At its open meeting on December 5, 2011, the Commodity Futures Trading Commission (the "Commission" or "CFTC") took action on several significant items, including (1) adopting significant amendments to Rule 1.25, which governs the investing of commodity customer segregated funds and to Rule 30.7 as well, which governs the investing of funds held in a foreign futures or options customer account and (2) proposing rules for public comment which would establish a process for a swap execution facility ("SEF") or a designated contract market ("DCM") to make a swap available to trade under Section 2(h)(8) of the Commodity Exchange Act (the "CEA") pursuant to Section 723 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (the "Dodd-Frank Act").

Amendments to Rules 1.25 and 30.7

The Commission amended Rule 1.25, which restricts the ability of a futures commission merchant ("FCM") or a derivatives clearing organization ("DCO") to invest commodity customer segregated funds, in a number of significant respects. Among other things, these amendments narrow the scope of investment choices, including eliminating certain in-house and affiliate transactions, removing corporate debt obligations not guaranteed by the United States and foreign sovereign debt from the list of permitted investments, clarify the liquidity requirement, remove the rating requirements pursuant to the Dodd-Frank Act, and expand concentration limits, including asset-based, issuer-based and counterparty concentration limitations. The Commission, however, did maintain U.S. agency obligations and investments in money market mutual funds (each, a "MMMF") as permitted investments, subject to certain terms and conditions. For example, obligations issued by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac) are permitted investments only as long as these entities are operating under the conservatorship of the Federal Housing Finance Agency. Other permitted investments under Rule 1.25 as amended include U.S. Treasury securities, municipal securities, commercial paper guaranteed by The Temporary Liquidity Guarantee Program ("TLGP"), corporate notes guaranteed by the TGLP, and certificates of deposit. The Commission also extended the customer segregated funds investment requirements in Rule 1.25 to Rule 30.7 funds.1 The Commission is providing an implementation period of 180 days following the publication of these rules and all persons must be in compliance by June 18, 2012.2

In particular, the Commission will no longer permit dually registered broker-dealer/FCMs to engage in certain in-house transactions with customer segregated funds. These transactions involve an exchange of cash or permitted investments for customer funds and provide the economic equivalent of repurchase and reverse repurchase transactions with third parties. The Commission did clarify that this prohibition on in-house transactions would not affect an in-house sale of a permitted investment at fair market prices in which an instrument owned by a dually registered broker-dealer/FCM is purchased with customer segregated funds for the customer segregated funds account. The Commission also clarified that the prohibition on in-house transactions would not prevent a dually registered broker-dealer/FCM who receives customer collateral not acceptable at a DCO or foreign board of trade from exchanging that collateral for acceptable collateral held by its dually registered broker-dealer "to the extent necessary to meet margin requirements."3

As noted, the Commission is preserving the ability to invest customer segregated funds in a MMMF, subject to a number of concentration limits which are designed to promote the objectives of preserving principal and maintaining liquidity of customer funds. For MMMFs other than Treasury-only MMMFs, the Commission is imposing a 50 percent asset-based concentration limit, subject to a limitation on investment in small MMMFs. (An FCM or DCO may invest all of its customer segregated funds in Treasury-only MMMFs, subject to the limitation on investment in small MMMFs.) In this regard, an FCM or DCO may only invest up to 10 percent of its customer segregated funds in a small MMMF. A "small MMMF" is a fund that does not have both at least $1 billion in assets and a management company that has at least $25 billion in MMMF funds under management. In addition, while there is no family-of-funds or issuer-based concentration limit for Treasury-only MMMFs, there will be a 25 percent family-of-funds issuer-based limitation and a 10 percent individual fund issuer-based limitation for all other MMMFs.4

The Commission is also imposing a counterparty concentration limit of 25 percent of total assets held in segregation for securities subject to reverse repurchase agreements. The Commission believes this limit is necessary for safeguarding customer funds even though, in the event of a counterparty's default, the amounts owed under any reverse repurchase agreements would be collateralized with Rule 1.25 permitted securities of equivalent or greater value.

Just as the Commission is no longer permitting in-house transactions, the Commission is eliminating repurchase and reverse repurchase transactions with affiliate counterparties. The Commission based this determination on its concerns relating to concentration of credit risk and the potential for conflicts of interest to arise during times of financial crisis.

While Rule 1.25 will no longer permit investments of commodity customer segregated funds in foreign sovereign debt, the Commission will consider requests by FCMs or DCOs for an exemption pursuant to Section 4(c) of the CEA. The Commission noted that it may be amenable to granting such an exemption in certain circumstances.

The Commission also clarified the liquidity requirement in Rule 1.25 by removing the "readily marketable" standard and replacing it with "highly liquid", which is defined as having the ability to be converted into cash within one business day, without a material discount in value. While an FCM may use pricing data that reasonably provides evidence of liquidity, the Commission is taking the position that theoretical pricing data is not enough by itself to establish that a security is highly liquid. The Commission also clarified that the "highly liquid" standard is for Rule 1.25 only and will not be substituted for "ready market" elsewhere in Commission regulations at this time.

Process for a DCM or SEF to Make a Swap Available to Trade

Under Section 2(h)(7) of the CEA, a swap transaction which is subject to mandatory clearing must be executed on a DCM or a SEF, unless no DCM or SEF "makes the swap available to trade" pursuant to Section 2(h)(8)(B) of the CEA.5 The Commission is proposing to establish a process for determining when a swap is available to trade that includes some involvement by the CFTC in this determination pursuant to Rules 37.10 and 38.12. 76 Fed. Reg. 77728 (Dec. 14, 2011).6 Comments are due on February 13, 2012.

Under the proposed rules, a SEF or DCM would initially determine that a swap is available to trade and submit the determination to the Commission either for approval or self-certification, pursuant to proposed Rule 37.10 or Rule 38.12, respectively, and the existing filing procedures in Part 40 of the CFTC's rules. In either case these determinations would be treated as a "rule" and the SEF or DCM would have to provide an explanation and analysis of the proposed rules and its compliance with applicable provisions of the CEA, including considering the liquidity-related factors identified in proposed Rules 37.10(b) or 38.12(b) which are set forth below. In the case of a request for approval, the Commission would have a 45 day review period, which could be extended for an additional 45 days in certain circumstances. If the SEF or DCM self-certifies the determination, the Commission would have 10 business days to review the rule before it is deemed certified and can be made effective, unless the Commission issues a stay of the certification for an additional 90 days from the date of notice to the SEF or DCM. If the Commission issues a stay of certification, there will be a 30 day public comment period for the proposed rule. During a stay of the certification, the Commission may notify the SEF or DCM that it objects to the proposed certification on the grounds that the proposed rule is inconsistent with the CEA or the Commission's regulations.

Under this proposal, if the Commission approves a SEF's or DCM's determination filing or permits a certified available to trade determination filing to become effective, then the swap involved would be deemed available to trade and if it is also subject to the clearing requirement, the swap generally would have to be executed on or subject to the rules of a SEF or DCM. In that connection, the Commission has proposed to phase in compliance with the trade execution requirement, so that the swap would be subject to mandatory trading on a SEF or DCM upon the later of the following: (1) the applicable deadline for compliance with the clearing requirement or (2) 30 days after the swap is first available to trade on either a SEF or DCM.7

The Commission is proposing in Rules 37.10(b) and 38.12(b) that a SEF or DCM consider the following liquidity-related factors in determining to make a swap available to trade: (i) whether there are ready and willing buyers and sellers; (ii) the frequency or size of transactions on SEFs or DCMs, or of bilateral transactions; (iii) the trading volume on SEFs or DCMs, or of bilateral transactions; (iv) the number and types of market participants; (v) the bid/ask spread; (vi) the usual number of resting firm or indicative bids and offers; (vii) whether a SEF's trading system or platform or a DCM's trading facility will support trading in the swap; and (viii) any other factor that the SEF or DCM may consider relevant. No single factor would be dispositive, as the SEF or DCM may consider any one factor or several factors to make a swap available to trade. However, the mere listing or trading of a swap on a SEF or DCM would not mean that the swap is available to trade. The Commission is also proposing to require a SEF or DCM to conduct an annual review and assessment of each swap it has made available to trade utilizing the same factors and provide a report to the Commission of its review and assessment, including any supporting information or data.

Upon a determination that a swap is available to trade, all other SEFs and DCMs listing or offering for trading such a swap and/or any "economically equivalent" swap, would be obligated to make those swaps available to trade pursuant to the Commission's proposal. However, this determination would not require other SEFs or DCMs to list or offer such swaps or an economically equivalent swap for trading. For this purpose, an "economically equivalent swap" would mean a swap that the SEF or DCM determines to be economically equivalent with another swap "after consideration of each swap's material pricing terms."

The Commission is requesting comment on the following questions:

  • Should the Commission allow a SEF or DCM to submit its available to trade determination with respect to a group, category, type, or class of swaps? How should the Commission define group, category, type, or class of swaps?
  • Is the Commission's proposed approach regarding the determination that a swap is available to trade appropriate? If not, what approach is appropriate and why? Should a SEF or DCM consider total open interest and notional outstanding for similar tenors?
  • In evaluating the factors in the proposal, should the Commission allow a SEF or DCM to consider the same swap or an economically equivalent swap on another SEF or DCM? What are the advantages and disadvantages of such an approach? Should a SEF or DCM consider the amount of activity in the same swap or an economically equivalent swap available primarily or solely in bilateral transactions?
  • Should the Commission allow a SEF or DCM to submit an available to trade determination if such SEF or DCM does not itself list the subject swap for trading? If so, in evaluating the factors under the proposal, should the Commission allow the SEF or DCM to consider the same swap or an economically equivalent swap on another SEF or DCM? What are the advantages and disadvantages of such an approach? Should a SEF or DCM consider the amount of activity in the same swap or an economically equivalent swap available primarily or solely in bilateral transactions?
  • When a DCM or SEF makes a swap available to trade, should all other DCMs and SEFs listing or offering for trading such swap and/or any economically equivalent swap be required to make those swaps available to trade? What would be the economic impact on those DCMs and SEFs that would be required to make those swaps and/or economically equivalent swaps available to trade?
  • If a SEF or DCM is required to make an economically equivalent swap available to trade, should that SEF or DCM be required to submit, under Part 40 procedures, its reasoning for deciding that a certain swap is or is not economically equivalent to another swap? Should a SEF or DCM be required to consider the factors under the proposal? Should a SEF or DCM be able to use the factors under the proposal to submit to the Commission for consideration that an economically equivalent swap should not be subject to the "made available to trade" requirement? Should a DCM or SEF provide the Commission notice that an economically equivalent swap has been made available to trade? If so, should the Commission provide notice to the public? If so, how? How would market participants conducting bilateral transactions know that an economically equivalent swap has been made available to trade?
  • Is the Commission's proposed definition of the term "economically equivalent swap" appropriate? If not, how should the Commission revise the proposed definition and why? Are there other factors that the Commission should consider when defining the term economically equivalent swap? Should the Commission require that DCMs and SEFs consider specific material pricing terms? If so, what terms and why? For instance, should DCMs and SEFs consider same tenor or same underlying instrument? Should the Commission or DCMs and SEFs make the determination of which swaps are economically equivalent?
  • Is the Commission's proposal that DCMs and SEFs conduct reviews and assessments appropriate? If not, what is appropriate and why?
  • Should the Commission specify a process whereby a swap that has been determined to be available to trade may be determined to no longer be available to trade? If so, should the Commission use the rule submission procedure under Part 40 for this process and why? Should such a determination apply to all DCMs and SEFs universally or should it only apply to the particular DCM or SEF that seeks to no longer make a swap available to trade? What are the advantages and disadvantages of such approach? If the Commission should not specify a process to no longer make a swap available to trade, explain why.

Footnotes

1 The Commission has proposed rules that would limit the investment of segregated initial margin for uncleared swaps to permitted investments under Rule 1.25. See 75 Fed. Reg. 75432 (Dec. 3, 2010).

2 See 76 Fed. Reg. 78776, 78791 (Dec. 19, 2011).

3 Id. at 78783.

4 The Commission adopted all other asset-based concentration limits as proposed. These limits restrict permitted investments by asset class and are designed to increase safety by promoting diversification. For example, municipal securities are subject to a 10 percent concentration limit, U.S. agency obligations have a 50 percent limit and certificates of deposit have a 25 percent limit. U.S. Treasury securities are not subject to any concentration limit.

5 A swap which is not subject to mandatory clearing is also not subject to the trade execution requirement. Thus, if one of the counterparties to a swap is an eligible "end user" under Section 2(h)(7) of the CEA (referred to as the "end user exception"), the swap is not subject to the clearing requirement and thus need not be executed on a DCM or SEF.

6 The Commission has previously requested comment on the "made available for trading" issue. See 76 Fed. Reg. 1214 (Jan. 7, 2011).

7 See Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements Under Section 2(h) of the CEA, 76 Fed. Reg. 58186 (Sept. 20, 2011).

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