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Final Rules on Investment of Customer Funds under Dodd-Frank Issued by CFTC
Practical Law Legal Update 9-515-2197 (Approx. 5 pages)
Final Rules on Investment of Customer Funds under Dodd-Frank Issued by CFTC
by PLC Finance
| Published on 08 Dec 2011 • USA (National/Federal) |
The CFTC issued final rules implementing changes required under Dodd-Frank to CFTC regulations that cover the investment by derivatives clearing organizations (DCOs) and futures commission merchants (FCMs) of customer funds collateralizing non-security-based swaps.
On December 5, 2011, the CFTC approved final rules under the Dodd-Frank Act limiting investment by derivatives clearinghouses and their clearing members of funds collateralizing derivatives such as futures and commodity options, referred to as "customer funds." These rules aim to provide greater protection for customer funds and reduce systemic risk. Extensive misplacement of customer funds was associated with the collapses of both Lehman Brothers and MF Global.
Among other things, the rules narrow the list of permitted investments in which derivatives clearing organizations (DCOs) and futures contract merchants (FCMs) may invest customer funds (often referred to as rehypothecation), eliminating repurchase agreements with affiliates and investment in foreign sovereign debt. The rules also attempt to ensure that funds can be quickly converted to cash to meet margin calls or to be returned to customers on demand.
Customer funds must be segregated from the DCO's or FCM's own funds and other accounts, but may be and often are aggregated in general customer accounts at the FCM (usually a broker-dealer) or the clearinghouse.
The final rules amend CFTC Regulation 1.25 which covers the investment of segregated customer funds, and CFTC Regulation 30.7 which covers the investment of customer money and property associated with positions in foreign futures and options.
The final rules cover, among other things:
- Permitted investments. The final rules narrow the scope of permitted investments in which DCOs and FCMs holding customer funds may invest those funds to eliminate investments that may involve unacceptable levels of risk. The new rules:
- impose limitations on the ability of FCMs and DCOs to invest in debt issued by Fannie Mae and Freddie Mac but permit investments in certain other US agency obligations and US treasuries;
- eliminate foreign sovereign debt as a permitted investment;
- eliminate certain in-house transactions, such as repurchase agreements (repos) and reverse repos with affiliates;
- limit investments in commercial paper and corporate notes or bonds to those that are federally guaranteed as to principal and interest under the Temporary Liquidity Guarantee Program (TLGP) and which meet certain other standards; and
- restrict investments in bank certificates of deposit to instruments which can be redeemed at the issuing bank within one business day, with any penalty for early withdrawal limited to accrued interest earned according to its written terms.
- Liquidity requirement. Under the final rules, customer funds must be invested in highly liquid assets to be permissible, meaning that these investments must be convertible into cash in one business day without a material discount in value.
- Removal of credit rating requirements. The final rules remove all credit rating requirements for investments under Regulation 1.25. Regulation 1.25 previously required that customer funds be invested only in assets given the highest short-term rating by a nationally recognized statistical rating organizations (NRSRO) or one of the two highest long-term ratings by an NRSRO. However, the removal of references to credit ratings from these regulations does not prohibit a DCO or FCM from taking into account credit ratings as one of many factors to be considered in making a decision regarding investment of customer funds.
- Asset-based concentration limits. The final rules aim to lower the risk associated with the investment of customer funds by promoting diversification via new asset-based concentration limits for the investment of customer funds. These limit the amount of direct exposure an FCM or DCO can have to the credit risk of a particular investment as a percentage of total segregated customer funds held. Specifically, the final rules include the following asset-based concentration limits:
- no limit on US government securities;
- 50% for US agency obligations fully guaranteed by the US government, with limitations on debt issued by Fannie Mae and Freddie Mac;
- 25% for commercial paper and corporate notes or bonds guaranteed by the FDIC under the TLGP;
- 25% for non-negotiable bank certificates of deposit;
- 10% for municipal securities; and
- 50% for aggregate interests in money market mutual funds (MMMFs) (other than US-treasury-only MMMFs), except for small MMMFs, which are limited to 10% in the aggregate.
- Issuer-based concentration limits. The final rules establish:
- a 25% "family-of-funds" limitation for MMMFs (none for MMMFs consisting entirely of US treasuries); and
- a 10% individual fund limitation for all other MMMFs.
This requires FCMs and DCOs to diversify their MMMF portfolios. The final rules do not change the existing issuer-based concentration limits for other types of direct investments under Regulation 1.25, which are:- 25% for US agency obligations fully guaranteed by the US government;
- 5% for federally guaranteed commercial paper and federally guaranteed corporate notes or bonds;
- 5% for non-negotiable bank certificates of deposit; and
- 5% for municipal securities.
- Counterparty repo limits. The final rules also add a new counterparty concentration limit for securities subject to reverse repos (rather than held as direct investments by an FCM or DCO). The rules require that not more than 25% of total funds segregated in customer accounts may be held in securities purchased by the FCM or DCO from a single counterparty that are subject to an agreement to resell them to that counterparty.
- Acknowledgement letters and next-day redemption requirements. The final rules clarify that acknowledgement letters for MMMFs must be from a party with substantial control over the MMMF's assets who has sufficient knowledge and authority to facilitate redemption. The final rules also clarify next-day redemption requirement for MMMFs.
- Regulation 30.7 amendment. The final rules conform the investment standards of Regulation 30.7, which applies to funds held in customer accounts to cover positions in foreign futures and foreign options, with the standards of Regulation 1.25, covering investments of customer funds. Many of the same concerns arise under both regulations. This change will likely have limited impact, however, because the industry commonly uses Regulation 1.25 standards for investments of 30.7 funds.
- Depository limitation for 30.7 funds. Under the final rules, a customer may no longer request that a bank or trust company located outside the US act as a depository for 30.7 funds unless the bank or trust company has in excess of $1 billion of regulatory capital. Previously, a bank or trust company that did not meet the requirements could still be designated as an acceptable depository by request of its customer and with the approval of the CFTC.
The final rules take effect on February 17, 2012. Brokerages will be required to comply by June 18, 2012. For more information on the final rules, see the CFTC Q&A.
For more information on CFTC rulemaking under the Dodd-Frank Act, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives. To learn more about counterparty collateral issues, see Practice Note, Practical Guide to Counterparty Collateral Negotiation: Considerations for End Users. For more information on the mechanics of derivatives clearing, see Practice Note, Mechanics of Derivatives Clearing.