Federal Register: November 3, 2010 (Volume 75, Number 212)

DOCID: fr03no10-21 FR Doc 2010-27657

COMMODITY FUTURES TRADING COMMISSION

Commodity Futures Trading Commission

CFR Citation: 17 CFR Parts 1 and 30

RIN ID: RIN 3038-AC15

NOTICE: PROPOSED RULES

DOCID: fr03no10-21

DOCUMENT ACTION: Proposed rule.

SUBJECT CATEGORY:

Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions

DATES: Comments must be received on or before December 3, 2010.

DOCUMENT SUMMARY:

The Commodity Futures Trading Commission (Commission or CFTC) is proposing to amend its regulations regarding the investment of customer segregated funds and funds held in an account subject to Commission Regulation 30.7 (30.7 funds). Certain amendments reflect the implementation of new statutory provisions enacted under Title IX of the DoddFrank Wall Street Reform and Consumer Protection Act. The proposed rules address: Certain changes to the list of permitted investments, a clarification of the liquidity requirement, the removal of rating requirements, an expansion of concentration limits including assetbased, issuerbased, and counterparty concentration restrictions. It also addresses revisions to the acknowledgment letter requirement for investment in a money market mutual fund (MMMF), revisions to the list of exceptions to the nextday redemption requirement for MMMFs, the application of customer segregated funds investment limitations to 30.7 funds, the removal of ratings requirements for depositories of 30.7 funds, and the elimination of the option to designate a depository for 30.7 funds.

SUMMARY:

Investment of Customer Funds and Funds Held in Account for Foreign Futures and Foreign Options Transactions

SUPPLEMENTAL INFORMATION

Table of Contents
I. Background

A. Regulation 1.25

B. Regulation 30.7

C. Advance Notice of Proposed Rulemaking

D. The DoddFrank Act
II. Discussion of the Proposed Rules

A. Permitted Investments

1. Government Sponsored Enterprise Securities

2. Commercial Paper and Corporate Notes or Bonds

3. Foreign Sovereign Debt

4. InHouse Transactions

B. General Terms and Conditions

1. Marketability

2. Ratings

3. Restrictions on Instrument Features

4. Concentration Limits
(a) AssetBased Concentration Limits
(b) IssuerBased Concentration Limits
(c) Counterparty Concentration Limits

C. Money Market Mutual Funds

1. Acknowledgment Letters

2. NextDay Redemption Requirement

D. Repurchase and Reverse Repurchase Agreements

E. Regulation 30.7

1. Harmonization

2. Ratings

3. Designation as a Depository for 30.7 Funds
III. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

C. Costs and Benefits of the Proposed Rules
Text of Rules
I. Background

A. Regulation 1.25

Under Section 4d(a)(2) of the Commodity Exchange Act (Act),\2\ the investment of customer segregated funds is limited to obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities), and general obligations of any State or of any political subdivision thereof (municipal securities). Pursuant to authority under Section 4(c) of the Act,\3\ the Commission substantially expanded the list of permitted investments by amending Commission Regulation 1.25 \4\ in December 2000 to permit investments in general obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities or GSE securities), bank certificates of deposit (CDs), commercial paper, corporate notes,\5\ general obligations of a sovereign nation, and interests in MMMFs.\6\ In connection
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with that expansion, the Commission included several provisions intended to control exposure to credit, liquidity, and market risks associated with the additional investments, e.g., requirements that the investments satisfy specified rating standards and concentration limits, and be readily marketable and subject to prompt liquidation.\7\ \2\ 7 U.S.C. 6d(a)(2).
\3\ 7 U.S.C. 6(c).
\4\ 17 CFR 1.25.
\5\ This category of permitted investment was later amended to read ``corporate notes or bonds.'' See 70 FR 28190, 28197 (May 17, 2005).
\6\ See 65 FR 77993 (Dec. 13, 2000) (publishing final rules); and 65 FR 82270 (Dec. 28, 2000) (making technical corrections and accelerating effective date of final rules from February 12, 2001 to December 28, 2000).

\7\ Id.

The Commission further modified Regulation 1.25 in 2004 and 2005. In February 2004, the Commission adopted amendments regarding repurchase agreements using customerdeposited securities and timeto maturity requirements for securities deposited in connection with certain collateral management programs of derivatives clearing organizations (DCOs).\8\ In May 2005, the Commission adopted amendments related to standards for investing in instruments with embedded derivatives, requirements for adjustable rate securities, concentration limits on reverse repurchase agreements, transactions by futures commission merchants (FCMs) that are also registered as securities brokers or dealers (inhouse transactions), rating standards and registration requirements for MMMFs, an auditability standard for investment records, and certain technical changes.\9\
\8\ 69 FR 6140 (Feb. 10, 2004).

\9\ 70 FR 28190.

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.'' \10\

\10\ 17 CFR 1.25(b).

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 followup 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. B. Regulation 30.7

Regulation 30.7 \11\ governs an FCM's treatment of customer money, securities, and property associated with positions in foreign futures and foreign options. Regulation 30.7 was issued pursuant to the Commission's plenary authority under Section 4(b) of the Act.\12\ Because Congress did not expressly apply the limitations of Section 4d of the Act to 30.7 funds, the Commission historically has not subjected those funds to the investment limitations applicable to customer segregated funds.
\11\ 17 CFR 30.7.

\12\ 7 U.S.C. 6(b).

The investment guidelines for 30.7 funds are general in nature.\13\ Although Regulation 1.25 investments offer a safe harbor, the Commission does not currently limit investments of 30.7 funds to permitted investments under Regulation 1.25. Appropriate depositories for 30.7 funds currently include certain financial institutions in the United States, financial institutions in a foreign jurisdiction meeting certain capital and credit rating requirements, and any institution not otherwise meeting the foregoing criteria, but which is designated as a depository upon the request of a customer and the approval of the Commission.
\13\ See Commission Form 1FRFCM Instructions at 129 (Mar. 2010) (``In investing funds required to be maintained in separate section 30.7 account(s), FCMs are bound by their fiduciary obligations to customers and the requirement that the secured amount required to be set aside be at all times liquid and sufficient to cover all obligations to such customers. Regulation 1.25 investments would be appropriate, as would investments in any other readily marketable securities.'').

C. Advance Notice of Proposed Rulemaking

In May 2009, the Commission issued an advance notice of proposed rulemaking (ANPR) \14\ to solicit public comment prior to proposing amendments to Regulations 1.25 and 30.7. The Commission stated that it was considering significantly revising the scope and character of permitted investments for customer segregated funds and 30.7 funds. In this regard, the Commission sought comments, information, research, and data regarding regulatory requirements that might better safeguard customer segregated funds. It also sought comments, information, research, and data regarding the impact of applying the requirements of Regulation 1.25 to investments of 30.7 funds.

\14\ 74 FR 23962 (May 22, 2009).

The Commission received twelve comment letters in response to the ANPR, and it has considered those comments in formulating its proposal.\15\ Eleven of the 12 letters supported maintaining the current list of permitted investments and/or specifically ensuring that MMMFs remain a permitted investment. Five of the letters were dedicated solely to the topic of MMMFs, providing detailed discussions of their usefulness to FCMs. Several letters addressed issues regarding ratings, liquidity, concentration, and portfolio weighted average time to maturity. The alignment of Regulation 30.7 with Regulation 1.25 was viewed as noncontroversial.
\15\ The Commission received comment letters from CME Group Inc. (CME), Crane Data LLC (Crane), The Dreyfus Corporation (Dreyfus), FCStone Group Inc. (FCStone), Federated Investors, Inc. (Federated), Futures Industry Association (FIA), Investment Company Institute (ICI), MF Global Inc. (MF Global), National Futures Association (NFA), Newedge USA, LLC (Newedge), and Treasury Strategies, Inc. (TSI). Two letters were received from Federated: A July 10, 2009 letter (Federated letter I) and an August 24, 2009 letter.

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.''

D. The DoddFrank Act

On July 21, 2010, President Obama signed the DoddFrank Wall Street Reform and Consumer Protection Act (DoddFrank Act).\16\ Title IX of the
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DoddFrank Act \17\ was promulgated in order to increase investor protection, promote transparency and improve disclosure.
\16\ See DoddFrank Wall Street Reform and Consumer Protection Act, Public Law 111203, 124 Stat. 1376 (2010). The text of the DoddFrank Act may be accessed at http://www.cftc.gov./ LawRegulation/OTCDERIVATIVES/index.htm.
\17\ Pursuant to Section 901 of the DoddFrank Act, Title IX may be cited as the ``Investor Protection and Securities Reform Act of 2010.''

Section 939A of the DoddFrank Act obligates federal agencies to review their respective regulations and make appropriate amendments in order to decrease reliance on credit ratings. The DoddFrank Act requires the Commission to conduct this review within one year after the date of enactment.\18\ The Commission is proposing amendments to Regulations 1.25 and 30.7 that include removal of provisions setting forth credit rating requirements. Separate rulemakings proposed today address the elimination of credit ratings from Regulations 1.49 and 4.24 and the removal of Appendix A to Part 40 (which contains a reference to credit ratings).

\18\ See Section 939A(a) of the DoddFrank Act.

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.
II. Discussion of the Proposed Rules

A. Permitted Investments

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, issuerspecific 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, assetbased 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 inhouse 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.

1. Government Sponsored Enterprise Securities

The Commission proposes to amend paragraph (a)(1)(iii) to expressly add U.S. government corporation obligations \19\ to GSE securities (together, U.S. agency obligations) and to add the requirement that the U.S. agency obligations must be fully guaranteed as to principal and interest by the United States. GSEs are chartered by Congress but are privately owned and operated. Securities issued by GSEs do not have an explicit federal guarantee although they are considered by some to have an ``implicit'' guarantee due to their federal affiliation.\20\ Obligations of U.S. government corporations, such as the Government National Mortgage Association (known as Ginnie Mae), are explicitly backed by the full faith and credit of the United States. Although the Commission is not aware of any GSE securities that have an explicit federal guarantee, it believes that GSE securities should remain on the list of permitted investments in the event this status changes in the future.
\19\ See 31 U.S.C. 9101 (defining ``government corporation''). \20\ Frank J. Fabozzi with Steven V. Mann, The Handbook of Fixed Income Securities, 242245 (McGraw Hill 7th ed. 2005).

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.\21\ The Commission requests comment on whether GSE securities should remain as permitted investments under Regulation 1.25, either subject to a Federal guarantee requirement or not.
\21\ Although U.S. Government corporation obligations backed by the full faith and credit of the United States could also be categorized as U.S. Government securities under Regulation 1.25(a)(1)(i), the Commission is distinguishing them from other government securities, such as Treasury securities, because they cannot be expected to have the same liquidity even if they satisfy the ``highly liquid'' requirement under proposed. Regulation 1.25(b)(1). See also discussion of concentration limits in Section II.B.4. of this notice.

2. Commercial Paper and Corporate Notes or Bonds

In order to simplify the regulation by eliminating rarelyused 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'' \22\ and ``corporate notes or bonds'' \23\ to commercial paper and corporate notes or bonds that are federally guaranteed as to principal and interest under the Temporary Liquidity Guarantee Program (TLGP) and meet certain other prudential standards.\24\
\22\ Regulation 1.25(a)(1)(v).
\23\ Regulation 1.25(a)(1)(vi).
\24\ Commercial paper would remain available as a direct investment for MMMFs and corporate notes or bonds would remain available as indirect investments for MMMFs by means of a repurchase agreement. Additionally, it should be noted that two commenters suggested expanding the list of permitted investments to include commercial paper and corporate notes or bonds guaranteed by foreign sovereign governments. However, as the Commission has determined that foreign sovereign debt is itself unsuitable as a permitted investment, going forward (explained in more detail below), it follows that corporate debt guaranteed by a foreign sovereign government would also not be permissible.

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Information obtained during the 2007 Review indicated that commercial paper and corporate notes or bonds were not widely used by FCMs or DCOs.\25\ Consistent with this, the NFA states in its comment letter that most firms invest about 33 percent of their customer funds in government securities, 10 percent in MMMFs, and the balance maintained in bank accounts or on deposit with a carrying broker. \25\ The 2007 Review indicated that out of 87 FCM respondents, only nine held commercial paper and seven held corporate notes/bonds as direct investments during the November 30, 2006December 1, 2007 period. Further, 26 FCM respondents engaged in reverse repurchase agreements as of December 1, 2007 and none received commercial paper or corporate notes or bonds in those transactions.

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 preexisting 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.\26\
\26\ Letter from Ananda Radhakrishnan, Director, Division of Clearing and Intermediary Oversight, CFTC, to Debra Kokal, Chairman of the Joint Audit Committee (Jan. 15, 2010) (TLGP Letter).

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.\27\ The Commission proposes to delete current paragraph (b)(3)(iv) and replace it with language codifying the criteria for federally backed commercial paper and corporate notes or bonds. Accordingly, the Commission proposes to delete paragraph (b)(3)(i)(B) and amend paragraph (b)(3)(iii) to remove references to paragraph (b)(3)(iv). The Commission requests comment on the proscription of commercial paper and corporate notes or bonds that are not federally guaranteed under the TLGP, the liquidity of TLGP debt, and whether the removal of the requirements for adjustable rate securities will have any unintended or detrimental effects on Regulation 1.25 investments.
\27\ The original purpose of this paragraph was to set parameters for adjustable rate securities issued by corporations and, to a lesser extent, GSEs. As proposed, Regulation 1.25 would only permit corporate and GSE securities that had explicit U.S. Government guarantees. Therefore, the mechanics of an adjustable rate component for these instruments would no longer require oversight for Regulation 1.25 purposes.

3. Foreign Sovereign Debt

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 \28\ and that fact, in combination with recent events undermining confidence in the solvency of a number of foreign countries, supports the Commission's proposed action. Removal of foreign sovereign debt from the list of permitted investments is not expected to significantly impact FCM and DCO investment strategies for customer funds. The Commission notes that, aside from general appeals to maintain the current list of permitted investments, only one commenter specifically addressed foreign sovereign debt.\29\
\28\ The 2007 Review indicated that out of 87 FCM respondents, only three held an investment in foreign sovereign debt at any time during that year. It should also be noted that only one FCM invested in such debt under Regulation 30.7.
\29\ FIA, in its comment letter, recommended expanding investment in foreign sovereign debt beyond the current rule, which limits an FCM's investment in foreign sovereign debt to the amount of its liabilities to its clients in that foreign country's currency (FIA letter at 5). As the Commission is prepared to remove foreign sovereign debt entirely, a more detailed analysis of this

recommendation is unnecessary.

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, i.e., the risk of the sovereign's default.

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.

4. InHouse Transactions

The Commission proposes to eliminate inhouse 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.\30\
\30\ See discussion infra at Section II.D, regarding proposed Regulation 1.25(d)(3).

In 2005, two commenters recommended that the Commission permit FCMs that are dually registered as securities brokers or dealers to engage [[Page 67646]]
in inhouse transactions.\31\ At the time, the Commission concluded that inhouse transactions would allow FCMs to realize ``greater capital efficiency'' and further reasoned that ``the substitution of one permitted investment for another in an inhouse transaction [would] not present an unacceptable level of risk to the customer segregated account.'' \32\ The Commission therefore amended Regulation 1.25 to allow an FCM/brokerdealer to enter into transactions that are the economic equivalent of a repurchase or reverse repurchase agreement, subject to certain requirements.\33\ More specifically, an FCM may exchange customer money for permitted investments held in its capacity as a brokerdealer, it may exchange customer securities for permitted investments held in its capacity as a brokerdealer, and it may exchange customer securities for cash held in its capacity as a broker dealer.\34\
\31\ See 70 FR at 28193 (FIA and Lehman Brothers supporting in house transactions).
\32\ 70 FR 5577, 5581 (Feb. 3, 2005).
\33\ See Regulation 1.25(a)(3) and (e).

\34\ Regulation 1.25(a)(3)(i)(iii).

Recent market events have, however, increased concerns about the concentration of credit risk within the FCM/brokerdealer corporate entity in connection with inhouse 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 inhouse 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 inhouse 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 inhouse 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.\35\ In discussing whether MMMF investments satisfy the overall objective of preserving principal and maintaining liquidity, the Commission specifically requests comment on whether changes in the settlement mechanisms for the triparty repo market might impact a MMMF's ability to meet the requirements of Regulation 1.25.\36\
\35\ MMMFs are discussed in greater detail infra, in Sections II.B.4 and II.C of this notice.
\36\ An industry task force recently concluded an extensive review of the triparty repo market to identify ways in which it could be improved. See Payments Risk Committee, Task Force on Tri Party Repo Infrastructure, http://www.newyorkfed.org/tripartyrepo/ task_force_report.html (May 17, 2010). In contrast to current practice, under which funds from maturing repos are available early in the day, modifications to the settlement arrangements for tri party repo transactions may result in payments occurring later in the day. To the extent that MMMFs invest in triparty repos, this change could impact their ability to pay out large amounts of cash early in the day.

B. General Terms and Conditions

FCMs and DCOs may invest customer funds only in enumerated permitted investments ``consistent with the objectives of preserving principal and maintaining liquidity * * *.'' \37\ In furtherance of this general standard, paragraph (b) of Regulation 1.25 establishes various specific requirements designed to minimize credit, market, and liquidity risk. Among them are a requirement that the investment be ``readily marketable,'' that it meet specified rating requirements, and that it not exceed specified issuer concentration limits. The Commission is proposing to amend these standards to facilitate the preservation of principal and maintenance of liquidity by establishing clear, prudential standards that further investment quality and portfolio diversification. The Commission notes that an investment that meets the technical requirements of Regulation 1.25 but does not meet the overarching prudential standard cannot qualify as a permitted investment.
\37\ Regulation 1.25(b).

1. Marketability

Regulation 1.25(b)(1) states that ``[e]xcept for interests in money market mutual funds, investments must be `readily marketable' as defined in Sec. 240.15c31 of this title.'' \38\ The Commission proposes to remove the ``readily marketable'' requirement from paragraph (b)(1) and substitute in its place a ``highly liquid'' standard.\39\ The Commission did not receive any comment letters specifically discussing the meaning and application of the ``readily marketable'' requirement.\40\
\38\ See 17 CFR 240.15c31(c)(11)(i) (SEC regulation defining ``ready market'').
\39\ Related to this proposed new standard, the provision in paragraph (a)(2)(ii)(A) that requires securities subject to repurchase agreements to be `` `readily marketable' as defined in Sec. 240.15c1 of this title'' also would be amended to provide that securities subject to repurchase agreements must be `` `highly liquid' as defined in paragraph (b)(2) of this section.''
\40\ FIA, MF Global and Newedge mentioned marketability in their letters but no significant changes were recommended.

The term ``ready market'' is borrowed from the Securities and Exchange Commission (SEC) capital rules and is interpreted by the SEC.\41\ That standard is used in setting appropriate haircuts for the purpose of calculating capital. Although its inclusion in Regulation 1.25 was intended to be a proxy for the concept of liquidity, it is not a concept that is otherwise easily applied as a prudential standard in determining the appropriateness of a debt instrument for investment of customer funds.
\41\ The term ``ready market'' is defined, in relevant part, to ``include a recognized established securities market in which there exists independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined for a particular security almost instantaneously and where payment will be received in settlement of a sale at such price within a relatively short time conforming to trade custom.'' 17 CFR 240.15c3

1(c)(11)(i).

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
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highly liquid if there is a reasonable basis to conclude that, under stable financial conditions, the instrument has the ability to be converted into cash within one business day, without greater than a 1 percent haircut off of its book value.

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.

2. Ratings

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.\42\
\42\ The Commission received three letters regarding rating requirements, but none focused on the question of whether or not to retain ratings.

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).\43\ In November 2009, the SEC adopted rules imposing enhanced disclosure and conflict of interest requirements for NRSROs.\44\ The SEC also has opened comment periods on other proposed amendments, including one that would remove references to NRSROs from its net capital rule.\45\ \43\ See 74 FR 52358 (Oct. 9, 2009) (publishing final rules and proposing additional rule amendments).
\44\ See 74 FR 63832 (Dec. 4, 2009) (publishing final rules and proposing additional rule amendments).
\45\ 74 FR at 5237778 (proposing removal of certain references to NRSROs in the SEC's net capital rules for brokerdealers).

The DoddFrank 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 DoddFrank Act mandates the removal of certain references to NRSROs in several statutes,\46\ and Section 939A requires all Federal agencies to review references to NRSROs in their regulations, to remove reliance on credit ratings and, if appropriate, to replace such reliance with other standards of creditworthiness.
\46\ Sections 7(b)(1)(E)(i), 28(d) and 28(e) of the Federal Deposit Insurance Act (12 U.S.C. 1811 et seq.), Section 1319 of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C. 4519), Section 6(a)(5)(A)(iv)(I) of the Investment Company Act of 1940 (15 U.S.C. 80a6(a)(5)(A)(iv)(I)), Section 5136A of title LXII of the Revised Statutes of the United States (12 U.S.C. 24a), and Section 3(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78a(3)(a)).

The Commission, therefore, intends to remove credit rating requirements from Regulation 1.25.\47\ Alternative standards of credit worthiness are not being proposed. Evidence that rating agencies have not reliably gauged the safety of debt instruments in the past and the fact that other Regulation 1.25 proposed amendments published in this notice obviate much of the need for credit ratings, have helped to shape the Commission's decision.
\47\ See infra Section II.E.2 regarding the corresponding change in Regulation 30.7.

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.

3. Restrictions on Instrument Features

Currently, both nonnegotiable and negotiable CDs are permitted under Regulation 1.25. Paragraph (b)(3)(v) details the required redemption features of both types of CDs.

Nonnegotiable 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 nonnegotiable 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 nonnegotiable 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.\48\
\48\ While it proposes to eliminate negotiable CDs as an interest bearing vehicle for purposes of Regulation 1.25, the Commission notes that Section 627 of the DoddFrank Act removes the prohibition on payments of interest on demand deposits. Demand deposits which meet Regulation 1.25 standards of liquidity may, therefore, be a source of interest income to DCOs and FCMs. [[Page 67648]]

4. Concentration Limits

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 inhouse transactions. The Commission proposes to adopt assetbased
concentration limits for direct investments and a counterparty concentration limit for reverse repurchase agreements in addition to amending its issuerbased concentration limits and rescinding concentration limits applied to inhouse transactions.\49\
\49\ The Commission is aware that other diversification methods exist or could be devised (such as the diversification requirements for MMMF investments in CME's IEF2 collateral management program) and believes that such methods can coexist with the proposed concentration limits.
(a) Assetbased concentration limits. Assetbased 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 assetbased concentration limits. The Commission agrees that such limits could increase the safety of customer funds by promoting diversification.

Specifically, the Commission proposes the following assetbased 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 nonnegotiable CDs;
  • A 10 percent concentration limit for municipal securities; and
  • A 10 percent concentration limit for interests in MMMFs.

    Assetbased concentration limits are consistent with the Commission's historical view that not all permitted investments have identical risk profiles.\50\ In its efforts to increase the safety of permitted investments on a portfolio basis, the Commission has decided to assign to each permitted investment an assetbased concentration limit that correlates to its level of risk and liquidity relative to other permitted investments.\51\
    \50\ See 70 FR at 5581 (discussing the relative risk profiles of permitted investments in the context of repurchase agreements). \51\ The Commission notes that paragraphs (b)(4)(ii)(iii) of Regulation 1.25 would apply to both assetbased and issuerbased concentration limits. Therefore, for the purpose of calculating assetbased concentration limits, instruments purchased by an FCM or DCO as a result of a reverse repurchase agreement under paragraph (b)(4)(iii) would be combined with instruments held by the FCM or DCO as direct investments.

    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.\52\
    \52\ FIA, MF Global and Newedge each assigned a 100 percent concentration limit to U.S. government securities. See FIA letter at 3, MF Global letter at 2, and Newedge letter at 5.

    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.\53\
    \53\ FIA, MF Global and Newedge each assigned a 75 percent concentration limit to GSE securities. See FIA letter at 3, MF Global letter at 2, and Newedge letter at 5.

    The Commission categorizes TLGP debt securities as corporate securities,\54\ which are riskier than U.S. government securities. While TLGP debt securities have an explicit FDIC guarantee, which provides confidence for TLGP debt investors that they will receive the full amount of principal and interest in the event of an issuer default, the timing of such a payment is uncertain. Additionally, while TLGP debt securities that meet the Commission's requirements have a liquid secondary market, that might not always be the case. The Commission therefore proposes to apply a 25 percent concentration limit for TLGP debt securities as well.

    \54\ See TLGP Letter.

    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 assetbased 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 assetbased 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.\55\
    \55\ FIA, MF Global and Newedge each assigned a 25 percent concentration limit to all assets that were not U.S. government securities, GSE securities or MMMFs. See FIA letter at 3, MF Global letter at 2, and Newedge letter at 5.

    MMMFs have been widely used as an investment for customer segregated funds.\56\ As discussed in the next section, their portfolio diversification, administrative ease, and heightened prudential standards recently imposed by the SEC, continue to make MMMFs an attractive investment option. However, their volatility during the 2008 financial crisis, which culminated in one fund ``breaking the buck'' and many more funds requiring infusions of capital, underscores the fact that investments in MMMFs are not without risk.\57\ To mitigate these risks, the Commission proposes to assign a 10 percent concentration limit for MMMFs.\58\ The Commission believes that this concentration limit is commensurate with the risks posed by MMMFs. The Commission solicits comment regarding whether 10 percent is an appropriate assetbased concentration limit for MMMFs. The Commission welcomes opinions on what alternative assetbased concentration limit might be appropriate for MMMFs and, if such
    [[Page 67649]]
    assetbased concentration limit is higher than 10 percent, what corresponding issuerbased concentration limit should be adopted. \56\ The 2007 Review indicated that out of 87 FCM respondents, 46 had invested customer funds in MMMFs at some point during the November 30, 2006December 1, 2007 period.
    \57\ See 75 FR 10060, 10078 n.234 (Mar. 4, 2010).
    \58\ FIA recommended a 100 percent concentration limit, Newedge recommended a 50 percent concentration limit, and MF Global recommended a 25 percent concentration limit for MMMFs. See FIA letter at 3, Newedge letter at 5, and MF Global letter at 2. (b) Issuerbased concentration limits. The Commission has considered the current concentration limits and proposes to amend its issuerbased 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 issuerbased 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 1.25permissible 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 assetbased and issuerbased 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) issuerbased 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 inhouse transactions; renumber as a new paragraph (iv) the provision regarding treatment of customerowned 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 assetbased 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.

    C. Money Market Mutual Funds

    The continued use of MMMFs was the sole focus of five comment letters,\59\ a substantial focus of one,\60\ and referenced positively by an additional four.\61\ Taken together, the letters conveyed a consensus that MMMFs are both safe and administratively efficient. In their respective comment letters, Federated noted that MMMFs are subject to the overlapping regulatory regimes overseen by the SEC, and ICI highlighted the quality, liquidity and diversity of an MMMF's holdings. Further, TSI noted that out of 700800 MMMFs, only one failed during the September 2008 financial turmoil, a crisis which Dreyfus likened to a ``1,000 year flood.''
    \59\ See Crane letter, Dreyfus letter, Federated letter I, ICI letter, and TSI letter.
    \60\ See CME letter at 56.
    \61\ See FCStone letter at 2, MF Global letter at 2, Newedge letter at 5, and NFA letter at 1.

    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.\62\ Lending credence to such concerns, the SEC has estimated that, in order to avoid breaking the buck, nearly 20 percent of all MMMFs received financial support from their money managers or affiliates from mid2007 through the end of 2008.\63\
    \62\ See 75 FR at 10078 n.234 (SEC final rulemaking adopting amendments to regulations governing MMMFs, describing the September 2008 run on MMMFs: ``On September 17, 2008, approximately 25% of prime institutional money market funds experienced outflows greater than 5% of total assets; on September 18, 2008, approximately 30% of prime institutional money market funds experienced outflows greater than 5%; and on September 19, 2008, approximately 22% of prime institutional money market funds experienced outflows greater than 5%'').

    \63\ See 74 FR 32688, 32693 (July 8, 2009).

    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 assetbased 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.\64\
    \64\ See 75 FR 10060 (SEC final rulemaking decreasing the percentage of second tier securities (which are securities that do not receive the highest rating from an NRSRO or, if unrated, securities that are comparable in quality to securities that do not receive the highest rating from an NRSRO) from 5 percent to 3 percent, reducing the dollarweighted average portfolio maturity from 90 days to 60 days, introducing a dollarweighted average life to maturity of 120 days, and imposing new daily and weekly liquidity requirements, among others).

    The Commission requests comment on whether MMMF investments should be limited to Treasury MMMFs,\65\ or to those MMMFs that have portfolios consisting only of permitted investments under Regulation 1.25.
    \65\ A ``Treasuries fund'' must have at least 80 percent of its assets invested in U.S. treasuries at all times, as required by 17 CFR 270.35d1.

    The Commission is proposing two technical amendments to paragraph (c) of Regulation 1.25. First, the Commission is proposing to clarify the acknowledgment letter requirement under paragraph (c)(3); and second, the Commission is proposing to revise and clarify the exceptions to the nextday redemption requirement under paragraph (c)(5)(ii).

    1. Acknowledgment Letters

    The Commission is proposing to amend Regulation 1.25(c)(3) to clarify
    [[Page 67650]]
    the appropriate party to provide an acknowledgment letter where customer funds are invested in MMMFs. Regulation 1.26 requires an FCM or DCO which invests customer funds in instruments permitted under Regulation 1.25 to create a segregated account at a depository for such instruments and to obtain an acknowledgment letter from the depository. Because interests in MMMFs generally are not held at a depository in the first instance, like other permitted investments, Regulation 1.25(c)(3) currently provides an exception to the Regulation 1.26 requirement that an acknowledgment letter be provided by a depository. Regulation 1.25(c)(3) requires the ``sponsor of the fund and the fund itself'' to provide an acknowledgment letter when the MMMF shares are held by a fund's shareholder servicing agent.

    The Commission has received a number of inquiries regarding the meaning of this provision and the definition of ``sponsor,'' a term that is not defined in the Investment Company Act. While the term is not defined, it is nonetheless used throughout the Investment Company Act and is generally understood to refer to the entity that organizes the fund. Such an entity typically provides seed capital to the investment company and may be an affiliated investment adviser or underwriter to the investment company.

    The Commission seeks to clarify that the intent of Regulation 1.25(c)(3) is to require an acknowledgment letter from a party that has substantial control over the fund's assets and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds invested in shares of an MMMF. The Commission has concluded that in many circumstances, the fund sponsor, the investment adviser, or fund manager would satisfy this requirement. To the extent there are circumstances where an entity such as the Administrator would be in this position, proposed Regulation 1.25(c)(3) encompasses such an entity. The Commission requests comment on whether the proposed standard is appropriate and whether there are other entities that could serve as examples.

    The Commission is also proposing to remove the current language in Regulation 1.25(c)(3) relating to the issuer of the acknowledgment letter when the shares of the fund are held by the fund's shareholder servicing agent. This revision is designed to eliminate any confusion as to whether the acknowledgment letter requirement is applied differently based on the presence or absence of a shareholder servicing agent. The Commission requests comment on whether removal of this language helps clarify the intent of Regulation 1.25(c)(3).

    The Commission is accordingly proposing to amend Regulation 1.25(c)(3) to set forth a functional definition accompanied by specific examples. The proposed amendment would require an FCM or DCO to obtain the acknowledgment letter required by Regulation 1.26 \66\ from an entity that has substantial control over the fund's assets and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds. The proposed language would specify that such an entity may include the fund sponsor or investment adviser.\67\
    \66\ In a related proposed rulemaking, the Commission has proposed to add a new paragraph (c) to Regulation 1.26 which would specifically govern acknowledgment letters for MMMFs. The Commission also has proposed a mandatory form of acknowledgment letter in proposed Appendix A to Regulation 1.26. See 75 FR 47738 (Aug. 9, 2010).
    \67\ A fund sponsor or investment adviser would be identified as appropriate entities to provide an acknowledgment letter, because they would typically be expected to satisfy the proposed standard. However, in any circumstance where the fund sponsor or investment adviser does not meet that standard, the acknowledgment letter would have to be obtained from another entity that can meet the regulatory requirement.

    2. NextDay Redemption Requirement

    Regulation 1.25(c) requires that ``[a] fund shall be legally obligated to redeem an interest and to make payment in satisfaction thereof by the business day following a redemption request.'' \68\ This ``nextday redemption'' requirement is a significant feature of Regulation 1.25 and is meant to ensure adequate liquidity.\69\ Regulation 1.25(c)(5)(ii) lists four exceptions to the nextday redemption requirement, and incorporates by reference the emergency conditions listed in Section 22(e) of the Investment Company Act (Section 22(e)).\70\ The Commission has received questions from FCMs regarding Regulation 1.25(c)(5), particularly because the exceptions listed in paragraph (c)(5)(ii) overlap with some of those appearing in Section 22(e).
    \68\ Regulation 1.25(c)(5)(i).
    \69\ See 70 FR 5585 (noting that ``[t]he Commission believes the oneday liquidity requirement for investments in MMMFs is necessary to ensure that the funding requirements of FCMs will not be impeded by a long liquidity time frame.'').

    \70\ 15 U.S.C. 80a22(e).

    Recently, as part of its MMMF reform initiative, the SEC adopted a rule that provides the basis for another exception to the nextday redemption requirement.\71\ Promulgated under Section 22(e), Rule 22e3 \72\ permits MMMFs to suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund.\73\ Before Rule 22e3 may be invoked, the fund's board, including a majority of its disinterested directors, must determine that the extent of the deviation between the fund's amortized cost per share and its current net asset value per share may result in material dilution or other unfair results,\74\ and the board, including a majority of its disinterested directors, must irrevocably approve the liquidation of the fund.\75\ In addition, prior to suspending redemption, the fund must notify the SEC of its decision.\76\ \71\ See Letter from Ananda Radhakrishnan, Director, Division of Clearing and Intermediary Oversight, CFTC, to Debra Kokal, Chairman of the Joint Audit Committee (June 3, 2010) (stating that Rule 22e3 falls within the exceptions to the nextday redemption requirement under Regulation 1.25).
    \72\ 17 CFR 270.22e3.
    \73\ See 75 FR at 10088.
    \74\ 17 CFR 270.22e3(a)(1).
    \75\ 17 CFR 270.22e3(a)(2).

    \76\ 17 CFT 270.22e3(a)(3).

    In order to expressly incorporate Rule 22e3 into the permitted exceptions for purposes of clarity, and to otherwise clarify the existing exceptions to the nextday redemption requirement, the Commission has decided to amend paragraph (c)(5)(ii) of Regulation 1.25 by more closely aligning the language of that paragraph with the language in Section 22(e) and specifically including Rule 22e3. Section 22(e) will, however, continue to be incorporated by reference so as to provide for any future amendment or regulatory actions by the SEC.

    The Commission will include, as Appendix A to the rule text, safe harbor language that can be used by MMMFs to ensure that their prospectuses comply with Regulation 1.25(c)(5). The proposed language tracks the proposed paragraph (c)(5).

    The Commission requests comment on all aspects of its proposed amendments to paragraph (c). The Commission seeks comment specifically on any proposed regulatory language that

    FOR FURTHER INFORMATION CONTACT

    Phyllis P. Dietz, Associate Director, 2024185449, pdietz@cftc.gov, or Jon DeBord, AttorneyAdvisor, 202 4185478, jdebord@cftc.gov, or Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1151 21st Street, NW., Washington, DC 20581.