[Federal Register: February 2, 2005 (Volume 70, Number 21)]
[Notices]
[Page 5417-5419]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr02fe05-31]
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COMMODITY FUTURES TRADING COMMISSION
AGENCY: Commodity Futures Trading Commission.
ACTION: Proposed withdrawal of staff interpretation.
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SUMMARY: Section 4d(a)(2) of the Commodity Exchange Act (``CEA'') and
related Commission regulations (hereinafter collectively referred to as
``segregation requirements'') require that, among other things, all
funds deposited with a futures commission merchant (``FCM'') to
purchase, margin, guarantee, or secure futures or commodity options
transactions and all accruals thereon (``customer funds'' or ``customer
margin'') be accounted for separately, be held for the benefit of
customers and deposited under an account name that clearly identifies
them as such, and not be commingled with the FCM's own funds,\1\
Further, the Division of Clearing and Intermediary Oversight
(``Division'') has construed these provisions to prohibit any
impediments or restrictions upon an FCM's ability to obtain immediate
access to customer funds.
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\1\ 7 U.S.C. 6d(a)(2). The Commission segregation requirements
are set forth in Regulations 1.20-1.30, 132 and 1.36 [17 CFR 1.20-
1.30, 1.32 and 1.36].
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In 1984, the Division of Trading and Markets (``T&M,'' predecessor
to the Division) issued an interpretation, Financial and Segregation
Interpretation No. 10 (``Interpretation No. 10''), to address whether,
and the circumstances under which, the use of bank custodial accounts
(otherwise known as ``safekeeping accounts'' or ``third-party custodial
accounts'') to maintain customer funds would be consistent with the
segregation requirements of the CEA.\2\ At the time, investment
companies registered under the Investment Company Act of 1940 (the
``Investment Company Act'') (``RICs'') were generally barred from using
any FCM or futures clearinghouse as a custodian of fund assets and,
thus, third-party custodial accounts were the only permissible means
available to RICs to use the risk management tools available through
the futures markets.\3\ With Interpretation No. 10, T&M took the
position that customer funds held in third-party custodial accounts
could be deemed properly segregated for purposes of Section 4d(a)(2),
provided that certain terms and conditions designed to ensure FCMs'
immediate and unimpeded access to the funds were met.
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\2\ See Financial and Segregation Interpretation No. 10,
Treatment of Funds Deposited in Safekeeping Accounts, Comm. Fut. L.
Rep. (CCH) ] 7120 (May 23, 1984).
\3\ Until immediately prior to the issuance of Interpretation
No. 10, the Department of Labor (``DOL'') viewed customer margin as
client assets for purposes of the custody requirements and certain
other fiduciary provisions of the Employee Retirement Income
Security Act of 1974 (``ERISA'') [29 U.S.C. 1001-1461], requiring
separate safekeeping of such assets. Since then, and currently, DOL
subscribes to the view that such assets are not client assets for
purposes of ERISA.
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Today, RICs are, for the most part, no longer prohibited from
depositing customer margin directly with FCMs and thus may engage in
futures trading generally in the same manner as other futures
customers. This, coupled with the fact that third-party custodial
accounts may present not insignificant regulatory concerns, as well as
costs and burdens for market participants, leads the Division to
believe that Interpretation No. 10 is no longer necessary or justified,
except in certain limited circumstances. In this notice, the Division
is inviting comments concerning Interpretation No. 10 and specifically,
whether Interpretation No. 10 should be withdrawn.
DATES: Comments must be received on or before April 4, 2005.
ADDRESSES: Comments should be sent to Jean A. Webb, Secretary,
Commodity Futures Trading Commission, Three Lafayette Center, 1155 21st
Street, NW., Washington, DC 20581. Comments may be sent by facsimile
transmission to (202) 418-5521, by e-mail to secretary@cftc.gov, or
electronically by accessing http://www.regulations.gov. Reference
should be made to ``Proposed Withdrawal of Interpretation No. 10.''
FOR FURTHER INFORMATION CONTACT: Carlene S. Kim, Senior Special
Counsel, Division of Clearing and Intermediary Oversight, Commodity
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,
NW., Washington, DC 20581. Telephone: (202) 418-5613.
SUPPLEMENTAL INFORMATION:
I. Interpretation No. 10
Section 4d(a)(2) of the CEA and related Commission regulations
require that, among other things, all funds deposited with an FCM to
purchase, margin, guarantee, or secure futures or commodity options
transactions and all accruals thereon, be accounted for separately by
the FCM and deposited under an account name that clearly identifies
them as such, not be commingled with the FCM's own funds, and be held
for the benefit of customers.\4\ The segregation requirements are
intended to prevent an FCM from using customer property to margin the
trades of other customers or of the FCM itself. Further, the Division
has interpreted the segregation requirements to preclude any
impediments or restrictions on the FCM's ability to obtain the
immediate access to customer funds.\5\ The immediate and unfettered
access requirement avoids potential delay or interruption in securing
required margin payments that, in times of significant market
disruption or otherwise, could magnify the impact of such market
[[Page 5418]]
disruption and impair the liquidity of other FCMs and clearinghouses.
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\4\ U.S.C. 6(d)(a)2).
\5\ See also, note 16, Interpretation No. 10, citing
Administrative Determination No. 29 of the Commodity Exchange
Authority, the Commission's predecessor agency, dated September 28,
1937, which stated in pertinent part that ``the deposit, by a
futures commission merchant, of customer funds * * * under
conditions whereby such funds would not be subject to withdrawal
upon demand would be repugnant to the spirit and purpose of the
Commodity Exchange Act. All funds deposited in a bank should in all
cases be subject to withdrawal on demand.''
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At the time that T&M issued Interpretation No. 10, institutional
participation in the futures market was on the rise. Certain of these
institutional participants--including pension plans and RICs--sought to
use bank custodial accounts to hold margin under circumstances that
raised questions about whether the accounts would be deemed properly
segregated for purposes of Section 4d(a)(2) of the CEA. For example,
RICs were prohibited from using FCMs and futures clearinghouses as
custodians of their assets.\6\ They were, however, permitted (but not
required) to maintain a bank custodial account under the name of an FCM
to hold initial margin under an arrangement whereby the FCM would be
permitted to dispose of the funds in the account upon default by the
investment company in making a required margin payment.\7\
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\6\ See Section 17(f) of the Investment Company Act, 15 U.S.C.
80a-17(f). At that time (but no longer), under Section 17(f) and
related rules RICs were generally permitted to maintain their assets
only in the custody of a bank, a member of a national securities
exchange, or a national securities depository. FCMs and futures
clearinghouses did not fall within one of these categories. In this
regard, the SEC did not adopt the position taken by DOL, which did
not view customer margin as client assets for purposes of the
custody requirements and certain other fiduciary provisions of the
ERISA.
\7\ This relief was available pursuant to SEC staff no-action
letters and exemptive orders. Other conditions to the relief
required that prior to directing any disposition of funds, the FCM
represent that all conditions precedent to its right to direct
disposition have been satisfied. In addition, the RIC, when it had
the right to receive variation payment from an FCM, was required to
promptly demand such payment. See, e.g., Prudential-Bache
IncomeVertible Plus Fund, Inc., SEC No-Action Letter (Nov. 20,
1985), available at 1985 SEC No-Act. LEXIS 2782.
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In view of the fact that RICs were barred from depositing customer
funds directly with an FCM or a futures clearinghouse, and that third-
party custodial arrangements represented their sole means of utilizing
the risk management tools offered by the futures markets, T&M issued
Interpretation No. 10 to allow third-party custodial accounts to be
deemed properly segregated within the meaning of Section 4d(a)(2) of
the CEA, under conditions designed to ensure that FCMs have immediate
and unfettered access to customer funds in the third-party custodial
accounts.\8\ Specifically, an FCM could consider funds maintained in a
third-party bank custodial account to be properly segregated if: (i)
The account were maintained in the name of the FCM carrying the
account, for the benefit of the customer; (ii) the FCM could liquidate
open positions if the account became undermargined or went into
deficit, without obtaining permission from a third party custodian of
the account; (iii) the FCM could withdraw funds from the account upon
demand with no right of the customer (or its fiduciary) to stop,
interrupt or otherwise interfere with such withdrawal and the customer
(and its fiduciary) could not withdraw or otherwise have access to the
funds in the account except through the FCM; (iv) the account would not
be located in a bank which was an affiliate or fiduciary of the
customer; and (v) any release of funds to the customer from the account
would be preceded by a notice to and consent of the carrying FCM.
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\8\ While specifically directed to the third-party accounts of
pension plans and RICs, the views expressed in the interpretation
applied equally to any other customer of an FCM (e.g., an insurance
company). See Interpretation No. 10, Comm. Fut. L. Rep. (CCH) ]
7120, note 1.
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II. Developments Concerning Interpretation No. 10
Today RICs may directly deposit customer margin with FCMs and
futures clearing houses and thus participate in futures trading
generally in the same manner as other futures customers. In 1996 the
SEC adopted rule 17f-6, which permits, but does not require a RIC to
maintain its assets with an FCM in connection with futures transactions
effected on U.S. and foreign exchanges, provided that the FCM is not an
affiliate of the RIC.\9\ As a result, Interpretation No. 10 is no
longer necessary in most cases for RICs to participate in the futures
market.
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\9\ Investment Company Act Rule 17f-6(b)(3) [17 CFR 270.17f-
6(b)(3)]. Specifically, a RIC may not place fund assets with an FCM
that is an affiliate of the fund or its adviser. Other conditions in
the rule provide that the manner in which an FCM maintains fund
assets must be governed by a written contract and any gains on fund
transactions must be maintained with the carrying FCM only in de
minimis amounts.
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This, considered together with the potentially significant
supervisory risks associated with the use of third-party accounts in
connection with futures trading, make it necessary and appropriate to
consider the withdrawal of Interpretation No. 10. Specifically, third-
party custodial accounts continue to raise concerns about potential
systemic liquidity risks which could result from any potential
diversion of FCM capital to cover undermargined customer accounts,
which would otherwise be available for use in the marketplace. These
risks may be heightened in times of market volatility when liquidity is
most critical. In addition, initial margin requirements typically rise
during such periods, creating additional stress on FCM resources.
In addition, the holding of customer margin in any such account has
and continues to present both some uncertainty as to the treatment of
funds in the event of an FCM insolvency,\10\ and some potential for
funds to be inadvertently released from the account without the prior
knowledge or consent of the FCM.\11\ For these reasons, the Division
solicits comments on whether Interpretation No. 10 should be withdrawn,
except in the following limited circumstance. Specifically, an FCM
would be permitted to rely on Interpretation No. 10 to the extent that
it is not eligible to hold RIC assets under SEC rule 17f-6.\12\ The
Division believes that retaining the application of Interpretation No.
10 in this limited circumstance would be appropriate because to do
otherwise would require a RIC that clears through an FCM that is its
affiliate (or an affiliate of its adviser) to alter existing clearing
arrangements with potentially undue disruption and cost.
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\10\ The Division's position is that third-party custodial
accounts are subject to the U.S. Bankruptcy Code and applicable
provision in the CEA, which provide that customer assets relating to
futures transactions generally have priority over other creditors'
claims, and are subject to distribution based on each customer's pro
data share of the available customer property. 11 U.S.C. 766;
Commission rule 190.18 [17 CFR 190.08]. However, this issue has not
been judicially determined.
\11\ See also Staff Advisory entitled ``Responsibilities of
Futures Commission Merchants and Relevant Depositories with Respect
to Third Party Custodial Accounts'' (July 25, 1996) (``Advisory)'',
available at http://www.cftc.gov/opa/press96/opa37-96.htm. The
Advisory addressed certain third-party custodial practices and
arrangements that appeared to be, or could be implemented in a
manner that is, inconsistent with the terms and conditions of
Interpretation No. 10.
\12\ As discussed above, under Rule 17f-6, a RIC may not deposit
fund assets with any FCM that is an affiliate of the fund or its
adviser.
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The Division notes that the withdrawal of Interpretation No. 10
would not forbid the use of such accounts but, rather, would mean that
funds in such accounts would not be deemed properly segregated under
Section 4d(a)(2) and therefore could not be included in an FCM's
required daily computation of total customer amount of customer funds
on deposit in segregated accounts.
III. Request for Comments.
The Division is requesting comments on whether withdrawal of
Interpretation No. 10 would have any adverse impact on institutional
customers, such as pension plans or RICs, or their ability to
participate in the futures market and
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whether there are any legal or prudential considerations that support
the use by institutional customers of third-party custodial accounts in
effecting futures transactions. In addition, the Division is seeking
comments on the costs and expenses incurred by FCMs, including
financing and potential opportunity costs, in connection with
maintaining third-party accounts relative to regular customer accounts.
Finally, the Division would expect that any withdrawal of
Interpretation No. 10 would be made effective not less than six months
following the publication of a final notice. The Division seeks comment
on whether the six-month time period is appropriate and sufficient for
FCMs and banks to make the necessary adjustments with respect to third-
party custodial arrangements.
Dated: January 27, 2005.
By the Division of Clearing and Intermediary Oversight.
James L. Carley,
Director, Division of Clearing and Intermediary Oversight.
[FR Doc. 05-1907 Filed 2-1-05; 8:45 am]
BILLING CODE 6351-01-M