligations of the United States, any state (or subdivision thereof), or obligations fully guaranteed as to principal and interest by the United States. Between 2000 and 2005, the CFTC expanded the list of permitted investments to include obligations of government sponsored entities (e.g., Fannie Mae and Freddie Mac), bank certificates of deposit, commercial paper, corporate notes, foreign sovereign debt, interests in MMMFs and transactions with an affiliate of the FCM that is registered as a broker-dealer.3 The CFTC also included concentration limits on certain investments, marketability requirements and rating standards, among other requirements. The amendments to Rule 1.25 effectively roll back some of the changes made between 2000 and 2005.
Although the CFTC’s vote on amended Rule 1.25 followed on the heels of the collapse of MF Global, the CFTC initially raised the issue of proposing amendments to Rule 1.25 in 2009. While some claims have been made that the amendments to Rule 1.25 would have prevented the shortfall in customer segregated funds at MF Global, the amendments do not increase or decrease the strength of the longstanding statutory and regulatory prohibition on violating the sanctity of customer segregation. In any event, it is difficult to confirm how the amendments to Rule 1.25 might have affected the MF Global episode until a full public accounting of the pertinent facts has been made.4
Amendments to Rule 1.25
Changes to the Types of Permitted Investments
Corporate Obligations Not Guaranteed by the U.S.
Corporate obligations not guaranteed by the U.S. are no longer permissible investments because of the “credit, liquidity, and market risks posed by corporate debt securities.”5 Corporate debt securities guaranteed as to principal and interest by the Temporary Liquidity Guarantee Program (TLGP)6 are allowed if such security is part of an issuance larger than $1 billion, denominated in U.S. dollars and fully guaranteed by the U.S. for its entire term.7
Investments in Foreign Sovereign Debt Securities
Investments in foreign sovereign debt securities are no longer permitted. Prior to the amendment, such investments were permitted to the extent an FCM or DCO held balances owed to customers denominated in that country’s currency. The CFTC rejected comments that argued that investments in foreign sovereign debt securities are necessary to manage currency risk and increase diversification and liquidity, citing the volatility, risk and lack of liquidity of many foreign sovereign debt securities as reasons for prohibiting investments in foreign sovereign debt securities.8 The CFTC will consider permitting investments in foreign sovereign debt on a case-by-case basis to the extent an FCM or DCO can demonstrate that (1) it is has balances owed to customers in that country’s currency and (2) such sovereign debt services would preserve principal and maintain liquidity of customer funds.9
In-House Transactions
In-house transactions between an FCM or DCO and an affiliate involving customer funds are no longer permitted.10 This includes a prohibition on repurchase and reverse repurchase agreements with affiliates.11 Responding to several comments arguing in favor of permitting repurchase and reverse repurchase transactions with affiliates, the CFTC stated that “the concentration of credit risk and the potential for conflicts of interest during times of crisis” are too great in in-house transactions.12 The CFTC also distinguished in-house transactions from third-party repurchase and reverse repurchase transactions, which contain market-based safeguards such as being “transacted at arms-length (often by means of a tri-party repo mechanism), on a delivery versus payment basis, and [are] memorialized by a legally binding contract.”13
Fannie Mae and Freddie Mac Obligations
Last, the CFTC added a restriction that only permits investments in obligations issued by Fannie Mae and Freddie Mac so long as those “entities operate under the conservatorship or receivership of the Federal Housing Finance Agency with capital support from the United States.”14 This new limit is significantly less restrictive than the CFTC’s proposal, which would have prohibited all investments in obligations of U.S. government corporations or government sponsored enterprises (U.S. agency obligations).15 The CFTC agreed with numerous comments that investments in U.S. agency obligations should be permitted because those obligations generally performed well in the recent financial crises and are fully guaranteed by the U.S. government.
Other Changes – Liquidity, Credit Ratings, Restrictions on CDs, Concentration Limits
Investments Must Be “Highly Liquid”
Investments of customer funds now must be “‘highly liquid’ such that they have the ability to be converted into cash within one business day without material discount in value.”16 This standard is “to ensure that investments can be promptly liquidated in order to meet a margin call, pay variation settlement, or return funds to the customer upon demand.”17
References to Credit Ratings Are Removed
As required by Dodd-Frank § 939A, the CFTC also removed all references to credit ratings from Rule 1.25. This means that high credit ratings are no longer required for investments and will not provide a safe harbor for investments. One commenter noted that complete removal of ratings criteria may hinder an FCM’s or DCO’s ability to complete a thorough risk assessment of every issuer. The CFTC responded “that the removal of references to ratings does not prohibit a DCO or FCM from taking into account credit ratings as one of many factors to be considered in making an investment decision.”18
Restrictions on Investments in CDs
Amended Rule 1.25(b)(2)(v) restricts investments in CDs to those CDs that are “redeemable at the issuing bank within one business day, with any penalty for early withdrawal limited to any accrued interest according to its written terms.” The CFTC noted that customer principal can be jeopardized by market fluctuations if a CD is not redeemable or is subject to early redemption penalties in excess of accrued interest. In response to a request for clarification, the CFTC stated “that a brokered CD with a put option back to the issuing bank is an acceptable investment, assuming the issuing bank obligates itself to redeem within one business day and that the strike price for the put is not less than the original principal amount of the CD.”19
Concentration Limits
Amended Rule 1.25(b)(3)(i) adds asset-based concentration limits for several asset classes. The maximum percentage of total assets held in segregation by the FCM or DCO are now as follows:
(1) U.S. government securities — no limit;
(2) U.S. agency obligations — 50 percent;
(3) TLGP guaranteed commercial paper or corporate notes or bonds — 25 percent;
(4) CDs — 25 percent;
(5) municipal securities — 10 percent;
(6) MMMFs comprising only U.S. government securities — no limit; and
(7) all other MMMFs — 50 percent.
Investments in any MMMFs with less than $1 billion in assets or a management company with less than $25 billion in assets are limited to 10 percent of total assets held in segregation by the FCM or DCO.
Amended Rule 1.25(b)(3)(ii) also modifies the issuer-based concentration limits for securities investments. Investments from a single issuer or related issuers are limited to a percentage of total assets held in segregation by the FCM or DCO as follows:
(1) a single issuer of U.S. agency obligations — 25 percent;
(2) a single issuer of municipal securities or CDs — 5 percent;
(3) a single issuer of TLGP guaranteed commercial paper or corporate security — 5 percent;
(4) interests in any single family of MMMFs — 25 percent; and
(5) an MMMF that does not solely hold U.S. government securities — 10 percent.
The amended rule further details how to calculate and apply the concentration limits, such as when an issuer’s securities should be aggregated with securities of an affiliate of the issuer and how repurchase and reverse repurchase agreements should be counted.
Technical Changes Relating to Investments in MMMFs
The CFTC also made two technical revisions to rules relating to investments in MMMFs. An FCM or DCO must receive an acknowledgement letter for each investment of customer money in an MMMF. The acknowledgement letter now may come “from a party that has substantial control over MMMF shares purchased . . . and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds invested in shares of the MMMF.”20 Appropriate entities may include the fund sponsor or depository acting as custodian for fund shares.21
The second technical change incorporates SEC regulations that set forth the emergency conditions that qualify for an exemption to the one-day redemption requirement and provides safe-harbor language that can be used by MMMFs in their prospectuses.22
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1 Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78,776 (Dec. 19, 2011) (the Final Rules). The Final Rules also amend Rule 30.7 (treatment of foreign futures and foreign options secured amount) to impose the investment restrictions in Rule 1.25 and to make certain other technical amendments.
2 The CEA statutory provisions addressing DCO and FCM investment of customer funds can be found in CEA § 5b(c)(2)(F)(iii) (as amended by Dodd-Frank § 725(c)) for DCOs, § 4d(a)(2) for FCM cleared futures accounts and § 4d(f)(4) (added by Dodd-Frank § 724(a)) for FCM cleared swap accounts.
3 Rules Relating to Intermediaries of Commodity Interest Transactions, 65 Fed. Reg. 77,993 (Dec. 13, 2000); Investment of Customer Funds, 69 Fed. Reg. 6,140 (Feb. 10, 2004); Investment of Customer Funds and Record of Investments, 70 Fed. Reg. 28,190 (May 2005).
4 Recent reports about MF Global’s exposure to foreign sovereign debt refer to investments by an MF Global entity that was not registered with the CFTC as an FCM made with MF Global’s own funds, not customer funds. See, e.g., Testimony of CFTC Commissioner Jill Sommers before the U.S. House of Representatives, Committee on Agriculture (Dec. 8, 2011), http://www.cftc.gov/PressRoom/SpeechesTestimony/opasommers-18.
5 76 Fed. Reg. at 78,779. The CFTC also notes that, according to a review it conducted in 2007, DCOs and FCMs rarely invest customer funds in corporate debt securities.
6 TLGP is a program managed by the Federal Deposit Insurance Corporation that guarantees newly issued senior unsecured debt of banks, thrifts and certain holding companies. TLGP expires in 2012. For additional information, see http://www.fdic.gov/regulations/resources/TLGP/index.html.
7 Rules 1.25(a)(1)(v)-(vi) and 1.25(b)(2)(vi).
8 See 76 Fed. Reg. 78,781. The CFTC also noted that a review it conducted in 2007 of FCM and DCO investments indicated that investments in foreign sovereign debt were minimal.
9 See 76 Fed. Reg. 78,782. The CFTC will consider individual requests to invest in foreign debt securities under its exemptive authority in CEA § 4(c).
10 See 76 Fed. Reg. 78,783. The prohibition against in-house transactions does not apply to fair market value sales or collateral exchanges for the benefit of the customer.
11 Rule 1.25(d)(3).
12 76 Fed. Reg. at 78,790. The CFTC also noted that it would be inconsistent to prohibit “an investment in the debt instrument of an affiliate (effectively a collateralized loan between affiliates)” in one part of the rules while permitting “a repurchase agreement between affiliates (which is the functional equivalent of a short-term collateralized loan between affiliates).” Id.
13 76 Fed. Reg. at 78,782-83.
14 Rule 1.25(a)(3).
15 Rule 1.25(a)(1)(iii).
16 Rule 1.25(b)(1). The amendment uses the concept of liquidity to replace the term “readily marketable” and cross-references to that definition in SEC regulations.
17 76 Fed. Reg. at 78,784.
18 Id.
19 76 Fed. Reg. at 78,785.
20 76 Fed. Reg. at 78,789.
21 Rule 1.25(c)(3).
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