By: Lawrence B. Patent, Charles R. Mills
Recent rule proposals of the Commodity Futures Trading Commission ("CFTC") continue the agency’s interest in securing a stronger regulatory grip on over-the-counter ("OTC") derivatives and protection of customer deposits of futures margin. While it is not surprising that the CFTC would consider such amendments in light of recent economic conditions, the proposals could have the effect of further decreasing the number of future commission merchants ("FCMs"), as well as leading to less-well-capitalized FCMs, and resulting in reduced liquidity in the system just as clearing of OTC derivatives becomes more prevalent.
The proposals would mandate that an FCM’s minimum capital requirements treat cleared OTC transactions in a manner equivalent to exchange-traded transactions. In the same release, the CFTC requested comment on whether to increase the minimum adjusted net capital for firms dually-registered as FCMs and securities broker-dealers ("BDs") to equal the combined (aggregate) net capital requirements of the CFTC and the Securities and Exchange Commission ("SEC"). Currently, these dually-registered firms need only maintain the greater of the amounts required by the CFTC or SEC.
In the October 24, 2008 issue of this Newsletter, we reported on a CFTC interpretation published on October 2, 2008, which states that, in an FCM bankruptcy, claims related to OTC contracts cleared by a derivatives clearing organization ("DCO") will be entitled to the same preferential treatment as claims that are based upon exchange-traded futures contracts. The CFTC’s rule proposals published May 7, 2009 provide that an FCM’s required adjusted net capital include an amount equal to ten percent of the maintenance margin level of customer and non-customer cleared OTC derivative positions. FCMs also would be required to take the same haircuts on proprietary cleared OTC derivative positions that are required for exchange-traded futures and options: 100 percent of maintenance margin if the FCM is a member of the clearing organization, and 150 percent if the FCM is not a member.
Incorporating Cleared OTC Positions Into Minimum Financial Requirements
The proposed amendments would apply to OTC derivatives, including credit default swaps, that are submitted for clearing on any (1) U.S. DCO, (2) non-U.S. clearing organization permitted to clear such transactions under the laws of the relevant jurisdiction, (3) multilateral clearing organization authorized under Section 409 of the Federal Deposit Insurance Corporation Improvement Act, which could also be non-U.S., or (4) securities clearing organization. The CFTC stated that it is proposing these amendments because DCOs have become significant clearers of OTC derivatives and that this development has increased the risk exposure of FCMs in a manner not currently reflected in CFTC regulations. The proposed amendments, however, would extend to OTC derivatives beyond those cleared by DCOs and held in segregated customer accounts, and thereby include OTC derivatives other than those whose holders are to be accorded preferential treatment in the event of the FCM’s bankruptcy.
The idea underlying the CFTC’s proposal – that enhanced capital requirements might be thought to provide greater customer and systemic protections against the risk of defaults by FCMs – must be examined and weighed against the fact that higher financial requirements for FCMs in a poor economy could reduce the number of FCMs participating in clearing OTC transactions, thereby reducing liquidity and concentrating systemic risk among fewer market participants. The CFTC’s proposals might also provide an incentive for FCMs not to submit OTC positions for clearing if the capital impact would be too severe, and may also cause customers to avoid clearing as well if clearing fees would be increased.
Minimum Capital Requirements for FCM/BDs
Although the CFTC did not propose a specific amendment to its regulations concerning the minimum adjusted net capital required for dually-registered FCM/BDs, it solicited comments on whether to change that level from the greater of to the sum of the amounts required by CFTC and SEC. The CFTC explained that it was soliciting comments on this issue because, in the event of liquidation, an FCM/BD’s assets would be available to satisfy any unsecured claims of creditors, including any unsecured claims of futures and securities customers. Requiring that an FCM/BD maintain the sum of the CFTC and SEC minimums would, in the CFTC’s view, reflect more fully the scope of customer business and increase the “equity available to satisfy . . . unsecured claims of customers.”
The CFTC proposal presumes that, if capital requirements are increased, enterprises would continue to organize themselves so that futures and securities business is conducted through a single entity. Currently, a BD may decide that it makes sense to operate its futures business through the same legal entity, because such business is normally smaller than its securities business, and where that is the case, such a structure does not increase its minimum capital requirement (i.e., under the “greater of” formulation, the SEC minimum will exceed the CFTC minimum and the futures business can be done “for free”). However, if that is no longer the case, and a dually-registered firm would experience an increase in its minimum capital requirement, the BD may decide to establish a subsidiary or affiliate that would be registered as an FCM with a relatively modest amount of capital as compared to that maintained by FCM/BDs. If so, and if the separate FCM were forced to liquidate in bankruptcy, there would likely be fewer assets available to satisfy unsecured creditor claims, including unsecured customer claims, than would be the case if the firm were an FCM/BD. A change from the “greater of” standard to a “sum of” requirement could therefore result in fewer assets available to creditors in a bankruptcy.
Comments on the proposal are due by July 6, 2009.
Investment of Customer Funds
The CFTC also recently issued an advance notice of proposed rulemaking concerning the investment of customer funds, which was published in the Federal Register on May 22, 2009. The Commodity Exchange Act ("CEAct") specifies that customer funds related to futures and options traded on a U.S. contract market may be invested by FCMs and DCOs only in U.S. government securities and municipal securities. Nevertheless, beginning in 2000, the CFTC used its general exemptive authority under Section 4(c) of the CEAct to permit the investment of customer funds in other instruments, including government sponsored enterprise securities, bank certificates of deposit, commercial paper, corporate notes, general obligations of a sovereign nation, and interests in money market mutual funds ("MMMFs"). Investment of funds of U.S.-located customers related to futures trading on non-U.S. exchanges is governed by CFTC Regulation 30.7, which does not limit the type of investment of such funds, but requires that an FCM maintain records that include a description of the obligations in which such investments were made.
CFTC Regulation 1.25, which governs the investment of customer funds related to trades made on U.S. contract markets, contains a general prudential standard that all permitted investments be “consistent with the objectives of preserving principal and maintaining liquidity.” The CFTC has been mindful of how important the earnings on investment of customer funds are to the net income of FCMs and thus had been open during the earlier part of this decade to an expansion of permissible investments. The CFTC noted that FCMs have managed the investment of customer funds and Regulation 30.7 funds responsibly during the recent economic downturn. However, the CFTC cited the market events of the past year, notably the failures of certain government sponsored enterprises, difficulties encountered by certain MMMFs in honoring redemption requests, illiquidity of certain adjustable rate securities, and turmoil in the credit ratings industry, as challenges to many of the fundamental assumptions regarding investment of customer funds. Although the CFTC in its advance notice states that it “welcomes comments . . . in support of any new instruments that might qualify as permitted investments,” the general tenor of the notice is directed towards soliciting comments concerning retaining, rescinding, or modifying existing authority. It would appear that the expansion of permissible investments is over.
The CFTC also is soliciting comment about applying the standards of Regulation 1.25 to Regulation 30.7, so that investment of customer funds related to trades on non-U.S. exchanges would be subject to the same limits applicable to funds related to trades on U.S. contract markets.
Any new restrictions on the investment of customer funds are likely to further squeeze the bottom line of FCMs, and contribute to a further contraction in the number of FCMs, which has been cut almost in half over the last 14 years (from 255 in August 1995 to 134 as of the end of 2008).
Comments are due by July 21, 2009.
Conclusion
It is not surprising that the CFTC would consider amendments to its regulations governing minimum capital requirements and the investment of customer funds following recent economic conditions. The proposals and requests for comment referred to above, however, could have the effect of further decreasing the number of FCMs, leading to less-well-capitalized FCMs, and resulting in a diminution of liquidity in the system just as clearing of OTC derivatives becomes more prevalent and desired, and even mandatory.
