By Margaret Scullin
The Commodity Futures Trading Commission (CFTC) approved its final set of customer protection reforms on October 30, 2013. These rules address customer funds held by futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) and apply to domestic and foreign futures customers, as well as cleared swaps customers. Other rules were approved addressing protection of uncleared swaps collateral.
Several of the reforms were developed in response to the bankruptcies of FCM’s MF Global and Peregrine Financial in 2011 and 2012, respectively. A few of the reforms had already been introduced by the National Futures Association, a self-regulatory organization that was Peregrine’s primary regulator and is overseen by the CFTC. For example, the CFTC adopted what had been dubbed the “Corzine rule” (after MF Global CEO Jon Corzine) restricting withdrawals of funds from customer segregated accounts. The rule requires written approval of senior management and notification to the regulator prior to withdrawal of more than 25% of the FCM’s proprietary funds (referred to as “residual interest”) from customer segregated accounts. The new rules also require daily segregated account reports to regulators, including identification of depositories of customer funds. Reports and notices will be required to be delivered electronically and the CFTC will be granted direct online access (in read-only format) to FCMs’ depository accounts. These changes, while reflecting technological advancements, are intended to prevent the falsification and interception of paper statements that Peregrine’s CEO employed for years to avoid detection of his misappropriation of customer funds. The rules also introduce enhanced auditing of FCMs and require new mandatory disclosures to FCM customers.
Residual Interest Controversy
The rules that generated the most comments and opposition were those related to FCMs’ residual interest in customer segregated accounts. Existing section 4d of the Commodity Exchange Act prohibits the use of one customer’s funds to margin, secure or guarantee the positions of any other person. Rules intended to implement this prohibition were met with numerous practical objections. The CFTC has emphasized that this prohibition applies at all times. This reminder was apparently needed because, at MF Global, customer segregated funds were often used intra-day to meet the firm’s liquidity needs and then returned (or intended to be returned) before the end-of-day segregation calculation was performed. In order to avoid the use of one customer’s collateral for another customer’s positions, the FCM is required to use its own property to cover any margin deficit, to the extent it has not collected from its under-margined customer(s). The CFTC had proposed a rule that would require an FCM to maintain a residual interest in the customer segregated account at least equal to any margin deficiency in the account “at all times”. Commenters objected that it would be practically impossible to meet a continuous calculation requirement and that calculation of the residual interest requirement should be made at a point in time. Commenters also noted that the section 4d prohibition is a prohibition on “use” of customer collateral and that use would not occur until settlement. The CFTC amended the language in the final rule to provide for calculation of the residual interest requirement by reference to the DCO’s daily settlement time.
Several commenters raised concerns about the timing for meeting the residual interest requirement. At what point in time must an FCM cover any shortfall in the customer segregated account? It was noted that, the sooner the FCM is required to do so, the more likely that FCM would require pre-funding of margin from its customers. Pre-funding of margin not only adds burdens to customers but also increases their exposure to their FCMs. If the FCM chooses instead to fund any shortfall from its own resources, that will likely translate into higher fees for customers. The CFTC responded to these concerns by delaying implementation of and phasing in the residual interest deadline for FCMs. Beginning one year after the rule is published in the Federal Register, the deadline will be 6pm Eastern time on the date of settlement. The phase-in period will expire on December 31, 2018, at which time the deadline will become the time of settlement, unless the phase-in period is earlier terminated or the phase-in schedule is amended. During the phase-in period, the CFTC must conduct and publish a report on the feasibility, costs and benefits of shortening the deadline to the time of settlement. Termination of the phase-in period cannot be ordered until nine months after the study has been published and at least one year’s notice must be given of termination.
The residual interest deadline described above will apply only to domestic futures accounts. The CFTC noted that the rules applicable to cleared swaps accounts (17 CFR Part 22, implementing Legal Segregation with Operational Commingling or LSOC) and related CFTC staff interpretations already require the FCM to cover any margin deficiency in a customer segregated account by the time of settlement. Interestingly, the CFTC primarily cites a regulatory update from the Joint Audit Committee (a representative committee of U.S. futures exchanges and regulatory organizations) in support of this statement. While the CFTC’s Staff Interpretation Regarding Part 22 is clear that an FCM must use its own property to cover any shortfall where its cleared swaps customer is under-margined, it does not discuss the timing of that obligation.
The rules also impose a capital charge on FCMs that are under-margined with respect to futures accounts. A capital charge for FCMs that are under-margined with respect to cleared swaps accounts is expected to be included in the swap dealer capital requirements, which have yet to be finalized.
Protection of Uncleared Swaps Collateral
The new rules regarding protection of uncleared swaps collateral supplement the existing requirement that swap dealers and major swap participants notify their uncleared swaps counterparties of their right to have their collateral segregated with a third party custodian. This requirement applies only to initial margin, although the parties may agree to also segregate variation margin.
The rules define the terms “segregate”, “initial margin” and “variation margin”. They also provide details as to the required frequency of notices of the right to segregation and to whom they must be delivered. Reports must also be delivered on a quarterly basis to counterparties that do not elect segregation, confirming that their collateral is being held in accordance with the terms of the parties’ agreement.
Swap dealers and major swap participants are not prohibited from using an affiliated custodian, but they must offer their customers the option of using a credit-worthy unaffiliated custodian as an alternative.
Segregated initial margin will be subject to the same restrictions on permitted investments as cleared swaps collateral (Regulation 1.25 will apply), despite several commenters’ objections to this proposal. While the CFTC acknowledged that these restrictions may lower investment returns, they noted that lower risk is associated with lower returns and that this rule protects counterparties’ collateral. The rule contains specific requirements for the written custody agreement. These relate to provisions regarding conditions for withdrawal of collateral, including a requirement that certain notices to the custodian be made under penalty of perjury. The CFTC did not address commenters’ concerns about these provisions. ISDA recently published a form of Account Control Agreement for the segregation of initial margin, which would need to be amended to comply with these requirements.
Commissioner O’Malia asked whether uncleared swaps counterparties have been availing of the collateral segregation being offered. The CFTC staff did not have that information available but may seek it, resources permitting. O’Malia indicated a concern that counterparties may be declining segregation, leaving their collateral unprotected. It seems that restricting investments to those specified by CFTC regulation, rather than allowing the parties to negotiate permitted investments, might discourage these custodial arrangements.
The CFTC staff expressed confidence, when asked by CFTC Chairman Gensler, that these new rules would likely prevent a repeat of the abuses that led to the MF Global and Peregrine bankruptcies. The CFTC Chairman quickly pointed out that FCMs will continue to fail for various reasons and that the purpose of the rules is to protect customer funds when they do. The lingering question that remains for the industry is whether the anticipated benefits will be outweighed by the associated costs.