Daily Rules, Proposed Rules, and Notices of the Federal Government
All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to
Under Section 4d(a)(2) of the Commodity Exchange Act (Act),
The Commission further modified Regulation 1.25 in 2004 and 2005. In February 2004, the Commission adopted amendments regarding repurchase agreements using customer-deposited securities and time-to-maturity requirements for securities deposited in connection with certain collateral management programs of derivatives clearing organizations (DCOs).
The Commission has been, and continues to be, mindful that customer segregated funds must be invested in a manner that minimizes their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs and to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk. Toward these ends, Regulation 1.25 establishes a general prudential standard by requiring that all permitted investments be “consistent with the objectives of preserving principal and maintaining liquidity.”
In 2007, the Commission's Division of Clearing and Intermediary Oversight (Division) launched a review of the nature and extent of investments of customer segregated funds and 30.7 funds (2007 Review) in order to further its understanding of investment strategies and practices and to assess whether any changes to the Commission's regulations would be appropriate. As part of this review, all registered DCOs and FCMs carrying customer accounts provided responses to a series of questions. As the Division was conducting follow-up interviews with respondents, the market events of September 2008 occurred and changed the financial landscape such that much of the data previously gathered no longer reflected current market conditions. However, much of that data remains useful as an indication of how Regulation 1.25 was implemented in a more stable financial environment, and recent events in the economy have underscored the importance of conducting periodic reassessments and, as necessary, revising regulatory policies to strengthen safeguards designed to minimize risk.
The investment guidelines for 30.7 funds are general in nature.
In May 2009, the Commission issued an advance notice of proposed rulemaking (ANPR)
The Commission received twelve comment letters in response to the ANPR, and it has considered those comments in formulating its proposal.
The FIA's comment letter expressed its view that “all of the permitted investments described in Rule 1.25(a) are compatible with the Commission's objectives of preserving principal and maintaining liquidity.” This opinion was echoed by MF Global, Newedge and FC Stone. CME asserted that only “a small subset of the complete list of Regulation 1.25 permitted investments are actually used by the industry. * * *” NFA also wrote that investments in instruments other than U.S. government securities and MMMFs are “negligible” and recommended that the Commission eliminate asset classes not “utilized to any material extent.”
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
Section 939A of the Dodd-Frank Act obligates federal agencies to review their respective regulations and make appropriate amendments in order to decrease reliance on credit ratings. The Dodd-Frank Act requires the Commission to conduct this review within one year after the date of enactment.
The Commission is now proposing amendments to Regulations 1.25 and 30.7 and requests comment on all aspects of the proposed rules, as well as comment on the specific provisions and issues highlighted in the discussion below. In addition, commenters are welcome to offer their views regarding any other related matters that are raised by the proposed amendments.
In proposing amendments to Regulation 1.25, the Commission seeks to simplify the regulation and impose requirements that can better ensure the preservation of principal and maintenance of liquidity. The Commission has endeavored to tailor its proposal to achieve these goals while retaining an appropriate degree of investment flexibility and opportunities for attaining capital efficiency for DCOs and FCMs investing customer segregated funds.
The Commission seeks to simplify Regulation 1.25 by narrowing the scope of investment choices in order to eliminate the potential use of instruments that may pose an unacceptable level of risk. In their July 2009 comment letters, both NFA and CME suggested contracting the scope of permitted investments by eliminating asset classes used negligibly as investment vehicles.
The Commission seeks to increase the safety of Regulation 1.25 investments by promoting diversification. For example, issuer-specific concentration limits control how much exposure an FCM or DCO has to the credit risk of any one investment. The Commission believes that greater diversification can be achieved through instituting two additional types of concentration limits. First, asset-based concentration limits, suggested by the FIA, MF Global and Newedge in their comment letters, reduce market risk by limiting how much of any one class of instrument an FCM or DCO can have in its portfolio at any one time. Second, repurchase agreement counterparty concentration limits serve to cap an FCM or DCO's exposure to the credit risk of a counterparty.
Below, the Commission details its proposal to remove government sponsored enterprise (GSE) securities that are not backed by the full faith and credit of the United States, corporate debt obligations not guaranteed by the United States, general obligations of a sovereign nation (foreign sovereign debt), and in-house transactions from the list of permitted investments. These proposed changes reflect the position of the Commission that the safety of a particular instrument or transaction must be viewed through the lens of its likely performance during a period of market volatility and financial instability.
The Commission proposes to amend paragraph (a)(1)(iii) to expressly add U.S. government corporation obligations
The failure of two GSEs during the financial crisis has moved the Commission to view the securities of such GSEs as inappropriate for investments of customer funds. In 2008, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) failed due to problems in the subprime mortgage market. While Fannie Mae and Freddie Mac were bailed out in 2008, the U.S. government had no obligation to do so and investors cannot rely on another bailout should a GSE fail in the future.
In consideration of the above, the Commission proposes to amend paragraph (a)(1)(iii) of Regulation 1.25 by permitting investments in only those U.S. agency obligations that are fully guaranteed as to principal and interest by the United States.
In order to simplify the regulation by eliminating rarely-used instruments, and in light of the credit, liquidity, and market risks posed by corporate debt securities, the Commission proposes to limit investments in “commercial paper”
Information obtained during the 2007 Review indicated that commercial paper and corporate notes or bonds were not widely used by FCMs or DCOs.
In the fall of 2008, the Federal Deposit Insurance Corporation (FDIC) created the TLGP, which guarantees principal and interest on certain types of corporate debt. Although the TLGP debt securities are backed by the full faith and credit of the U.S. Government and therefore pose minimal credit risk to the buyer for the period during which the guarantee is effective, initially there was concern as to whether the securities were readily marketable and sufficiently liquid so that the holders of such securities would be able to liquidate them quickly and easily without having to incur a substantial discount.
In February 2010, having evaluated the growing market for TLGP debt securities, the Division issued an interpretative letter concluding that TLGP debt securities are sufficiently liquid, and might therefore qualify as permitted investments under Regulation 1.25 if they meet the following criteria in addition to satisfying the pre-existing requirements imposed by Regulation 1.25: (1) The size of the issuance is greater than $1 billion; (2) the debt security is denominated in U.S. dollars; and (3) the debt security is guaranteed for its entire term.
Although the TLGP expires in 2012, the Commission believes it is useful to include commercial paper and corporate notes or bonds that are fully guaranteed as to principal and interest by the United States as permitted investments because this would permit continuing investment in TLGP debt securities, even though the Commission has proposed to otherwise eliminate commercial paper and corporate notes or bonds. Therefore, the Commission proposes to limit the commercial paper and corporate notes or bonds that can qualify as permitted investments to only those guaranteed as to principal and interest under the TLGP and that meet the criteria set forth in the Division's interpretation. As a result of this limitation, paragraph (b)(3)(iv), which relates to adjustable rate securities, is no longer necessary.
The Commission proposes to remove foreign sovereign debt as a permitted investment in the interests of both simplifying the regulation and safeguarding customer funds. The 2007 Review revealed negligible investment in foreign sovereign debt
Currently, an FCM or DCO can invest customer funds in foreign sovereign debt subject to two limitations: (1) The debt must be rated in the highest category by at least one nationally recognized statistical rating organization (NRSRO) and (2) the FCM or DCO may invest in such debt only to the extent it has balances in segregated accounts owed to its customers or its clearing member FCMs, respectively, denominated in that country's currency. The purpose of permitting investments in foreign sovereign debt is to facilitate investments of customer funds in the form of foreign currency without the need to convert that foreign currency to a U.S. dollar denominated asset, which would increase the FCM or DCO's exposure to currency risk. An investment in the sovereign debt of the same country that issues the foreign currency would limit the FCM or DCO's exposure to sovereign risk,
Both the lack of investment in foreign sovereign debt and the recent global financial volatility have caused the Commission to reevaluate this provision. First, as noted above, it appears that foreign sovereign debt is rarely used as an investment tool by FCMs. Second, the financial crisis has highlighted the fact that certain countries' debt can exceed an acceptable level of risk.
In consideration of the above, the Commission proposes to remove foreign sovereign debt as a permitted investment under Regulation 1.25 and renumber paragraph (a)(1) accordingly. The Commission requests comment on whether foreign sovereign debt should remain, to any extent, as a permitted investment and, if so, what requirements or limitations might be imposed in order to minimize sovereign risk.
The Commission proposes to eliminate in-house transactions permitted under paragraph (a)(3) and subject to the requirements of paragraph (e) of Regulation 1.25. This proposal is consistent with the Commission's proposed prohibition on an FCM or DCO entering into a repurchase or reverse repurchase agreement with a counterparty that is an affiliate of the FCM or DCO.
In 2005, two commenters recommended that the Commission permit FCMs that are dually registered as securities brokers or dealers to engage
Recent market events have, however, increased concerns about the concentration of credit risk within the FCM/broker-dealer corporate entity in connection with in-house transactions. Therefore, consistent with the Commission's proposal to prohibit FCMs from entering into repurchase and reverse repurchase agreements with affiliates, the Commission is proposing to eliminate in-house transactions as permitted investments for customer funds under paragraph (a)(3) of Regulation 1.25 and rescind paragraph (e), which sets forth the requirements for in-house transactions. Accordingly, paragraph (f) will be redesignated as new paragraph (e).
The Commission requests comment on the impact of this proposal on the business practices of FCMs and DCOs. Specifically, the Commission requests that commenters present scenarios in which a repurchase or reverse repurchase agreement with a third party could not be satisfactorily substituted for an in-house transaction.
The Commission requests comment on any other aspect of the proposed changes to paragraph (a) of Regulation 1.25. In particular, the Commission solicits comment on whether MMMFs should be eliminated as a permitted investment.
FCMs and DCOs may invest customer funds only in enumerated permitted investments “consistent with the objectives of preserving principal and maintaining liquidity * * *.”
Regulation 1.25(b)(1) states that “[e]xcept for interests in money market mutual funds, investments must be `readily marketable' as defined in § 240.15c3-1 of this title.”
The term “ready market” is borrowed from the Securities and Exchange Commission (SEC) capital rules and is interpreted by the SEC.
It is the Commission's view that the “readily marketable” language should be eliminated as it creates an overlapping and confusing standard when applied in the context of the express objective of “maintaining liquidity.” While “liquidity” and “ready market” appear to be interchangeable concepts, they have distinctly different origins and uses: The objective of “maintaining liquidity” is to ensure that investments can be promptly liquidated in order to meet a margin call, pay variation settlement, or return funds to the customer upon demand. As noted above, the SEC's “ready market” standard is intended for a different purpose and is easier to apply to exchange traded equity securities than debt securities.
Although Regulation 1.25 requires that investments be consistent with the objective of maintaining liquidity, the Commission has not articulated an explanation or a definition of the concept of “liquidity.” The Commission therefore proposes to define “highly liquid” functionally, as having the ability to be converted into cash within one business day, without a material discount in value. This approach focuses on outcome rather than process, and the Commission believes it will be easier to apply to debt securities than the current “readily marketable” standard.
An alternative to using a materiality standard in the definition of highly liquid is to employ a more formulaic and measurable approach. An example of a calculable standard would be one that provides that an instrument is
The Commission proposes to amend paragraph (b)(1) to eliminate the marketability standard and in its place establish a requirement that permitted investments be highly liquid. The Commission requests comment on whether the proposed definition of “highly liquid” accurately reflects the industry's understanding of that term, and whether the term “material” might be replaced with a more precise or, perhaps, even calculable standard. The Commission welcomes comment on the ease or difficulty in applying the proposed or alternative “highly liquid” standards.
The Commission proposes to remove all rating requirements from Regulation 1.25. This proposal is mandated by Section 939A of the Dodd-Frank Act. Further, the proposal reflects the Commission's views that ratings are not sufficiently reliable as currently administered, that there is reduced need for a measure of credit risk given the proposed elimination of certain permitted investments, and that FCMs and DCOs should bear greater responsibility for understanding and evaluating their investments.
The original purpose of imposing rating requirements was to mitigate credit risk associated with permitted investments which included commercial paper and corporate notes. Recent events in the financial markets, however, revealed significant weaknesses in the ratings industry.
Eliminating or restricting rating requirements has been considered by Congress and regulators with some frequency during the past two years. This has been motivated, at least in part, by public sentiment that credit rating agencies did not accurately rate debt in the months and years leading up to the financial crisis, worsening the financial crisis and increasing investors' losses. The SEC, in September 2009, adopted rule amendments that removed references to NRSROs from a variety of SEC rules and forms promulgated under the Securities Exchange Act of 1934 and from certain rules promulgated under the Investment Company Act of 1940 (Investment Company Act).
The Dodd-Frank Act contains several measures that focus both on decreasing reliance on NRSROs and improving the performance of NRSROs when they must be relied upon. Section 939 of the Dodd-Frank Act mandates the removal of certain references to NRSROs in several statutes,
The Commission, therefore, intends to remove credit rating requirements from Regulation 1.25.
While some might argue that imperfect information is better than none at all, several factors outweigh the possible risks associated with removing rating requirements. First, eliminating commercial paper and corporate notes or bonds as permitted investments would take away a large class of potentially risky investments for which ratings would be relevant. Second, the issuer concentration limits and proposed asset-based concentration limits should reduce the likelihood that one problem investment would destabilize an entire investment portfolio. Finally, removing rating requirements would not absolve FCMs and DCOs from investing in safe, highly liquid investments; rather it would shift to FCMs and DCOs more of the responsibility to diligently research their investments.
In light of the above analysis, the Commission proposes to eliminate paragraph (b)(2) of Regulation 1.25 and renumber the subsequent provisions of paragraph (b) accordingly.
Currently, both non-negotiable and negotiable CDs are permitted under Regulation 1.25. Paragraph (b)(3)(v) details the required redemption features of both types of CDs.
Non-negotiable CDs represent a direct obligation of the issuing bank to the purchaser. The CD is wholly owned by the purchaser until early redemption or the final maturity of the CD. To be permitted under Regulation 1.25, the terms of the CD must allow the purchaser to redeem the CD at the issuing bank within one business day, with any penalty for early withdrawal limited to any accrued interest earned. Therefore, other than in the event of a bank default, an investor is assured of the return of its principal.
Negotiable CDs are considerably different than non-negotiable CDs in that they are typically purchased by a broker on behalf of a large number of investors. The large size of the purchase by the broker results in a more favorable interest rate for the purchasers, who essentially own shares of the negotiable CD. Unlike a non-negotiable CD, the purchaser of a negotiable CD cannot redeem its interest from the issuing bank. Rather, an investor seeking redemption prior to a CD's maturity date must liquidate the CD in the secondary market. Depending on the negotiated CD terms (interest rate and duration) and the current economic conditions, the market for a given CD can be illiquid and can result in the inability to redeem within one business day and/or a significant loss of principal.
Therefore, the Commission proposes to amend paragraph (b)(3)(v) by restricting CDs to only those instruments which can be redeemed at the issuing bank within one business day, with any penalty for early withdrawal limited to accrued interest earned according to its written terms.
Paragraph (b)(4) of Regulation 1.25 currently sets forth issuer-based concentration limits for direct investments, securities subject to repurchase or reverse repurchase agreements, and in-house transactions. The Commission proposes to adopt asset-based concentration limits for direct investments and a counterparty concentration limit for reverse repurchase agreements in addition to amending its issuer-based concentration limits and rescinding concentration limits applied to in-house transactions.
(a) Asset-based concentration limits. Asset-based concentration limits would dictate the amount of funds an FCM or DCO could hold in any one class of investments, expressed as a percentage of total assets held in segregation. In their comment letters, the FIA, MF Global and Newedge specifically suggested the incorporation of asset-based concentration limits. The Commission agrees that such limits could increase the safety of customer funds by promoting diversification.
Specifically, the Commission proposes the following asset-based limits in light of its evaluation of credit, liquidity, and market risk:
• No concentration limit (100 percent) for U.S. government securities;
• A 50 percent concentration limit for U.S. agency obligations fully guaranteed as to principal and interest by the United States;
• A 25 percent concentration limit for TLGP guaranteed commercial paper and corporate notes or bonds;
• A 25 percent concentration limit for non-negotiable CDs;
• A 10 percent concentration limit for municipal securities; and
• A 10 percent concentration limit for interests in MMMFs.
Asset-based concentration limits are consistent with the Commission's historical view that not all permitted investments have identical risk profiles.
U.S. government securities are backed by the full faith and credit of the U.S. government, are highly liquid, and are the safest of the permitted investments. As such, the Commission proposes a 100 percent concentration limit, allowing an FCM or DCO to invest all of its segregated funds in U.S. government securities.
U.S. agency obligations, as proposed, must be fully guaranteed as to principal and interest by the United States. The Commission views these as sufficiently safe but potentially not as liquid as a Treasury security. Because of this concern, and in the interest of promoting diversification, the Commission proposes a 50 percent concentration limit.
The Commission categorizes TLGP debt securities as corporate securities,
CDs are safe for relatively small amounts, but the risk increases for larger sums. The rise in bank failures since 2008 is a cause for concern with regard to CDs because they are FDIC insured to a maximum of only $250,000. As a result, the Commission proposes to apply a 25 percent concentration limit to CDs.
In evaluating possible asset-based concentration limits for TLGP debt securities and CDs, the Commission determined that the same concentration limit should apply to both, even though the risk profiles of the asset classes are different. The Commission recognizes that TLGP debt securities pose no risk to principal, unlike bank CDs which are subject to the possible default of the issuing bank. However, a CD which must be redeemable within one business day under Regulation 1.25(b)(3)(v) could prove to be more liquid than TLGP debt securities during a time of market stress. The Commission requests comment on whether there should be differentiation between asset-based concentration limits for TLGP debt securities and CDs and, if so, what those different concentration limits should be.
Municipal securities are backed by the state or local government that issues them, and they have traditionally been viewed as a safe investment. However, municipal securities have been volatile and, in some cases, increasingly illiquid over the past two years. Therefore, the Commission proposes to apply a 10 percent concentration limit to municipal securities.
MMMFs have been widely used as an investment for customer segregated funds.
(b) Issuer-based concentration limits. The Commission has considered the current concentration limits and proposes to amend its issuer-based limits for direct investments to include a 2 percent limit for an MMMF family of funds, expressed as a percentage of total assets held in segregation. Currently, there is no concentration limit applied to MMMFs and the Commission believes that it is prudent to require FCMs and DCOs to diversify their MMMF portfolios. The 25 percent issuer-based limitation for GSEs (now U.S. agency obligations) and the 5 percent issuer-based limitation for municipal securities, commercial paper, corporate notes or bonds, and CDs will remain in place.
(c) Counterparty concentration limits. Finally, the Commission proposes a counterparty concentration limit of 5 percent of total assets held in segregation for securities subject to reverse repurchase agreements. Under Regulation 1.25(b)(4)(iii), concentration limits for reverse repurchase agreements are derived from the concentration limits that would have been assigned to the underlying securities had the FCM or DCO made a direct investment. Therefore, under current rules, an FCM or DCO could have 100 percent of its segregated funds subject to one reverse repurchase agreement. The obvious concern in such a scenario is the credit risk of the counterparty. This credit risk, while concentrated, is significantly mitigated by the fact that in exchange for cash, the FCM or DCO is holding Regulation 1.25-permissible securities of equivalent or greater value. However, a default by the counterparty would put pressure on the FCM or DCO to convert such securities into cash immediately and would exacerbate the market risk to the FCM or DCO, given that a decrease in the value of the security or an increase in interest rates could result in the FCM or DCO realizing a loss. Even though the market risk would be mitigated by asset-based and issuer-based concentration limits, a situation of this type could seriously jeopardize an FCM or DCO's overall ability to preserve principal and maintain liquidity with respect to customer funds.
In accordance with the above discussion, the Commission proposes to amend paragraph (b)(4) to add a new paragraph (i) setting forth asset-based concentration limits for direct investments; amend and renumber as new paragraph (ii) issuer-based concentration limits for direct investments; amend and renumber as new paragraph (iii) concentration limits for reverse repurchase agreements; delete the existing paragraph (iv) due to the Commission's proposed elimination of in-house transactions; renumber as a new paragraph (iv) the provision regarding treatment of customer-owned securities; and add a new paragraph (v) setting forth counterparty concentration limits for reverse repurchase agreements.
The Commission requests comment on any and all aspects of the proposed concentration limits, including whether asset-based concentration limits are an effective means for facilitating investment portfolio diversification and whether there are other methods that should be considered. In addition, the Commission requests comment on whether the proposed concentration levels are appropriate for the categories of investments to which they are assigned and whether there should be different standards for FCMs and DCOs.
The continued use of MMMFs was the sole focus of five comment letters,
While the Commission appreciates the benefits of MMMFs, it also is cognizant of their risks. Reserve Primary Fund, the September 2008 failure referenced by TSI, was an MMMF that satisfied the enumerated requirements of Regulation 1.25 and at one point was a $63 billion fund. The Reserve Primary Fund's breaking the buck called attention to the risk to principal and potential lack of sufficient liquidity of any MMMF investment. In the wake of the Reserve Primary Fund problem, the Commission has been forced to consider the possibility that any number of MMMFs that meet the technical requirements of Regulation 1.25(c) might not meet the Regulation 1.25 objective of preserving principal and maintaining liquidity, particularly during volatile market conditions.
In response to the potential risks posed by investments in MMMFs, the Commission is proposing to institute the concentration limits discussed above. However, the Commission has decided to refrain from further restricting investments in MMMFs at this time. The Commission is hopeful that the combination of its asset-based limitations, issuer-based limitations applied to a single family of funds, and the SEC's recent MMMF reforms will adequately address the risks associated with MMMFs.
The Commission requests comment on whether MMMF investments should be limited to Treasury MMMFs,