FR Doc 2010-29836[Federal Register: December 2, 2010 (Volume 75, Number 231)]

[Proposed Rules]

[Page 75162-75168]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr02de10-6]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 190

RIN 3038-AD99

Protection of Cleared Swaps Customers Before and After Commodity

Broker Bankruptcies

AGENCY: Commodity Futures Trading Commission.

ACTION: Advanced notice of proposed rulemaking; request for comments.

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SUMMARY: The Commodity Futures Trading Commission (the “CFTC” or

“Commission”) seeks comment on possible models for implementing new

statutory provisions enacted by Title VII of the Dodd-Frank Wall Street

Reform and Consumer Protection Act (“Dodd-Frank”) concerning the

protection of collateral posted by customers clearing swaps.

DATES: Submit comments on or before January 18, 2011.

ADDRESSES: You may submit comments, identified by RIN number 3038-AD99,

by any of the following methods:

Agency Web site, via its Comments Online process: http://

comments.cftc.gov. Follow the instructions for submitting comments

through the Web site.

Mail: David A. Stawick, Secretary of the Commission,

Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

Street, NW., Washington, DC 20581.

Hand Delivery/Courier: same as mail above.

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

Please submit your comments by only one method.

All comments must be submitted in English, or if not, accompanied

by an English translation. Comments will be posted as received to

http://www.cftc.gov. You should submit only information that you wish

to make available publicly. If you wish the Commission to consider

information that you believe is exempt from disclosure under the

Freedom of Information Act, a petition for confidential treatment of

the exempt information may be submitted according to the procedures

established in CFTC Regulation 145.9, 17 CFR 145.9.

The Commission reserves the right, but shall have no obligation, to

review, pre-screen, filter, redact, refuse or remove any or all of your

submission from www.cftc.gov that it may deem to be inappropriate for

publication, such as obscene language. All submissions that have been

redacted or removed that contain comments on the merits of the

rulemaking will be retained in the public comment file and will be

considered as required under the Administrative Procedure Act and other

applicable laws, and may be accessible under the Freedom of Information

Act.

FOR FURTHER INFORMATION CONTACT: Robert B. Wasserman, Associate

Director, Division of Clearing and Intermediary Oversight (DCIO), at

202-418-5092 or [email protected]; Martin White, Assistant General

Counsel, at 202-418-5129 or [email protected]; or Nancy Liao Schnabel,

Special Counsel, DCIO, at 202-418-5344 or [email protected]. in each

case, also at the Commodity Futures Trading Commission, Three Lafayette

Centre, 1155 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Introduction

This Advanced Notice of Proposed Rulemaking (“ANPR”) is intended

to obtain comment from interested parties concerning the appropriate

model for protecting the margin collateral posted by customers clearing

swaps transactions. As discussed in more detail below, the statutory

language in Dodd-Frank concerning the protection of swaps customer

margin is substantially similar, though not identical, to analogous

provisions in Section 4d(a) of the Commodity Exchange Act (“CEA”) 1

applicable to the protection of collateral posted by customers with

respect to exchange-traded futures. The Commission therefore is seeking

comment on whether to adopt a similar model to protect the margin

collateral posted by customers clearing swaps transactions as it

currently employs with respect to exchange-traded futures, or whether

another model is appropriate.

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1 7 U.S.C. 6d(a).

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Section 4d(f)(2) of the CEA,2 as added by Section 724 of Dodd-

Frank, provides that “property of a swaps customer [received to margin

a swap]* * * shall not be commingled with the funds of the futures

commission merchant or be used to margin, secure or guarantee any

trades or contracts of any swaps customer or person other than the

person for whom the same are held.3 Section 4d(f)(6) of the CEA makes

it unlawful for a depository, including a derivatives clearing

organization (“DCO”), that has received such swaps customer property

“to hold, dispose of, or use any such * * * property as belonging to *

* * any person other than the swaps customer of the futures commission

merchant.” 4

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2 7 U.S.C. 6d(f)(2).

3 Section 4d(f)(3)(A) of the CEA provides an exception

permitting commingling “for convenience.”

4 7 U.S.C. 6d(f)(6) (emphasis added). This section was added

by Section 724(a) of Dodd-Frank, Public Law 111-203, 124 Stat. 1376.

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The provisions applicable to the margin posted by exchange-traded

futures customers are similar, but not identical. Section 4d(a)(2)

provides that “property received [by a futures commission merchant] to

margin, guarantee or secure the [exchange-traded] contracts of any

customer of such [futures commission merchant] * * * shall not be

commingled with the funds of such commission merchant or be used to

guarantee the trades or contracts * * * of any person other than the

one for whom the same are held.” 5 Section 4d(b) makes it unlawful

for a DCO that has received such customer property “to hold, dispose

of, or use any such * * * property as belonging to * * * any person

other

[[Page 75163]]

than the customers of such futures commission merchant.”

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5 Section 4d(a)(2) provides a similar exception permitting

commingling “for convenience.”.

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Commission Regulation (“Reg. Sec. ”) 1.22 6 prohibits a

futures commission merchant (“FCM”) from using, or permitting the

use, of one futures’ customer’s funds to margin, guarantee or secure

another customer’s futures trades or contracts. Thus, if a futures

customer sustains losses sufficient to cause it to have a debit balance

(i.e., the customer owes the FCM money), the FCM must deposit its own

capital to “top up” the loss. Pursuant to existing industry custom

and Reg Sec. 1.20(b), however, futures commission merchants (“FCMs”)

segregate futures customer property posted as collateral with a DCO on

an omnibus basis: Such property is treated separately from the property

of the FCM, but futures customers are treated as a group, rather than

individually.

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6 17 CFR 1.22.

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Thus, if a futures customer suffers sufficient losses that the

customer’s debit balance exceeds the FCM’s available capital, and such

customer (the “defaulting customer”) fails to promptly pay such loss,

the FCM may, as a practical matter, be unable to “top up” the loss,

and the FCM may be unable to make a required payment to a DCO with

respect to that FCM’s customer account. Such an FCM would then be a

defaulter to the DCO (a “Defaulting FCM”). In case of such an FCM

default in the futures customer account, the DCO is permitted to use

the collateral of all customers of the Defaulting FCM to meet the net

customer obligation of the Defaulting FCM to the DCO (including the use

of any customer gains to meet customer losses), without regard to which

customers gained or lost, or which customers defaulted or made full

payment.

In such a case, customers of the Defaulting FCM other than the

defaulting customer may lose collateral they have posted with the

Defaulting FCM, and/or gains on their positions. The risk these other

customers face shall be referred to as “fellow-customer risk.”

II. Maximizing Customer Protection and Minimizing Cost

In considering how to implement Section 4d(f) of the Dodd-Frank

Act, the Commission and its staff have heard countervailing concerns

from various stakeholders. Some customers have noted that, in the

context of uncleared swaps that they currently engage in–and may be

obligated to clear under Dodd-Frank 7–they are able to negotiate for

individual segregation, with independent third parties, of collateral

that they post for such uncleared swaps. These customers contend that

it is inappropriate that they should be subject to an additional risk

(fellow-customer risk) when clearing their positions.8 Pension funds,

in particular, are concerned about their obligations under the Employee

Retirement Income Security Act, and about having their collateral used

to subsidize others.9

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7 See generally CEA 2(h), added by Dodd-Frank 723(a).

8 See, e.g., Staff Roundtable on Individual Customer

Collateral Protection (“Roundtable”) at 20-21 (Statement of Mr.

Szycher), 12, 79 (Statements of Mr. Kaswell), 10 (Statement of Mr.

Thum), available at http://www.cftc.gov/LawRegulation/DoddFrankAct/

OTC_6_SegBankruptcy.html.

9 Roundtable at 18 (Statement of Mr. Szycher).

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FCMs and DCOs, on the other hand, point out that models of

protecting swaps customer collateral that are different from the

current model for protecting futures customer collateral would bring

significant added costs, which they aver would ultimately be borne by

the customers. Moreover, the use of fellow-customer collateral is

included in existing DCO models for dealing with member defaults. The

Commission has proposed to require DCOs to maintain default resources

sufficient to

[e]nable the derivatives clearing organization to meet its

financial obligations to its clearing members notwithstanding a

default by the clearing member creating the largest financial

exposure for the derivatives clearing organization in extreme but

plausible market conditions.10

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10 See Financial Resources Requirements for Derivatives

Clearing Organizations, 75 FR 63113, 63118 (proposed regulation

39.11(a)(1)) (Oct. 14, 2010).

Systemically-important DCOs would be required to maintain default

resources sufficient to cover a default by the two clearing members

creating the largest combined financial exposure in such

conditions.11

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11 Id. at 63119 (proposed regulation 39.29(a)).

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Typically, DCOs use a variety of resources in addressing defaults

arising from a member’s customer account.12 These resources, which

are frequently referred to as a “waterfall,” typically include, in

order, the property of the Defaulting Member, the margin posted on

behalf of all of that members’ customers, a portion of the capital of

the DCO, and the default fund contributions of other members of the

DCO.13

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12 Customers would not be exposed to loss in the case of a

default arising from their FCM’s proprietary account.

13 See, e.g., CME Rule 802.

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If the collateral of non-defaulting swaps customers is not

available as a default resource, DCOs will need to change their models

for sizing their default waterfalls, and/or the size of the components

of those default waterfalls. One means to do this would be to increase

the collateral required to margin each customer’s positions. One DCO

estimated that it might need to increase collateral from a 99%

confidence level to a 99.99% confidence level, which would cause an

increase in required collateral of approximately 60%.14 These

increases in required margin levels would be passed on to customers, as

an FCM is required to collect margin from a customer at a level no less

than that imposed by the clearing house on the clearing member FCM. The

Commission requests that DCOs provide data in support of their

assertions.

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14 See, e.g., Roundtable at 137-138 (Colloquy between Ms.

Taylor and Mr. Maguire).

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An alternative approach to reacting to changes in the model for

sizing default waterfalls would be to increase clearing members’

default fund contributions. FCMs note that if they are required to

commit added capital to clearing, they would pass such costs on to

customers. Certain models for protecting collateral posted by customers

clearing swaps could also cause significant added administrative costs,

in requiring more transactions per customer every day, which costs

would also be passed on to customers.15 The Commission requests that

FCMs provide data supporting these assertions.

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15 See, e.g., Roundtable at 62-73 (Statements of Ms. Burke).

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The Commission is seeking to achieve two basic goals: Protection of

customers and their collateral, and minimization of costs imposed on

customers and on the industry as a whole. It is considering four models

of achieving these goals with respect to cleared swaps. These are

listed in order below, from most protective of customer collateral to

least protective of customer collateral.

Each of these various models would potentially impose different

levels of costs upon the various parties–i.e., customers, FCMs, and

DCOs–both pre- and post-default. Accordingly, the Commission seeks to

obtain further information about the costs and benefits of such models.

III. Description of the Models

The Commission seeks comment on each of the following four

potential models, as well as any additional models that may be proposed

by commenters:

[[Page 75164]]

(1) Full Physical Segregation–Each customer’s cleared swaps

account, and all property collateralizing that account, is kept

separately for and on behalf of that cleared swaps customer, at the

FCM, at the DCO, and at each depository.

a. Impact on Customers’ Risk: Each customer is protected from

losses on the positions or investments of any other customer.

b. Impact on DCO Default Resources: The collateral attributable to

any non-defaulting customer is not available as a DCO default resource

(2) Legal Segregation With Commingling–The collateral of all

cleared swaps customers of an FCM member of a DCO is kept on an omnibus

basis, but is attributed to each customer based on the collateral

requirements, as set by the clearinghouse, attributable to each

customer’s swaps.

a. Process: Payments and collections of both initial margin and

variation margin between the DCO and its member FCMs customer accounts

are made on an omnibus basis. Each FCM member reports to the DCO, on a

daily basis, the portfolio of rights and obligations attributable to

each cleared swaps customer. The performance bond collateral required

at the DCO for each customer’s swaps is a function, defined by the DCO,

of that portfolio of rights and obligations. The collateral required

for all of an FCM member’s customers is the sum of the collateral

requirements for each of such customers.

b. Posting Collateral:

i. The FCM may post the total required customer margin on an

omnibus basis, without regard to the customer to whom any particular

item of collateral (e.g., a particular security) belongs.

ii. If the FCM loans to a customer any portion of the property

necessary to margin that customer’s positions, that collateral is

treated at the DCO as belonging to the customer, and at the FCM as a

debt from the customer to the FCM.

iii. The DCO may require an FCM to post its own capital as

collateral for its guarantee of its customers.

c. Use of Collateral in Case of Default–If the FCM defaults, the

DCO must treat each customer’s swaps positions, and related margin

(based on the positions reported as of the day previous to the default)

individually, debiting each customer’s account with losses attributable

to that customer’s positions, and crediting each customer’s account

with gains attributable to that customer’s positions. However, if the

value of the margin account is reduced below the required level as a

result of market fluctuations in the value of the collateral, the

margin attributed to each customer would be adjusted accordingly on a

pro rata basis. The DCO has recourse to any collateral posted by the

FCM as part of its own capital.

d. Transfer or Return of Positions and Collateral–The DCO may, at

its election, transfer the swaps positions and related collateral of

any or all of the defaulting FCM’s customers to a willing transferee,

or liquidate such swaps positions and return the remaining collateral

to the FCM (or its trustee in bankruptcy).

e. Impact on Customers’ Risk–Each customer of the defaulting FCM

is protected from losses on the positions of other customers, but bears

some risk of loss on the value of collateral (subject to the investment

restrictions of Commission Regulation 1.25).16

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16 17 CFR 1.25.

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f. Impact on DCO Default Resources–The remaining collateral

attributable to each of the defaulting FCM’s customers is not available

as a DCO Default Resource.

(3) Moving Customers to the Back of the Waterfall–This model is

similar to Model 2 above, Legal Segregation With Commingling, with two

modifications:

a. The DCO may use the remaining collateral attributable to each of

the defaulting FCM’s customers as a DCO default resource.

b. Before using the remaining collateral attributable to any

customer, however, the DCO must first apply (i) the DCO’s contribution

to its default resources from its own capital and (ii) the guarantee

fund contributions of all members of the DCO.

c. Impact on Customers’ Risk–Each customer of the defaulting FCM

is protected from losses on the positions of other customers, except in

the most extreme of circumstances (a default which consumes the DCO’s

guarantee fund), in which case the customers are at risk of losing

their collateral. Customers also bear some risk of loss on the value of

collateral (subject to the investment restrictions of Regulation 1.25).

d. Impact on DCO Default Resources–The remaining collateral

attributable to each of the defaulting FCM’s customers is available as

a DCO Default Resource. Because the total required default resources

(including the DCO’s contribution and the guarantee fund) are

substantial,17 the remaining collateral of customers will only be

used in the case of an extremely large default.

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17 See supra footnotes 10-11.

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(4) Baseline Model–The current approach to futures. The rights and

obligations arising out of the cleared swaps positions of all cleared

swaps customers of an FCM member of a DCO, as well as the money,

securities and other property collateralizing such rights and

obligations, are held at the DCO on an omnibus basis. The DCO has

recourse to all such collateral in the event of any failure of the FCM

member to meet a margin call (initial or variation) with respect to the

FCM’s cleared swaps customer account at that DCO.

a. Impact on Customers’ Risk–Each customer of the defaulting FCM

is exposed to loss of their collateral due to losses on the positions

of other customers. Customers also bear some risk of loss on the value

of collateral (subject to the investment restrictions of Regulation

1.25).

b. Impact on DCO Default Resources–The remaining collateral

attributable to each of the defaulting FCM’s customers is fully

available as a DCO default resource, and may be used before the DCO’s

contribution or the default fund contributions of other clearing

members.

IV. Cost and Benefit Questions

The Commission seeks comment on all of the following questions from

all members of the public, but will direct specific questions to three

particular groups of stakeholders:

(1) Cleared Swaps Customers, including asset management firms and

others who may act on their behalf.

(2) FCMs who currently intermediate swaps on behalf of customers,

or who intend to do so in the future, or trade organizations with FCM

members.

(3) DCOs.

1. For Cleared Swaps Customers

a. What are the benefits of each of the models relative to the

baseline model and relative to other models?

b. What costs would you expect to incur for each of the models

relative to the baseline model? Please provide a detailed basis for

that estimate.

c. How should the Commission balance such costs and benefits?

2. For FCMs

For Each Model (Other Than the Baseline Model)

a. Compliance:

i. What compliance activities (including gathering of information)

would you need to perform as a result of that model that you do not

perform now (i.e., as part of the baseline model).

ii. What is a reasonable estimate of the initial and annualized

ongoing cost of

[[Page 75165]]

such incremental activities (relative to the baseline model) for your

institution? Please provide a detailed basis for that estimate.

iii. How can such costs be estimated industry-wide? Please provide

a detailed basis for that estimate?

b. Risk environment:

i. How do you see the industry adapting to the risk changes

attendant to the model?

ii. What types of costs would you expect your institution to incur

if the industry adapts to that model in the most efficient manner

feasible? How are these costs different from the costs you would incur

under the baseline model?

iii. What is a reasonable estimate of the initial and annualized

ongoing incremental cost incurred by your institution? Are these costs

the same for each FCM clearing member, or a function of activity level?

Please provide a detailed basis for that estimate.

iv. How can such costs be estimated industry-wide? Please provide a

detailed basis for that estimate?

c. What benefits does the model present relative to the baseline

model, and relative to other models?

3. For DCOs

For Each Model (Other Than the Baseline Model)

a. Compliance (internal):

i. What compliance activities (including gathering of information)

would you need to perform as a result of that model that you do not

perform now (i.e., as part of the baseline model)?

ii. What is a reasonable estimate of the initial and annualized

ongoing cost of such incremental activities (relative to the baseline

model) for your DCO? Please provide a detailed basis for that estimate.

b. Compliance (members):

i. What compliance activities (including gathering of information)

would you expect each of your members to perform as a result of that

model that they do not perform now (i.e., as part of the baseline

model).

ii. What is a reasonable estimate of the initial and annualized

ongoing cost of such incremental activities (relative to the baseline

model) for each such member? Do these costs vary with the member’s

level of activity? How? Please provide a detailed basis for your

estimates.

iii. What is a reasonable estimate of the initial and ongoing costs

of such activities across your membership? May there be some members

who do not incur these costs? Please provide a detailed basis for these

estimates.

c. Changes to default management structure:

i. What changes to your default management structure (relative to

the baseline model) would the model require?

ii. Costs to the DCO

1. What types of costs would these changes impose on the DCO if the

industry adapts to that model in the most efficient manner feasible?

How are these costs different from the costs the DCO would incur under

the baseline model?

2. What is a reasonable estimate of the initial and annualized

ongoing incremental cost to the DCO? Please provide a detailed basis

for that estimate.

iii. Costs to members

1. What types of costs would these changes to the DCO’s default

management impose on members if the industry adapts to that model in

the most efficient manner feasible? How are these costs different from

the costs the members would incur under the baseline model?

2. What is a reasonable estimate of the initial and annualized

ongoing incremental cost to each member? Are these costs the same for

each member, or are they a function of activity level? Please provide a

detailed basis for that estimate.

3. What is a reasonable estimate of the initial and ongoing costs

of such activities across your membership? May there be some members

who do not incur these costs? Please provide a detailed basis for these

estimates.

iv. To what extent do the costs identified above represent

increased costs to the system as a whole (i.e., customers, FCMs, and

DCOs considered together) and to what extent do they represent a shift

of risk and/or cost between those groups?

b. What benefits does the model present relative to the baseline

model, and relative to other models?

For all commenters:

2. Optional Models

A point frequently raised is that individual customer protection

should be made available on an optional basis. There are questions as

to how such a model could be implemented, and how the costs imposed by

a customer obtaining individual protection could be attributed to–and

charged to–that customer. For example, in the “Full Physical

Segregation” and “Legal Segregation with Commingling” models

discussed above, a significant portion of the marginal costs may arise

from the fact that the collateral posted by the opting-out customer

would not be available in the event of a default caused by other

customers of the same FCM. How could a payment by the opting-out

customer be used to address the changes to the DCO’s default management

structure that would be attributable to that opting out? Considered

from another perspective, how much cost would be avoided from an

optional as contrasted to a mandatory implementation of each of the

models above? Also, what would be the effect on customers of an FCM in

bankruptcy if different DCOs of which the FCM was a member adopted

different voluntary models? If a marketplace in which varying models

were in use was otherwise desirable, what changes to the Regulation

Part 190 rules regarding bankruptcy account classes could or should be

made to accommodate such variety?

3. Moral Hazard: Customers risk-managing their FCMs:

Another point frequently raised is that customers should risk-

manage their FCMs, and provide market discipline by doing business with

FCMs that pose less risk. DCOs already monitor the eligibility of their

members, supervising the member’s risk relative to collateral and

capital, and considering members’ risk management.18 The Commission

is aware of concerns that, if the risk that customers will lose swaps

collateral posted at an FCM is minimized, there will be less incentive

for FCMs to maintain capital in excess of the minimum levels required

by the Commission and the DCOs of which such FCMs are members. These

concerns lead to a number of questions:

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18 See Sections 5b(c)(2)(C)(i)(I), (c)(2)(C)(ii), (c)(2)(D) of

the CEA (participant eligibility and risk management).

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a. To what extent would each model lead to moral hazard concerns?

How, if at all, could such concerns be addressed?

b. Are the capital requirements currently imposed by the Commission

on FCMs and by DCOs on their clearing members sufficient? If not, what

steps should DCOs or the Commission take to address this insufficiency?

c. Do the rules and procedures of DCOs currently provide adequate

tools and incentives for DCOs to supervise their clearing members so as

to mitigate the risk of default? If not, what steps should DCOs or the

Commission take to address this inadequacy?

In analyzing costs, the Commission needs to consider the additional

cost incurred by customers risk-managing their FCMs on an initial and

ongoing

[[Page 75166]]

basis.19 This leads to a number of questions:

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19 Cf. Roundtable at 45-46 (Statement of Mr. Prager) (DCOs

have advantages over clients in conducting risk management of FCMs).

—————————————————————————

d. What information would each customer need, on an initial and an

ongoing basis, to effectively manage the risk posed by fellow-customers

at an FCM?

e. What information should be provided to each customer regarding

the FCM’s risk management policies, and how those policies are, in

fact, implemented with respect to other customers, on both an initial

and ongoing basis?

f. What information should be provided to each customer regarding

fellow-customer risk, on both an initial and ongoing basis?

g. What is or would be the cost, per customer, on an annualized

basis, of conducting this risk management?

h. What is or would be the cost to the industry as a whole, on an

annualized basis, of customer-conducted FCM risk management?

V. Other Questions

1. Did Congress evince an intent as to whether the Commission

should adopt any one or more of these models?

How do commenters view Interpretation 85-3, and how should it

inform the rulemaking on segregation of collateral for cleared swaps

customers? (A copy of this interpretation is attached as an appendix to

this Request for Comment.)

Issued in Washington, DC, on November 19, 2010, by the

Commission.

David A. Stawick,

Secretary of the Commission.

APPENDIX

Interpretative Statement, No. 85-3, Regarding the Use of Segregated

Funds by Clearing Organizations Upon Default by Member Firms. (OGC Aug.

12, 1985)

Use of Segregated Funds by Clearing Organizations Upon Defaults

By Member Firms

The rights of a clearing organization to make use of margin

funds deposited by a clearing member firm that has defaulted on an

obligation to the clearing organization are defined by the rules and

by-laws of the clearing organization subject to limitations imposed

by the Commodity Exchange Act (“Act”) and the rules and

regulations promulgated thereunder, 17 CFR 1, et seq. (1984).

Clearing organization rules and by-laws commonly provide that upon

the failure of a member firm to satisfy an obligation owed the

clearing organization, the clearing organization may use all margin

funds and property of the member firm within the clearing

organization’s custody to satisfy the firm’s obligations to the

clearing organization. In our view, Section 4d(2) of the Act does

not preclude the clearing organization from applying all margin

deposits of a defaulting firm to discharge such firm’s obligations

on behalf of the customer account for which they were deposited with

the clearing organization. The clearing organization may be

precluded from exercising such rights in limited circumstances,

however, by reason of its knowledge of or participation in a

violation of the Act or other provision of law by the defaulting

firm or other parties that renders its rights to such funds inferior

to those of the clearing firm’s customers.

Section 4d(2) of the Act, 7 U.S.C. 6d, defines the manner in

which futures commission merchants (“FCMs”), clearing

organizations, and other depositories of funds deposited by

commodity customers to margin or settle futures transactions, or

accruing to customers as the result of such trades, must deal with

such funds. Section 4d(2) requires that FCMs “treat and deal with”

funds deposited by a customer to margin or settle trades or

contracts or accruing as the result of such trades or contracts “as

belonging to such customer,” separately account for such funds, and

refrain from using such funds “to margin or guarantee the trades or

contracts, or to secure or extend the credit, of any customer or

person other than the one for whom the same are held.” Section

4d(2) specifically authorizes FCMs to commingle such funds, for

purposes of convenience, in the same account or accounts with any

bank, trust company or clearing organization of a contract market.

This provision also authorizes withdrawals from such funds of “such

share thereof as in the normal course of business shall be

necessary” to margin, guarantee, secure, transfer, adjust, or

settle trades or contracts, “including the payment of commissions,

brokerage, interest, taxes, storage and other charges, lawfully

accruing in connection with such contracts and trades.”

The final sentence of Section 4d(2) defines the obligations of

clearing organizations, depositories and all other recipients of

customer margin funds and property in the following terms:

It shall be unlawful for any person, including but not limited

to any clearing agency of a contract market and any depository, that

has received any money, securities, or property for deposit in a

separate account as provided in paragraph (2) of this section, to

hold, dispose of or use any such money, securities, or property as

belonging to the depositing futures commission merchant or any

person other than the customers of such futures commission merchant.

This provision prohibits clearing organizations and all other

depositories of customer funds from using such funds to discharge

proprietary obligations of the depositing FCM or for any purpose

other than to margin, guarantee, secure, transfer, adjust, or settle

trades or contracts of the depositing firm’s customers, including

the payment of commissions and other charges “lawfully accruing in

connection with” such contracts and trades.

In our view, Section 4d(2)’s provisions with respect to clearing

organizations’ treatment of customer funds must be construed in

light of the fact that clearing organizations’ direct customers are,

generally, clearing firms, not the ultimate “customers” who

entered into the futures contracts and options positions accepted

for clearance by the clearing organization. Margin deposits posted

with clearing organizations by their member firms normally consist,

at least in part, of funds belonging to clearing firm customers,

whose margin deposits were posted with the clearing firm and

subsequently drawn upon by the clearing firm to satisfy its margin

obligations to the clearing organization. The clearing organization

normally has no direct dealings with such customers and has

knowledge neither of their specific identities nor of the extent of

their respective ownership interests in margin funds posted by its

clearing firms. Consequently, to the extent that Section 4d(2) of

the Act requires that clearing organizations use margin deposits on

behalf of the “customers of such [depositing] futures commission

merchant,” we are of the view that it requires only that the

clearing organization use such funds as the property of the clearing

firm’s customers collectively, but does not require the clearing

organization to treat such funds as the property of the particular

customers who deposited them or to whose positions they have

accrued.

This view accords with the legislative history of Section 4d(2)

of the Act. The Act did not specifically govern the treatment of

commodity customer funds by clearing organizations and other

depositories of customer margin funds until the enactment of Section

4d(2)’s final paragraph, quoted above, in 1968. The legislative

history of this provision reflects Congress’s intention to ensure

that customer funds would not be used to discharge the general

obligations of the FCM or otherwise diverted from their lawful

purposes. According to the Senate Report, for example, the amendment

was proposed “to prohibit expressly customers’ funds from being

used to offset liabilities of the futures commission merchants or

otherwise being misappropriated.” S. Rep. No. 947, 90th Cong. 2d

Sess. 7 (1968). See also H.R. Rep. No. 743, 90th Cong., 1st Sess. 4-

5 (1967).

The Commodity Exchange Authority’s Administrator described the

1968 amendment as one which would afford additional protection

against a situation presented in the De Angelis salad oil case “in

which one of the banks actually took over funds of customers of one

of the brokerage firms to offset liabilities of the firm.” Amend

the Commodity Exchange Act: Hearings on H.R. 11930 and H.R. 12317

Before the House Comm. on Agriculture 57 (1967) (Testimony of Alex

C. Caldwell, Administrator, Commodity Exchange Authority). The

proposed amendment would require that banks and other depositories

“keep separate the funds of the customers and of the brokerage

firms which they do not have to do now.” Id. The Act’s legislative

history thus evinces an intention that depositories treat customers’

funds as the property of the

[[Page 75167]]

customers of the depositing FCM, as distinguished from the FCM’s own

property or that of any other person.

Our conclusion that Section 4d(2) generally allows clearing

organizations to treat customer funds as the property of the

depositing firm’s customers, collectively, without regard to the

respective interests of particular customers, also finds support in

the legislative history of the Bankruptcy Reform Act of 1978. In

recommending new provisions to govern bankruptcy liquidations of

commodity firms, the Commission described the clearing house system

then (and now) operant in the futures market as one in which “a

clearing house deals only with its clearing members” and thus

“does not know the specific customer on whose behalf a particular

contract was entered into by one of its clearing members.”

Bankruptcy Act Revision: Hearings on H.R. 31 and H.R. 32 Before the

Subcomm. on Civil and Constitutional Rights, House Comm. on the

Judiciary, 94th Cong., 2d Sess. 2377, 2395 (Statement of William T.

Bagley) (1976). The Commission explained that this system allows a

clearing organization to use “whatever funds are on deposit with it

on behalf of customers to meet variation margin calls with respect

to customers’ trades or contracts” and, following a clearing member

default, the defaulting firm’s “original margin deposits are

immediately available to offset any losses the clearing house might

incur” as a result of answering variation margin calls to the

defaulting firm. Id. at 2397, 2405.

The Commission’s regulations are also consistent with the view

that the clearing organization’s direct obligations under Section

4d(2) include an obligation to treat customer funds as the property

of the depositing FCM’s customers but do not include a duty to

separately account for or to employ such funds as the property of

particular customers. Regulation 1.20(b), 17 CFR 1.20(b) (1984), for

example, requires that a clearing organization separately account

for and segregate all customers’ funds received from a member of the

clearing organization to purchase, margin, guarantee, secure or

settle the trades, contracts or commodity options of the clearing

member’s customers and all money accruing to such customers as the

result of such trades, contracts, or commodity options “as

belonging to such commodity or option customers,” and specifies

that a clearing organization shall not hold, use or dispose of such

customer funds “except as belonging to such commodity or option

customers.” 17 CFR 1.20(b) (1984).1

—————————————————————————

1 To the extent that the final sentence of Regulation 1.20(a),

17 CFR 1.20(a) (1984), may be read to require that clearing

organizations treat customer funds as the property of the particular

customer who deposited them, we consider it inconsistent with

Regulation 1.20(b), which more specifically addresses the

obligations of clearing organizations, and with this agency’s view

of clearing organizations’ obligations. The current language of

Regulation 1.20(a)’s final sentence apparently reflects an

unintentionally broad modification of that provision made in

connection with amendments of a number of Commission regulations to

reflect establishment of the Commission’s exchange-traded options

program. Until these 1981 revisions of the Commission’s regulations,

Regulation 1.20(a)’s last sentence referred to “customers” in the

plural, made no express reference to clearing organizations and was

substantially consistent with the final sentence of Section 4d(2).

The Commission’s proposed rules regarding exchange-traded options

would have modified this language only to the extent of including

option customers within its protections: “Nor shall any such funds

be held, disposed of, or used as belong [sic] to the depositing

futures commission merchant or any person other than the commodity

or option customers of such futures commission merchant.” 46 FR

33315 (1981). As adopted, however, the Commission’s final rules

concerning the regulation of exchange-traded commodity options

included Regulation 1.20(a)’s final sentence in its current form, a

modification that apparently was not intended to be substantive. In

the preamble to these rules, the Commission stated that it was

adopting revised Regulations 1.20 through 1.30 “essentially as

proposed.” 46 FR 54508 (1981). We suggest that a technical

amendment to Regulation 1.20(a) be proposed in the near future to

conform its final sentence to its intended meaning.

—————————————————————————

Regulation 1.22, 17 CFR 1.22 (1984), which precludes FCMs from

using or permitting the use of “the customer funds of one commodity

and/or option customer to purchase, margin, or settle the trades,

contracts, or commodity options of, or to secure or extend the

credit of, any person other than such customer or option customer,”

refers only to FCMs and, hence, does not govern clearing

organizations or other depositories of customer funds.2

—————————————————————————

2 See also Regulation 1.36, which governs recordkeeping

concerning securities and other property received from customers and

option customers. Regulation 1.36 requires FCMs to maintain a

record, showing “separately for each customer or option customer”

the securities or property received, name and address of the

depositing customer and other pertinent information. By contrast,

clearing organizations with which clearing member firms deposit

securities or property belonging to particular customers or option

customers of such members in lieu of cash margin are required to

maintain records “which will show separately for each member” the

date of receipt of such securities and property and other pertinent

data but are not required to maintain records of the names of the

particular customers of the member firm from whom such securities

and property were received.

—————————————————————————

Our conclusion that Section 4d(2) does not preclude a clearing

organization from using all margin funds deposited by a clearing

member firm to satisfy obligations arising from the account for

which such funds were deposited reflects the essential function of

margin deposits in the futures markets’ clearing system. Clearing

organizations generally stand as guarantors of the net futures and

options obligations of the member firms and require margin deposits

as security for the performance of obligations which, in the event

of a member’s default, the clearing organization must discharge.

Margin deposits at the clearing level thus facilitate the clearing

organization’s performance of its guarantee obligations, serving to

confine losses stemming from a clearing firm default to the

defaulting firm and preventing their spread to the market as a

whole.

In sum, we conclude that clearing organization rules and by-laws

awarding clearing organizations the right to apply all customer

margin funds within their custody to satisfy nonproprietary

obligations of defaulting clearing firms are not inconsistent with

Section 4d(2) of the Act or the Commission’s regulations. Clearing

organizations’ rights with regard to the use of customer margin

deposits of their member firms are not, however, wholly unlimited. A

clearing organization may not use the margin deposits of one

clearing member firm to satisfy obligations of another clearing firm

or of any other person. In addition, as noted above, the final

paragraph of Section 4d(2) of the Act was enacted to present use of

customer funds to satisfy the FCM’s own obligations. Consequently,

customer margin funds deposited by a member FCM may not be used to

margin, guarantee or settle the futures or options transactions or

to satisfy any other proprietary obligation of the depositing firm.

Such funds must be used to margin, guarantee, secure, or settle

trades or contracts of the depositing FCM’s customers or for charges

“lawfully accruing in connection with” such contracts and not for

any other purpose.3 Finally, a clearing organization’s rights with

respect to the use of customer margin funds may be limited in

particular circumstances by reason of the clearing organization’s

knowledge of or participation in a violation of the Act or other

provision of law that precludes it from obtaining rights to such

funds superior to those of one or more customers of the defaulting

clearing member. Such a violation could occur, for example, in

circumstances in which the clearing organization received particular

margin funds with actual knowledge that the depositing firm has

breached its duty under Section 4d(2) to segregate and separately

account for customer funds and that the funds in question have been

deposited with it to margin, secure, guarantee or settle the trades

or contracts of a person other than the customer who deposited such

funds or to whom they have accrued. The clearing organization’s

knowing participation in such use of customer funds could subject it

to aiding and abetting liability under Section 13(a) of the Act and

would preclude it from obtaining rights to such funds superior to

those of the innocent customer.

—————————————————————————

3 This prohibition includes a proscription against the use of

customer margin funds deposited in connection with futures or option

transactions to discharge obligations, including customers’

obligations, incurred in connection with transactions that are not

within the purview of the Act or the rules and regulations

promulgated thereunder.

—————————————————————————

Statement of Chairman Gary Gensler: Protection of Cleared Swaps

Customers Before and After Commodity Broker Bankruptcies

I support the advance notice of proposed rulemaking concerning

protection of collateral of customers entering into cleared swaps.

There has been much public input into these matters, but I think it

is appropriate to have a formal ANPR soliciting input on a number of

options and questions on how best to protect customers’ collateral

in the event of another customer’s default. This is particularly

important as we move forward to implement Congress’s mandate that

for the first time standardized swaps

[[Page 75168]]

must be cleared. I am hopeful that we will hear from a broad range

of market participants, including clearinghouses, futures commission

merchants, pension funds, asset managers and other end-users, on the

costs, benefits and feasibility of various approaches to protecting

customers’ money.

[FR Doc. 2010-29836 Filed 12-1-10; 8:45 am]

BILLING CODE 6351-01-P

Last Updated: December 2, 2010