Commodity Futures Trading Commission.
The Commodity Futures Trading Commission (Commission) proposes to amend its regulations to allow futures commission merchants (FCMs) and derivatives clearing organizations (DCO) to engage in repurchase agreements with securities Start Printed Page 38655deposited by customers subject to certain conditions and to modify the portfolio time-to-maturity requirements for securities deposited in connection with certain collateral management programs of DCOs pursuant to certain conditions. The Commission also is requesting comment on several other provisions of the rule: Whether the portfolio time-to-maturity requirement should be modified for portfolios consisting exclusively of Treasury securities; whether the restriction on embedded derivatives should be modified; whether the list of permitted benchmarks for variable rate securities should be expanded; and whether the concentration limitations on reverse repurchase agreements should be changed. The Commission is proposing these rule amendments and requesting comment as part of its continuing efforts to facilitate the safe and efficient handling of customer funds, and in response to inquiries received as firms gain experience implementing the revisions adopted in December 2000.
Comments must be received on or before July 30, 2003.
Comments on the proposed amendments should be sent to Jean A. Webb, Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. Comments may be sent by facsimile transmission to (202) 418-5521, or by e-mail to email@example.com. Reference should be made to “Proposed Amendments to Regulation 1.25.”Start Further Info
FOR FURTHER INFORMATION CONTACT:
John C. Lawton, Deputy Director and Chief Counsel, or Lois Gregory, Special Counsel, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. Telephone (202) 418-5450.End Further Info End Preamble Start Supplemental Information
Commission Regulation 1.25 (17 CFR 1.25) sets forth the types of instruments in which FCMs and DCOs are permitted to invest customer segregated funds. Regulation 1.25 was substantially amended in December 2000 to expand the list of permitted investments. In connection with the expansion, the Commission added several provisions intended to minimize the credit, liquidity, and volatility risk associated with the additional investments. The Commission is proposing to modify some of those provisions. The Commission is also requesting comment on several other provisions of the rule.
II. Proposed Amendments
A. Repurchase Agreements Involving Collateral Deposited by Customers
CFTC Interpretative Letter 84-24 (“84-24”) permits FCMs to engage in repurchase agreements (“repos”) with collateral deposited by customers (“customer collateral”) subject to certain terms and conditions. When the Commission adopted the amendments to Regulation 1.25 in December 2000, it included provisions governing repos and reverse repos involving investments purchased with customer funds (“permitted investments”) subject to terms and conditions that differ in a number of ways from those in 84-24. The Commission did not address 84-24 at that time.
Various market participants have suggested that repos involving customer collateral should be permitted under the terms and conditions applicable to permitted investments. They believe that increased use of repos could enhance yield. They also note that certain types of collateral, while permissible as margin at the FCM level, are not acceptable at the clearinghouse level. Permitting repos of such collateral could ease cash flow problems that sometimes arise from this circumstance.
The Commission is proposing to amend Regulation 1.25(a)(2) to permit FCMs and DCOs to engage in repos of customer-deposited securities subject to certain terms and conditions. The proposal would eliminate the requirement currently set forth in 84-24 that the FCM provide written disclosure of the mechanics of the transaction and obtain written authorization from the customer. If the Commission adopted the proposal, 84-24 would be superseded.
Proposed paragraph (a)(2)(ii)(A) would provide that, to be eligible, securities must meet the marketability requirements of Regulation 1.25(b)(1). This is intended to ensure that, if a repo counterparty should default, the FCM or DCO could use the cash proceeds from the repo to buy the securities elsewhere.
Proposed paragraph (a)(2)(ii)(B) would provide that securities subject to repurchase agreements must not be “specifically identifiable property” as defined in section 190.01(kk) of the Commission's rules. Such property is generally not eligible for repo.
Proposed paragraph (a)(2)(ii)(C) would provide that the terms and conditions of such a repo must be in accordance with the requirements of Rule 1.25(d). The Commission believes that these safeguards, currently applicable to repos for permitted investments, are appropriate to apply to customer-deposited securities as well.
Proposed paragraph (a)(2)(ii)(D) would provide that, in the unlikely event of a default by a counterparty to a repurchase agreement, the FCM must take steps to ensure that the default does not result in any cost or expense to the customer. The Commission believes that this requirement is appropriate in light of the proposal to eliminate the disclosure and consent requirements of 84-24. Given this lack of express authorization, any risk of loss created by the transaction should be borne by the FCM. The Commission believes that although the standards set forth in paragraph (a)(2)(ii)(C) should minimize the risk of default, nonetheless, if there is such a default, the FCM must make the customer whole.
The Commission requests comment on all aspects of this proposal. In particular, the Commission requests comment on whether it is appropriate to permit repos of customer collateral without prior written consent, and, if so, whether the limitations set forth in the proposal are appropriate. In this regard, the Commission specifically requests comment on whether a one-way notice disclosure to the customer should be required and whether a mechanism should be provided under which a customer could instruct the FCM that repos of its collateral would not be permitted. The Commission also requests comment on how an FCM may fulfill its obligations to its customer in the event a repo counterparty fails to perform. Is it sufficient if the FCM gives the customer the cash equivalent of the securities plus any transaction costs that might be incurred in replacing the securities? Or, should the FCM replace the securities? Would cash compensation be insufficient, for example, if a customer needed the particular security to maintain the risk profile of its portfolio?
The Commission further requests comment on whether the terms and conditions applicable to DCOs engaging in repos should differ in any way from those applicable to FCMs. The Commission also requests comment on whether customer collateral that is subject to repo should be treated for concentration purposes like permitted investments under paragraph (b)(4)(ii) or continue to be treated under paragraph (b)(4)(v). Finally, the Start Printed Page 38656Commission requests comment on whether there are tax implications that should be considered in connection with this proposal.
B. Time-to-Maturity Requirements for Certain Collateral
Rule 1.25(b)(5) establishes a time-to-maturity requirement for the portfolio of permitted investments. Certain industry participants have requested limited relief from this provision. In particular, a DCO is developing a program whereby FCMs could deposit certain collateral on an overnight basis to meet certain special margin charges. Absent amendment of the rule, the deposit of such collateral could cause the FCM's portfolio to exceed the time-to-maturity limits of Rule 1.25(b)(5).
In order to encourage development of such innovative collateral management programs, and thereby facilitate the efficient use of capital, the Commission is proposing to amend Rule 1.25(b)(5). Under the proposal, certain instruments may be treated as if they had a time-to-maturity of one day if certain terms and conditions are satisfied. First, the instrument must be deposited with a DCO solely on an overnight basis. Second, the instrument must be one that the FCM owns or has the unqualified right to pledge, and free of any lien. Third, the instrument must be used for the purpose of meeting concentration margin or other similar charges that are in addition to the basic margin requirement established by the DCO. Fourth, the DCO must price the instrument each day based on a current mark-to-market value. Fifth, the DCO must haircut the instrument by at least 2 percent. The Commission understands that 2 percent is the standard haircut generally used in the repo market.
The time-to-maturity requirement in 1.25(b)(5) is intended to limit the market risk of permitted investments. The Commission believes that it is appropriate to provide some additional flexibility under the circumstances and with the safeguards described above. That is, when instruments are held at a DCO solely on an overnight basis, subject to a haircut, and for the purpose of satisfying a margin cushion over and above the basic performance bond requirement, a modified treatment is appropriate. This treatment could increase capital efficiency at the FCM level by permitting additional instruments to be used for margin while enhancing systemic security at the DCO level by increasing the amount of collateral held to support positions.
The Commission requests comment on the appropriateness of the proposed terms and conditions. In particular, the Commission requests comment on whether the haircut is appropriate and whether the relief should be limited to instruments deposited to meet concentration and similar margin requirements, as proposed or whether the modified treatment should be extended to apply to initial margin generally. If the latter, should alternative safeguards be developed? For example, would it be appropriate to apply the relief to the extent that an FCM holds excess funds in segregation?
C. Time to Maturity—Treasury Portfolio
As noted above, current Rule 1.25(b)(5) limits the dollar weighted average of the time-to-maturity for permitted investments to no longer than 24 months. In expanding the range of permissible investments in December 2000, the Commission added this requirement.
One FCM has informed a self-regulatory organization that the FCM invests exclusively in obligations of the U.S. Treasury. This FCM believes that because Treasury instruments do not pose the same risks that other permitted investments pose, the time-to-maturity limitation should not apply.
The Commission requests comment on whether an alternate safeguard to limit risk, such as appropriate haircuts, would be more appropriate than the time-to-maturity requirement of Rule 1.25(b)(5) with respect to a portfolio consisting exclusively of U.S. Treasury securities.
D. Embedded Derivatives
Rule 1.25(b)(3)(i) prohibits instruments with embedded derivatives. Some market participants have suggested that there are certain instruments containing embedded derivatives that have a lower level of risk than some of the other investments permitted under the rule. The Commission requests comment on whether Rule 1.25(b)(3)(i) should be amended to modify the prohibition on investments in securities that contain an embedded derivative. In this regard, commenters are asked to describe how the level of risk of such securities could be limited.
E. Variable Rate Securities—Permitted Benchmarks
Rule 1.25(b)(3)(iv) permits investment in variable rate securities provided that they correlate to certain specified benchmarks. Industry representatives have noted that the benchmarks used in the marketplace evolve over time. They have suggested the rule should provide that the interest rate on variable rate securities may be benchmarked to any fixed rate instrument that is a permitted investment under the rule. The Commission requests comment on whether the provision on permitted benchmarks should be amended, and if so, what the applicable standard should be.
F. Reverse Repos—Concentration Limits
Rule 1.25(b)(4)(iii) establishes concentration limits for reverse repos. Industry representatives have indicated that because of the need to engage in manual processing, this investment alternative has generally proved not to be viable. They have expressed a desire to work with Commission staff to develop a proposal that would continue to address the risks of reverse repos. The Commission requests comment on market participants' experience with the current provisions relating to reverse repos and suggestions on how best to address the risks of these transactions.
III. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (“RFA”), 5 U.S.C. 601 et seq. (1994 & Supp. II 1996), requires federal agencies, in proposing rules, to consider the impact of those rules on small businesses. The rule amendments discussed herein would affect FCMs. The Commission has previously established certain definitions of “small entities” to be used by the Commission in evaluating the impact of its rules on small entities in accordance with the RFA. The Commission has previously determined that registered FCMs are not small entities for the purpose of the RFA. The amendments proposed herein would not require any registrant to change its current method of doing business. The proposed amendments should reduce, rather than increase, the regulatory requirements that apply to registered FCMs. Accordingly, pursuant to 5 U.S.C. 605(b), the Chairman, on behalf of the Commission, certifies that Start Printed Page 38657these proposed amendments will not have a significant economic impact on a substantial number of small entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (“PRA”) imposes certain requirements on federal agencies (including the Commission) in connection with their conducting or sponsoring any collection of information as defined by the PRA. The proposed rule amendments do not require a new collection of information on the part of any entities subject to the proposed rule amendments. Accordingly, for purposes of the PRA, the Commission certifies that these proposed rule amendments, if promulgated in final form, would not impose any new reporting or recordkeeping requirements.Start List of Subjects
Lists of Subjects in 17 CFR Part 1End List of Subjects Start Part
PART 1—GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. The authority citation for Part 1 continues to read as follows:
2. Section 1.25 is proposed to be amended by revising paragraphs (a)(2) and (b)(5) to read as follows:
(a) * * *
(2)(i) In addition, a futures commission merchant or clearing organization may buy and sell the permitted investments listed in paragraphs (a)(1)(i) through (viii) of this section pursuant to agreements for resale or repurchase of the instruments, in accordance with the provisions of paragraph (d) of this section.
(ii) A futures commission merchant or a clearing organization may sell securities deposited by customers as margin pursuant to agreements to repurchase subject to the following:
(A) Securities subject to such repurchase agreements must meet the marketability requirement of paragraph (b)(1) of this section.
(B) Securities subject to such repurchase agreements must not be “specifically identifiable property” as defined in § 190.01(kk) of this chapter.
(C) The terms and conditions of such an agreement to repurchase must be in accordance with the provisions of paragraph (d) of this section.
(D) Upon the default by a counterparty to a repurchase agreement, the futures commission merchant or clearing organization must take steps to ensure that the default does not result in any cost or expense to the customer.
(b) * * *
(5) Time-to-maturity. (i) Except for investments in money market mutual funds, the dollar-weighted average of the time-to-maturity of the portfolio, as that average is computed pursuant to § 270.2a-7 of this title, may not exceed 24 months.
(ii) For purposes of determining the time-to-maturity of the portfolio, an instrument that is set forth in paragraphs (a)(1)(i) through (vii) of this section may be treated as having a one-day time-to-maturity if the following terms and conditions are satisfied:
(A) The instrument is deposited solely on an overnight basis with a derivatives clearing organization pursuant to the terms and conditions of a collateral management program;
(B) The instrument is one that the futures commission merchant owns or has an unqualified right to pledge, is not subject to any lien, and is deposited by the futures commission merchant into a segregated account at a registered derivatives clearing organization;
(C) The instrument is used only for the purpose of meeting concentration margin or other similar charges assessed by a derivatives clearing organization in addition to the basic margin requirement established by the derivatives clearing organization;
(D) The derivatives clearing organization prices the instrument each day based on the current mark-to-market value; and
(E) The derivatives clearing organization reduces the assigned value of the instrument each day by a haircut of at least 2 percent.
Issued in Washington, DC on June 25, 2003, by the Commission.
Jean A. Webb,
Secretary of the Commission.
2. CFTC Staff Letter No. 84-24, [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶22,449 (Dec. 5, 1984).Back to Citation
3. Regulation 1.25(a)(2) and 1.25(d).Back to Citation
4. Instruments that have been given to an FCM by a customer for deposit in a segregated account currently are not subject to the time-to-maturity provisions of Rule 1.25 and this would remain the case under this proposal. Instruments that have been purchased by an FCM with customer funds and are being held in a segregated account currently are subject to those provisions and this generally would remain the case under the proposal. The proposal would provide relief with regard to instruments that had been held by an FCM in its non-segregated inventory and that were deposited on an overnight basis into a segregated account at a DCO. So long as an FCM had an unqualified right to pledge the instruments, they could include instruments obtained through reverse repurchase transactions, or otherwise.Back to Citation
5. 47 FR 18618-18621 (April 30, 1982).Back to Citation
6. 47 FR 18619-18620.Back to Citation
[FR Doc. 03-16473 Filed 6-27-03; 8:45 am]
BILLING CODE 6351-01-U