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From Securities Regulation Daily, October 30, 2013

CFTC adopts enhanced customer protection rules

By Lene Powell, J.D.

In a 3-1 vote, the CFTC voted to approve final rules designed to enhance customer protection for commodity futures customer funds held by Futures Commission Merchants (FCMs) and Designated Clearing Organizations (DCOs). Commissioner Scott O’Malia dissented.

The rules are part of a series of related rulemakings on customer protection that the CFTC undertook after the failure of MF Global in 2011 and Peregrine Financial Group (Peregrine) in 2012. Asked by CFTC Chairman Gary Gensler whether the new rules would prevent similar happenings in the future, Director of the Division of Clearing and Intermediary Oversight Ananda Radhakrishnan first noted that the two failures were different from one another. Peregrine’s collapse occurred due to misappropriation by the CEO using forged bank statements, whereas MF Global raided customer funds to cover an enormous amount of proprietary trades that had gone bad. The new rules would have prevented this misconduct, he said.

Transparency. According to Gensler, the new rules will significantly increase transparency, with regulators being given greater access to view FCM bank accounts. Additionally, FCMs will be required to post certain financial information on their websites twice a month, giving the public more information about FCM financial status.

Preventing commingling of funds. Commissioner Chilton said the rules ensure against the improper commingling of funds by eliminating some tolerated methodologies for computing the amount of funds held and how funds are treated. The rules prescribe new calculation methods, including specifying when foreign funds can be included in the calculation and restricting the amount of customer funds that an FCM may hold in depositories outside of the United States to the amount of margin required by a foreign clearing organization or broker, plus a 20% cushion.

Risk management. According to Chilton, the rules impose risk management requirements for FCMs, including written policies and procedures reasonably designed to ensure that customer funds are separately accounted for and segregated or secured as belonging to customers. The rules require FCMs to provide the CFTC with notice, creating an early warning system on segregated funds violations; amend FCM capital requirements to require that FCMs demonstrate, upon CFTC request, access to sufficient liquidity; and require FCMs to file daily segregated funds and secured amount schedules and other reporting.

The rules also impose restrictions on the movement of funds within the firm, by requiring that the firm's senior management pre-approve any withdrawal from customer segregated or secured accountings where the withdrawal or series of withdrawals exceeds 25 percent of the FCM's excess segregated or secured funds and the withdrawal was not made for the benefit of the FCM's customers.

Residual interest. In the most debated portion of the rule, each FCM must compute a targeted amount of excess funds (i.e., proprietary funds or “residual interest”) that the FCM seeks to maintain in customer segregated or secured accounts as a cushion to help ensure that the FCM does not become undersegregated or undersecured. According to O’Malia, the final rules would decrease the time in which customers’ margin calls must arrive to their FCM from the current three days to just one day. If margin is not collected, the FCM must take a capital charge.

The new margin deadline would be phased in over a period of five years. In the first year, there would be no change. After that year, FCMs will be required to comply with the residual-interest requirement as of the close of business on the day following the margin-deficit calculation. Thirty months after publication of the rule, CFTC staff must conduct a study determining the feasibility, costs and benefits of moving the residual-interest deadline to the completion of the first clearing-settlement cycle following the trade date. The study will be published for public comment, and a public roundtable will be held to solicit the views of market participants. Finally, after five years, the residual-interest requirement will move up to the first clearing settlement cycle of the day, typically first thing in the morning.

Commissioner Mark Wetjen approved of this phased-in approach, saying it gives the industry an opportunity to streamline margin-collection practices and to take advantage of any technological solutions that may be developed in the meantime. He said that judging by the comment file, the vast majority of the marketplace could comply with more abbreviated timelines for margin calls and payments today.

O’Malia objected to the residual interest requirement, saying that decreasing the margin deadline would result in a drastic increase in pre-funding of margin, possibly nearly double the amounts currently required. As a result, many small agribusiness hedgers will have to consider alternative risk management tools or, even worse, will be forced out of the market. The commissioner offered an amendment that would have left the deadline at the close of business on the following day. The amendment was rejected by the other commissioners.

Other finalized rules. Gensler said the Commission had also finalized two other rules by seriatim vote before the open meeting. The first rule relates to the protection of customer funds when entering into uncleared swap transactions. The new rule implements the statutory mandate that counterparties of swap dealers be given a choice regarding whether or not they get the protections that come from segregation of monies and collateral they post as initial margin.

According to Chairman Gensler, swap dealers will be required to give each of their counterparties the choice regarding segregation, and the dealers will have to provide the prices for the various segregation choices. Further, the dealers must give the customers at least one custodial arrangement choice not affiliated with the swap dealer’s bank. The rule also clarifies that if a counterparty chooses segregation for its funds, those funds will not be tied up in the bankruptcy of its swap dealer.

The second rule requires that accounts which trade more than a certain volume in a day must disclose who owns or controls them.

Volcker Rule status. Several commissioners touched on the status of the much-anticipated Volcker Rule. Wetjen said he is “looking forward” to taking up the rule by the end of the year. O’Malia said he has not seen the draft document yet, and asked Gensler to send him a copy. Gensler replied that he does not have a copy of the document yet, and that the staffs of five regulatory agencies plus the Department of the Treasury are working through the documents. A meeting will be scheduled for the second or third week of December 2013, and he will share the document as soon as he has it.

MainStory: TopStory CommodityFutures ExchangesMarketRegulation Swaps

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