Final Rules on Protection of FCM Customer Funds Adopted by CFTC | Practical Law

Final Rules on Protection of FCM Customer Funds Adopted by CFTC | Practical Law

The CFTC adopted final rules designed to protect customer funds, margin posted by customers of futures commission merchants (FCMs) to collateralize positions under futures contracts, after customer funds were misplaced in two high profile FCM failures.

Final Rules on Protection of FCM Customer Funds Adopted by CFTC

Practical Law Legal Update 3-547-8066 (Approx. 5 pages)

Final Rules on Protection of FCM Customer Funds Adopted by CFTC

by Practical Law Finance
Published on 06 Nov 2013 • USA (National/Federal)
The CFTC adopted final rules designed to protect customer funds, margin posted by customers of futures commission merchants (FCMs) to collateralize positions under futures contracts, after customer funds were misplaced in two high profile FCM failures.
On October 30, 2013, the CFTC adopted final rules that aim to protect customer funds held by futures commission merchants (FCMs). Customer funds consist of margin collateral posted by customers of FCMs to cover exposure under their futures contracts. The final rules:
  • Specify the manner in which an FCM must hold customer funds.
  • Are designed to introduce transparency into how FCMs and derivatives clearing organizations (DCOs), registered derivatives clearinghouses of which FCMs are clearing members, maintain their customer accounts.
The final customer funds rules are substantially similar to the proposed rules on segregation of customer funds and follow CFTC guidance issued last year (see Legal Update, CFTC: Clearing Banks Must Hold Secured Customer Funds in Separate Account) and aim to close loopholes, strengthen internal risk controls and require FCMs to be more transparent by providing more information to customers. The final rules become effective January 13, 2014.
The CFTC initially proposed these rules in October 2012, after the collapses of FCMs MF Global Holding, Inc. and Peregrine Financial Group Inc., which both filed for bankruptcy after misplacing a total of almost $2 billion in customer funds.
Under the final customer funds rules, an FCM must:
  • Segregate customer funds from its own assets.
  • Deposit segregated customer funds into an account with a bank or trust company (depository) that identifies the non-FCM owner of the account.
  • Obtain a written acknowledgement from the depository that the funds in the account are customer funds being held in accordance with the CEA and CFTC regulations. Regulation 1.20 in its current form already requires FCMs and DCOs to obtain depository acknowledgment letters.
An FCM may deposit customer funds with a bank or trust company, a DCO, or with another FCM.
Under the final rules FCMs are prohibited from using customer funds to margin or secure positions for any entity other than the customer. FCMs may commingle customer funds from various customers of that FCM to facilitate operations, so long as they are held in one or more segregated omnibus customer funds accounts with a recognized depository.
The final customer funds rules include a fundamental difference from the proposed rules: Under the proposed rules, an FCM would have been required to maintain enough residual interest, composed of funds from the FCM's own accounts, in segregated and secured customer accounts to cover all of its customers' margin deficits "at all times." The CFTC intended this obligation to prevent FCMs from using end-of-day balancing to obscure a shortfall in customer segregated accounts. Some industry groups, such as the National Grain and Feed Association (NGFA), complained that these requirements would have been overly burdensome, since it essentially required FCMs to calculate margin deficits in real time or demand money up front from their customers to cover potential shortfalls.
Under the final rules, after the first year following the publication of the final rules in the Federal Register during which there will exist no residual interest requirement, FCMs will be permitted to wait until 6:00 p.m. on the next trading day following a margin deficit calculation to hold the required amount of residual interest. The phase-in period for this requirement is five years. By 2019, FCMs will need to hold the residual interest at the time point of the daily settlement that will complete during the next trading day.
In addition, the final customer funds rules require FCMs to:
  • Pay a capital charge for an unmet margin call one day after the residual-interest deadline. Currently, an FCM reduces its capital, or incurs a capital charge, for customer and noncustomer accounts that are undermargined three days after a margin call is issued. Under the capital charge provision of the final rules, FCMs must take a capital charge for undermargined customer accounts if more than one business day passes after a margin call. FCMs will therefore charge their customers a penalty for one-day missed margin calls, where they now have three days. Some market participants have been critical of this aspect of the final rules (see Market Criticism of the Rules).
  • Provide the CFTC with daily reports about the segregated account computation and details regarding the holding of customer funds. FCMs are required to provide to the CFTC daily electronic reports regarding their futures customers' DCM trading activity. DCMs are designated contract markets, which are major CFTC-registered derivatives exchanges, of which FCMs are members. FCMs must submit a daily record as of the close of business each day detailing the amount of:
    • funds the FCM holds in segregated accounts;
    • the FCM’s total obligation to its customers computed under a method specified in section 1.32 of the final rules; and
    • the FCM’s aggregate residual interest in all of its futures customer segregated accounts.
  • Adopt a robust risk management program designed to monitor and manage the risks to which the FCM is reasonably subject. Some of these risks are related to operations, capital and customer fund segregation. These programs must utilize written policies and procedures designed to ensure that customer funds are held separately from the FCM's own accounts, segregated and labeled as belonging to customers. Under the final rules, the FCM must establish a risk management unit that is independent from its business unit to administer this program.
  • Promptly notify the CFTC upon the occurrence of certain reportable solvency and other material events. Notice of material changes including changes in the operations of the firm such as a change in senior management or a material change in the FCM’s clearing arrangements, must be electronically filed with the CFTC.
  • Provide more disclosure up front to customers. Some of these disclosures include specific disclosures related to the FCM's business, operations and general risks associated with using an FCM.
Also under the final rules, the CFTC:
  • Removed the "Alternative Method" calculation exemption. This Alternative Method exemption created a loophole that permitted FCMs to set aside in separate accounts an amount of funds for the benefit of their foreign futures or foreign options customers. Requirements for the collateral of these customers were substantially less stringent for funds deposited with an FCM under the Alternative Method than requirements for the collateral of futures customers deposited in Cleared Swaps Customer Funds accounts. Under the final rules, this is no longer the case.
  • Modified the Form 1-FR-FCM Schedules. These schedules, which include the Statement of Financial Condition, Segregation, Cleared Swaps Segregations and Secured Amount Schedules, were changed to provide greater transparency into the financial condition of FCMs and enhance compliance with CFTC's FCM financial requirements. Under one of these requirements, the FCM must disclose its targeted residual interest on each Segregation schedule.

Market Criticism of the Rules

US agricultural organizations, most of which are represented by the NGFA, contend that virtually all sectors of US production agriculture and agribusiness use futures and other commodity derivatives to which these final rules apply for risk management. These organizations rely on smaller and medium-sized FCMs to conduct their derivatives trading and have responded negatively to these final rules because small and mid-sized FCMs, as compared to their larger counterparts, are expected to have more difficulty with complying with these new rules.
Ag groups have been particularly critical of the reduction from the three-day residual-interest deadline to one day. These groups claim that one day is not enough time for FCMs to receive all their margin funds. Farmers, ranchers and other similar hedgers normally send their margin calls by check. The final rules will most likely cause these smaller FCMs to demand money up front from their customers to cover potential shortfalls. As a result, these groups called for the CFTC to maintain the current three-day grace period before the FCM incurs a capital charge, which it declined to do.
Update: On July 30, 2014, the CFTC published in the Federal Register certain corrections to these final rules. These corrections include the addition of erroneously omitted language to section 30.7(d)(1). The language from the proposed rule that was meant to be included in the final rule states that a FCM is not required to obtain an acknowledgment letter from a DCO if the DCO maintains rules that:
  • Have been submitted to the CFTC.
  • Provide for the segregation of customer funds in accordance with all relevant provisions of the CEA and CFTC Regulations.
This correction is effective on July 30, 2014.