Commentaries

CFTC Adopts More Stringent Customer Funds' Protection Rules

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Published Date : October 30, 2013

The CFTC today approved sweeping new rules in an effort to enhance the protection of customer funds held by futures brokers and derivatives clearing organizations.

The most controversial provision – based on a reversal of a decades long interpretation of applicable law -- requires future commission merchants (FCMs), within one year after the new rules' effective date, to maintain by 6 pm Eastern Time on each business day an amount of their own funds in their customer accounts (their so-called "residual interest") at least equal to their customers' aggregate under margined amounts for the prior trade date – even if all margin is expected by an FCM to be paid by each customer fully and timely. This residual interest requirement must be calculated and maintained separately for customer accounts trading domestic futures and options and non-US futures and options (a separate residual interest requirement for customer cleared swaps accounts (i.e., LSOC -- legal segregation with operational commingling) was approved last year by the CFTC and is not impacted by this new requirement).

Moreover, unless the CFTC adopts different rules, the time required for FCMs to maintain their enhanced minimum residual interest in their customer accounts will automatically accelerate after December 31, 2018, to the business day following trade date prior to the time of the daily settlement with each designated clearing organization.

The CFTC is obligated to publish a study within 30 months of these new rules being published in the Federal Register regarding the practicality, costs and benefits of further accelerating the time required for FCMs to maintain their enhanced minimum residual interest to the time of daily settlement on so called T+1 (i.e., the day following trade date).

In addition, the CFTC adopted new rules mandating certain new general and specific disclosures to existing and prospective clients regarding the overall risks of participating in the futures and swaps markets, as well as the risks of dealing with a specific FCM. Among the specific information that an FCM must now disclose includes:

the name, title, business address, business background, areas of responsibility and the nature of duties of each of its principals;
its significant types of business activities and product lines, and the approximate percentage of the FCM's assets and capital used to support each type of activity;
a description of its business on behalf of customers, including its policies and procedures related to its choice of bank depositories, custodians and counterparties in connection with its handling of customer funds; and
the material risks of giving customer funds to the FCM, including a discussion of the FCM's creditworthiness, leverage, capital, liquidity, principal liabilities, and risks created by its affiliates and their activities.

Other requirements of the new rules require FCMs:

to make prompt notice to the CFTC of certain additional rule violations, such as investing customer funds in non-approved investments (notice of certain rule violations already are required);
to separate duties among individuals responsible for ensuring protection of customer funds from individuals (a) advising customers on trading activities, (b) approving or overseeing cash receipts and disbursements, and (c) recording and reporting financial transactions;
at least annually to train all finance, treasury, operations, regulatory, compliance, settlement and other relevant officers regarding applicable customer funds' protection requirements;
to adopt a risk management program approved by the FCM's governing body designed to monitor and manage the risks associated with the firm's FCM activities. As part of this FCMs must establish a risk management unit that reports to senior management that is separate from a firms' business unit. This risk management unit must have appropriate authority, qualified personnel and other resources;
to require all FCMs (not just combined broker dealer FCMs) to file an annual certified financial report with the Commission and the FCM's self regulatory organization (e.g., National Futures Association, Chicago Mercantile Exchange) within 60 days of year-end (not 90, as currently required);
to reduce its regulatory capital (in connection with assessing its minimum capital requirement) by the amount of all margin calls made but not paid for more than one business day (currently the time frame is generally longer);
to make parallel the customer funds' protections afforded customers who trade domestic futures and options and non-US traded futures and options;
to use a standard template letter with depositories who hold customer funds. Among other things this template letter requires the depositories to agree to provide the CFTC with direct, read-only electronic access to certain information regarding the FCM's customer funds' accounts); and
to utilize only public accountants for their certified annual reports who meet minimum qualifications, such as maintaining registration with the Public Company Accounting Oversight Board and who undergo periodic inspections by the PCAOB.

Many of the rules adopted by the CFTC today, conform to rules previously adopted by the NFA and CME in response to the collapse of MF Global two years ago tomorrow and Peregrine Financial Group during July 2012.

The Commission also amended rules related to SRO examination programs of FCMs. SRO examinations must now apply PCAOB audit standards, and a CFTC-approved examinations expert must now review each SRO supervisory program at least once every three years.

These new rules will be effective 60 days after they are published in the Federal Register. The compliance dates vary as follows:

by 90 days afterwards (e.g., 150 days after publication), FCMs must provided revised general risk disclosure statements to all customers;
by 180 days afterwards, FCMs must (a) obtain revised acknowledgement letters from their depositories; (b) provide customers with specific disclosure requirements and post certain historical financial and segregation schedules on their website; and (c) file with the CFTC copies of their risk management programs. SROs must submit to the CFTC their supervisory programs with examination expert review;
by June 1, 2014, FCMs are required to file their certified financial statements within 60 days of their year end, and FCM auditors must be PCAOB registered and comply with PCAOB audit standards;
by one year afterwards, FCMs must implement the 6 pm T+1 residual interest requirement and the revised number of days to calculate under-margined capital charges;
by December 31, 2015, All PCAOB registered auditors of FCMs must have been examined by PCAOB; and
after December 31, 2018, FCMs must implement the settlement time T+1 residual interest requirement unless the CFTC passes a contrary rule.

In the CFTC's original proposed rules regarding enhanced customer funds' protection (issued November 14, 2012), the Commission had requested comment on whether in an FCM's annual compliance report, the Chief Executive Office or Chief Compliance Officer should have a separate certification related to the FCM's compliance with provisions of law pertaining to the safeguarding of customer funds that would impost a higher duty of strict liability in connection with those sections. The CFTC in the final rules declined to adopt such a higher standard.

Separately, today, the CFTC also adopted rules under Dodd Frank that (1) require swap dealers and major swap dealers to notify counterparties to uncleared swaps that they have the right to require any initial margin they post to be segregated at an independent custodian, and (2) to clarify that securities held in a portfolio margin account carried as a futures account or a cleared swaps customer account at an FCM is customer property and these accounts should be protected and treated just like ordinary customer futures and options accounts in case of an FCM bankruptcy. The CFTC also amended reporting requirements (including Ownership and Control Reports) for futures and swaps so it can identify more easily relationships between trading accounts, special accounts, reportable positions, and market activity.

My view:
The revised enhanced residual interest requirements for FCMs surely will impact detrimentally at least some customers going forward. Some customers likely will be impacted by being required to maintain anticipated margin pre-trade, while others will be impacted by being assessed costs incurred by FCMs to front their margin payment obligations. What is ironic is that had these enhanced residual interest requirements been in effect at the time of MF Global's or Peregrine's collapse, at least some customers at these FCMs likely would have been in a worse, not better position because they likely would have been required to post margin pre-trade. It is also remarkable that the current CFTC has determined that the CFTC's decades long prior interpretation of applicable law regarding the handling of customer funds was wrong and needs to be corrected now.

For more details, see:

Enhanced Customer Funds' Protection Rules:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister103013b.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/custprot_factsheet_final.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/custprot_qa_final.pdf
Swaps Posted Margin Rules:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister103013.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/unclearedswaps_factsheet_final.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/unclearedswaps_qa_final.pdf
New Reporting Rules, including OCRs:
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister103013c.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/ocr_factsheet_final.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/ocr_qa_final.pdf

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of October 30, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.

CFTC Adopts More Stringent Customer Funds' Protection Rules

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