Proposed Rule: Commodity Exchange Act: Investment of Customer Funds and Related Recordkeeping Requirements

Federal Register / Vol. 70, No.
22 / Thursday, February 3, 2005 / Proposed Rules 5577
Dated: January 13, 2005. standards for investing in instruments Table of Contents
Julie L. Williams, with embedded derivatives, I. Background
Acting Comptroller of the Currency. requirements for adjustable rate II. Discussion of the Proposed Rules
By order of the Board of Governors of the securities (including auction rate A. Instruments With Embedded Derivatives
Federal Reserve System on January 26, 2005. securities), concentration limits on B. Adjustable Rate Securities
reverse repurchase agreements (‘‘reverse 1. Permitted Benchmarks
Jennifer J. Johnson,
repos’’), transactions by futures 2. Supplemental Requirements
Secretary of the Board. 3. Technical Amendments
commission merchants (‘‘FCMs’’) that 4. Auction Rate Securities
Federal Deposit Insurance Corporation. are also registered as securities broker- C. Reverse Repos—Concentration Limits
By order of the Board of Directors. dealers (‘‘FCM/BDs’’), rating standards D. Transactions by FCM/BDs
Dated at Washington, DC, this 18th day of and registration requirement for money E. Rating Standards for MMMFs
January, 2005. market mutual funds (‘‘MMMFs’’), F. Registration Requirement for MMMFs
Robert E. Feldman, auditability standard for investment G. Auditability Standard for Investment
Executive Secretary. records, and certain technical changes. Records
Dated: January 25, 2005. Among those technical changes is an H. Additional Technical Amendments
amendment to the Commission’s 1. Clarifying and Codifying MMMF
James E. Gilleran, Redemption Requirements
Director, Office of Thrift Supervision. recordkeeping rules in connection with (i) Next-Day Redemption Requirement
[FR Doc. 05–2079 Filed 2–2–05; 8:45 am] repurchase agreements (‘‘repos’’) and (ii) Exceptions to the Next-Day Redemption
BILLING CODE 4810–33–C; 6210–01–C; 6714–01–C;
proposed transactions by FCM/BDs. Requirement
6720–01–C DATES: Comments must be received on 2. Clarifying Rating Standards for
or before March 7, 2005. Certificates of Deposit
3. Clarifying Corporate Bonds as Permitted
ADDRESSES: Comments on the proposed Investments
COMMODITY FUTURES TRADING amendments should be sent to Jean A. 4. Clarifying References to Transferred
COMMISSION Webb, Secretary, Commodity Futures Securities
Trading Commission, Three Lafayette 5. Clarifying Payment and Delivery
17 CFR Part 1 Procedures for Reverse Repos and Repos
Centre, 1155 21st Street, NW.,
RIN 3038–AC15 Washington, DC 20581. Comments may 6. Changing Paragraph (a)(1) ‘‘Customer
be sent by facsimile transmission to Funds’’ to ‘‘Customer Money’’
Investment of Customer Funds and 7. Conforming Reference to
(202) 418–5521, by e-mail to
Record of Investments ‘‘Marketability’’ Requirement
secretary@cftc.gov, or electronically by 8. Conforming Terminology for
AGENCY: Commodity Futures Trading accessing http://www.regulations.gov. ‘‘Derivatives Clearing Organizations’’
Commission. Reference should be made to ‘‘Proposed 9. Conforming Terminology for
Amendments to Rule 1.25.’’ ‘‘Government Sponsored Enterprise’’
ACTION: Proposed rule.
FOR FURTHER INFORMATION CONTACT: 10. Conforming Terminology for ‘‘Futures
Commission Merchant’’
SUMMARY: The Commodity Futures Phyllis P. Dietz, Special Counsel,
11. Clarifying the Meaning of ‘‘NRSRO’’
Trading Commission (‘‘Commission’’) is Division of Clearing and Intermediary III. Time to Maturity—Treasury Portfolio
proposing to amend its regulations Oversight, Commodity Futures Trading IV. Section 4(c)
regarding investment of customer funds Commission, Three Lafayette Centre, V. Related Matters
and related recordkeeping requirements. 1155 21st Street, NW., Washington, DC A. Regulatory Flexibility Act
The proposed amendments address 20581. Telephone (202) 418–5430.
EP03FE05.110</GPH>
B. Paperwork Reduction Act
VerDate jul<14>2003 14:49 Feb 02, 2005 Jkt 205001 PO 00000 Frm 00007 Fmt 4702 Sfmt 4702 E:\FR\FM\03FEP1.SGM 03FEP1
5578 Federal Register / Vol. 70, No. 22 / Thursday, February 3, 2005 / Proposed Rules
C. Costs and Benefits of the Proposed Rules proposed amendments, discussed in The Commission solicits comment on
Text of Rules section II.A. through C. of this release, all aspects of the proposed amendments
SUPPLEMENTARY INFORMATION: relate to standards for investing in to Rules 1.25 and 1.27. Commenters are
I. Background instruments with embedded derivatives, welcome to offer their views regarding
permitted benchmarks for adjustable any other matters that are raised by the
Commission Rule 1.25 (17 CFR 1.25) rate securities,5 and concentration limits proposed rules.
sets forth the types of instruments in on reverse repos. The discussion of
which FCMs and derivatives clearing these issues incorporates comments II. Discussion of the Proposed Rules
organizations (‘‘DCOs’’) are permitted to submitted by the Futures Industry A. Instruments With Embedded
invest customer assets that are required Association (‘‘FIA’’), National Futures Derivatives
to be segregated under the Commodity Association (‘‘NFA’’), and Lehman
Exchange Act 1 (‘‘Act’’). The Brothers, in 2003.6 Rule 1.25(b)(3)(i) expressly prohibits
Commission believes that it is important The Commission is also proposing investment of customer funds in
to have customer funds invested in a amendments that address several new instruments with embedded
manner that minimizes their exposure issues, as discussed in section II.D. derivatives.8 Some market participants
to credit, liquidity, and market risks not through G. of this release. In this regard, have suggested that there are certain
only because they are customer assets, the Commission is proposing an instruments containing embedded
but also because, to the extent they amendment requested by the FIA derivatives that have a level of risk
represent a performance bond against regarding certain transactions by FCM/ similar to or lower than some of the
customer obligations under derivatives BDs,7 an amendment to eliminate the other investments permitted under the
contracts, these assets must be capable rating requirement for MMMFs, an rule and that embedded derivatives may
of being quickly converted to cash at a amendment to require that all permitted otherwise have risk-neutral or even risk-
predictable value to minimize systemic MMMFs be registered with the mitigating effects. In June 2003, the
risk. Securities and Exchange Commission Commission requested comment on
Rule 1.25 was substantially amended (‘‘SEC’’), and an amendment whether Rule 1.25(b)(3)(i) should be
in December 2000 to expand the list of establishing an auditability standard for amended to modify the prohibition on
permitted investments beyond the investment records. investments in securities that contain an
Treasury and municipal securities that Further, in Section II.H. of this embedded derivative. In this regard,
are expressly permitted by the Act.2 In release, the Commission is proposing commenters were asked to describe how
connection with that expansion, the technical amendments to Rule 1.25 to the level of risk of such securities could
Commission added several provisions clarify the following: (1) The next-day be limited.
intended to control exposures to credit, redemption requirement for MMMFs The FIA commented that many GSE
liquidity, and market risks associated (also codifying previously published securities contain caps, floors, puts, and
with the additional investments. exceptions to that requirement); (2) the
On June 30, 2003, the Commission calls. The FIA recommended that the
rating standards for certificates of Commission permit FCMs to invest in
published for public comment proposed deposit; (3) the permissibility of
amendments to two provisions of Rule securities with such features, provided
investing in corporate bonds; (4) the they are directly related to the interest
1.25, and it further requested comment inapplicability of segregation rules to
(without proposing specific rate characteristics of the security. The
securities transferred pursuant to a repo; FIA stated that this standard is similar
amendments) on several other (5) payment and delivery procedures for
provisions of the rule.3 In February to one found in Generally Accepted
repos and reverse repos; and (6) the Accounting Principles Statement of
2004, the Commission adopted final distinction between investment of
rule amendments regarding repos with Financial Accounting Standards No.
customer money and investment of 133, under which embedded derivatives
customer-deposited securities and customer-deposited securities. The
modified time-to-maturity requirements that are ‘‘clearly and closely related’’ to
technical amendments would also the ‘‘host contract’’ are accounted for
for securities deposited in connection conform references to applicable
with certain collateral management together with the underlying
marketability standards, update and instrument. The FIA further stated that
programs of DCOs.4 The Commission conform the terminology referring to a
did not, however, take any action on the caps, floors, puts and calls would all be
DCO, conform the terminology referring considered ‘‘clearly and closely related’’
other matters raised in its June 30, 2003 to a government sponsored enterprise
release. as long as they are a function of the
(‘‘GSE’’), conform the terminology same rate in the underlying security.
The Commission is now proposing referring to an FCM, and clarify the
specific rule amendments related to the meaning of the term ‘‘NRSRO.’’ Since the FIA submitted its comment
remaining issues raised in its June 30, letter, FIA representatives have held
2003 request for public comment. These 5 In addition to addressing the issues raised in its further discussions with Commission
June 30, 2003 release, the Commission is also staff to consider the establishment of
1 Section 4d(a)(2) of the Act, 7 U.S.C. 6d(a)(2),
proposing two supplemental requirements for more specific criteria that could provide
requires segregation of customer funds. It provides, adjustable rate securities, as well as technical
in relevant part, that customer-deposited ‘‘money,
greater clarity for FCMs and DCOs, as
amendments relating to terminology. Among the
securities, and property shall be separately technical amendments is a proposal to substitute well as designated self-regulatory
accounted for and shall not be commingled with the the term ‘‘adjustable rate security’’ for the term organization and Commission auditors.
funds of [the FCM] or be used to margin or ‘‘variable-rate security,’’ as the latter term is Such standards would be more readily
guarantee the trades or contracts, or to secure or currently used. See Section II.B.3. of this release for
extend the credit, of any customer or person other
auditable, furthering the goal of
a discussion of proposed changes in terminology.
than the one for whom the same are held.’’ 6 These comment letters are available in the ensuring compliance.
2 See 65 FR 77993 (Dec. 13, 2000) (publishing
comment file accompanying the June 30, 2003
final rules); and 65 FR 82270 (Dec. 28, 2000) release, at http://www.cftc.gov. 8 Rule 1.25(b)(3)(i) currently provides that ‘‘[w]ith
(making technical corrections and accelerating 7 In connection with this proposal, the the exception of money market mutual funds, no
effective date of final rules from February 12, 2001 Commission is also proposing technical permitted investment may contain an embedded
to December 28, 2000). amendments to Rule 1.27 to clarify the derivative of any kind, including but not limited to
3 68 FR 38654 (June 30, 2003).
recordkeeping requirements applicable to repos and a call option, put option, or collar, cap, or floor on
4 69 FR 6140 (Feb. 10, 2004). proposed transactions by FCM/BDs. interest paid.’’
Federal Register / Vol. 70, No. 22 / Thursday, February 3, 2005 / Proposed Rules 5579
As the Commission has previously interest rates fall, or for other reasons, amended and, if so, what the applicable
stated, it believes that expanding the list a callable instrument can afford its standard should be.
of permitted investments can enhance holders the opportunity to achieve a The FIA recommended that Rule
the yield available to FCMs, DCOs, and higher yield without exposing 1.25(b)(3)(iv) be amended to provide
their customers, without compromising themselves to greater credit risk by that permissible benchmarks can
the ability of FCMs to quickly convert seeking higher yields from other issuers include any fixed rate instrument that is
such investments to cash at a that may be less creditworthy. That is, a ‘‘permitted investment’’ under the
predictable value.9 In light of the reinvestment risk presented by rule. The FIA reasoned that, if an FCM
discussions with market participants, callable instruments is of far less is authorized to purchase a fixed rate
the Commission acknowledges that supervisory concern, if any, than the instrument, e.g., a six-month Treasury
there are some embedded derivatives credit risk that may be presented by a bill, and continuously roll that
that, at a minimum, do not appear to shifting of investments to less instrument over, then it should be able
heighten the material risks of permitted creditworthy issuers, even within the to purchase an instrument benchmarked
investments and may serve to mitigate population permitted by the credit to that fixed rate security. This would
risks under certain circumstances. rating requirements and other allow FCMs to respond to new
The Commission, having carefully requirements of Rule 1.25. benchmarks as they evolve. In this
considered the merits of permitting regard, the FIA noted its understanding
investment of customer money in a Second, proposed paragraph that, in Europe, the Euribor has become
limited selection of instruments with (b)(3)(i)(B) addresses permissible more popular than LIBOR as a
embedded derivatives, proposes to interest rate features. The proposed benchmark in many instruments.
amend Rule 1.25(b)(3)(i) to permit FCMs revision now would permit caps, floors, The Commission agrees that it is
and DCOs to invest in instruments with or collars on the interest paid pursuant appropriate to afford greater latitude in
certain embedded derivatives, subject to to the terms of an adjustable rate establishing benchmarks for floating rate
certain express standards. Commission instrument. Upper and/or lower limits securities, thereby enabling FCMs and
staff have worked with market on interest do not jeopardize the DCOs to more readily respond to
participants to develop these standards, principal amount payable at maturity. changes in the market. The Commission
with the goal of excluding inappropriate Although upper limits (caps) on therefore proposes to amend Rule
instruments while including adjustable rates may constrain the yield 1.25(b)(3)(iv), proposing new paragraph
instruments that offer an attractive yield achieved if prevailing rates rise (b)(3)(iv)(A)(2), to provide that, in
at an acceptable level of risk. substantially, lower limits (floors) may addition to the benchmarks already
As a preliminary matter, the protect the yield achieved if prevailing enumerated in the rule, floating rate
Commission proposes a technical rates fall significantly. securities may be benchmarked to rates
amendment to paragraph (b)(3)(iii), to Proposed paragraph (b)(3)(i) further on any fixed rate instruments that are
clarify its continued intent to maintain provides that the terms of the ‘‘permitted investments’’ under Rule
an express prohibition against any instrument must obligate the issuer to 1.25(a). It should be noted that any
instrument that, itself, constitutes a fully repay the principal amount of the resulting interest payment must be
derivative instrument. This was the instrument at not less than par value, determined solely by reference to one or
original intent of paragraph (b)(3)(iii) upon maturity. The preservation of more permissible interest rates or
which already prohibits payments principal is a fundamental premise relationships between a constant and
linked to any underlying commodity upon which the Commission has based one or more permissible interest rates.
except as expressly permitted by its policies regarding permitted In addition, the Commission believes
paragraph (b)(3)(iv) with respect to investments. It is important to ensure it appropriate to clarify that neither the
adjustable rate securities. that principal is protected, especially as existing text requiring that the interest
Proposed paragraph (b)(3)(i) would payments on variable rate securities
instruments become more complex in
continue to generally prohibit ‘‘correlate closely and on an
their structure.
investments in instruments with unleveraged basis’’ to certain
embedded derivatives, carving out an B. Adjustable Rate Securities benchmark rates, nor the proposed text
exception only for two categories of requiring that the interest payments on
embedded derivatives that may be 1. Permitted Benchmarks floating rate securities ‘‘be determined
contained in instruments that meet Rule 1.25(b)(3)(iv) currently permits solely by reference, on an unleveraged
specified criteria. investment in ‘‘variable-rate basis,’’ to those and other benchmarks,
Proposed paragraph (b)(3)(i) sets forth securities,’’ 10 provided that the interest should be read to foreclose interest
the types of embedded derivatives that payments that include some fixed
rates thereon correlate closely and on an
would be permissible. First, proposed arithmetic spread added to the
unleveraged basis to a benchmark of
paragraph (b)(3)(i)(A) permits an benchmark rate itself, provided that no
either the Federal Funds target or
instrument to have a call feature, in such spread may constitute any
effective rate, the prime rate, the three-
whole or in part, at par, on the principal multiple of the benchmark rate. This
month Treasury Bill rate, or the one-
amount of the instrument before its reflects the original intent of this
month or three-month LIBOR rate.
stated maturity date. The Commission provision, and should eliminate
Market participants have noted that the
notes that the issuer’s right to call an potential errors or ambiguities in
benchmarks used in the marketplace
instrument prior to maturity does not interpreting what is meant by the phrase
evolve over time. In its June 30, 2003
jeopardize the principal amount, but ‘‘unleveraged basis.’’
release, the Commission requested
merely accelerates the maturity of the
comment on whether the provision on 2. Supplemental Requirements
instrument. Because the issuer of a
permitted benchmarks should be
callable instrument typically offers a The Commission is proposing to
higher return to investors in return for 10 See Section II.B.3. of this release for a
amend paragraph (b)(3)(iv) by adding
the right to call the issue if prevailing discussion of the Commission’s proposed
two supplemental requirements that it
amendments to clarify use of the terms ‘‘adjustable believes are prudent and necessary in
9 See 65 FR at 39014. rate,’’ ‘‘floating rate,’’ and ‘‘variable rate.’’ light of the increasing number and
complexity of adjustable rate securities value that approximates its amortized outstanding amount of securities. The
that could qualify as permitted cost. Also using the SEC’s definition, ‘‘auctions’’ are for the purpose of rate-
investments for FCMs and DCOs. Under proposed paragraph (b)(3)(iv)(B)(3) setting and, absent other express terms
proposed paragraph (b)(3)(iv)(A)(3), any defines ‘‘variable rate security’’ as a of the agreement, do not constitute an
benchmark rate would have to be security, the terms of which provide for opportunity either for the holders to put
expressed in the same currency as the the adjustment of its interest rate on set the securities to the issuer or for the
adjustable rate security referencing it. dates (such as the last day of a month issuer to call the securities from the
This eliminates the need to calculate or calendar quarter) and that, upon each holders. As with other debt securities,
and account for changes in applicable adjustment until the final maturity of holders of ARS may attempt to resell
currency exchange rates. Under the instrument or the period remaining them by contacting broker-dealers or
proposed paragraph (b)(3)(iv)(A)(4), the until the principal amount can be other potential buyers, but there is no
periodic coupon payments could not be recovered through demand, can continuous bid/offer stream, although
a negative amount. This is designed to reasonably be expected to have a market bids and offers may be available upon
prevent FCMs and DCOs from investing value that approximates its amortized request from major dealers active in the
in instruments that the Commission cost. market.
believes do not reflect an acceptable It has been represented to the
4. Auction Rate Securities Commission that the interest payments
level of risk.
The Commission received an inquiry on the particular issue which was the
3. Technical Amendments from an FCM interested in investing subject of the inquiry, and those of
The Commission is proposing to customer funds in certain auction rate many other ARS issues, demonstrate
revise certain terminology used in securities (‘‘ARS’’). The specific close historical correlation to key short-
paragraph (b)(3)(iv) for the purpose of instruments described by this FCM were term interest rates. As described,
clarifying, not changing, the meaning of issued by a quasi-governmental therefore, the process of establishing
this provision. Paragraph (b)(3)(iv) corporate entity established in the periodic interest payments in such a
currently uses the term ‘‘variable-rate Commonwealth of Massachusetts. Such manner would not violate the
securities’’ without distinguishing an issuer cannot be considered to be a requirements of current paragraph
between securities for which periodic political subdivision of a State as (b)(3)(iv) or proposed paragraph
interest payments vary by formula or described in the Act and in paragraph (b)(3)(iv)(A)(1), if, in fact, they are
other reference calculation any time a (a)(ii) of Rule 1.25 but, rather, must be closely correlated to a permitted
specified interest rate changes (termed a considered to be a corporate issuer benchmark.
‘‘floating rate security’’ by the SEC),11 under paragraph (a)(vi).
and those for which periodic interest Currently, paragraph (a)(vi) uses the C. Reverse Repos—Concentration Limits
payments are adjusted on set dates term ‘‘corporate notes,’’ which may Rule 1.25(b)(4)(iii) establishes
(termed a ‘‘variable rate security’’ by the create some uncertainty as to the concentration limits for reverse repos.14
SEC).12 For purposes of clarity and to Commission’s intent regarding the These restrictions, which were adopted
ensure consistency with the paragraph duration of such instruments. In in response to public comment, take
(b)(5) time-to-maturity provision,13 the particular, the specific instruments that into consideration the identity of both
Commission is proposing to amend were the subject of the inquiry have the issuer of the securities and the
paragraph (b)(3)(iv) to distinguish the maturity dates many years in the future. counterparty to the reverse repo.
terms ‘‘floating rate security’’ and As discussed in section II.H.3. of this Consideration as to counterparty was
‘‘variable rate security’’ and, where release, the Commission is proposing a based on the counterparty having direct
appropriate, to use the term ‘‘adjustable technical change to now use the term control over which specific securities
rate security,’’ to refer to either or both ‘‘corporate notes or bonds,’’ for clarity. would be supplied in a transaction.15
of the foregoing. Accordingly, an ARS that had an initial Given industry experience over the past
In this regard, the Commission term to maturity exceeding five or even several years, however, it has been
proposes to add a new paragraph ten years would not be prohibited brought to the attention of the
(b)(3)(iv)(B), defining the above terms outright, but would, as with all other Commission that the ability of FCMs
for purposes of paragraph (b)(3)(iv). securities in the portfolio, be subject to and DCOs to monitor compliance with
Proposed paragraph (b)(3)(iv)(B)(1) the portfolio time-to-maturity this two-prong standard has proven to
defines ‘‘adjustable rate security’’ as requirements consistent with paragraph be operationally unworkable. As a
described above. Using the SEC’s (b)(5), which focuses on the remaining result, in June 2003, the Commission
definition, proposed paragraph time to maturity. requested comment on market
(b)(3)(iv)(B)(2) defines ‘‘floating rate This inquiry also raises the separate participants’ experience with the
security’’ as a security, the terms of question of whether the process by current provisions relating to reverse
which provide for the adjustment of its which the periodic interest payments repos and suggestions on how best to
interest rate whenever a specified are determined for ARS is permissible. address the risks of these transactions.
interest rate changes and that, at any It appears that the typical process is to The FIA commented that, although
time until the final maturity of the reset the interest rate through ‘‘Dutch the concentration limits for reverse
instrument or the period remaining auctions’’ held on relatively short repos were imposed to remove
until the principal amount can be cycles, such as 7, 14, 28, or 35 days, restrictions that commenters previously
recovered through demand, can with interest paid at the end of each
14 As used in this release, the term ‘‘reverse repo’’
reasonably be expected to have a market auction period. The full principal is due
means an agreement under which an FCM or DCO
at a set maturity date, typically years buys a security that is a permitted investment from
11 See SEC Rule 2a–7(a)(13), 17 CFR 270.2a– from the date of issue. In such an a qualified counterparty, with a commitment to
7(a)(13). auction, broker-dealers submit bids to resell that security to the counterparty at a later
12 See SEC Rule 2a–7(a)(29), 17 CFR 270.2a–
an auction agent (typically a large date. A ‘‘repo’’ is an agreement under which an
7(a)(29). FCM or DCO sells a security to a qualified
13 Under Rule 1.25(b)(5), the portfolio time-to- money center bank). The interest rate for counterparty, with a commitment to repurchase that
maturity calculation is computed pursuant to SEC the next period is set by identifying the security at a later date.
Rule 2a–7. lowest rate that will clear the total 15 See 65 FR 77993, 78002 (Dec. 13, 2000).
had identified as inhibiting their use of exchange for permitted investments that customer-deposited securities that are
reverse repos, as a practical matter, an the FCM/BD holds in its capacity as a not acceptable as collateral for DCO
FCM cannot monitor such transactions broker-dealer. The FIA further proposed performance bond requirements could
by security, size and counterparty that the FCM/BD transactions be subject be exchanged for securities that are
except through manual processing. As a to the recordkeeping requirements of acceptable. This would permit the more
result, this investment alternative has Commission rules 1.25, 1.26, 1.27, 1.28, efficient use of an FCM/BD’s total
not proved to be viable. The FIA and 1.36, as well as applicable SEC holdings. There also would be certain
expressed the view that all securities rules. With respect to transactions operational efficiencies given the ability
held by an FCM, either through an involving customer-owned securities, to readily substitute forms of collateral
investment of customer funds or the FIA stated that the records should prior to delivering that collateral to a
through a reverse repo, should be reflect the customer’s continued DCO.
subject to the concentration limits for ownership interest in those securities. The Commission recognizes that all
direct investments. The FIA proposed to apply to in- permitted investments under Rule
The Commission proposes to amend house transactions certain standards 1.25(a)(1) do not have the same risk
paragraph (b)(4)(iii) to make reverse that currently apply to repos and reverse profile, and that substitution of one type
repos subject to the concentration limits repos under Rule 1.25(d), i.e., the of permitted investment for another
for direct investments under Rule identification of securities by coupon could alter the risk profile of a customer
1.25(b)(4)(i). In re-evaluating the rate, par amount, market value, maturity segregated account. However, the
existing concentration limits, the date, and CUSIP or ISIN number Commission has previously determined
Commission has concluded that (paragraph (d)(1)); the ability to unwind that all of the instruments that are
imposing issuer-based concentration a transaction within one business day or permitted investments are appropriate
limits, as originally proposed for on demand (paragraph (d)(5)); and the investments for customer money,
permitted investments including recognition of an accomplished subject to specified requirements. Thus,
securities obtained through reverse transaction only when the securities are the substitution of one permitted
repos, is an appropriate and adequate actually received by the custodian of the investment for another in an in-house
safeguard.16 The Commission’s primary FCM’s customer segregated account transaction will not present an
regulatory concern focuses on the actual (paragraph (d)(8)). The FIA proposed to unacceptable level of risk to the
holdings in the customer segregated apply the concentration requirements customer segregated account.
account (i.e., cash, securities, or other applicable to direct investments In light of the above considerations,
property) at any given time. (paragraph (b)(4)(i)) and to treat the the Commission is proposing to amend
Accordingly, under the proposal, all securities deposited in the customer Rule 1.25 by adding new paragraphs
investment securities in the account, segregated account as a result of the in- (a)(3) and (e) 19 to permit FCM/BDs to
whether obtained pursuant to direct house transaction as having a one-day engage in in-house transactions subject
investment or reverse repo, would be time-to-maturity. to specified requirements.
subject to the same concentration limits. Lehman Brothers asserted its belief Proposed paragraph (a)(3)(i) provides
that such transactions are permissible that customer money may be exchanged
D. Transactions by FCM/BDs under Section 4d(a)(2) of the Act 18 and for securities that are permitted
In its comment letter responding to Rule 1.25, and do not present any investments and are held by an FCM/BD
the Commission’s June 30, 2003 request unique customer protection concerns. in connection with its securities broker
for public comment, the FIA proposed Lehman Brothers described the or dealer activities. Proposed paragraph
adding a new provision to Rule 1.25 that proposed transactions as an alternative (a)(3)(ii) provides that securities
would permit an FCM/BD to engage in to reverse repos and repos entered into deposited by customers as margin may
transactions that involve the exchange between an FCM/BD and a third party. be exchanged for securities that are
of customer money or customer- In considering issues related to the permitted investments and are held by
deposited securities for securities that investment of customer money or an FCM/BD in connection with its
are held by the FCM in its capacity as securities by an FCM, the Commission’s securities broker or dealer activities.
a securities broker-dealer (‘‘in-house primary interest is in preserving the Proposed paragraph (a)(3)(iii) provides
transactions’’).17 Lehman Brothers also integrity of the customer segregated that securities deposited by customers
submitted a comment letter in support account. Not only must there be as margin may be exchanged for cash
of the FIA’s proposal. sufficient value in the account at all that is held by an FCM/BD in
The FIA recommended that the times, but the quality of investments connection with its securities broker or
Commission authorize an FCM/BD that, must reflect an acceptable level of dealer activities.
in its capacity as a broker-dealer, owns credit, market, and liquidity risk. In this The authority granted under
or has the unqualified right to pledge regard, it is important that non-cash paragraph (a)(3) would be subject to the
securities that are ‘‘permitted assets can be quickly converted to cash requirements of proposed new
investments,’’ to invest customer money at a predictable value. paragraph (e), which incorporates many
by effecting a transfer of such securities The in-house transactions proposed of the same restrictions currently
to the customer segregated account. by FIA and Lehman Brothers are imposed on repo and reverse repo
Similarly, in lieu of using customer- intended to provide the economic transactions under paragraph (d).
deposited securities in a repo with a equivalent of repos and reverse repos Certain provisions of paragraph (e) have
third party, the FIA proposed that an with third parties. A key benefit that the been adapted to reflect the operational
FCM/BD should be authorized to effect in-house transactions offer is that they differences between an in-house
similar transactions by means of a can assist an FCM both in achieving transaction and a third-party
transfer of customer-owned securities in greater capital efficiency and in transaction.
accomplishing important risk Proposed paragraph (e)(1) requires
16 See 65 FR 39008, 39020 (June 22, 2000).
17 Since
management goals, including internal that the FCM, in connection with its
the submission of its comment letter, the
FIA has further requested that the provision also
diversification targets. For example,
address transactions in which customer-deposited 19 The current paragraph (e) would be
securities are exchanged for cash. 18 7 U.S.C. 6d(a)(2). redesignated as paragraph (f).
securities broker or dealer activities, and reverse repos under Rule securities to the customer segregated
must own or have the unqualified right 1.25(d)(6).22 custodial account must be made
to pledge the securities that are Proposed paragraph (e)(5)(iv) simultaneously with the transfer of
exchanged for customer money or incorporates the Rule 1.25(d)(7) securities from the customer segregated
securities held in the customer restrictions on the subsequent use of the custodial account. Securities held in the
segregated account. The securities may securities. It provides that the securities customer segregated custodial account
be held as part of the broker-dealer may not be used in another similar cannot be released prior to the transfer
inventory or may have been deposited transaction and may not otherwise be of securities to that account. Any
with the broker-dealer by its customers. hypothecated or pledged, except such transfer of securities to the customer
Proposed paragraph (e)(2) requires securities may be pledged on behalf of segregated custodial account cannot be
that the transaction can be reversed customers at another FCM or a DCO. It recognized as accomplished until the
within one business day or upon permits substitution of securities if: (1) securities are actually received by the
demand. This standard also applies to The securities being substituted and the custodian of such account. Upon
repos and reverse repos under Rule original securities are specifically unwinding of the transaction, the
1.25(d)(5), with the goal of establishing identified by date of substitution, customer segregated custodial account
investment liquidity. market values substituted, coupon rates, must receive the securities
Proposed paragraph (e)(3) par amounts, maturity dates and CUSIP simultaneously with the delivery or
incorporates the Rule 1.25(d)(1) or ISIN numbers; (2) substitution is transfer of securities from the customer
requirement that the securities made on a ‘‘delivery versus delivery’’ segregated custodial account.
transferred from and to the customer basis; and (3) the market value of the Proposed paragraph (e)(6)(iii) governs
segregated account be specifically substituted securities is at least equal to transactions under proposed paragraph
identified by coupon rate, par amount, that of the original securities. (a)(3)(iii). It provides that the transfer of
market value, maturity date, and CUSIP Proposed paragraph (e)(6) sets forth money to the customer segregated cash
or ISIN number. the payment and delivery procedures account must be made simultaneously
Proposed paragraph (e)(4) establishes for in-house transactions. Adapted from with the transfer of securities from the
two general requirements for the types Rule 1.25(d)(8), the provisions are customer segregated custodial account.
of customer-deposited securities that designed to ensure that in-house Securities held in the customer
can be used in the in-house transactions are carried out in a manner segregated custodial account cannot be
transactions. These same requirements that does not jeopardize the adequacy of released prior to the transfer of money
apply to customer-deposited securities funds held in the customer segregated to the customer segregated cash account.
used in repos under Rule 1.25(a)(2)(ii). account. Any transfer of money to the customer
Paragraph (e)(4)(i) incorporates the Rule Proposed paragraph (e)(6)(i) governs segregated cash account cannot be
1.25(a)(2)(ii)(A) requirement that the transactions under proposed paragraph recognized as accomplished until the
securities must be ‘‘readily marketable’’ (a)(3)(i). It provides that the transfer of money is actually received by the
as defined in SEC Rule 15c3–1.20 securities to the customer segregated custodian of such account. Upon
Paragraph (e)(4)(ii) incorporates the custodial account must be made unwinding of the transaction, the
Rule 1.25(a)(2)(ii)(B) requirement that simultaneously with the transfer of customer segregated custodial account
the securities not be ‘‘specifically money from the customer segregated must receive the securities
identifiable property’’ as defined in Rule cash account. Money held in the simultaneously with the disbursement
190.01(kk). customer segregated cash account of money from the customer segregated
Proposed paragraph (e)(5) establishes cannot be disbursed prior to the transfer cash account.
requirements for securities that will be of securities to the customer segregated Proposed paragraph (e)(7) provides
transferred to the customer segregated custodial account. Any transfer of that the FCM must maintain all books
account as a result of the in-house securities to the customer segregated and records with respect to the in-house
transaction, clarifying the treatment of custodial account cannot be recognized transactions in accordance with Rules
these securities once they are held in as accomplished until the securities are 1.25, 1.27, 1.31, and 1.36, as well as the
the customer segregated account. actually received by the custodian of applicable rules and regulations of the
Proposed paragraph (e)(5)(i) requires such account. Upon unwinding of the SEC. This clarifies the pre-existing
that the securities be priced daily based transaction, the customer segregated obligations of the FCM, and it is adapted
on the current mark-to-market value. cash account must receive same-day from Rule 1.25(d)(10).
Proposed paragraph (e)(5)(ii) provides funds credited to such account Proposed paragraph (e)(8)
that the securities will be subject to the incorporates the requirements of Rule
simultaneously with the delivery or
concentration limit requirements 1.25(d)(11). It provides that an actual
transfer of securities from the customer
applicable to direct investments, as transfer of securities by book entry must
segregated custodial account.
provided in proposed Rule 1.25(b)(4)(iv) Proposed paragraph (e)(6)(ii) governs be made consistent with Federal or State
(discussed below). This is the same transactions under proposed paragraph commercial law, as applicable.
treatment that the Commission is (a)(3)(ii). It provides that the transfer of Moreover, at all times, securities
proposing to apply to repos and reverse transferred to the customer segregated
repos.21 Proposed paragraph (e)(5)(iii) 22 Note that the Commission has not included in account are to be reflected as ‘‘customer
provides that the securities transferred this paragraph the FIA’s proposed one-day time-to- property.’’
to the customer segregated account must maturity treatment for securities transferred to the Proposed paragraph (e)(9) provides
customer segregated account. Although an in-house that, for purposes of Rules 1.25, 1.26,
be held in a safekeeping account with a transaction could be reversed within one day, the
bank, a DCO, or the Depository Trust rule would not require that it be reversed within
1.27, 1.28 and 1.29, securities
Company in an account that complies that time frame. Effectively, these instruments transferred to the customer segregated
with the requirements of Rule 1.26. This would be subject to the same risks associated with account will be considered to be
the price sensitivity of direct investments and, customer funds until the money or
same requirement is applied to repos accordingly, should be subject to the same
standards in order to maximize the protection of
securities for which they were
20 17 CFR 240.15c3–1. principal. Special treatment would undermine the exchanged are transferred back to the
21 See section II.C. of this release. purpose of the time-to-maturity requirement. customer segregated account. As a
result, in the event of the bankruptcy of subject to certain standards set forth in SEC Rule 2a–7 26 make the rating
the FCM, any securities transferred to the rule. Among those standards is the requirement unnecessary. In this regard,
and held in the customer segregated requirement that MMMFs that are rated Federated observes that the rule
account as a result of an in-house by a nationally recognized statistical imposes strict portfolio quality,
transaction could be immediately rating organization (‘‘NRSRO’’) must be diversification, and maturity standards,
transferred to another FCM. This rated at the highest rating of the which greatly limit the possibility of
provision adapts, in part, the provisions NRSRO.23 While the rule does not significant deviation between the share
set forth in Rule 1.25(d)(12). permit investments in lower rated price of a fund and its per share net
Proposed paragraph (e)(10) addresses MMMFs, it does not prohibit asset value. Additionally, Federated
the failure to return customer-deposited investments in unrated MMMFs. As a notes that MMMFs are subject to board
securities to the customer segregated result, a rated MMMF that does not have oversight regarding credit quality
account. Adapted from Rule the highest rating is not acceptable as a requirements and investment
1.25(a)(2)(ii)(D), it provides that in the permitted investment, but an unrated procedures.
event the FCM is unable to return to the MMMF is acceptable.24 Rule 1.25(c) sets forth additional
customer any customer-deposited The Commission has been asked to requirements for MMMFs. Paragraph
securities used in an in-house consider eliminating the rating (c)(1) establishes SEC Rule 2a–7 as a
transaction the FCM must act promptly requirement for MMMFs. In particular, basic standard of adequacy. More
to ensure that there is no resulting direct Federated Investors, Inc., (‘‘Federated’’) specifically, paragraph (c)(1) provides
or indirect cost or expense to the has expressed the view that the rating that, generally, the MMMF must be an
customer. requirement creates a competitive investment company that is registered
As explained above, under proposed inequity for rated MMMFs that have with the SEC under the Investment
paragraph (e)(5)(ii), the Commission yield and portfolio characteristics Company Act of 1940 and that holds
would apply the concentration limits for itself out to investors as an MMMF in
similar to the unrated funds that are
direct investments to securities accordance with SEC Rule 2a–7.27
commonly used by FCMs for investment
transferred to the customer segregated It appears that the rating requirement
of customer funds.25 According to
account as a result of an in-house for MMMFs under Rule 1.25(b)(2)(i)(E)
Federated, lower rated MMMFs, like
transaction. To effect this treatment, the is not essential in light of the other risk-
many unrated MMMFs, do not qualify
Commission proposes to amend Rule limiting provisions applicable to
for the highest rating by an NRSRO
1.25(b)(4) by adding a new paragraph MMMFs under Rule 1.25 and SEC Rule
because they hold split-rated and other
(iv) to provide that, for purposes of 2a–7. In consideration of the anomalous
securities in their portfolios, which are
determining compliance with applicable situation created by the use of unrated
not approved by the NRSROs for triple-
concentration limits, securities funds as permitted investments, the
transferred to a customer segregated A rated funds, and because the average
maturity of their portfolios may exceed Commission is proposing to amend Rule
account pursuant to Rule 1.25(a)(3) will 1.25(b)(2)(i)(E) to eliminate the rating
be combined with securities held by the 60 days.
As an example of the competitive requirement for MMMFs.
FCM as direct investments. In adding
this new provision, the Commission inequity, Federated points to its F. Registration Requirement for MMMFs
would also redesignate existing Federated Prime Value Obligations
Fund, a single-A rated fund that it As discussed above, Rule 1.25(c)(1)
paragraphs (b)(4)(iv) and (v) as (b)(4)(v) provides that, generally, an MMMF
and (vi), respectively. describes as having essentially the same
yield and portfolio characteristics as must be an investment company that is
The Commission also proposes an registered with the SEC under the
additional technical amendment to Rule unrated competitors. Like unrated
competitors, the fund cannot receive a Investment Company Act of 1940 and
1.27 to clarify the applicability of that holds itself out to investors as an
recordkeeping requirements to triple-A rating because it holds split-
rated and other securities in its MMMF in accordance with SEC Rule
securities transferred to and from the 2a–7. Paragraph (c)(1) further provides
customer custodial account pursuant to portfolio, which are not approved by the
NRSROs for triple-A rated funds, and that an MMMF sponsor may petition the
repos and in-house transactions. Rule Commission for an exemption from this
1.27 provides that each FCM that because the average maturity of its
portfolio may exceed 60 days. Because requirement, and the Commission may
invests customer funds and each DCO grant such an exemption if the MMMF
that invests customer funds of its of the single-A rating, however, the
Prime Value Obligations Fund, unlike can demonstrate that it will operate in
clearing members’ customers or option a manner designed to preserve principal
customers must keep a record showing competing unrated funds, cannot be
used for investment of customer funds. and to maintain liquidity. The
specified information. Among the items exemption request must include a
to be recorded are the amount of money Federated believes that the fact that the
fund is rated should make it a more description of how the fund’s structure,
so invested (paragraph (a)(3)) and the operations and financial reporting are
date on which such investments were acceptable investment than an unrated
fund. expected to differ from the requirements
liquidated or otherwise disposed of and in SEC Rule 2a–7 and applicable risk-
the amount of money received of such Federated asserts that the rating
limiting provisions contained in Rule
disposition, if any (paragraph (a)(6)). limitation does not provide additional
1.25. In addition, the MMMF must
The Commission proposes to insert, investor protections. It further argues
specify the information that it would
after the reference to ‘‘amount of that the investor protections afforded by
money’’ the phrase ‘‘or current market 26 17 CFR 270.2a–7.
value of securities.’’ This would clarify 23 See
Rule 1.25(b)(2)(i)(E). 27 A fund sponsor may petition for exemption
that amounts recorded must include the 24 The Commission notes that a substantial
from this requirement, and the Commission may
value of securities, as well as cash. percentage of customer money invested in MMMFs grant an exemption, if the fund can demonstrate
is invested in unrated funds. that it will operate in a manner designed to preserve
E. Rating Standards for MMMFs 25 See letter from Melanie L. Fein, Goodwin principal and to maintain liquidity. As discussed in
Proctor LLP, on behalf of Federated, dated April 8, Section II.F. of this release, however, the
Rule 1.25 permits FCMs and DCOs to 2004, available in the comment file accompanying Commission is proposing to eliminate this
invest customer funds in MMMFs, this proposed rulemaking, at http://www.cftc.gov. exemption provision.
make available to the Commission on an qualifying permitted investments, the H. Additional Technical Amendments
on-going basis. Commission believes that this potential
The Commission has not received any 1. Clarifying and Codifying MMMF
loss would be mitigated by the
formal exemption requests under Redemption Requirements
availability of additional MMMF
paragraph (c)(1), but it has received investments under the Commission’s The Commission currently permits
several informal inquiries. In evaluating proposed amendment to permit FCMs and DCOs to invest customer
these inquiries, Commission staff have investments in MMMFs that are rated money in MMMFs in accordance with
explored alternative standards that below the top rating of an NRSRO.29 the standards set forth in Rule 1.25(c).
could be used to ascertain whether an The requirement that all MMMFs be Among those standards is the
MMMF will operate in a manner registered and qualify as SEC Rule 2a– requirement that the MMMF be able to
designed to preserve principal and to 7 funds, without exception, is consistent redeem the interest of the FCM or DCO
maintain liquidity and, therefore, could with the Commission’s reliance on SEC by the business day following a
be exempted. As a result of this Rule 2a–7 standards in its proposal to redemption request. The Commission
exercise, it has become apparent that eliminate rating requirements for proposes to amend paragraph (c)(5) to
establishing such standards presents MMMFs. clarify that the MMMF must be legally
substantial practical and policy issues. obligated to redeem the interest and
For example, from a practical G. Auditability Standard for Investment
make payment in satisfaction thereof by
standpoint, granting an exemption Records
the business day following the
would require that the Commission, on Rule 1.27 sets forth recordkeeping redemption request. In addition, the
a case-by-case basis, review a particular requirements for FCMs and DCOs in Commission proposes a further
MMMF’s risk-limiting policies and connection with the investment of amendment to codify previously
procedures and determine that, customer funds under Rule 1.25. More articulated exceptions to the next-day
notwithstanding deviations from the specifically, the rule lists the types of redemption requirement.
Rule 2a–7 requirements, those policies information that an FCM or DCO must
and procedures will operate to preserve (i) Next-Day Redemption Requirement
retain, subject to the further
principal and to maintain liquidity. recordkeeping requirements of Rule In response to inquires from
Moreover, if an exemption were granted, 1.31. participants in the futures and mutual
Commission staff would have to The Commission proposes to amend fund industries, the Commission
maintain oversight over the exempt Rule 1.27 by adding a new provision to proposes to amend paragraph (c)(5) to
MMMF to ascertain that it continues to establish an auditability standard for clarify that next-day redemption and
operate in accordance with the pricing information related to all payment is mandatory. To effect this,
Commission’s standards. The instruments acquired through the the Commission proposes to eliminate
Commission believes that it would be the language requiring that the MMMF
investment of customer funds. Such a
inefficient to devote substantial ‘‘must be able to redeem an interest by
standard will facilitate the maintenance
resources to the exemption process. In the next business day following a
of reliable and readily available
addition, the Commission is concerned redemption request’’ and to substitute in
valuation information that can be
that this process could produce
properly audited. This is particularly its place a provision that requires the
inconsistent results and give rise to an
important with respect to instruments fund to ‘‘be legally obligated to redeem
uncertain framework for regulatory
for which historical valuation an interest and make payment in
oversight.
From a policy standpoint, the information may not be retrievable from satisfaction thereof by the business day
Commission is concerned that by third party sources at the time of an following a redemption request.’’ The
granting an exemption, the Commission audit. revised language unambiguously
may be perceived as expressing a view Accordingly, the Commission establishes the mandatory nature of the
about the adequacy of an MMMF’s proposes to amend Rule 1.27 by adding redemption obligation and also clarifies
overall risk-limiting policies and a new paragraph (a)(8), to require FCMs the distinction between redemption
procedures and, ultimately, upon the and DCOs to maintain supporting (valuation) of MMMF interests and
investment quality of any particular documentation of the daily valuation of actual payment for those redeemed
MMMF. The Commission does not wish instruments acquired through the interests.
to provide, or be perceived as providing, investment of customer funds, including The Commission recognizes that the
any such assurances to FCMs or DCOs the valuation methodology and third phrase, ‘‘able to redeem,’’ on its face,
that might be interested in investing party information. Such supporting could be interpreted to mean the
customer money in an exempt MMMF. documentation must be sufficient to MMMF must have the capability to
In light of the above considerations, enable auditors to verify information to redeem, but need not have the
the Commission believes that the external sources and recalculate the obligation to redeem. However, this is
exemptive process, in this situation, valuation for a given instrument. not the intended meaning of the
does not serve the best interests of the The Commission requests comment provision.
futures industry or the public. on the practices and procedures that In adopting the next-day redemption
Accordingly, the Commission is FCMs and DCOs would have to requirement in December 2000, the
proposing to amend paragraph (c)(1) to implement in order to comply with such Commission responded to a public
eliminate the availability of an a standard and whether compliance comment recommending that the one-
exemption for unregistered funds.28 would require substantial operational day liquidity requirement be extended
While this removes the possibility of changes. To the extent that there may be to seven days to be consistent with SEC
adding certain MMMFs to the pool of issues regarding implementation of requirements and the longer settlement
procedures to facilitate auditability, the time frames associated with direct
28 Related to this, the Commission also proposes
Commission requests comment on how investments.30 The Commission
a technical amendment that would delete the it should address those issues. explained its position as follows:
reference to ‘‘a fund exempted in accordance with
paragraph (c)(1) of this section’’ at the end of
paragraph (c)(2). 29 See discussion in Section II.E. of this release. 30 See 65 FR at 78003.
The Commission believes the one-day for certain exceptions to the practice of hold customer funds, a bank or trust
liquidity requirement for investments in next-day redemption.32 company located outside the United
MMMFs is necessary to ensure that the The letter specifically identified States must satisfy either of the
funding requirements of FCMs will not circumstances in which next-day following requirements: (1) It must have
be impeded by a long liquidity time redemption could be excused: (1) Non- in excess of $1 billion of regulatory
frame. Since a material portion of an routine closure of the Fedwire or capital; or (2) the bank or trust
FCM’s customer funds could well be applicable Federal Reserve Banks; (2) company’s commercial paper or long-
invested in a single MMMF, this is an non-routine closure of the New York term debt instrument, or if the
Stock Exchange or general market institution is part of a holding company
important provision of the rule. The
conditions leading to a broad restriction system, its holding company’s
Commission notes that, although sales
of trading on the New York Stock commercial paper or long-term debt
of directly-owned securities settle in Exchange, i.e., a restriction of trading instrument, must be rated in one of the
longer than one-day time-frames, an due to market-wide events; or (3) two highest rating categories by at least
FCM or clearing organization could declaration of a market emergency by one NRSRO.
obtain liquidity by entering into a the SEC. The letter also included a Consistent with this approach, the
repurchase transaction. Therefore, the catch-all provision that included Commission believes that it is
Commission has retained the one-day emergency conditions set forth in appropriate to use, as a proxy for a
liquidity requirement imposed on Section 22(e) of the Investment certificate of deposit rating, NRSRO
investments in MMMFs and, in view of Company Act of 1940.33 ratings for the commercial paper or
the importance of this provision, has The Commission proposes to codify long-term debt instrument of the issuer
clarified that demonstration that this these exceptions in new paragraph of the certificate of deposit or such
requirement has been met may include (c)(5)(ii) and, in so doing, to redesignate issuer’s parent holding company.
either an appropriate provision in the the existing paragraph (c)(5), as Accordingly, the Commission proposes
offering memorandum of the fund or a amended, as paragraph (c)(5)(i). The to delete the reference to certificates of
separate side agreement between the Commission recognizes that there is deposit in paragraph (b)(2)(i)(B) of Rule
fund and an FCM or clearing some overlap between the enumerated 1.25 and insert a new paragraph (E) that
organization.31 exceptions and those contained in would apply the same standard
Section 22(e), but it believes that this is contained in paragraph (b)(2)(i)(B) to the
Thus, the next-day redemption appropriate given the need to provide commercial paper or long-term debt
requirement is not met even if an for all relevant circumstances. instrument issued by the certificate of
MMMF, as a matter of practice, offers deposit issuer or its holding company.
same-day or next-day redemption if 2. Clarifying Rating Standards for
there is no binding obligation to do so. Certificates of Deposit 3. Clarifying Corporate Bonds as
Rule 1.25(b)(2)(i)(B) sets forth the Permitted Investments
The second provision of paragraph
rating requirements for municipal Paragraph (a)(vi) currently uses the
(c)(5) suggests two ways in which an
securities, GSE securities, commercial term ‘‘corporate note,’’ which may be
FCM or DCO may demonstrate paper, corporate notes that are not asset- interpreted by some market participants
compliance with the next-day backed, and certificates of deposit.34 to mean obligations whose original term
redemption requirement, i.e., an The Commission notes that certificates to maturity does not exceed five years
appropriate provision in the fund’s of deposit, unlike the other instruments or perhaps ten years. However, the
offering memorandum or a separate side listed in that paragraph, are not directly Commission proposes to clarify that this
agreement between the fund and the rated by an NRSRO. is not its intent by amending paragraphs
FCM or DCO. In view of the proposed Because NRSRO ratings reflect the (a)(1)(vi), (b)(2)(i)(B) and (C), and
changes in the first provision of financial strength of the issuer of an (b)(4)(i)(C) to use the term ‘‘corporate
paragraph (c)(5), the Commission instrument, they offer a useful standard, notes or bonds.’’ Rather than constrain
believes that it is not necessary to among others, for determining whether the types of permitted investments on
specify ways in which an FCM or DCO an instrument can be a permitted the basis of their original term to
can demonstrate that the requirement investment for customer money. maturity, the Commission has addressed
has been met. The Commission Although certificates of deposit are not the issue of the greater price sensitivity
therefore proposes to eliminate the rated by NRSROs, it is possible to apply of longer-term and fixed rate
second provision and to substitute in its a rating standard by using, as a proxy, instruments to changes in prevailing
place a provision that requires the FCM the ratings of other instruments issued interest rates by adopting the portfolio
or DCO to retain documentation by the issuers of certificates of deposit. time-to-maturity requirements of
demonstrating compliance with the For example, the Commission has paragraph (b)(5); thus, it is the
previously taken this approach in remaining term to maturity that is
next-day redemption requirement. Such
establishing standards for foreign relevant.
documentation can then be produced
depository institutions that may hold
for audit purposes. customer funds. In this regard, Rule 4. Clarifying References to Transferred
(ii) Exceptions to the Next-Day 1.49(d)(3)(i) provides that, in order to Securities
Redemption Requirement Rule 1.25(a)(2) permits FCMs and
32 See CFTC Staff Letter No. 01–31, [2000–2002
DCOs to enter into repos using
In response to an inquiry from the Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶28,521
(Apr. 2, 2001).
customer-deposited securities and
Board of Trade Clearing Corporation in 33 15 U.S.C. 80a–22(e). securities that are permitted
2001, the Commission’s Division of 34 More specifically, Rule 1.25(b)(2)(i)(B) provides investments purchased with customer
Trading and Markets issued a letter as follows: ‘‘Municipal securities, government money. Such transactions are subject to
stating that it would raise no issue in sponsored agency securities, certificates of deposit, the provisions of paragraph (d) of Rule
connection with MMMFs that provide commercial paper, and corporate notes, except
notes that are asset-backed, must have the highest
1.25. Among those provisions is
short-term rating of an NRSRO or one of the two paragraph (d)(6), which requires that the
31 Id. highest long-term ratings of an NRSRO.’’ ‘‘securities transferred under the
agreement’’ must be held in a The Commission requests comment 7. Conforming Reference to

safekeeping account with a bank, a on whether these amendments ‘‘Marketability’’ Requirement
DCO, or the Depository Trust Company accurately reflect the current practices Rule 1.25(a)(2)(ii), which permits
in an account that complies with the of FCMs and DCOs and, if not, how FCMs and DCOs to sell customer-
requirements of Rule 1.26. existing business practices operate to deposited securities pursuant to repos,
The Commission has been asked otherwise enable FCMs and DCOs sets forth various requirements for such
whether the reference to ‘‘securities engaging in repurchase transactions to transactions. Among them is the
transferred under the agreement’’ is maintain the proper amount of funds in requirement, under paragraph
intended to include not only in-coming segregated accounts at all times. (a)(2)(ii)(A), that securities subject to
securities, but out-going securities as repurchase must meet the marketability
well. Such an interpretation would 6. Changing Paragraph (a)(1) ‘‘Customer
requirement contained in paragraph
mean that any out-going securities, in Funds’’ to ‘‘Customer Money’’
(b)(1) of Rule 1.25. Paragraph (b)(1), in
addition to any in-coming cash, would turn, cross-references the marketability
Rule 1.25(a)(1) authorizes FCMs and
have to be held in a customer segregated requirement contained in SEC Rule
DCOs to invest ‘‘customer funds’’ in
account in accordance with Rule 1.26.35 15c3–1. For purposes of clarity, the
This is not the intended outcome, and enumerated permitted investments.
Paragraph (a)(1) uses the term Commission proposes to amend Rule
the Commission therefore is proposing 1.25(a)(2)(ii)(A) to eliminate the cross-
to amend paragraph (d)(6) to clarify that ‘‘customer funds’’ to describe customer
money deposited with an FCM or a DCO reference to paragraph (b)(1) and
Rule 1.26 applies only to securities substitute that paragraph’s direct cross-
transferred to (not from) an FCM or to margin futures or options positions.
reference to SEC Rule 15c3–1.
DCO.36 Because the term ‘‘customer funds’’ is
The Commission also is proposing otherwise defined in Rule 1.3(gg) to 8. Conforming Terminology for
technical amendments to paragraphs include more than customer money, the ‘‘Derivatives Clearing Organizations’’
(d)(3) and (d)(11) to similarly clarify that Commission proposes to amend Rule 1.25 uses the term ‘‘clearing
the securities referred to in those paragraph (a)(1) to substitute the term organization’’ to describe an entity that
provisions are securities transferred to ‘‘customer money’’ for the term performs clearing functions. The Act, as
(not from) the customer segregated ‘‘customer funds.’’ amended by the Commodity Futures
custodial account of an FCM or DCO. The word ‘‘money’’ is used in Section Modernization Act of 2000,39 now
4d(a)(2) of the Act with reference to provides that a clearing organization for
5. Clarifying Payment and Delivery
permitted investments, and the term a contract market must register as a
Procedures for Reverse Repos and Repos
‘‘customer money’’ was originally used ‘‘derivatives clearing organization’’ and
The Commission is proposing to in Rule 1.25. The term was changed to must comply with core principles set
amend paragraph (d)(8) to clarify ‘‘customer funds’’ in 1968 when the forth in the statute.40 The Commission
payment and delivery procedures for Commission’s predecessor agency, the proposes technical amendments to Rule
reverse repos and repos. Paragraph Commodity Exchange Authority, 1.25 to change the term ‘‘clearing
(d)(8) currently provides that the organization’’ to ‘‘derivatives clearing
adopted revisions to conform the rule to
‘‘transfer of securities’’ must be made on organization.’’ This will conform the
amendments to Section 4d of the Act.37
a delivery versus payment basis in language of Rule 1.25 to the language of
No explanation was given for the change
immediately available funds. The the Act, more accurately reflecting the
in terminology.
Commission proposes to amend this current statutory framework.
provision to clarify that the delivery Subsequently, in 1981, the As an additional matter, in
versus payment requirement applies to Commission adopted a definition of connection with its proposed technical
the transfer of securities to (not from) ‘‘customer funds’’ in Rule 1.3(gg), when amendments to Rule 1.27,41 the
the customer segregated custodial it adopted rules related to futures Commission also proposes to change the
account, as would be the case in a options.38 That term encompasses more term ‘‘clearing organization’’ to
reverse repo. The Commission further than money, and includes securities and ‘‘derivatives clearing organization’’ in
proposes to add a sentence clarifying other property belonging to the that rule.
that the transfer of funds to the customer. 9. Conforming Terminology for
customer segregated cash account, as Substituting the term ‘‘customer ‘‘Government Sponsored Enterprise’’
would be the case in a repo, must be money’’ for the term ‘‘customer funds’’
made on a payment versus delivery The Commission is also proposing a
in paragraph (a)(1) conforms the technical amendment to Rule 1.25 to
basis. language of that paragraph to the change terminology referring to
35 Rule 1.26 addresses the treatment of
language of Section 4d(a)(2) of the Act government sponsored ‘‘agency’’
instruments purchased with customer funds, but
and clarifies the meaning of the term in securities to government sponsored
does not address the treatment of cash received by relation to other provisions of Rule 1.25. ‘‘enterprise’’ securities. This would
an FCM or DCO pursuant to a repo. The The need for this proposed change in conform the language in the rule to the
Commission believes that it is not necessary to terminology arises in the context of
specify in Rule 1.26 that cash acquired in exchange terminology commonly used in the
for securities under a repo must be held in a
distinguishing between customer money marketplace. This change would be
customer segregated cash account because this and customer-deposited securities, reflected in the list of permitted
requirement is clear from the language of Section which are the subject of Rule investments (paragraph (a)(1)(iii)), the
4d(a)(2) of the Act. 1.25(a)(2)(ii) (repos with customer-
36 The Commission notes that with respect to the
rating requirements (paragraph
in-house transactions discussed in Section II.D. of
deposited securities) and proposed Rule
this release, proposed Rule 1.25(e)(5)(iii) 1.25(a)(3)(ii) and (iii) (in-house 39 Appendix E of Pub. L. No. 106–554, 114 Stat.
specifically provides that securities transferred to transactions with customer-deposited 2763 (2000).
40 See Section 5b of the Act, 7 U.S.C. 7a–1. See
the customer segregated account as a result of the securities).
transaction must be held in a safekeeping account also Section 1a(9) of the Act, 7 U.S.C. 1a(9)
with a bank, a DCO, or the Depository Trust (defining the term ‘‘derivatives clearing
37 33 FR 14455 (Sept. 26, 1968). organization’’).
Company in an account that complies with the
requirements of Rule 1.26. 38 46 FR 33312 (June 29, 1981). 41 See Section II.D. of this release.
(b)(2)(i)(B)), and the concentration limits minimum financial requirements, receive comments on this decision from
(paragraph (b)(4)(i)(B)). pursuant to which the haircuts on any interested persons.
Treasury instruments increase as the
10. Conforming Terminology for IV. Section 4(c)
time to maturity increases.42 However,
‘‘Futures Commission Merchant’’
the Commission believes that a situation Section 4(c) of the Act 45 provides
The Commission is proposing a in which an FCM would have to turn to that, in order to promote responsible
technical amendment to Rule 1.25 to its own capital to meet its obligations to economic or financial innovation and
substitute the term ‘‘futures commission a clearing organization or customers is fair competition, the Commission, by
merchant’’ for the acronym, ‘‘FCM,’’ as far less desirable than one in which an rule, regulation or order, after notice
used in paragraph (c)(3). This would FCM is able to quickly convert assets and opportunity for hearing, may
provide conformity in the use of the acquired with customer funds into cash exempt any agreement, contract, or
term futures commission merchant at a predictable value. transaction, or class thereof, including
throughout the rule. The NFA, while noting that Treasury any person or class of persons offering,
11. Clarifying the Meaning of ‘‘NRSRO’’ instruments do not pose the same entering into, rendering advice or
(credit) risks as other permitted rendering other services with respect to,
Rule 1.25(b)(2) sets forth the rating investments, stated its belief that these the agreement, contract, or transaction,
requirements for permitted investments. instruments should be subject to from the contract market designation
The rule refers to ratings by an haircuts. However, the introduction of requirement of Section 4(a) of the Act,
‘‘NRSRO,’’ the acronym for a haircut requirements into the or any other provision of the Act other
‘‘nationally recognized statistical rating segregation calculations would be than Section 2(a)(1)(C)(ii) or (D), if the
organization.’’ The Commission unprecedented, could involve Commission determines that the
proposes to amend paragraph (b)(2)(i) to substantial operational challenges or exemption would be consistent with the
formally set forth the acronym as a costs for FCMs, and has not otherwise public interest.
defined term and to cross-reference the been proposed or determined to be The proposed rules would be
definition of that term contained in SEC appropriate. promulgated under Section 4d(a)(2) of
Rule 2a–7. The Commission believes that the the Act,46 which governs investment of
III. Time to Maturity—Treasury time-to-maturity requirement added by customer funds. Section 4d(a)(2)
Portfolio the December 2000 amendments provides that customer money may be
remains an important constraint on the invested in obligations of the United
Rule 1.25(b)(5) limits the dollar-
greater market risk inherent with longer- States, in general obligations of any
weighted average of the time to maturity
term and fixed rate instruments in a State or of any political subdivision
for permitted investments to no longer
portfolio of customer funds. Rule thereof, and in obligations fully
than 24 months. In expanding the range
1.25(b)(5) requires the calculation of guaranteed as to principal and interest
of permitted investments in December
portfolio time-to-maturity as that by the United States. It further provides
2000, the Commission added this
average is computed pursuant to SEC that such investments must be made in
requirement as a means for addressing
Rule 2a–7 for MMMFs.43 It should be accordance with such rules and
the greater market risk associated with
noted that this calculation addresses regulations and subject to such
longer-term and fixed rate instruments.
In June 2003, the Commission floating rate government securities and conditions as the Commission may
requested comment on the applicability variable rate government securities that prescribe.
of time-to-maturity requirements for an are adjusted at least every two years by The Commission proposes to expand
FCM that invests solely in obligations of deeming the time to maturity for such the range of instruments in which FCMs
the U.S. Treasury. It had been suggested instruments to be, respectively, either may invest customer funds beyond
that, because Treasury securities do not one day or the time remaining to the those listed in Section 4d(a)(2) of the
pose the same credit risks as other next variable rate adjustment.44 The Act (i.e., securities with embedded
permitted investments, the time-to- Commission believes this approach derivatives and MMMFs rated below the
maturity limitation should not apply. properly considers the lower relative highest rating of an NRSRO), to enhance
The Commission requested comment price sensitivities of short-term versus the yield available to FCMs, DCOs, and
specifically on whether an alternate long-term instruments and adjustable their customers without compromising
safeguard to limit risk, such as rate (floating or variable) versus fixed the safety of customer funds. These
appropriate haircuts, would be more rate instruments. proposed rules should enable FCMs and
meaningful than the time-to-maturity Accordingly, the Commission DCOs to remain competitive globally
requirement of Rule 1.25(b)(5). continues to believe that application of and domestically, while maintaining
Both the FIA and NFA supported the this requirement to all portfolios, safeguards against systemic risk.
elimination of the time-to-maturity including those consisting solely of In light of the foregoing, the
requirement for a portfolio of securities Treasuries or other government Commission believes that the adoption
consisting solely of Treasury securities, does not unduly or of the proposed rules regarding the
instruments. The FIA observed that, improperly restrict an FCM’s investment expansion of permitted instruments for
prior to the adoption of the December flexibility under Rule 1.25. Thus, the the investment of customer funds would
2000 amendments to Rule 1.25, an FCM Commission has determined that it will promote responsible economic and
could invest customer money not propose any changes to its time-to- financial innovation and fair
exclusively in Treasury securities maturity requirement for portfolios competition, and would be consistent
without regard to the dollar-weighted consisting solely of Treasury securities. with the ‘‘public interest,’’ as that term
time to maturity of such instruments. The Commission would be pleased to is used in Section 4(c) of the Act.
Acknowledging that a portfolio 42 See
The Commission solicits public
17 CFR 1.17(c)(5)(v).
consisting solely of long-dated Treasury 43 See
comment on whether the proposed rules
17 CFR 270.2a–7.
instruments is not without (market) risk, 44 See discussion of the terms ‘‘floating rate
the FIA concluded that these risks are security’’ and ‘‘variable rate security’’ in Section 45 7 U.S.C. 6(c).
addressed by the Commission’s II.B.3. of this release. 46 7 U.S.C. 6d(a)(2).
satisfy the requirements for exemption of futures markets; (3) price discovery; may be transferred to the customer
under Section 4(c) of the Act. (4) sound risk management practices; segregated account, treatment of those
and (5) other public interest securities when held in the account, and
V. Related Matters
considerations. Accordingly, the procedures for effecting transactions.
A. Regulatory Flexibility Act Commission could, in its discretion, Proposed requirements are designed to
The Regulatory Flexibility Act give greater weight to any one of the five ensure that at no time will in-house
(‘‘RFA’’) 47 requires Federal agencies, in considerations and could, in its transactions cause the customer
promulgating rules, to consider the discretion, determine that, segregated account to fall below a
impact of those rules on small notwithstanding its costs, a particular sufficient level. Certain other proposed
businesses. The rule amendments rule was necessary or appropriate to amendments, such as the registration
adopted herein will affect FCMs and protect the public interest or to requirement for MMMFs and
DCOs. The Commission has previously effectuate any of the provisions or to clarification as to mandatory next-day
established certain definitions of ‘‘small accomplish any of the purposes of the redemption and payment for MMMF
entities’’ to be used by the Commission Act. interests, strengthen risk management
in evaluating the impact of its rules on The Commission has evaluated the standards that are already in place.
small entities in accordance with the costs and benefits of the proposed rules 5. Other public considerations. The
RFA.48 The Commission has previously in light of the specific considerations proposed amendments reflect industry
determined that registered FCMs 49 and identified in Section 15(a) of the Act, as and Commission experience with Rule
DCOs 50 are not small entities for the follows: 1.25 since the rule was expanded in
1. Protection of market participants December 2000. They provide FCMs
purpose of the RFA. Accordingly,
and the public. The proposed rules and DCOs with greater flexibility in
pursuant to 5 U.S.C. 605(b), the Acting
facilitate greater capital efficiency for making investments with customer
Chairman, on behalf of the Commission,
FCMs and DCOs, while protecting funds, while strengthening the rules that
certifies that the proposed rules will not
customers by establishing prudent protect the safety of such funds and
have a significant economic impact on
standards for investment of customer preserve the rights of customers. For
a substantial number of small entities.
funds. Several of the proposed example, the proposed amendments
B. Paperwork Reduction Act amendments narrow and refine earlier governing in-house transactions provide
The Paperwork Reduction Act of 1995 standards based on industry and FCM/BDs with an efficient and cost-
(‘‘PRA’’) imposes certain requirements Commission experience since the effective method for maximizing
on Federal agencies (including the December 2000 rulemaking in which investment opportunities within the
Commission) in connection with their Rule 1.25 was substantially revised and confines of strict risk management
conducting or sponsoring any collection expanded. In this regard, for example, requirements. Similarly, the proposed
of information as defined by the PRA. the proposed amendments relating to amendments expand the range of
The proposed rule amendments do not the mandatory registration requirement investments to include certain
require a new collection of information for MMMFs and auditability standard instruments with embedded derivatives
on the part of any entities subject to the for investment records establish stricter and MMMFs of any rating, and enable
proposed rule amendments. standards. Similarly, proposed FCMs and DCOs to consider a broader
Accordingly, for purposes of the PRA, amendments that expand investment range of investment possibilities within
the Commission certifies that these opportunities for FCMs and DCOs, such prescribed limitations.
proposed rule amendments, if as those permitting investment in The proposed amendments are
promulgated in final form, would not instruments with embedded derivatives, expected to enhance the ability of FCMs
impose any new reporting or carefully circumscribe the activity in and DCOs to earn revenue from the
recordkeeping requirements. order to protect the customer segregated investment of customer funds, while
account. maintaining safeguards against systemic
C. Costs and Benefits of the Proposed 2. Efficiency, competitiveness, and risk. FCMs and DCOs choosing to make
Rules financial integrity of futures markets. such investments will bear all costs
Section 15(a) of the Act requires that The proposed rules will facilitate greater associated with their investments.
the Commission, before promulgating a efficiency and competitiveness for Accordingly, after considering the five
regulation under the Act or issuing an FCMs and DCOs, but they will not affect factors enumerated in the Act, the
order, consider the costs and benefits of the efficiency and competitiveness of Commission has determined to propose
its action. By its terms, Section 15(a) futures markets. The proposed the rules and rule amendments set forth
does not require the Commission to amendments will not affect the financial below. The Commission invites public
quantify the costs and benefits of a new integrity of futures markets. comment on its application of the cost-
rule or determine whether the benefits 3. Price discovery. The proposed benefit provision. Commenters also are
of the rule outweigh its costs. Rather, amendments will not affect price invited to submit, with their comment
Section 15(a) simply requires the discovery. letters, any data that quantifies the costs
Commission to ‘‘consider the costs and 4. Sound risk management practices. and benefits of the proposal.
benefits’’ of its action. The proposed amendments impose
sound risk management practices upon Lists of Subjects in 17 CFR Part 1
Section 15(a) further specifies that
FCMs and DCOs that invest customer Brokers, Commodity futures,
costs and benefits shall be evaluated in
funds under the rules. They balance the Consumer protection, Reporting and
light of the following considerations: (1)
need for investment flexibility with the recordkeeping requirements.
Protection of market participants and
the public; (2) efficiency, need to preserve customer funds. For In consideration of the foregoing and
competitiveness, and financial integrity example, while proposing to permit pursuant to the authority contained in
FCM/BDs to engage in in-house the Commodity Exchange Act, in
47 5 U.S.C. 601 et seq. transactions, the Commission sets forth particular, Sections 4d, 4(c), and 8a(5)
48 47 FR 18618 (Apr. 30, 1982). specific requirements for such thereof, 7 U.S.C. 6d, 6(c) and 12a(5),
49 Id. at 18619. transactions. These include standards respectively, the Commission hereby
50 66 FR 45604, 45609 (Aug. 29, 2001). relating to the type of securities that proposes to amend Chapter I of Title 17
of the Code of Federal Regulations as (B) Securities subject to such or bonds, except notes or bonds that are
follows: repurchase agreements must not be asset-backed, must have the highest
‘‘specifically identifiable property’’ as short-term rating of an NRSRO or one of
PART 1—GENERAL REGULATIONS defined in § 190.01(kk) of this chapter. the two highest long-term ratings of an
UNDER THE COMMODITY EXCHANGE (C) The terms and conditions of such NRSRO;
ACT an agreement to repurchase must be in (C) Corporate notes or bonds that are
accordance with the provisions of asset-backed must have the highest
1. The authority citation for part 1
paragraph (d) of this section. ratings of an NRSRO;
continues to read as follows: (D) Upon the default by a (D) Sovereign debt must be rated in
Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, counterparty to a repurchase agreement, the highest category by at least one
6d, 6e, 6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, the futures commission merchant or NRSRO; and
6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a, 13a–1, derivatives clearing organization shall (E) With respect to certificates of
16, 16a, 19, 21, 23, and 24, as amended by deposit, the commercial paper or long-
act promptly to ensure that the default
the Commodity Futures Modernization Act of
2000, Appendix E of Public Law 106–554, does not result in any direct or indirect term debt instrument of the issuer of a
114 Stat. 2763 (2000). cost or expense to the customer. certificate of deposit or, if the issuer is
(3) In addition, subject to the part of a holding company system, its
2. Section 1.25 is proposed to be provisions of paragraph (e) of this holding company’s commercial paper or
revised to read as follows: section, a futures commission merchant long-term debt instrument, must have
§ 1.25 Investment of customer funds. that is also registered with the Securities the highest short-term rating of an
and Exchange Commission as a NRSRO or one of the two highest long-
(a) Permitted investments. (1) Subject
securities broker or dealer pursuant to term ratings of an NRSRO.
to the terms and conditions set forth in (ii) Effect of downgrade. If an NRSRO
section 15(b)(1) of the Securities and
this section, a futures commission lowers the rating of an instrument that
Exchange Act of 1934 may enter into
merchant or a derivatives clearing was previously a permitted investment
transactions in which:
organization may invest customer (i) Customer money is exchanged for on the basis of that rating to below the
money in the following instruments securities that are permitted minimum rating required under this
(permitted investments): investments and are held by the futures section, the value of the instrument
(i) Obligations of the United States commission merchant in connection recognized for segregation purposes will
and obligations fully guaranteed as to with its securities broker or dealer be the lesser of:
principal and interest by the United activities; (A) The current market value of the
States (U.S. government securities); (ii) Securities deposited by customers instrument; or
(ii) General obligations of any State or as margin are exchanged for securities (B) The market value of the
of any political subdivision thereof that are permitted investments and are instrument on the business day
(municipal securities); held by the futures commission preceding the downgrade, reduced by
(iii) General obligations issued by any merchant in connection with its 20 percent of that value for each
enterprise sponsored by the United securities broker or dealer activities; or business day that has elapsed since the
States (government sponsored enterprise (iii) Securities deposited by customers downgrade.
securities); as margin are exchanged for cash that is (3) Restrictions on instrument
(iv) Certificates of deposit issued by a held by the futures commission features. (i) With the exception of
bank (certificates of deposit) as defined merchant in connection with its money market mutual funds, no
in section 3(a)(6) of the Securities securities broker or dealer activities. permitted investment may contain an
Exchange Act of 1934, or a domestic (b) General terms and conditions. A embedded derivative of any kind,
branch of a foreign bank that carries futures commission merchant or a except as follows:
deposits insured by the Federal Deposit derivatives clearing organization is (A) The issuer of an instrument
Insurance Corporation; required to manage the permitted otherwise permitted by this section may
(v) Commercial paper; investments consistent with the have an option to call, in whole or in
(vi) Corporate notes or bonds; objectives of preserving principal and part, at par, the principal amount of the
(vii) General obligations of a sovereign maintaining liquidity and according to instrument before its stated maturity
nation; and the following specific requirements: date; or
(viii) Interests in money market (1) Marketability. Except for interests (B) An instrument that meets the
mutual funds. in money market mutual funds, requirements of paragraph (b)(3)(iv) of
(2)(i) In addition, a futures investments must be ‘‘readily this section may provide for a cap, floor,
commission merchant or derivatives marketable’’ as defined in § 240.15c3–1 or collar on the interest paid; provided,
clearing organization may buy and sell of this title. however, that the terms of such
the permitted investments listed in (2) Ratings. (i) Initial requirement. instrument obligate the issuer to repay
paragraphs (a)(1)(i) through (viii) of this Instruments that are required to be rated the principal amount of the instrument
section pursuant to agreements for by this section must be rated by a at not less than par value upon maturity.
resale or repurchase of the instruments, nationally recognized statistical rating (ii) No instrument may contain
in accordance with the provisions of organization (NRSRO), as that term is interest-only payment features.
paragraph (d) of this section. defined in § 270.2a–7 of this title. For an (iii) No instrument may provide
(ii) A futures commission merchant or investment to qualify as a permitted payments linked to a commodity,
a derivatives clearing organization may investment, ratings are required as currency, reference instrument, index,
sell securities deposited by customers as follows: or benchmark except as provided in
margin pursuant to agreements to (A) U.S. government securities and paragraph (b)(3)(iv) of this section, and
repurchase subject to the following: money market mutual funds need not be it may not otherwise constitute a
(A) Securities subject to such rated; derivative instrument.
repurchase agreements must be ‘‘readily (B) Municipal securities, government (iv) (A) Adjustable rate securities are
marketable’’ as defined in § 240.15c3–1 sponsored enterprise securities, permitted, subject to the following
of this title. commercial paper, and corporate notes requirements:
(1) The interest payments on variable securities held by a futures commission interest in a permitted money market
rate securities must correlate closely merchant or derivatives clearing mutual fund is not deemed to be a
and on an unleveraged basis to a organization may not exceed 25 percent security issued by its sponsoring entity.
benchmark of either the Federal Funds of total assets held in segregation by the (vi) Treatment of customer-owned
target or effective rate, the prime rate, futures commission merchant or securities. For purposes of determining
the three-month Treasury Bill rate, or derivatives clearing organization. compliance with the concentration
the one-month or three-month LIBOR (C) Securities of any single issuer of limits set forth in this section, securities
rate; municipal securities, certificates of owned by the customers of a futures
(2) The interest payment, in any deposit, commercial paper, or corporate commission merchant and posted as
period, on floating rate securities must notes or bonds held by a futures margin collateral are not included in
be determined solely by reference, on an commission merchant or derivatives total assets held in segregation by the
unleveraged basis, to a benchmark of clearing organization may not exceed 5 futures commission merchant, and
either the Federal Funds target or percent of total assets held in securities posted by a futures
effective rate, the prime rate, the three- segregation by the futures commission commission merchant with a derivatives
month Treasury Bill rate, the one-month merchant or derivatives clearing clearing organization are not included
or three-month LIBOR rate, or the organization. in total assets held in segregation by the
interest rate of any fixed rate instrument (D) Sovereign debt is subject to the derivatives clearing organization.
that is a permitted investment listed in following limits: A futures commission (5) Time-to-maturity. (i) Except for
paragraph (a)(1) of this section; merchant may invest in the sovereign investments in money market mutual
(3) Benchmark rates must be debt of a country to the extent it has funds, the dollar-weighted average of
expressed in the same currency as the balances in segregated accounts owed to the time-to-maturity of the portfolio, as
adjustable rate securities that reference its customers denominated in that that average is computed pursuant to
them; and country’s currency; a derivatives § 270.2a–7 of this title, may not exceed
(4) No interest payment on an clearing organization may invest in the 24 months.
adjustable rate security, in any period, sovereign debt of a country to the extent
(ii) For purposes of determining the
can be a negative amount. it has balances in segregated accounts
time-to-maturity of the portfolio, an
(B) For purposes of this paragraph, the owed to its clearing member futures
instrument that is set forth in
following definitions shall apply: commission merchants denominated in
paragraphs (a)(1)(i) through (vii) of this
(1) The term adjustable rate security that country’s currency.
(ii) Repurchase agreements. For section may be treated as having a one-
means, a floating rate security, a
purposes of determining compliance day time-to-maturity if the following
variable rate security, or both.
(2) The term floating rate security with the concentration limits set forth in terms and conditions are satisfied:
means a security, the terms of which this section, securities sold by a futures (A) The instrument is deposited solely
provide for the adjustment of its interest commission merchant or derivatives on an overnight basis with a derivatives
rate whenever a specified interest rate clearing organization subject to clearing organization pursuant to the
changes and that, at any time until the agreements to repurchase shall be terms and conditions of a collateral
final maturity of the instrument or the combined with securities held by the management program that has become
period remaining until the principal futures commission merchant or effective in accordance with § 39.4 of
amount can be recovered through derivatives clearing organization as this chapter;
demand, can reasonably be expected to direct investments. (B) The instrument is one that the
have a market value that approximates (iii) Reverse repurchase agreements. futures commission merchant owns or
its amortized cost. For purposes of determining compliance has an unqualified right to pledge, is not
(3) The term variable rate security with the concentration limits set forth in subject to any lien, and is deposited by
means a security, the terms of which this section, securities purchased by a the futures commission merchant into a
provide for the adjustment of its interest futures commission merchant or segregated account at a derivatives
rate on set dates (such as the last day of derivatives clearing organization subject clearing organization;
a month or calendar quarter) and that, to agreements to resell shall be (C) The derivatives clearing
upon each adjustment until the final combined with securities held by the organization prices the instrument each
maturity of the instrument or the period futures commission merchant or day based on the current mark-to-market
remaining until the principal amount derivatives clearing organization as value; and
can be recovered through demand, can direct investments. (D) The derivatives clearing
reasonably be expected to have a market (iv) Transactions under paragraph organization reduces the assigned value
value that approximates its amortized (a)(3). For purposes of determining of the instrument each day by a haircut
cost. compliance with the concentration of at least 2 percent.
(v) Certificates of deposit, if limits set forth in this section, securities (6) Investments in instruments issued
negotiable, must be able to be liquidated transferred to a customer segregated by affiliates. (i) A futures commission
within one business day or, if not account pursuant to paragraphs (a)(3)(i) merchant shall not invest customer
negotiable, must be redeemable at the or (a)(3)(ii) of this section shall be funds in obligations of an entity
issuing bank within one business day, combined with securities held by the affiliated with the futures commission
with any penalty for early withdrawal futures commission merchant as direct merchant, and a derivatives clearing
limited to any accrued interest earned investments. organization shall not invest customer
according to its written terms. (v) Treatment of securities issued by funds in obligations of an entity
(4) Concentration. (i) Direct affiliates. For purposes of determining affiliated with the derivatives clearing
investments. (A) U.S. Government compliance with the concentration organization. An affiliate includes
securities and money market mutual limits set forth in this section, securities parent companies, including all entities
funds shall not be subject to a issued by entities that are affiliated, as through the ultimate holding company,
concentration limit or other limitation. defined in paragraph (b)(6) of this subsidiaries to the lowest level, and
(B) Securities of any single issuer of section, shall be aggregated and deemed companies under common ownership of
government sponsored enterprise the securities of a single issuer. An such parent company or affiliates.
(ii) A futures commission merchant or clearing organization shall retain in paragraphs (d)(1) through (d)(12) of
derivatives clearing organization may documentation demonstrating this section and which states that the
invest customer funds in a fund compliance with this requirement. parties thereto intend the transaction to
affiliated with that futures commission (ii) Exception. A fund may provide for be treated as a purchase and sale of
merchant or derivatives clearing the postponement of redemption and securities.
organization. payment due to any of the following (5) The term of the agreement is no
(7) Recordkeeping. A futures circumstances: more than one business day, or reversal
commission merchant and a derivatives (A) Non-routine closure of the of the transaction is possible on
clearing organization shall prepare and Fedwire or applicable Federal Reserve demand.
maintain a record that will show for Banks; (6) Securities transferred to the
each business day with respect to each (B) Non-routine closure of the New futures commission merchant or
type of investment made pursuant to York Stock Exchange or general market derivatives clearing organization under
this section, the following information: conditions leading to a broad restriction the agreement are held in a safekeeping
(i) The type of instruments in which of trading on the New York Stock account with a bank as referred to in
customer funds have been invested; Exchange; paragraph (d)(2) of this section, a
(ii) The original cost of the (C) Declaration of a market emergency derivatives clearing organization, or the
instruments; and by the Securities and Exchange Depository Trust Company in an
(iii) The current market value of the Commission; or account that complies with the
instruments. (D) Emergency conditions set forth in requirements of § 1.26.
(c) Money market mutual funds. The section 22(e) of the Investment (7) The futures commission merchant
following provisions will apply to the Company Act of 1940. or the derivatives clearing organization
investment of customer funds in money (6) The agreement pursuant to which may not use securities received under
market mutual funds (the fund). the futures commission merchant or the agreement in another similar
(1) The fund must be an investment derivatives clearing organization has transaction and may not otherwise
company that is registered under the acquired and is holding its interest in a hypothecate or pledge such securities,
Investment Company Act of 1940 with fund must contain no provision that except securities may be pledged on
the Securities and Exchange would prevent the pledging or behalf of customers at another futures
Commission and that holds itself out to transferring of shares. commission merchant or derivatives
investors as a money market fund, in (d) Repurchase and reverse clearing organization. Substitution of
accordance with § 270.2a–7 of this title. repurchase agreements. A futures securities is allowed, provided,
(2) The fund must be sponsored by a commission merchant or derivatives however, that:
federally-regulated financial institution, clearing organization may buy and sell (i) The qualifying securities being
a bank as defined in section 3(a)(6) of the permitted investments listed in substituted and original securities are
the Securities Exchange Act of 1934, an paragraphs (a)(1)(i) through (viii) of this specifically identified by date of
investment adviser registered under the section pursuant to agreements for substitution, market values substituted,
Investment Advisers Act of 1940, or a resale or repurchase of the securities coupon rates, par amounts, maturity
domestic branch of a foreign bank (agreements to repurchase or resell), dates and CUSIP or ISIN numbers;
insured by the Federal Deposit provided the agreements to repurchase (ii) Substitution is made on a
Insurance Corporation. or resell conform to the following ‘‘delivery versus delivery’’ basis; and
(3) A futures commission merchant or requirements: (iii) The market value of the
derivatives clearing organization shall (1) The securities are specifically substituted securities is at least equal to
maintain the confirmation relating to identified by coupon rate, par amount, that of the original securities.
the purchase in its records in market value, maturity date, and CUSIP (8) The transfer of securities to the
accordance with § 1.31 and note the or ISIN number. customer segregated custodial account
ownership of fund shares (by book-entry (2) Counterparties are limited to a is made on a delivery versus payment
or otherwise) in a custody account of bank as defined in section 3(a)(6) of the basis in immediately available funds.
the futures commission merchant or Securities Exchange Act of 1934, a The transfer of funds to the customer
derivatives clearing organization in domestic branch of a foreign bank segregated cash account is made on a
accordance with § 1.26(a). If the futures insured by the Federal Deposit payment versus delivery basis. The
commission merchant or the derivatives Insurance Corporation, a securities transfer is not recognized as
clearing organization holds its shares of broker or dealer, or a government accomplished until the funds and/or
the fund with the fund’s shareholder securities broker or government securities are actually received by the
servicing agent, the sponsor of the fund securities dealer registered with the custodian of the futures commission
and the fund itself are required to Securities and Exchange Commission or merchant’s or derivatives clearing
provide the acknowledgment letter which has filed notice pursuant to organization’s customer funds or
required by § 1.26. section 15C(a) of the Government securities purchased on behalf of
(4) The net asset value of the fund Securities Act of 1986. customers. The transfer or credit of
must be computed by 9 a.m. of the (3) The transaction is executed in securities covered by the agreement to
business day following each business compliance with the concentration limit the futures commission merchant’s or
day and made available to the futures requirements applicable to the securities derivatives clearing organization’s
commission merchant or derivatives transferred to the customer segregated customer segregated custodial account
clearing organization by that time. custodial account in connection with is made simultaneously with the
(5) (i) General requirement for the agreements to repurchase referred to disbursement of funds from the futures
redemption of interests. A fund shall be in paragraphs (b)(4)(ii) and (iii) of this commission merchant’s or derivatives
legally obligated to redeem an interest section. clearing organization’s customer
and to make payment in satisfaction (4) The transaction is made pursuant segregated cash account at the custodian
thereof by the business day following a to a written agreement signed by the bank. On the sale or resale of securities,
redemption request, and the futures parties to the agreement, which is the futures commission merchant’s or
commission merchant or derivatives consistent with the conditions set forth derivatives clearing organization’s
customer segregated cash account at the unqualified right to pledge the securities transfer of securities to the customer
custodian bank must receive same-day that are exchanged for customer money segregated custodial account shall be
funds credited to such segregated or securities held in the customer made simultaneously with the transfer
account simultaneously with the segregated account. of money from the customer segregated
delivery or transfer of securities from (2) The transaction can be reversed cash account. In no event shall money
the customer segregated custodial within one business day or upon held in the customer segregated cash
account. demand. account be disbursed prior to the
(9) A written confirmation to the (3) Securities transferred from the transfer of securities to the customer
futures commission merchant or customer segregated account and segregated custodial account. Any
derivatives clearing organization securities transferred to the customer transfer of securities to the customer
specifying the terms of the agreement segregated account as a result of the segregated custodial account shall not
and a safekeeping receipt are issued transaction are specifically identified by be recognized as accomplished until the
immediately upon entering into the coupon rate, par amount, market value, securities are actually received by the
transaction and a confirmation to the maturity date, and CUSIP or ISIN custodian of such account. Upon
futures commission merchant or number. unwinding of the transaction, the
derivatives clearing organization is (4) Securities deposited by customers customer segregated cash account shall
issued once the transaction is reversed. as margin and transferred from the receive same-day funds credited to such
(10) The transactions effecting the customer segregated account as a result account simultaneously with the
agreement are recorded in the record of the transaction are subject to the delivery or transfer of securities from
required to be maintained under § 1.27 following requirements: the customer segregated custodial
of investments of customer funds, and (i) The securities are ‘‘readily account.
the securities subject to such marketable’’ as defined in § 240.15c3–1 (ii) With respect to transactions under
transactions are specifically identified of this title. paragraph (a)(3)(ii) of this section, the
in such record as described in paragraph (ii) The securities are not ‘‘specifically transfer of securities to the customer
(d)(1) of this section and further identifiable property’’ as defined in segregated custodial account shall be
identified in such record as being § 190.01(kk) of this chapter. made simultaneously with the transfer
subject to repurchase and reverse (5) Securities transferred to the of securities from the customer
repurchase agreements. customer segregated account as a result segregated custodial account. In no
(11) An actual transfer of securities to of the transaction are subject to the event shall securities held in the
the customer segregated custodial following requirements: customer segregated custodial account
account by book entry is made (i) The securities are priced each day be released prior to the transfer of
consistent with Federal or State based on the current mark-to-market securities to that account. Any transfer
commercial law, as applicable. At all value. of securities to the customer segregated
times, securities received subject to an (ii) The securities are subject to the custodial account shall not be
agreement are reflected as ‘‘customer concentration limit requirements set recognized as accomplished until the
property.’’ forth in paragraph (b)(4)(iv) of this securities are actually received by the
(12) The agreement makes clear that, section. custodian of the customer segregated
in the event of the bankruptcy of the (iii) The securities are held in a custodial account. Upon unwinding of
futures commission merchant or safekeeping account with a bank, as the transaction, the customer segregated
derivatives clearing organization, any referred to in paragraph (d)(2) of this custodial account shall receive the
securities purchased with customer section, a derivatives clearing securities simultaneously with the
funds that are subject to an agreement organization, or the Depository Trust delivery or transfer of securities from
may be immediately transferred. The Company in an account that complies the customer segregated custodial
agreement also makes clear that, in the with the requirements of § 1.26. account.
event of a futures commission merchant (iv) The securities may not be used in (iii) With respect to transactions
or derivatives clearing organization another similar transaction and may not under paragraph (a)(3)(iii) of this
bankruptcy, the counterparty has no otherwise be hypothecated or pledged, section, the transfer of money to the
right to compel liquidation of securities except such securities may be pledged customer segregated cash account shall
subject to an agreement or to make a on behalf of customers at another be made simultaneously with the
priority claim for the difference between futures commission merchant or transfer of securities from the customer
current market value of the securities derivatives clearing organization. segregated custodial account. In no
and the price agreed upon for resale of Substitution of securities is allowed, event shall securities held in the
the securities to the counterparty, if the provided, however, that: customer segregated custodial account
former exceeds the latter. (A) The qualifying securities being be released prior to the transfer of
(e) Transactions by futures substituted and original securities are money to the customer segregated cash
commission merchants that are also specifically identified by date of account. Any transfer of money to the
registered securities brokers or dealers. substitution, market values substituted, customer segregated cash account shall
A futures commission merchant that is coupon rates, par amounts, maturity not be recognized as accomplished until
also registered with the Securities and dates and CUSIP or ISIN numbers; the money is actually received by the
Exchange Commission as a securities (B) Substitution is made on a custodian of the customer segregated
broker or dealer pursuant to section ‘‘delivery versus delivery’’ basis; and cash account. Upon unwinding of the
15(b)(1) of the Securities and Exchange (C) The market value of the transaction, the customer segregated
Act of 1934 may enter into transactions substituted securities is at least equal to custodial account shall receive the
pursuant to paragraph (a)(3) of this that of the original securities. securities simultaneously with the
section, subject to the following (6) The transactions are carried out in disbursement of money from the
requirements: accordance with the following customer segregated cash account.
(1) The futures commission merchant, procedures: (7) The futures commission merchant
in connection with its securities broker (i) With respect to transactions under maintains all books and records with
or dealer activities, owns or has the paragraph (a)(3)(i) of this section, the respect to the transactions in accordance
with §§ 1.25, 1.27, 1.31, and 1.36 and B. By adding the phrase ‘‘or current environmental organizations. Today, we
the applicable rules and regulations of market value of securities’’ after the are providing additional information
the Securities and Exchange phrase ‘‘The amount of money’’ in and soliciting comment on two of the
Commission. paragraph (a)(3); issues on which we granted
(8) An actual transfer of securities by C. By removing the word ‘‘and’’ at the reconsideration. The issues that we are
book entry is made consistent with end of paragraph (a)(6); addressing today are whether the
Federal or State commercial law, as D. By removing the period at the end section 185 fee provisions apply once
applicable. At all times, securities of paragraph (a)(7) and adding ‘‘; and’’ the 1-hour NAAQS is revoked and the
transferred to the customer segregated in its place; and timing for determining what is an
account are reflected as ‘‘customer E. By adding paragraph (a)(8) to read ‘‘applicable requirement’’ for purposes
property.’’ as follows: of anti-backsliding once the 1-hour
(9) For purposes of §§ 1.25, 1.26, 1.27, NAAQS is revoked. We will shortly
1.28 and 1.29, securities transferred to § 1.27 Record of investments.
address the issue of new source review
the customer segregated account are (a) * * *
(NSR) anti-backsliding in a separate
considered to be customer funds until (8) Daily valuation for each
action. We are requesting public
the customer money or securities for instrument and documentation
comment on the issues discussed in this
which they were exchanged are supporting the daily valuation for each
action, which are described in section
transferred back to the customer instrument. Such supporting
III of the Supplementary Information
segregated account. In the event of the documentation must be sufficient to
section of this preamble. We plan to
bankruptcy of the futures commission enable auditors to validate the valuation
issue a final decision on these issues no
merchant, any securities exchanged for and verify the accuracy of input
later than May 20, 2005.
customer funds and held in the information used in the valuation to
We are also proposing to revise the
customer segregated account may be external sources for any instrument.
implementation rule in two respects.
immediately transferred. * * * * * First we are proposing to find that
(10) In the event the futures Issued in Washington, DC, on January 27, contingency measures for failure to
commission merchant is unable to 2005, by the Commission. make reasonable further progress or
return to the customer any customer- attain by the applicable attainment date
Jean A. Webb,
deposited securities exchanged for the 1-hour ozone standard are no
Secretary of the Commission.
pursuant to paragraphs (a)(3)(ii) or longer required of an area after
(a)(3)(iii) of this section, the futures [FR Doc. 05–2000 Filed 2–2–05; 8:45 am]
revocation of that standard. Second,
commission merchant shall act BILLING CODE 6351–01–P
although § 51.905 of the rule provided
promptly to ensure that such inability
that areas designated nonattainment for
does not result in any direct or indirect
ENVIRONMENTAL PROTECTION the 1-hour NAAQS at the time of
cost or expense to the customer.
(f) Deposit of firm-owned securities AGENCY designation as nonattainment for the 8-
into segregation. A futures commission hour NAAQS remain subject to any
merchant shall not be prohibited from 40 CFR Part 51 outstanding 1-hour attainment
directly depositing unencumbered demonstration requirement, we failed to
[OAR 2003–0079, FRL–7867–1] list the attainment demonstration as an
securities of the type specified in this
section, which it owns for its own RIN 2060–AJ99 ‘‘applicable requirement.’’ We are
account, into a segregated safekeeping proposing to revise the definition of
Implementation of the 8-Hour Ozone ‘‘applicable requirement’’ to include the
account or from transferring any such
National Ambient Air Quality 1-hour attainment demonstration.
securities from a segregated account to
Standard—Phase 1: Reconsideration We are seeking comment only on the
its own account, up to the extent of its
residual financial interest in customers’ issues specifically identified in this
AGENCY: Environmental Protection
segregated funds; provided, however, document. We do not intend to respond
Agency (EPA).
that such investments, transfers of to comments addressing other issues.
ACTION: Proposed rule; notice of public
securities, and disposition of proceeds DATES: Comments must be received on
hearing.
from the sale or maturity of such or before March 21, 2005. A public
securities are recorded in the record of SUMMARY: The EPA is requesting hearing will be held on February 18,
investments required to be maintained comment on two issues raised in a 2005 and will convene at 9 a.m. and end
by § 1.27. All such securities may be petition for reconsideration action of at 2 p.m. Because of the need to resolve
segregated in safekeeping only with a EPA’s rule to implement the 8-hour the issues in this document in a timely
bank, trust company, derivatives ozone national ambient air quality manner, EPA will not grant requests for
clearing organization, or other registered standard (NAAQS or standard). In extensions of the public comment
futures commission merchant. addition, EPA is proposing to clarify period. For additional information on
Furthermore, for purposes of §§ 1.25, two aspects of the implementation rule. the public hearing, see the
1.26, 1.27, 1.28 and 1.29, investments On April 30, 2004, EPA issued a final SUPPLEMENTARY INFORMATION section of
permitted by § 1.25 that are owned by rule addressing key elements of the this preamble.
the futures commission merchant and program to implement the 8-hour ozone ADDRESSES: Submit your comments,
deposited into such a segregated NAAQS. Subsequently, on June 29, identified by Docket ID No. OAR–2003–
account shall be considered customer 2004 and September 24, 2004, three 0079, by one of the following methods:
funds until such investments are different parties each filed a petition for • Federal Rulemaking Portal: http://
withdrawn from segregation. reconsideration of certain specified www.regulations.gov. Follow the on-line
3. Section 1.27 is proposed to be aspects of the final rule. By letter dated instructions for submitting comments.
amended as follows: September 23, 2004, EPA granted Attention E-Docket No. OAR–2003–
A. By adding the word ‘‘derivatives’’ reconsideration of three issues raised in 0079.
before the term ‘‘clearing organization’’ the petition for reconsideration filed by • Agency Website: http://
in paragraphs (a) and (b); Earthjustice on behalf of several www.epa.gov/edocket. EDOCKET, EPA’s

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Federal Register / Vol. 70, No.

22 / Thursday, February 3, 2005 / Proposed Rules 5577

B. Paperwork Reduction Act

agreement’’ must be held in a The Commission requests comment 7. Conforming Reference to

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