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From Securities Regulation Daily, November 3, 2014

CFTC proposes tweaks to residual interest deadline, swaps recordkeeping, options exclusion

By Lene Powell, J.D.

In an open meeting, the CFTC voted to propose two rule amendments and an interpretation designed to resolve ambiguity and reduce uncertainty for market participants in three different areas. First, a rule concerning protection of customer funds at futures commission merchants would be amended to eliminate a planned future change that would move a margin deadline earlier in the day. Second, certain requirements relating to recordkeeping for commodity interest and related cash or forward transactions would be relaxed. Third, a staff interpretation regarding the exclusion from regulation of a certain type of forward contract would be clarified and strengthened. 

Commissioner Sharon Bowen noted that the actions were tweaks to past Commission actions, but were important all the same. She said, “I firmly believe that we need to get the little things right to get the big things right, and I feel we have gotten these small changes right.”

Residual interest deadline. Under Regulation 1.22 providing for protection of customer funds, on any day when a customer is required to post additional margin but has not yet done so, a futures commission merchant (FCM) must deposit its own capital in customer segregated accounts to make up the difference. This is often referred to as the FCM’s “residual interest.”

Last fall, the CFTC amended the regulation to provide that as of November 14, 2014, the FCM must deposit the additional funds by 6 p.m. Eastern Time on the date of settlement. In addition, the CFTC was to conduct a study on the practicability of moving that deadline even earlier, to the morning daily clearing settlement cycle or the time of settlement, or 9 a.m. Within nine months after publishing the study, the CFTC was to decide whether to move the deadline to 9 a.m. If the agency did not act, the deadline would automatically move to 9 a.m. as of December 31, 2018.

The proposed rule would eliminate the automatic moving of the deadline to 9 a.m. in 2018. The deadline will still move to 6 p.m. as of November 14 of this year, and the CFTC will still conduct a study of the practicability of making the deadline earlier. However, now the deadline would only move earlier than 6 p.m. after formal rulemaking.

Chairman Massad supported the amendment, saying that an earlier residual interest deadline does better protect customers from one another, but that the CFTC wants to move deliberately. Commissioner J. Christopher Giancarlo welcomed the amendment, saying that without revision, the rule would cause farmers and ranchers to prefund their futures margin accounts. This would likely drive many small and medium-sized agricultural producers out of the marketplace, and force a further reduction in the already strained FCM community that serves the agricultural community.

The commissioners voted 4-0 in support of the proposed amendment.

Recordkeeping under Regulation 1.35. Under Regulation 1.35, various types of market participants must keep written and oral records of transactions. After the rule was amended in December 2012, staff observed implementation of the changes and provided no-action relief from certain requirements, finding that the costs of complying with certain aspects of the rule for some market participants might exceed the potential benefits.

The proposed rule would amend Regulation 1.35 to make it consistent with no-action relief provided by staff in letters 14-60 and 14-72. Regarding written records, members of DCMs and SEFs that are not registered with the Commission will not have to keep text messages or store their other records in a manner that is identifiable and searchable by transaction. As to oral communications, commodity trading advisors will not have to record oral communications regarding their transactions. The amendment would also provide that pre-trade communications must be searchable, but would not need to be kept in a manner that allow for the identification of the transaction.

The commissioners voted 3-1 in support of the proposed amendment, with Commissioner Giancarlo voting no. He objected that it remained unclear what “searchable” means regarding paper records such as canceled checks, signed account agreements, and paper orders.

Forward contracts with embedded volumetric optionality. The Commodity Exchange Act generally excludes forward contracts from CFTC jurisdiction, other than in cases of fraud or manipulation. A forward contract is “any sale of any cash commodity for deferred shipment or delivery.”

An embedded volumetric commodity option is a type of option, often seen in energy commodities, used to hedge physical supply risk (as opposed to price risk) or to satisfy a regulatory requirement. A volumetric option allows for flexibility on delivery amounts in a contract that settles by physical delivery, allowing commercial market participants to adjust delivery volumes in response to changes in supply and demand requirements at the time of delivery. A forward contract with an embedded volumetric commodity option may qualify as an excluded forward (and not an option) if the optionality meets a seven-factor test, as specified in a staff FAQ issued in March 2014.

Some market participants reported that the seven-factor test was difficult to apply. In particular, the seventh factor, which looked at whether exercise of embedded volumetric optionality was based mainly on physical factors or regulatory requirements “outside the control” of the parties, was considered ambiguous and problematic. As explained by Commissioner Wetjen, the proposed rule would clarify the seventh prong by deleting the “outside of the control of the parties” language and providing that whether the test is met is determined by the intent of the parties at the outset of contract initiation. Thus, parties having some influence over factors affecting their demand for a nonfinancial commodity will not per se cause a contract to fail the seventh prong. Parties would be able to take a variety of factors into consideration when determining whether to exercise volumetric optionality, so long as the intended purpose was to address physical factors or regulatory requirements influencing the demand for, or supply of, the commodity.

The commissioners voted 4-0 in support of the proposed amendment.

MainStory: TopStory Derivatives CFTCNews CommodityFutures Swaps

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