Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations

Federal RegisterNov 14, 2012

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1, 3, 22, 30, and 140

RIN 3038-AD88

Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Commodity Futures Trading Commission (“Commission” or “CFTC”) is proposing to adopt new regulations and amend existing regulations to require enhanced customer protections, risk management programs, internal monitoring and controls, capital and liquidity standards, customer disclosures, and auditing and examination programs for futures commission merchants (“FCMs”). The proposal also addresses certain related issues concerning derivatives clearing organizations (“DCOs”) and chief compliance officers (“CCOs”). The proposed rules will afford greater assurances to market participants that: customer segregated funds and secured amounts are protected; customers are provided with appropriate notice of the risks of futures trading and of the FCMs with which they may choose to do business; FCMs are monitoring and managing risks in a robust manner; the capital and liquidity of FCMs are strengthened to safeguard their continued operations; and the auditing and examination programs of the Commission and the self-regulatory organizations (“SROs”) are monitoring the activities of FCMs in a prudent and thorough manner.

DATES:

Comments must be received on or before January 14, 2013.

ADDRESSES:

You may submit comments, identified by RIN 3038-AD88, by any of the following methods:

•

Agency Web site, via its Comments Online process:

http://comments.cftc.gov.

Follow the instructions for submitting comments through the Web site.

•

Mail:

Send to David A. Stawick, Secretary, Commodity Futures Trading Commission, 1155 21st Street NW., Washington, DC 20581.

•

Hand delivery/Courier:

Same as Mail above.

•

Federal eRulemaking Portal: http://www.regulations.gov/search/index.jsp.

Follow the instructions for submitting comments.

All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to

http://www.cftc.gov.

You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures set forth in § 145.9 of the Commission's regulations.

Commission regulations referred to herein are found at 17 CFR Ch. 1 (2012). Commission regulations are accessible on the Commission's Web site,

www.cftc.gov.

The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from

www.cftc.gov

that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT:

Division of Swap Dealer and Intermediary Oversight:

Gary Barnett, Director, 202-418-5977,

gbarnett@cftc.gov;

Thomas Smith, Deputy Director, 202-418-5495,

tsmith@cftc.gov;

Frank Fisanich, Chief Counsel, 202-418-5949,

ffisanich@cftc.gov;

or Ward P. Griffin, Associate Chief Counsel, 202-418-5425,

wgriffin@cftc.gov,

Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581, or Kevin Piccoli, Deputy Director, 646-746-9834,

kpiccoli@cftc.gov,

140 Broadway, 19th Floor, New York, NY 10005.

Division of Clearing and Risk:

Robert B. Wasserman, Chief Counsel, 202-418-5092,

rwasserman@cftc.gov,

Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

Office of the Chief Economist:

Camden Nunery, Economist,

cnunery@cftc.gov,

202-418-5723, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

A. General Statutory and Current Regulatory Structure

The protection of customers—and the safeguarding of money, securities or other property deposited by customers with an FCM—is a fundamental component of the Commission's disclosure and financial responsibility framework. Section 4d(a)(2)

of the Commodity Exchange Act (“Act”)

requires each FCM to segregate from its own assets all money, securities and other property deposited by futures customers to margin, secure, or guarantee futures contracts and options on futures contracts traded on designated contract markets.

Section 4d(a)(2) further requires an FCM to treat and deal with futures customer funds as belonging to the futures customer, and prohibits an FCM from using the funds deposited by a futures customer to margin or extend credit to any person other than the futures customer that deposited the funds. Section 4d(f) of the Act, which was added by section 724(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act,

requires each FCM to segregate from its own assets all money, securities and other property deposited by Cleared Swaps Customers to margin transactions in Cleared Swaps.

7 U.S.C. 6d(a)(2).

7 U.S.C. 1

et seq.

The term ” futures customer” is defined in § 1.3(iiii) to include any person who uses a futures commission merchant as an agent in connection with trading in any contract for the purchase or sale of a commodity for future delivery or an option on such contract (excluding any proprietary accounts under § 1.3(y)). The Commission adopted the definition of the term “futures customer” on October 16, 2012 as part of the final rulemaking that amended existing Commission regulations to incorporate swaps. The

Federal Register

release adopting the final rules can be accessed at

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister101612.pdf.

See

Dodd-Frank Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at

http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

The term “Cleared Swaps Customer” is defined in § 22.1 as any person entering into a Cleared Swap, but excludes: (1) Any owner or holder of a Cleared Swaps Proprietary Account with respect to the Cleared Swaps in such account; and (2) A clearing member of a DCO with respect to Cleared Swaps cleared on that DCO.

The Commission has adopted §§ 1.20 through 1.30, and § 1.32, to implement section 4d(a)(2) of the Act, and adopted Part 22 to implement section 4d(f) of the Act. The purpose of these regulations is to safeguard funds deposited by futures customers and Cleared Swaps Customers, respectively.

Regulation 1.20 requires each FCM and DCO to separately account for and to segregate from its own proprietary funds all money, securities, or other property deposited by futures customers for trading on designated contract markets. Regulation 1.20 also provides that an FCM or DCO may deposit futures customer funds only with a bank, trust company, and for FCMs only, a DCO or another FCM. The funds must be deposited under an account

name that clearly identifies the funds as belonging to the futures customers of the FCM or DCO and further shows that the funds are segregated as required by section 4d(a)(2) of the Act and Commission regulations. FCMs and DCOs also are required to obtain a written acknowledgment from a depository stating that the depository was informed that funds deposited are customer funds being held in accordance with the Act.

FCMs and DCOs also are restricted in their use of futures customer funds. Regulations 1.20 and 1.22 provide that the funds deposited by one futures customer may not be used to margin or to secure the contracts or option positions, or extend credit to any person, other than the futures customer that deposited the funds. An FCM or DCO, however, may for convenience commingle and hold funds deposited as margin by multiple futures customers in the same account or accounts with one of the recognized depositories. An FCM or DCO also may invest futures customer funds in certain permitted investments under § 1.25.

Part 22 of the Commission's regulations, which governs Cleared Swaps transactions, implements section 4d(f) of the Act and parallels many of the provisions in Part1 addressing the manner in which, and the responsibilities imposed upon, an FCM holding funds for futures customers trading on designated contract markets.

Regulation 22.2 requires an FCM to treat and to deal with funds deposited by Cleared Swaps Customers as belonging to such Cleared Swaps Customers and to hold such funds separately from the FCM's own funds. Regulation 22.4 provides that an FCM may deposit Cleared Swaps Customer Collateral with a bank, trust company, DCO, or another registered FCM. Regulation 22.6 requires that the account holding the Cleared Swaps Customers Collateral must clearly identify the account as an account for Cleared Swaps Customers of the FCM engaging in cleared swap transactions and that the funds maintained in the account are subject to the segregation provisions of section 4d(f) of the Act and Commission regulations.

The Commission approved the part 22 regulations on January 11, 2012, with an effective date of April 9, 2012. Compliance with the part 22 regulations is required by November 8, 2012.

See, Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions,

77 FR 6336 (Feb. 7, 2012).

Regulation 22.2(d) also prohibits an FCM from using the funds deposited by one Cleared Swaps Customer to purchase, margin, or settle cleared swap transactions of any person other the Cleared Swaps Customer that deposited the funds. Further, § 22.2(c) permits an FCM to commingle the Cleared Swaps Customer Collateral of multiple Cleared Swaps Customers into one or more accounts, and § 22.2(e)(1) permits an FCM to invest Cleared Swaps Customer Collateral in permitted investments under § 1.25.

In addition to holding funds for futures customers transacting on designated contract markets and for Cleared Swaps Customers engaging in cleared swap transactions, FCMs also hold funds for persons trading futures contracts listed on foreign boards of trade. Section 4(b) of the Act provides that the Commission may adopt rules and regulations proscribing fraud and requiring minimum financial standards, the disclosure of risk, the filing of reports, the keeping of books and records, the safeguarding of the funds deposited by persons for trading on foreign markets, and registration with the Commission by any person located in the United States who engages in the offer or sale of any contract of sale of a commodity for future delivery that is made subject to the rules of a board of trade located outside of the United States. Pursuant to the statutory authority of section 4(b), the Commission adopted Part 30 of its regulations to address foreign futures and foreign option transactions.

The segregation provisions for funds deposited by foreign futures or foreign options customers to margin foreign futures or foreign options transactions under Part 30, however, are significantly different from the requirements set forth in § 1.20 for futures customers trading on designated contract markets and Part 22 for Cleared Swaps Customers engaging in cleared swap transactions. Regulation 30.7 provides that an FCM may deposit the funds belonging to foreign futures or foreign options customers in an account or accounts maintained at a bank or trust company located in the United States; a bank or trust company located outside of the United States that has in excess of $1 billion of regulatory capital; an FCM registered with the Commission; a DCO; a member of a foreign board of trade; a foreign clearing organization; or a depository selected by the member of a foreign board of trade or foreign clearing organization. The account with the depository must be titled to clearly specify that the account holds funds belonging to the foreign futures or foreign options customers of the FCM that are trading on foreign futures markets. An FCM also is permitted to invest the funds deposited by foreign futures or foreign option customers in accordance with § 1.25.

However, unlike § 1.20 and Part 22, which require an FCM to hold a sufficient amount of funds in segregation to meet the total account equities of all of the FCM's futures customers and Cleared Swaps Customers at all times (

i.e.,

the Net Liquidating Equity Method), § 30.7 requires an FCM to maintain in separate accounts an amount of funds only sufficient to cover the margin required on open foreign futures contracts, plus or minus any unrealized gains or losses on such open positions, plus any funds representing premiums payable or received on foreign options (including any additional funds necessary to secure such options, plus or minus any unrealized gains or losses on such options) (

i.e.,

the “Alternative Method”). Thus, under the Part 30 Alternative Method an FCM is not required to maintain a sufficient amount of funds in such separate accounts to pay the full account balances of all of its foreign futures or foreign options customers at all times.

In addition to the segregation requirements of sections 4d(a)(2) and 4d(f) of the Act, and the secured amount requirements in Part 30 of the Commission's regulations, FCMs also are subject to minimum net capital and financial reporting requirements that are intended to ensure that such firms meet their financial obligations in a regulated marketplace, including their financial obligations to customers and DCOs. Each FCM is required to maintain a minimum level of “adjusted net capital,” which is generally defined under § 1.17 as the firm's net equity as computed under generally accepted accounting principles, less all of the firm's liabilities and further excluding all assets that are not liquid or readily marketable. Regulation 1.17(c)(5) further requires an FCM to impose capital charges (

i.e.,

deductions) on certain of its liquid assets to protect against possible market risks in such assets.

FCMs also are subject to financial recordkeeping and reporting requirements. FCMs that carry customer accounts are required under § 1.32 to prepare a schedule each business day demonstrating their compliance with the segregation and secured amount requirements. Regulation 1.32 requires the calculation to be performed by noon each business day, reflecting the account balances and open positions as of the close of business on the previous business day.

Each FCM also is required by § 1.10 to file with the Commission and with its

designated self-regulatory organization (“DSRO”) monthly unaudited financial statements and an annual audited financial report, as well as notices of certain predefined events.

Regulation 1.12 requires an FCM to file a notice with the Commission and with the firm's DSRO whenever, among other things, the firm: (1) Fails to maintain compliance with the Commission's capital requirements; (2) fails to hold sufficient funds in segregated or secured amount accounts to meet its regulatory requirements; (3) fails to maintain current books and records; or (4) experiences a significant reduction in capital from the previous month-end. The purpose of the regulatory notices is to alert the Commission and the firm's DSRO as early as possible to potential financial issues at the firm that may adversely impact the ability of the FCM to comply with its obligations to safeguard customer funds, or to meet its financial obligations to other FCMs or DCOs.

The term “self-regulatory organization” is defined by § 1.3 to mean a contract market, a swap execution facility, or a registered futures association. A DSRO is the SRO that is appointed to be primarily responsible for conducting ongoing financial surveillance of an FCM under a joint audit agreement submitted to and approved by the Commission under § 1.52.

The statutory mandate to segregate customer funds—to treat them as belonging to the customer and not use the funds inappropriately—takes on greater meaning in light of the devastating events experienced over the past year. Those events, which are discussed in greater detail below, demonstrate that the risks of misfeasance and malfeasance, and the risks of failing to maintain sufficient excess funds in segregation: (i) Put customer funds at risk; and (ii) are exacerbated by stresses on the business of the FCM. Many of those risks can be mitigated significantly by better risk management systems and controls, along with an increase in risk-oriented oversight and examination of the FCMs.

Determining what is a “sufficient” amount of excess funds in segregation for any particular FCM requires a full understanding of the business of that FCM, including a proper analysis of the factors that affect the actual amount of segregated funds held by the FCM relative to the minimum amount of segregated funds it is required to hold. Further, appropriate care must be taken to avoid withdrawing such excess funds at times of great stress to cover needs unrelated to the purposes for which excess segregated and secured funds are maintained. In times of stress, excess funds may look like an easy liquidity source to help cover other risks of the business; yet withdrawing it makes it unavailable when it may be most needed. The recent market events illustrate both the need to: (i) Require that care be taken about monitoring excess segregated and secured funds, and the conditions under and the extent to which such funds may be withdrawn; and (ii) place appropriate risk management controls around the other risks of the business to help relieve (A) the likelihood of an exigent event or, (B) if such an event occurs, the likelihood of a failure to prepare for such an event, which in either case could create pressures that result in an inappropriate withdrawal of customer funds.

Although the Commission's existing regulations provide an essential foundation to fostering a well-functioning marketplace, wherein customers are protected and institutional risks are minimized, recent events have demonstrated that additional measures are necessary to effectuate the fundamental purposes of the statutory provisions discussed above. Further, concurrently with the enhanced responsibilities for FCMs that are proposed herein, the oversight and examination systems must be enhanced to mitigate risks and effectuate the statutory purposes.

B. Self-Regulatory Structure

The Commission's oversight structure provides that SROs are the frontline regulators of FCMs, introducing brokers (“IBs”), commodity pool operators, and commodity trading advisors. In 2000, Congress affirmed the Commission's reliance on SROs by amending section 3 of the Commodity Exchange Act to state: “It is the purpose of this Act to serve the public interests through a system of effective self-regulation of trading facilities, clearing systems, market participants and market professionals under the oversight of the Commission.”

As part of its oversight responsibility, an SRO is required to conduct periodic examinations of member FCMs' compliance with Commission and SRO financial and related reporting requirements, including the FCMs' holding of customer funds in segregated and secured accounts. The Commission oversees the SROs by examining them for the performance of their duties. More recently, the Commission has moved to conducting quarterly reviews of the SROs' FCM examination program in which the Commission selects a small sample of the SRO's FCM work papers to review. In addition, the Commission also conducts limited-scope reviews of FCMs in a “for cause” situation that are sometimes referred to as “audits,” but they are not full-scale audits as accountants commonly use that term.

In addition, because there are multiple SROs who share the same member FCMs, to avoid subjecting FCMs to duplicative examinations from SROs, the Commission has a permissive system that allows the SROs to agree how to allocate FCMs amongst them. An SRO who is allocated certain FCMs for such examination is referred to as the DSRO of those FCMs.

Under Commission regulations, FCMs must have their annual financial statements audited by an independent certified public accountant following U.S. Generally Accepted Auditing Standards (“U.S. GAAS”). As part of this certified annual report, the independent accountant also must conduct appropriate reviews and tests to identify any material inadequacies in systems and controls that could violate the Commission's segregation or secured amount requirements. Any such inadequacies are required to be reported to the FCM's DSRO and to the Commission.

C. Futures Commission Merchant Insolvencies and Failures of Risk Management

Recent events demonstrate the need for revisions to the Commission's customer protection regime. Since October 2011, two FCMs have entered into insolvency proceedings. On October 31, 2011, MF Global, Inc. (“MFGI”), which was dually-registered as an FCM with the Commission and as a securities broker-dealer (“BD”) with the U.S. Securities and Exchange Commission (“SEC”), was placed into a liquidation proceeding under the Securities Investor Protection Act by the Securities Investor Protection Corporation (“SIPC”). The trustee appointed to oversee the liquidation of MFGI has reported a potential $900 million shortfall of funds necessary to repay the account balances due to customers trading futures on designated contract markets, and an approximately $700 million shortfall in funds immediately available to repay the account balances of customers trading on foreign futures markets.

The shortfall in customer segregated accounts is attributable by the MFGI Trustee to significant transfers of funds out of the customer accounts that were used by MFGI for various purposes other than to meet obligations to or on

behalf of customers. The trustee also is attempting to recover approximately $640 million of customer funds that was deposited by MFGI with its London, U.K. affiliate, MFGUK, as margin funds for trading on foreign markets. The MFGI trustee and the Special Administrators handling the liquidation of MFGUK are disputing the legal status of the funds and whether they are customer funds under English law. The outcome of this dispute will have a significant impact on the amount of funds that are returned to MFGI.

See Report of the Trustee's Investigation and Recommendations, In re MF Global Inc.,

No. 11-2790 (MG) SIPA (Bankr. S.D.N.Y. Jun. 4, 2012).

In addition, the Commission filed a civil injunctive complaint in federal district court on July 10, 2012, against Peregrine Financial Group, Inc. (“PFG”), a registered FCM and its Chief Executive Officer (“CEO”) and sole owner, Russell R. Wasendorf, Sr., alleging that PFG and Wasendorf, Sr. committed fraud by misappropriating customer funds, violated customer fund segregation laws, and made false statements regarding the amount of funds in customer segregated accounts in financial statements filed with the Commission. The complaint states that in July 2012 during an NFA examination PFG falsely represented that it held in excess of $220 million of customer funds when in fact it held approximately $5.1 million.

Complaint,

U.S. Commodity Futures Trading Commission v. Peregrine Financial Group, Inc., and Russell R. Wasendorf, Sr.,

No. 12-cv-5383 (N.D. Ill. July 10, 2012). A copy of the Commission's complaint has been posted to the Commission's Web site.

Recent incidents also have demonstrated the value of establishing robust risk management systems within FCMs and enhanced early warning systems to detect and address capital issues. In particular, problems that arise through an FCM's non-futures-related business can have a direct and significant impact on the FCM's regulatory capital, raising questions as to whether the FCM will be able to maintain the minimum financial requirements mandated by the Act and Commission regulations.

See, e.g.,

Edward Krudy, Jed Horowitz and John McCrank, “Knight's Future in Balance After Trading Disaster,” Reuters (Aug. 3, 2012),

available at http://in.reuters.com/article/2012/08/03/knightcapital-loss-idINL2E8J27QE20120803

(noting that a software issue caused the firm to incur a $440 million trading loss, which represented much of the firm's capital); Chris Dieterich and Nathalie Tadena, “Penson Worldwide's US Securities Accounts To Be Acquired By Apex Clearing,” available at

http://online.wsj.com/article/BT-CO-20120531-717791.html

(discussing circumstances that led Penson to sell its futures business).

These recent incidents have highlighted weaknesses in the customer protection regime prescribed in the Commission's regulations and through the self-regulatory system. In particular, questions have arisen on the requirements surrounding the holding and investment of customer funds, including the ability of FCMs to withdraw funds from customer segregated accounts and Part 30 secured accounts. Additionally, the incidents have underscored the need for additional safeguards—such as robust risk management systems, strengthened early-warning systems surrounding margin and capital requirements, and enhanced public disclosures—to promote the protection of customer funds and to minimize the systemic risk posed by certain actions of market participants. Further questions have arisen on the system of audits and examinations of FCMs, and whether the system functions adequately to monitor FCMs' activities, verify segregated fund and secured amount balances, and detect fraud. Consequently, the Commission has taken steps to study and address the issues raised by the incidents, and industry participants likewise have taken steps to address the issues. Such steps are described in greater detail in the next section.

D. Recent Commission Rulemakings and Other Initiatives Relating to Customer Protection

Since late 2011, the Commission has promulgated rules directly impacting the protection of customer funds. The Commission also has studied the current regulatory framework surrounding customer protection, particularly in light of the recent incidents outlined above, in order to identify potential enhancements to the systems and Commission regulations protecting customer funds. The Commission's efforts have been informed, in part, by efforts undertaken by industry participants. The proposed rule amendments set forth in this release have been informed by the efforts detailed below.

In December 2011, the Commission adopted final rule amendments revising the types of investments that an FCM or DCO can make with customer funds under § 1.25, for the purpose of affording greater protection for such funds.

Among other changes to §§ 1.25 and 30.7, the final rule amendments removed from the list of permitted investments: (1) corporate debt obligations not guaranteed by the United States; (2) foreign sovereign debt; and (3) in-house and affiliate transactions.

See,

Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 FR 78776 (Dec. 19, 2011).

In adopted the amendments to § 1.25, the Commission was mindful that customer segregated funds must be invested by FCMs and DCOs in a manner that minimizes their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs, and to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk. The amendments are consistent with the general prudential standard contained in § 1.25, which provides that all permitted investments must be “consistent with the objectives of preserving principal and maintaining liquidity.”

The Commission also approved final regulations that require DCOs to collect initial customer margin from FCMs on a gross basis.

Under the final regulations, FCMs are no longer permitted to offset one customer's margin requirement against another customer's margin requirements and deposit only the net margin collateral with the DCO. As a result of the rule change, a greater portion of customer initial margin will be posted by FCMs to the DCOs.

See

Commission Regulation 39.12(g)(8)(i) and

Derivatives Clearing Organization General Provisions and Core Principles,

76 FR 69334 (Nov. 8, 2011).

The Commission also approved a new margining regime for cleared swaps positions.

Under the traditional futures margining model, DCOs hold an FCM's customer funds on a collective basis and are permitted to use the collective margin funds held for the FCM's customers to satisfy a margin deficiency caused by a single customer. The Commission approved an alternative margin rule for cleared swap transactions. Under the “LSOC rule” (legal segregation with operational comingling), the DCOs that clear swaps transactions have greater information regarding the margin collateral of individual Swaps Customers, and each Swaps Customer's collateral is protected individually all the way to the clearinghouse.

See

77 FR 6336 (Feb. 7, 2012).

The Commission also included customer protection enhancements in the final rule for designated contract markets. These provisions codify into rules staff guidance on minimum requirements for SROs regarding their financial surveillance of FCMs.

The rules require that a DCM have arrangements and resources for effective

rule enforcement and trade and financial surveillance programs, including the authority to collect information and examine books and records of members and market participants. The rules also establish minimum financial standards for both member FCMs and IBs and non-intermediated market participants. The Commission expressly noted in the preamble of the Adopting Release that “a DCM's duty to set financial standards for its FCM members involves setting capital requirements, conducting surveillance of the potential future exposure of each FCM as compared to its capital, and taking appropriate action in light of the results of such surveillance.”

Further, the rules mandate that DCMs adopt rules for the protection of customer funds, including the segregation of customer and proprietary funds, the custody of customer funds, the investment standards for customer funds, intermediary default procedures and related recordkeeping.

See Core Principles and Other Requirements for Designated Contract Markets,

77 FR 36612 (June 19, 2012).

Id.

at 36646.

In addition to the rulemaking efforts outlined above, the Commission has sought additional information through a series of roundtables and other meetings. On February 29 and March 1, 2012, the Commission solicited comments and held a public roundtable to solicit input on customer protection issues from a broad cross-section of the futures industry, including market participants, FCMs, DCOs, SROs, securities regulators, foreign clearing organizations, and academics.

The roundtable focused on issues relating to the advisability and practicality of modifying the segregation models for customer funds; alternative models for the custody of customer collateral; enhancing FCM controls over the disbursement of customer funds; increasing transparency surrounding an FCM's holding and investment of customer funds; and lessons learned from recent commodity brokerage bankruptcy proceedings.

Further information on the public roundtable, including video recordings and transcripts of the discussions, have been posted to the Commission's Web site.

See http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff022912

(relating to Feb. 29, 2012);

http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff030112

(relating to Mar. 1, 2012).

The Commission also hosted a public meeting of the Technology Advisory Committee (“TAC”) on July 26, 2012.

Panelists and TAC members discussed potential technological solutions directed at enhancing the protection of customers funds by identifying and exploring technological issues and possible solutions relating to the ability of the Commission, SROs and customers to verify the location and status of funds held in customer segregated accounts.

Additional information, including documents submitted by meeting participants, has been posted to the Commission's Web site. See

http://www.cftc.gov/PressRoom/Events/opaevent_tac072612.

Commission staff hosted an additional roundtable on August 9, 2012, to discuss SRO requirements for examinations of FCMs and Commission oversight of SRO examination programs. The roundtable also focused on the role of the independent public accountant in the FCM examination process, and proposals addressing various alternatives to the current system for segregating customer funds.

In developing the proposals set forth in this release, the Commission also has been informed by efforts undertaken by industry participants. On February 29, 2012, the Futures Industry Association (“FIA”) initiated steps to educate customers on the extent of the protections provided under the current regulatory structure. FIA issued a list of Frequently Asked Questions (“FAQ”) prepared by members of the FIA Law and Compliance Division addressing the basics of segregation, collateral management and investments, capital requirements and other issues for FCMs and joint FCM/BDs, and clearinghouse guaranty funds.

The FAQ is intended to provide existing and potential customers with a better understanding of the risks of engaging in futures trading and a clear explanation of the extent of the protections provided to customers and their funds under the Act and Commission regulations.

The FIA's release addressing FAQs on the protection of customer funds is accessible on the FIA's Web site at

http://www.futuresindustry.org/downloads/PCF-FAQs.PDF.

FIA also issued a series of initial recommendations for the protection of customer funds.

The recommendations were prepared by the Financial Management Committee, whose members include representatives of FIA member firms, DCOs and depository institutions. The initial recommendations address enhanced disclosure on the protection of customer funds, reporting on segregated funds balances by FCMs, FCM internal controls surrounding the holding and disbursement of customer funds, and revisions to Part 30 regulations to make the protections comparable to those provided for customers trading on designated contract markets.

The FIA's initial recommendations are accessible on the FIA's Web site at

http://www.futuresindustry.org/downloads/Initial_Recommendations_for_Customer_Funds_Protection.pdf.

On July 13, 2012, the Commission approved new FCM financial requirements proposed by the National Futures Association (“NFA”).

The NFA Financial Requirements Section 16 and its related Interpretive Notice entitled

NFA Financial Requirements Section 16: FCM Financial Practices and Excess Segregated Funds/Secured Amount Disbursements

(collectively referred to as “the Segregated Funds Provisions”) were developed in consultation with Commission staff.

For more information relating to the new FCM financial requirements, see

http://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4072.

NFA's Segregated Funds Provisions require each FCM to: (1) Maintain written policies and procedures governing the deposit of the FCM's proprietary funds (

i.e.,

excess or residual funds) in customer segregated accounts and Part 30 secured accounts; (2) maintain a targeted amount of excess funds in segregate accounts and Part 30 secured accounts; (3) file on a daily basis the FCM's segregation and Part 30 secured amount computations with NFA; (4) obtain the approval of senior management prior to a withdrawal that is not for the benefit of customers, whenever the withdrawal equals 25 percent or more of the excess segregated or Part 30 secured amount funds; (5) file a notice with NFA of any withdrawal that is not for the benefit of customers, whenever the withdrawal equals 25 percent or more of the excess segregated or Part 30 secured amount funds; (6) file detailed information regarding the depositories holding customer funds and the investments made with customer funds as of the 15th day (or the next business day if the 15th is not a business day) and the last business day of each month; and (7) file additional monthly net capital and leverage information with NFA.

Significantly, NFA's Segregated Funds Provisions also require FCMs to compute their Part 30 secured amount requirement and compute their targeted excess Part 30 secured funds using the same Net Liquidating Equity Method that is required by the Act and Commission regulations for computing the segregation requirements for customers trading on U.S. contract markets under section 4d of the Act. FCMs are not permitted under the NFA rules to use the Alternative Method to compute the Part 30 secured amount requirement. The failure of an FCM to maintain its targeted amount of excess Part 30 funds computed using the Net

Liquidating Equity Method may result in NFA initiating a Membership Responsibility Action (“MRA”) against the firm.

In addition, in setting the target amount of excess funds, the FCM's management must perform a due diligence inquiry and consider various factors relating, as applicable, to the nature of the FCM's business, including the type and general creditworthiness of the FCM's customers, the trading activity of the customers, the types and volatility of the markets and products traded by the FCM's customers, and the FCM's own liquidity and capital needs. The FCM's Board of Directors (or similar governing body), CEO or Chief Financial Officer (“CFO”) must approve in writing the FCM's targeted residual amount, any changes thereto, and any material changes in the FCM's written policies and procedures.

The NFA Board of Directors also approved on August 16, 2012, amendments to NFA financial requirements for FCMs that will require each FCM to provide its DSRO with view-only access via the Internet to account information for each of the FCM's customer segregated funds account(s) maintained and held at a bank or trust company. The same requirement would apply to the FCM's customer secured account(s) held for customers trading on foreign futures exchanges.

In addition, the NFA rule amendments provide that if a bank or trust company is unable to allow the FCM to provide its DSRO with view-only full access via the Internet, the bank or trust company will not be deemed an acceptable depository to hold customer segregated and secured accounts. NFA intends to expand its oversight of FCMs under the amended rules, once the amendments are implemented, to receive daily reports from all depositories for customer segregated and secured accounts, including FCMs that are clearing members of DCOs. NFA plans to develop a program to compare the balances reported by the depositories with the balances reported by the FCMs in their daily segregation reports. An immediate alert would be generated for any material discrepancies.

E. Commission's Proposal

The incidents outlined above, coupled with the information generated through the recent efforts undertaken by the Commission and industry participants, demonstrate the need for new rules and amendments to existing rules. In particular, an examination of FCM business operations—including the non-futures business of FCMs—and the currently regulatory framework evince a need for enhanced customer protections, risk management programs, disclosure requirements, and auditing and examination programs. The amendments proposed herein address these issues in several ways.

First, recognizing problems surrounding the treatment of customer segregated funds and foreign futures or foreign options secured amounts, the Commission is proposing to amend several components of Parts 1, 22, and 30 of the Commission's regulations. The Commission believes that the proposed amendments will provide greater certainty to market participants that the customer funds entrusted to FCMs will be protected. Second, to address shortcomings in the risk management of FCMs, the Commission is proposing a new § 1.11 that will establish robust risk management programs. Third, the Commission determined that the current regulatory framework should be re-oriented to implement a more risk-based, forward-looking perspective, affording the Commission and SROs with read-only access to accounts holding customer funds and additional information on depositories and the customer assets held in such depositories. The proposed amendments to §§ 1.10, 1.12, 1.20, 1.26, and 1.32 address those and other issues. Fourth, given the difficulties that can arise in an FCM's business, and the direct and significant impact on the FCM's regulatory capital that can result from such difficulties, the Commission is proposing to amend § 1.17(a)(4) to ensure that an FCM's capital and liquidity are sufficient to safeguard the continuation of operations at the FCM. Fifth, to effect the change in orientation needed in FCM examinations programs, as well as to assure quality control over program contents, administration and oversight, the Commission is proposing to amend § 1.52, which, among other things, addresses the formation of Joint Audit Committees and the implementation of Joint Audit Programs. And sixth, recognizing the need to increase the information provided to customers concerning the risks of futures trading and the FCMs with which they may choose to conduct business, the Commission is proposing amendments to § 1.55 that will enhance the disclosures provided by FCMs. These amendments are discussed in greater detail in the next Section.

II. Section by Section Analysis of Proposed Commission Regulations and Proposed Amendments to Existing Commission Regulations

A. Proposed Amendments to § 1.10: Financial Reports of Futures Commission Merchants and Introducing Brokers

Regulation 1.10 requires each FCM to file with the Commission and with the firm's DSRO an unaudited financial report each month. The financial report must be prepared using Form 1-FR-FCM. An FCM, however, that is dually-registered as a BD, may file a Financial and Operational Combined Uniform Single Report under the Securities Exchange Act of 1934 (“FOCUS Report”) in lieu of the Form 1-FR-FCM. Each FCM also is required to file an annual report certified by an independent public accountant with the Commission and with its DSRO.

The unaudited monthly and certified annual financial reports are required to contain basic financial statements including a statement of financial condition, a statement of income (loss), and a statement of changes in ownership equity. The financial statements also are required to include additional schedules designed to address specific regulatory objectives to demonstrate that the FCM is in compliance with minimum capital and customer funds segregation requirements. These additional schedules include a statement of changes in liabilities subordinated to claims of general creditors, a statement of the computation of the minimum capital requirements (“Capital Computation Schedule”), a statement of segregation requirements and funds in segregation for customers trading on U.S. commodity exchanges (“Segregation Schedule”) and a statement of secured amounts and funds held in separate accounts for foreign futures and foreign options customers (“Secured Amount Schedule”). In addition, the certified annual report must contain a reconciliation of material differences between the Capital Computation Schedule, the Segregation Schedule, and the Secured Amount Schedule contained in the certified annual report and the unaudited monthly report for the FCM's year-end month.

The Forms 1-FR-FCM and the FOCUS Reports are necessary financial reporting for Commission and DSRO staff to assess the ongoing financial condition of an FCM and provide significant information regarding the operations of the firm that may impact the FCM's ability to maintain

compliance with Commission requirements and the protection of customer funds. The Form 1-FR-FCM and FOCUS Reports are filed electronically with the Commission and are subject to automated edits by the Commission's financial statement surveillance software. Alerts and edit checks, which may indicate a need for further analysis and follow-up by staff, are generated by the financial surveillance software and major issues are immediately and automatically forwarded to Commission staff for review.

The Segregation Schedule and the Secured Amount Schedule generally indicate, respectively, the total amount of funds held by the FCM in segregated or secured accounts, the total amount of funds that the FCM must hold in segregated or secured accounts to meet its regulatory obligations to futures customers and foreign futures or foreign options customers, and whether the firm holds excess segregated or secured funds in the segregated or secured accounts as of the reporting date. The Commission is proposing to amend § 1.10 to require each FCM to also disclose in the Segregation Schedule and in the Secured Amount Schedule

a target amount of “residual interest” (denoting the FCM's proprietary funds) that the FCM is required to maintain in customer segregated accounts and secured accounts based upon its written policies and procedures for computing a targeted amount required under the new risk management provisions in § 1.11 discussed in Section II.B below.

In addition to the target amount of residual interest, the FCM also will be required to report on the Segregation Schedule and the Secured Amount Schedule the sum of outstanding margin deficits of the relevant customers for each computation, to ensure that the residual interest is at all times in excess of such sum, demonstrating compliance with the newly proposed procedures in §§ 1.22 and 1.23, which shall require residual interest to exceed the sum of such margin deficits.

The Commission also proposes to revise the title of the “Secured Amount Schedule” by adding the term “30.7 Customer” to specify that the secured amount will include both U.S.-domiciled and foreign-domiciled customers consistent with the proposed amendments to Part 30 of the Commission Regulations discussed in Section II.R below.

The NFA recently adopted a similar amendment to its rules, mandating that its member FCMs maintain written policies and procedures identifying a target amount that the FCM will seek to maintain as its residual interest in customer segregated and secured accounts.

See

NFA Notice I-12-14 (July 18, 2012), available at

http://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4072.

As more fully discussed in Section II.B below, proposed § 1.11 will require each FCM that carries customer funds to determine a necessary level of excess segregated and secured funds that the firm should hold in segregated or secured accounts to ensure against becoming undersegregated or undersecured as a result of the withdrawal of proprietary funds from segregated or secured accounts. Each FCM is required under proposed § 1.11 to compute or determine the necessary target of residual interest based upon appropriate due diligence and consideration of various factors relating to the nature of the FCM's business,

including the type and general creditworthiness of the customer base, the amount of the undermargined customer accounts on any given day, and the volatility and liquidity of the markets and products traded by customers.

The term “Cleared Swaps Customer Collateral” is defined in § 22.1 to mean all money, securities, or other property received by a futures commission merchant or by a derivatives clearing organization from, for, or on behalf of a Cleared Swaps Customer to margin a Cleared Swap or the settlement value of a Cleared Swap, and includes any accruals on such Cleared Swap transactions.

The disclosure of the targeted amount of the FCM's residual interest in segregated or secured accounts will allow the Commission and DSRO to assess the size of the target relative to both the total funds held in segregation or secured accounts and to compare the target to other FCMs. Such information will assist the Commission and DSROs in assessing the potential risk that a firm may become undersegregated or undersecured, and will enhance the Commission's and DSRO's ability to protect customer funds.

The Commission also is proposing to revise Form 1-FR-FCM to adopt a new “Statement of Cleared Swap Customer Segregation Requirements and Funds in Cleared Swap Customer Accounts Under Section 4d(f) of the Act” (“Cleared Swaps Segregation Schedule”). The Commission is proposing the Cleared Swaps Segregation Schedule to implement provisions in section 724(a) of the Dodd-Frank Act.

Section 724(a) amended section 4d of the Act, and requires an FCM to segregate from its own assets any money, securities and other property deposited by a Cleared Swaps Customer to margin its cleared swaps positions. As part of the implementation of section 724(a) of the Dodd-Frank Act, the Commission adopted § 22.2(g) which requires an FCM to compute, as of the close of business each business day, a segregation computation demonstrating compliance with its obligation to hold sufficient funds in segregated accounts in an amount sufficient to cover the total Net Liquidating Equity of each of the FCM's Cleared Swaps Customers.

The proposed Cleared Swaps Segregation Schedule will be comparable to the current Segregation Schedule and will allow the Commission and the FCM's DSRO to obtain information on the FCM's holding of Cleared Swaps Customer Collateral to ensure that such funds are held in accordance with the provisions of Part 22 of the Commission's regulations and that the FCM is reporting that it has sufficient funds in segregated accounts to meet its obligations to all of its Cleared Swaps Customers computed under the Net Liquidating Equity Method.

See

Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at

http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

See

77 FR 6336 (February 7, 2012).

The Commission previously proposed a Cleared Swaps Segregation Schedule as part of its proposed regulations to adopt capital requirements for swap dealers and major swap participants.

In light of the Commission's decision to revise the Cleared Swaps Segregation Schedule from the version that was published for comment as part of the Commission's proposed capital rules for swap dealers and major swap participants by requiring the FCM to separately disclose its targeted residual interest in Cleared Swaps Customer Accounts and the sum of margin deficits for such accounts, the Commission is republishing the Cleared Swaps Segregation Schedule as part of this proposal to provide the public with an opportunity to comment on the proposal.

See Capital Requirements of Swap Dealers and Major Swap Participants,

76 FR 27802 (May 12, 2011).

Regulation 1.10(h) provides that a dually-registered FCM/BD may file a FOCUS Report in lieu of the Form 1-FR-FCM provided that all information that is required to be included in the Form 1-FR-FCM is included in the FOCUS Report. Currently, dual-registrant FCM/BDs include a Segregation Schedule and a Secured Amount Schedule in the FOCUS Report filings as supplemental schedules. If the Commission were to adopt a Cleared Swaps Segregation Schedule, dual-registrant FCM/BDs would have to include such schedule in their Focus Report filings.

The Commission also is proposing to amend § 1.10(g)(2) to provide that the Cleared Swaps Segregation Schedule is a public document. Regulation 1.10 currently provides that the Commission will treat the monthly Form 1-FR-FCM

reports and monthly FOCUS Reports as exempt from mandatory public disclosure for purposes of the Freedom of Information Act and the Government in the Sunshine Act, except for certain capital numbers and other financial information including the Segregation Schedules and the Secured Amount Schedules contained in the financial reports. The Commission is proposing to amend § 1.10(g)(2) to provide that the Cleared Swaps Segregation Schedule is a public document in the same manner as the Segregation Schedule and Secured Amount Schedule, and is available by requesting copies from the Commission.

Making the Cleared Swaps Segregation Schedule publicly available will benefit customers and potential customers by allowing them to review an FCM's compliance with its regulatory obligations and will provide a certain amount of detail as to how the FCM holds customer funds, which customers and potential customers will be able to assess from a risk perspective and also use to compare to other firms. This information, coupled with additional firm risk disclosures that the Commission is proposing in § 1.55 and discussed in detail in Section II.P below, will provide customers with greater transparency regarding the risks of entrusting their funds and engaging in transactions with particular FCMs. Customers also will be able to view the total amount of the targeted residual interest each FCM holds and to assess for themselves the adequacy of the targeted residual interest and whether the FCM holds funds in excess of the targeted residual interest.

The Commission also is proposing to amend several statements in the Form 1-FR-FCM. The Commission is proposing to amend the Statement of Financial Condition by adding a new line item 1.D. Line 1 currently separately details the amount of funds in segregation or separate accounts for futures customers and foreign futures or foreign option customers. Proposed line item 1.D. will set forth the amount of funds held by the FCM in segregated accounts for Cleared Swaps Customers. This amendment is necessary due to the adoption of the Part 22 regulations, which require the segregation of Cleared Swaps Customer Collateral and the proposed adoption of the Cleared Swaps Segregation Schedule as part of the Form 1-FR-FCM.

The Commission also is proposing to amend the Statement of Financial Condition by adding a new line item 22.F., which requires the separate disclosure of the FCM's liability to Cleared Swaps Customers. The Commission also is proposing to revise current line item 27.J. to require the FCM to disclose its obligation to retail forex customers. Currently, an FCM's obligation to retail forex customers is included with other miscellaneous liabilities and reported under current line item 27.J. “Other.” The separate reporting of an FCM's retail forex obligation will provide greater transparency on the Statement of Financial Condition regarding the firm's obligations to its retail counterparties in off-exchange foreign currency transactions, and is appropriate given the Commission's direct jurisdiction over such activities under section 2(c) of the Act when conducted by an FCM.

The Commission also is proposing to amend § 1.10(b)(1)(ii) to require that an FCM submit its certified annual report to the Commission and to its DSRO within 60 days of its year-end date. Currently, an FCM is required to submit the annual certified financial statements within 90 days of the firm's year-end date, except for FCMs that are dually-registered as FCM/BDs, which are require to submit the certified annual report within 60 days of the year-end date under both Commission and SEC regulations. Therefore, the proposal will only impact FCMs that are not dually-registered as BDs.

The proposal will align the filing deadlines for both FCMs and dual registrant FCMs/BDs. The annual certified financial report is a key component of the Commission's and DSROs' financial surveillance program, as it represents that an independent entity has conducted an audit following U.S. generally accepted auditing standards for the purpose of expressing an opinion on the financial statements of the FCM. Requiring standalone FCMs to submit the certified financial statements within 60 days of the firm's year-end date will allow Commission and DSRO staff to review the financial statements on a more timely basis to identify and address accounting or auditing issues that may impact the financial condition of the FCM.

In addition, the Commission notes that, pursuant to § 3.3(f)(2), the annual report of an FCM's CCO must be furnished electronically to the Commission simultaneously with the submission of Form 1-FR-FCM, as required under § 1.10(b)(2)(ii); simultaneously with the FOCUS Report, as required under § 1.10(h); or simultaneously with the financial condition report, as required under section 4s(f) of the Act, as applicable. Given the 60-day deadline proposed herein, the Commission is proposing a conforming amendment to § 3.3(f)(2) to reflect the proposed 60-day deadline.

The Commission is proposing to add a new requirement in § 1.10(b)(5) to require each FCM to file with the Commission on a monthly basis its balance sheet leverage ratio. FCMs currently are required to file the same leverage information with the NFA on a monthly basis. The Commission does not expect the imposition of this regulation to have any significant impact on the FCMs as the ratio is calculated from existing reported balances and already provided to NFA.

The leverage ratio will provide information regarding the amount of assets supported by the FCM's capital base. The Commission views leverage information as an important element in assessing the financial condition of an FCM as a high degree of balance sheet leverage may indicate that the firm does not have the capital to support its investment decisions, particularly if such investments loose a significant amount of their value in a short period of time or require substantial margin payments or other payments to support.

The Commission also is proposing to amend § 1.10(c)(2)(i) to require that all monthly unaudited Forms 1-FR-FCM or FOCUS Reports be filed electronically with the Commission. The Commission also is proposing to amend § 1.10(c)(2)(i) to require an FCM to file its certified financial statement in electronic format.

FCMs currently file the monthly unaudited financial statements with the Commission using the WinJammer Online Filing System (“WinJammer”) electronic filing system, and the proposed amendments are simply codifying current practices.

Annual certified financial reports currently are required to be filed in paper form, and are required to contain the manual signature of the public accountant that conducted the examination. Under the Commission's proposal, an FCM will use the WinJammer system to file its certified financial report as a “PDF” document. The electronic filing of certified annual reports will ensure that such documents are received in a timely manner and will allow Commission staff to initiate prompt reviews of the public accountant's report to identify any accounting issues or material inadequacies that might have been identified during the examination. The

timely review of the certified financial statements will enhance customer protections as deficiencies and other accounting issues will be promptly identified and reviewed.

WinJammer is a web-based application developed jointly by the Chicago Mercantile Exchange (“CME”) and the NFA. FCMs currently use WinJammer to transmit Forms 1-FR-FCM, FOCUS Reports, and other financial information and regulatory notices to the Commission and to the SROs.

The Commission also is proposing a technical amendment to § 1.10(c)(1). Regulation 1.10(c)(1) provides that any report or information required to be provided to the Commission by an IB or FCM will be considered filed when received by the Commission Regional office with jurisdiction over the state in which the FCM has its principal place of business. To ensure that reports are filed expeditiously with the correct Commission Regional office, the Commission's proposed amendment to § 1.10(c)(1) cross-references § 140.02, which sets forth the jurisdiction of each of the Commission's three Regional offices.

The Commission requests comment on all aspects the proposed amendments to § 1.10. Specifically, the Commission requests comments on the following questions:

• Should other schedules in the Form 1-FR-FCM be amended to provide additional information to the Commission and the FCM's SROs?

• The Commission is proposing to require FCMs to submit to the Commission and the firm's DSRO a monthly computation of the FCM's balance sheet leverage. The proposal is consistent with the leverage computation set forth in the rules of the NFA. Are there other measures of leverage that the Commission should consider adopting? Are there other financial statement ratios in addition to leverage that the Commission should consider requiring FCMs to submit to the Commission and DSROs?

B. Proposed § 1.11: Risk Management Program for Futures Commission Merchants

Proposed § 1.11 requires each FCM that carries customer accounts

to establish a risk management program designed to monitor and manage the risks associated with the FCM's activities as an FCM. It further provides: (1) That such risk management program consist of written policies and procedures; (2) that such policies and procedures be approved by the governing body of the FCM and be furnished to the Commission; and (3) that a risk management unit that is independent from the business unit be established to administer the risk management program.

Proposed § 1.11 contains an applicability provision in paragraph (a) that makes clear that the risk management program is only required of FCMs that accept money, securities, or property to margin or secure the trades or contracts of customers transacting in futures, options on futures, and swaps.

Paragraph (b) of proposed § 1.11 establishes definitions for the terms “Customer,” “Customer Account,” “Business Unit,” “Governing Body,” “Segregated Funds,” and “Senior Management.”

“Business Unit” is defined to clearly delineate the separation of the risk management unit required by the proposed rule from the other personnel of an FCM.

The term “Customer” is defined broadly to include futures customers (as defined in § 1.3) trading futures contracts or options on futures contracts listed on designated contract markets, 30.7 Customers (as proposed to be defined in § 30.1) trading futures contract or options on futures contracts listed on foreign contract markets, and Cleared Swaps Customers (as defined in § 22.1) engaging in cleared swap transactions.

The term “Customer Funds” is defined to mean funds deposited by futures customers, 30.7 Customers, and Cleared Swap Customers as margin or funds accruing to such customers from open futures or cleared swap transactions. Existing Commission regulations require FCMs to hold each of these types of customer deposited funds, as applicable, in separate accounts and to segregate such Customer Funds from the FCM's own funds and from each other type.

The term “Governing Body” is defined as the sole proprietor, if the FCM is a sole proprietorship; a general partner, if the FCM is a partnership; the board of directors, if the FCM is a corporation; and the chief executive officer, chief financial officer, the manager, the managing member, or those members vested with the management authority if the FCM is a limited liability company or limited partnership. “Senior Management” is defined to mean any officer or officers specifically granted the authority and responsibility to fulfill the requirements of senior management by the Governing Body. These definitions, as used in proposed § 1.11, are designed to ensure that there is accountability at the highest levels for the FCM's key internal controls and processes designed to protect the funds of the FCM's customers.

The term “Segregated Funds” is defined to mean money, securities, or other property held by a futures commission merchant in separate accounts pursuant to § 1.20 for futures customers, pursuant to § 22.2 for cleared swaps customers, and pursuant to § 30.7 for foreign futures and options customers. The definition makes clear that the requirements of § 1.11 applies to all customer funds that may be held by an FCM.

Proposed § 1.11(c)(4) requires FCMs to provide copies of the risk management policies and procedures to the Commission and the FCM's DSRO in order to allow the Commission and DSROs to monitor the status of risk management practices among FCMs. Submission of such policies and procedures to the Commission without further comment or action by the Commission or Commission staff should not be construed as an endorsement of the completeness or effectiveness of the risk management policies and procedures and no FCM should make a representation to the contrary. The Commission invites comments on the submission of risk management policies and procedures and, more generally, on whether the provisions of § 1.11 have achieved a sufficient level of detail for the purposes of designing a comprehensive risk management program.

Proposed § 1.11(e) provides for a non-exclusive list of the elements that must be a part of the risk management program of an FCM. Such policies and procedures should include: (1) identifying risks (including risks posed by affiliates, all lines of business of the FCM, and all other trading activity of the FCM) and setting of risk tolerance limits; (2) providing periodic risk exposure reports to senior management and the governing body; (3) operational risk controls; (4) capital controls; and (5) establishing a risk management program that takes into account risks associated with the safekeeping and segregation of customer funds.

In regard to customer funds, the Commission notes that FCMs are required by the Act and Commission regulations to segregate and safeguard funds deposited by customers for trading futures and/or swap contracts. Recent events have emphasized that it is essential that FCMs maintain adequate systems of internal controls, involving the participation and review of the firm's senior management, in order to properly safeguard customer funds. Accordingly, proposed § 1.11(e)(3)(i) requires that the risk management policies and procedures of an FCM related to the risks associated with safekeeping and segregation of customer funds must include: (1) The evaluation and monitoring of depositories;

(2)

account opening procedures that ensure the FCM obtains the acknowledgment required under § 1.20 from the depository and that the account is properly titled as belonging to the customers of the FCM;

(3) establishing and maintaining an adequate targeted amount of excess funds in customer accounts reasonably designed to ensure the FCM is at all times in compliance with the segregation requirements for customer funds under the Act and Commission regulations, as discussed further below; (4) controls ensuring that withdrawal of cash, securities, or other property from accounts holding customer funds not for the benefit of customers are in compliance with the Act and Commission regulations;

(5) procedures for assessing the appropriateness of investing customer funds in accordance with § 1.25;

(6) the valuation, marketability, and liquidity of customer funds and permitted investments made with customer funds; (7) the appropriate separation of duties of personnel responsible for compliance with the Act and Commission regulations relating to the protection and financial reporting of customer funds;

(8) procedures for the timely recording of transactions in the firm's books and records; and (9) annual training of personnel responsible for compliance with the Act and Commission regulations relating to the protection and financial reporting of customer funds.

The evaluation process must include documented criteria that any depository will be assessed against in order to qualify to hold funds

belonging to Customers. The criteria must address a depository's capitalization, creditworthiness, operational reliability, access to liquidity. The criteria must also address risks associated with concentration of Customer funds in any depository or group of depositories, the availability of deposit insurance, and the regulation and supervision of depositories. The evaluation criteria is intended to ensure that the FCM adopts an evaluation process which reviews potential depositories against substantive criteria relevant to the safe custody of Customer funds and that the FCM's process for evaluating and selecting depositories can be reviewed by regulators and auditors. The FCM also must maintain a documented process addressing the ongoing monitoring of selected depositories, including a thorough due diligence review of each depository at least annually.

As required by § 1.20, such account opening documentation is necessary to ensure that the depositories are aware of their obligations regarding the accounts and the statutory and regulatory protections afforded the funds held in the accounts due to their status as Segregated Funds.

The controls must include the conditions for pre-approval and the notice to the Commission for such withdrawals required by proposed § 1.23, § 22.17, or § 30.7, discussed below.

The FCM's assessment must take into consideration the market, credit, counterparty, operational, and liquidity risks associated with the investments.

The policies and procedures must provide for the separation of duties among personnel that are responsible for customer trading activities, and approving and overseeing cash receipts and disbursements (including investment and treasury operations). The policies and procedures must further require that any movement of funds to affiliated companies or parties be approved and documented.

Regarding the proposed requirement that FCMs establish and maintain an adequate targeted amount of excess funds in customer accounts, the Commission notes that FCMs currently deposit proprietary funds into both customer segregated accounts and Part 30 secured accounts as a buffer to minimize the possibility of the firm being in violation of its segregated and secured fund obligations at any time. Under the proposal, senior management of the FCM must perform appropriate due diligence in setting the amount of this buffer and must consider the nature of the FCM's business including the type and general creditworthiness of its customer base, the types of markets and products traded by the firm's customers, the proprietary trading activities of the FCM, the volatility and liquidity of the markets and products traded by the customers and the FCM, the FCM's own liquidity and capital needs, and historical trends in customer segregation and secured account funds balances, customer debits and margin deficits. The FCM also must reassess the adequacy of the targeted residual interest quarterly.

The Commission believes that each FCM must set the amount of excess segregated and secured funds required utilizing a quantitative and qualitative analysis that reasonably ensures compliance at all times with segregated and secured fund obligations. Such analysis must take into account the various factors that could affect segregated and secured balances, and must be sufficiently described in writing to allow the DSRO of the FCM and Commission to duplicate the calculations and test the assumptions. The analysis must provide a reasonable level of assurance that the excess is at an appropriate level for the FCM.

A failure to adopt or maintain appropriate risk management policies and procedures or to implement, monitor and enforce controls required by § 1.11 may result in a referral to the Commission's Division of Enforcement for appropriate action.

Separate from requiring the establishment of a target for residual interest, the Commission is further requiring, as discussed in more detail under Sections II.G, II.H, and II.I for §§ 1.20, 1.22, and 1.23, respectively, that residual interest at all times exceed the sum of outstanding margin deficits to provide a mechanism for ensuring compliance with the prohibition of the funds of one customer being used to margin or guarantee the positions of another customer under the Act and existing regulations.

Finally, to ensure the effectiveness of a risk management program, § 1.11(e)(4) requires that the risk management program include a supervisory system that is reasonably designed to ensure that the risk management policies and procedures are diligently followed. Furthermore, § 1.11(f) requires an annual review and testing of the adequacy of each FCM's risk management program by internal audit staff or a qualified external, third party service.

The Commission requests comment on all aspects of proposed § 1.11. Specifically, the Commission requests comment on the following:

• Should the Commission have different risk management requirements for FCMs based upon some measureable criteria, such as size of the firm or type of customers? How would the Commission design such criteria to distinguish between firms? Which elements in proposed § 1.11 should apply to smaller FCMs vs. larger FCMs? What elements should apply to all FCMs irrespective of the size of the firm?

• Does the proposed risk management program address the appropriate minimum elements that should be covered by an FCM risk management program?

• Regulation 3.3 requires the CCO of an FCM to provide an annual report to the Commission that must review each applicable requirement under the Act and Commission regulations, and with respect to each applicable requirement, identify the policies and procedures that are reasonably designed to ensure compliance with the requirement, and provide an assessment of the effectiveness of the policies and procedures.

The annual report also must include a certification by the CCO that, to the best of his or her knowledge and reasonable belief, and under penalty of law, the information contained in the annual report is accurate and complete. The Commission requests comment on whether the standard for the CCO's certification in the annual report (

i.e.,

based upon the CCO's knowledge and reasonable belief) is adequate for a certification of the FCM's compliance with policies and procedures for the safeguarding of customer funds. Should § 1.11 contain a separate CCO certification requirement

that would impose a higher duty of strict liability or some other higher obligation on a CCO?

Such report is mandated by § 3.3 of the Commission's regulations;

See Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants,

77 FR 20128, Apr. 3, 2012 (promulgating final rules concerning the CCOs of FCMs, swap dealers, and major swap participants);

see also

§ 4d(d) of the Act, 7 U.S.C. 6d(d).

• Should the risk management program require an FCM to conduct quarterly or periodic audits to detect any breach of the policies and procedures that address the proper segregation of customer funds?

• Should the Commission establish a phased-in compliance provision for § 1.11? If so, how long of a phase-in period should be provided? Should there be different phase-in periods for different provisions of the proposed regulation?

C. Proposed Amendments to § 1.12: Maintenance of Minimum Financial Requirements by Futures Commission Merchants and Introducing Brokers

The regulatory notices required under § 1.12 are intended to provide the Commission and SROs with prompt notice of potential adverse conditions at FCMs or IBs that may indicate or lead to a threat to the financial condition of the firm or the protection of customer funds held by the FCM. In adopting § 1.12 in 1978, the Commission stated that the establishment of an early warning system was necessary because “[a] fundamental purpose of the Act is to protect the public from financially irresponsible FCMs who handle customer funds.”

43 FR 39956, 39967 (Sept. 8, 1978).

Regulation 1.12 currently obligates FCMs and IBs to provide notice to the Commission and to the respective DSROs if certain specified reportable events occur. Reportable events include: failing to maintain the minimum level of required regulatory capital (§ 1.12 (a)); failing to maintain current books and records (§ 1.12(c)); and failing to comply with the requirements to properly segregate customer funds (§ 1.12(h)). The Commission is proposing to amend § 1.12 to include several additional reportable events and to revise the process for submitting reportable events to the Commission and DSROs.

Regulation 1.12(a) requires an FCM or IB that fails to maintain the minimum level of adjusted net capital required by § 1.17 to provide immediate notice to the Commission and to the entity's DSRO. The notice must include additional information to adequately reflect the FCM's or IB's current capital condition as of any date that the entity is undercapitalized.

The Commission is proposing to amend § 1.12(a) to explicitly provide that if the FCM or IB cannot compute or document its actual capital at the time it knows that it is undercapitalized, it must still provide the written notice required by § 1.12(a) immediately and cannot delay filing the notice until it has adequate information to compute its actual level of adjusted net capital. A purpose of the notice provision under § 1.12(a) is to provide the Commission and the DSROs with immediate notice of the undercapitalized condition of an FCM or IB. If an FCM or IB were to delay alerting the Commission that it was undercapitalized due to the fact that it could not accurately assess its capital condition, it would frustrate the intent of the notice provision. It is imperative that an FCM or IB provide immediate notice if the firm is undercapitalized. Upon the filing of a notice, Commission and SRO staff will contact the FCM or IB to obtain greater details of the financial condition of the firm, including information regarding its current financial condition or issues associated with the firm's inability to accurately determine its current financial condition.

Regulation 1.12(h) currently requires an FCM that fails to hold sufficient funds in segregated accounts to meet its obligations to futures customers, or that fails to hold sufficient funds in separate accounts for foreign futures or foreign options customers, to provide immediate notice to the Commission and to the FCM's DSRO. The Commission is proposing to amend paragraph (h) to include an explicit requirement that an FCM provide immediate notice to the Commission and to its DSRO if the FCM fails to hold sufficient funds in segregated accounts for Cleared Swaps Customers to meet its obligation to such customers.

Commencing November 8, 2012, the compliance date for certain Commission Part 22 regulations, FCMs will be required under § 22.2 to hold a sufficient amount of funds in Cleared Swaps Customer Accounts to meet the Net Liquidating Equity of each Cleared Swaps Customer.

Immediate notification of a failure to hold sufficient funds in segregation for Cleared Swaps Customers is essential for the Commission and DSROs to promptly assess the financial condition of an FCM and to determine if there are threats to the safety of the Cleared Swaps Customers' funds held by the FCM. The proposed amendment to § 1.12(h) also harmonizes the notice requirements whenever an FCM fails to hold sufficient funds for futures customers, 30.7 Customers, and Cleared Swaps Customers.

77 FR 6336 (Feb. 7, 2012).

The Commission also is proposing to amend § 1.12 by adding new paragraph (i) to require an FCM to provide notice whenever it discovers or is informed that it has invested funds held for customers in investments that are not permitted investments under § 1.25, or if the FCM holds permitted investments in a manner that is not in compliance with the provisions of § 1.25 (such as the investment concentration limits). The proposal will apply to funds held for futures customers, 30.7 Customers, and Cleared Swaps Customers.

The protection of customer funds is a core element of the Commission's regulatory program. FCMs are entrusted with a responsibility to use customer funds only for the benefit of the depositing customers.

FCMs are permitted, however, to invest customer funds pursuant to the standards and conditions set forth in § 1.25. Regulation 1.25 contains a list of permitted investments and other criteria that are intended to allow an FCM to receive the benefit of investing customer funds while also preserving the principal and maintaining the liquidity of the customer funds.

Regulation 1.20(a), 17 CFR 1.20(a).

Requiring an FCM to provide prompt notice of a § 1.25 violation will allow Commission and DSRO staff to assess whether customer funds are endangered and to work with the FCM to ensure that the impermissible investments are appropriately liquidated and customer funds remain intact. Commission and DSRO staff also will benefit from receiving notices of § 1.25 violations in that the notices will provide information regarding new investments that FCMs may engage in that are not permitted investments under § 1.25. Such information will be helpful for the Commission and DSRO in conducting reviews of other FCMs and in providing regulatory updates to the industry.

The Commission further notes that investing customer funds in investments that are not permitted investments under § 1.25, or holding investments in a manner that is otherwise not compliant with § 1.25 does not change the legal status of the funds as customer funds in the event of the bankruptcy of the FCM.

The Commission also is proposing to amend § 1.12 to provide a new paragraph (j) that will require an FCM to provide immediate notice to the Commission and to the firm's DSRO if the FCM does not hold an amount of funds in segregated accounts for futures customers or for Cleared Swaps Customers, or if the FCM does not hold sufficient funds in separate accounts for 30.7 Customers, sufficient to meet the firm's targeted residual interest in one or more of these accounts as computed

under proposed § 1.11, or if its residual interest in one or more of these accounts is less than the sum of outstanding margin deficits for such accounts. Proposed § 1.11 will require each FCM that carries customer funds to calculate an appropriate amount of excess funds (

i.e.,

proprietary funds) to hold in segregated or secured accounts to mitigate the FCM from being undersegregated or undersecured due to a withdrawal of proprietary funds from a segregated or secured account. The fact that an FCM is not holding a sufficient amount of excess funds in customer accounts to meet its targeted residual interest may be indicative of more severe financial or operational issues at the firm. In addition, if an FCM's residual interest is less than the sum of outstanding margin deficits in one such account, it is possible that funds of one customer in such account are at risk of margining or guaranteeing the open positions of another customer. Accordingly, the Commission is proposing to require an FCM to file immediate notice of such an event to allow Commission and DSRO staff to contact the FCM to assess the condition of the firm and the safety of customer funds.

The Commission also is proposing new paragraphs (k) and (l) for § 1.12. Paragraphs (k) and (l) will require an FCM to provide notice to the Commission and to the firm's DSRO in the event of a material adverse impact in the financial condition of the firm or a material change in the firm's operations. Proposed paragraph (k) will require an FCM to provide immediate notice if the FCM, its parent, or a material affiliate, experiences a material adverse impact to its creditworthiness or its ability to fund its obligations. Indications of a material adverse impact of an FCM's creditworthiness may include a bank or other financing entity withdrawing credit facilities, a credit rating downgrade, or the FCM being placed on “credit watch” by a credit rating agency. Proposed paragraph (l) will require an FCM to provide immediate notice of material changes in the operations of the firm, including: A change in senior management; the establishment or termination of a material line of business; a material change in the FCM's clearing arrangements; or a material change in the FCM's credit arrangements. Paragraph (l) is intended to provide the Commission with notice of material events, such as the departure of the FCM's CCO, CFO, or CEO.

As noted above, § 1.12 is intended to provide the Commission and DSROs with notice of potential issues that may impact the financial condition of an FCM or the safety of customer funds. The regulatory objective is for FCMs to provide material information to the Commission and DSROs as early as possible so that the Commission and DSROs can assess the information and communicate with the FCMs prior to a more serious issue developing that may impair the financial condition of the firms or the safety of customer funds. Proposed paragraphs (k) and (l) will provide the Commission and DSROs with notice of major events that will initiate a dialogue between the Commission, DSROs, and FCMs which will have the benefit of informing the Commission and DSROs of material events impacting FCMs. Such information would be used by the Commission and DSROs in setting the scope of the review and monitoring of the FCMs, including the determination of the risk of the firms for purposes of scheduling future examinations. Without paragraphs (k) and (l), the Commission and DSROs may not learn of material events at FCMs until the firms are subject to periodic examinations.

The Commission is proposing to add a new paragraph (m) to § 1.12 that will require an FCM that receives a notice, examination report, or any other correspondence from the SEC or a SRO to file a copy of such notice, examination report, or correspondence with the Commission. In order to perform comprehensive oversight of an FCM, the Commission and the DSROs need to receive prompt notice of any concern or adverse action taken by the SEC or a securities SRO. The protection of futures customers funds are not immune from issues that arise from the securities operations or business of a dual registrant FCM/BD. Requiring an FCM to provide prompt notice to the Commission and the firm's DSRO of any notice, examination report, or correspondence that the firm receives from the SEC or a securities SRO will allow the Commission and the DSRO to identify potential threats to the safety of customer funds.

The Commission is further proposing to amend the process that an FCM uses to file the notices required by § 1.12. Currently, § 1.12 requires an FCM to provide the Commission and DSROs with telephonic and facsimile notice in some situations, and to provide written notice by mail in other situations. An FCM also is permitted, but not required, to file notices and written reports with the Commission and with its DSRO using an electronic filing system in accordance with instructions issued by or approved by the Commission.

The Commission is proposing to amend § 1.12(n) to require that all notices and reports filed by an FCM with the Commission or with the FCM's DSRO must be in writing and submitted using an electronic filing system. Each FCM currently uses WinJammer to file regulatory notices with the Commission and with the firm's DSRO. The WinJammer system provides for the most effective mechanism for ensuring that regulatory notices are promptly received by the Commission and by the DSROs.

The regulation further provides that if the FCM cannot file a notice due to the electronic system being inoperable or for any other reason, it must contact the Commission Regional office with jurisdiction over the firm and make arrangements for the filing of the regulatory notices by filing the notice with the Commission via electronic mail at a specially designated email address established by the Commission;

fcmnotices@cftc.gov.

The Commission also is proposing to amend § 1.12(n) to require that each notice filed by an FCM, IB, or SRO under § 1.12 must include a discussion of what caused the reportable event, and what steps have been, or are being taken, to address the reportable event. The reporting entity, however, may not delay the reporting of a reportable event if it does not possess complete information on what caused the event, or the steps that have been taken or are being taken to address the event.

The Commission's proposed amendment to require the electronic filing of reports applies to both registered FCMs and applicants for registration as FCMs. Applicants for FCM registration currently file regulatory notices with NFA using WinJammer.

The amendments to §§ 1.12(b), (d), (e), (f) and (g) are necessary and technical in nature, and primarily revise internal cross-references to the filing requirements in § 1.12(n).

The Commission request comment on all aspects of the proposed amendments to § 1.12. Specifically, the Commission requests comment on the following:

• Are there other reportable events that the Commission should consider adding to § 1.12 that would benefit the Commission and the DSROs in the monitoring of the financial and operating conditions of FCMs?

• Should the Commission consider removing any of the reportable events listed in § 1.12? If so, why?

• Should any of the reportable events be made public by the Commission, SROs, or FCMs? If so, which reportable events? What benefit would the public receive from the disclosure of the reportable events? What would be the costs of disclosing the reportable events to the FCMs? Are there any negative

impacts of disclosing the reportable events?

• Are the reporting standards in proposed paragraphs (k) and (l) adequately detailed and objective so that an FCM can determine when there is a reportable event? If not, what standards should the Commission use to define a reportable event under paragraphs (k) and (l)?

D. Proposed Amendments to § 1.15: Risk Assessment Reporting Requirement for Futures Commission Merchants

Regulation 1.15 requires FCMs to submit certain risk assessment reports to the Commission. The risk assessment filings include FCM organizational charts; financial, operational, risk management policies, and systems maintained by the FCM; and fiscal year-end consolidated and consolidating financial information for the FCM and its highest level material affiliate.

The Commission is proposing to amend § 1.15(a)(4) to require each FCM that is subject to § 1.15 to submit its risk assessment information to the Commission electronically in accordance with instructions issued by the Commission. The Commission intends for FCMs to file the risk assessment materials using the WinJammer electronic filing system. The Commission requests comments on its proposed amendments to § 1.15.

E. Proposed Amendments to § 1.16: Qualifications and Reports of Accountants

Regulation 1.16 sets forth the qualifications a public accountant must possess in order to conduct audits of Commission registrants. Currently, a public accountant must be registered and in good standing under the laws of the place of the public accountant's principal office in order to conduct examinations of FCMs.

The Commission is proposing to amend § 1.16(b)(1) to require that the public accountant be registered with the Public Company Accounting Oversight Board (“PCAOB”) in addition to being in good standing with the relevant state licensing authorities. In addition, the public accountant must have undergone an examination by the PCAOB and any deficiencies noted during such examination must have been remediated to the satisfaction of the PCAOB. Regulation § 1.16(b)(4) also will impose an obligation on an FCM's governing body to ensure that a public accountant is qualified to perform an audit of the FCM by assessing the firm's experience in auditing FCMs, the firm's experience and knowledge of the Act and Commission regulations, and the depth and experience of the firm's auditing staff.

The Commission also is proposing to amend § 1.16(c)(2) to require a public accountant to state in the audit opinion whether the audit was conducted in accordance with U.S. GAAS after full consideration of the auditing standards adopted by the PCAOB. Currently, all audits of the certified financial statements of FCMs must be performed under U.S. GAAS. However, as the Commission is now proposing that certified public accountants must be registered with the PCAOB, it is necessary to also require that the auditing standards promulgated by the PCAOB be considered and adhered to where applicable. PCAOB requires auditors opining on a public company financial statements to comply with all applicable auditing standards, including PCAOB standards; whereas U.S. GAAS is required for the audits of non-public companies.

In 2003, the PCAOB adopted existing U.S. GAAS as interim standards, subject to periodic revision as the PCAOB deemed necessary. Since that time, the PCAOB has issued its own auditing standards in areas of the audit in which differentiated audit procedures or reporting requirements have been considered necessary. These areas largely pertain to audits of internal control over financial reporting as well as reports on those controls, audit documentation and engagement quality review. Generally speaking, the most significant difference between U.S. GAAS and PCAOB standards relates to the auditor's testing of internal controls over financial reporting which are meant to cover the auditor's opinion on the Sarbanes-Oxley Act Section 404 report on internal controls. From a regulatory perspective, an auditor's focus on internal controls is critical to helping to ensure that material errors in financial or regulatory reporting are identified on a timely basis, and the PCAOB standards provide more focus on the auditing standards in this regard. It should also be noted that auditors of BDs are now required to register with the PCAOB and follow PCAOB standards; thus, any dually-registered FCM/BDs will already have to comply with this requirement.

The proposed amendments to §§ 1.16(b)(1) and (c)(2) are designed to reasonably ensure the quality and competence of public accountants that engage in the audits of FCMs. FCMs are sophisticated financial market participants that are subject to extensive regulation. In addition, the complexity of FCM audits is increased substantially when a firm is engaged in proprietary trading or dually-registered as an FCM/BD. Public accountants must be knowledgeable regarding the business operations, regulatory obligations and financial reporting requirements for FCMs, and the governing body of the FCM must ensure that the public accountant has the knowledge, experience, and resources to conduct the audits. Also, requiring the public accountant to be registered with PCAOB will ensure that the public accountant is subject to periodic reviews to assess its compliance with industry standards.

While the Commission does not expect the proposed PCAOB registration requirement to have a material impact on FCMs, it recognizes that not all FCMs currently use CPAs that are registered with the PCAOB or CPAs that have been subject to an examination by the PCAOB. Currently, 111 of the 116 FCMs are examined by CPAs that are registered with the PCAOB. Also, 12 CPAs that are registered with the PCAOB have not yet been subject to a PCAOB examination. These 12 CPAs conduct examinations of 20 FCMs. Therefore, currently 25 of the 116 FCMs would not satisfy the proposed requirement that only PCAOB-registered CPAs that have been subject to at least one PCAOB review may be engaged to conduct an examination of the FCM's financial statements.

The Commission further notes, however, that 7 of the 20 FCMs are audited by a PCAOB-registered CPA that also conducts audits of BDs or public companies and, therefore, will be subject to PCAOB examination at a future date.

The Commission is proposing a technical amendment to § 1.16 to revise the definition of the term “customer.” Regulation 1.16 details the standards that a public accountant must meet in conducting a financial examination of an FCM. Currently, § 1.16(a)(4) defines the term “customer” to include futures customers, Cleared Swaps Customers, and foreign futures or foreign options customers. The Commission is proposing to amend § 1.16(a)(4) to revise the definition of customer to replace the term “foreign futures or foreign options customer” with the term “30.7 Customer” to make the provision consistent with the amendments contained in Part 30 of the Commission's regulations.

The Commission also is proposing to amend paragraph (f)(1)(i)(C) of § 1.16 to provide that any filing of a notice of the extension of time to file the audited financial reports must be submitted by the FCM to the Commission using an electronic filing system. The Commission intends for FCMs to use the WinJammer electronic filing system.

The Commission also is proposing to remove the requirement from § 1.16(c)(1) that annual financial reports contain the manual signature of the public accountant. Under the proposed amendments to § 1.10 discussed above, FCMs will be filing annual financial reports electronically, which will preclude the use of manual signature.

The Commission requests comment on all aspects of proposed § 1.16. Specifically, the Commission request comment on the following:

• A purpose of the requirement that FCMs engage only CPAs that are registered with the PCAOB and have been reviewed by the PCAOB is to enhance the quality of the audit examination conducted by CPAs. Does the PCAOB registration and examination process enhance the quality of FCM audit engagements?

• Are there viable alternatives that the Commission should consider to enhance the quality of CPA FCM examinations in lieu of PCAOB registration and examination?

• Should the Commission consider allowing the non-PCAOB registered CPAs or PCAOB-registered CPAs that have not been subject to a PCAOB review to contractually engage for a peer review from a qualified CPA who is aware of the reason for the peer review as a short-term measure to allow the non-compliant CPAs to continue to conduct audits of FCMs?

• If the Commission adopts the PCAOB registration and examination requirement, how should the Commission implement the effective or compliance dates? What factors should the Commission consider in setting an effective date or compliance date for this provision?

F. Proposed Amendments to § 1.17: Minimum Financial Requirements for Futures Commission Merchants and Introducing Brokers

The Commission is proposing to amend § 1.17 by adding a new provision that will authorize the Commission to require an FCM to transfer its customer business and cease operating as an FCM if the FCM cannot immediately certify to the Commission, and demonstrate with verifiable evidence, that the FCM has sufficient access to liquidity to continue operating as a going concern. The Commission also is proposing to amend § 1.17 to permit an FCM that is not a dually-registered FCM/BD to develop the framework proposed by the SEC, as set forth below, to establish, maintain and enforce written policies and procedures for determining creditworthiness, and upon a determination that a particular type of security has minimal credit risk, to apply lower deductions to such securities in computing the FCM's adjusted net capital.

Section 4f(b) of the Act provides that no person may be registered as an FCM unless such person meets the minimum financial requirements that the Commission has established by regulation to ensure that an FCM meets its obligations at all times as an FCM to its customer and to market participants, including DCOs. The Commission's minimum capital requirements for FCMs are set forth in § 1.17 and generally require an FCM to maintain adjusted net capital equal to or in excess of the greater of: $1 million; 8 percent of the risk maintenance margin required on customer and non-customer futures and options on futures positions carried by the FCM;

the amount of adjusted net capital required by the NFA; or, for dual-registrants, the amount of net capital required by the SEC. The term “adjusted net capital” is generally defined as the FCM's net, liquid assets less all of the FCM's liabilities (except certain qualifying subordinated debt). In computing its adjusted net capital, an FCM is required to reduce the value of proprietary futures and securities positions included in its liquid assets by certain prescribed amounts or percentages of the market value (otherwise known as “haircuts”) to discount for potential adverse market movements in the securities.

The term “noncustomer” is generally defined under § 1.17 as affiliates or management of an FCM.

Commission Regulation 1.17(a)(4) currently provides that an FCM must cease operating as an FCM and transfer its customers positions to another FCM if the FCM is not in compliance with the minimum capital requirements, or is unable to demonstrate its compliance with the minimum capital requirements. The FCM, however, can initiate customer trades for liquidation purposes only. Regulation 1.17(a)(4) further provides that the Commission or the FCM's DSRO may grant the FCM up to a maximum of 10 days to come back into compliance with the minimum capital requirements without having to cease operating as an FCM or transferring customer accounts.

The Commission is proposing to add an additional clause to § 1.17(a)(4), which will specify that the Commission may request certification in writing from an FCM that it has sufficient liquidity to continue operating as a going concern, and that if such certification is not provided immediately or the FCM is not able to demonstrate its access to liquidity with verifiable evidence, the FCM must transfer all customer accounts and immediately cease doing business as an FCM. The proposed liquidity provision is intended to cover circumstances that require immediate attention. The proposal is not intended to provide a mechanism for the Commission to require FCMs to demonstrate that they are a going concern for an extended period of time into the future. Rather, the purpose of the proposal is to provide the Commission with a means of addressing exigent circumstances by requiring an FCM to produce a written analysis showing the sources and uses of funds over a short period of time not to exceed one week.

The Commission believes this clause provides additional protection to customers in the event of an imminent liquidity drain on a registrant, which may not be immediately reflected in its accounting or regulatory capital business records. Market events or other external indicators may come to the attention of the Commission which suggest an FCM is under severe liquidity stress, which demonstrates that although the firm is still able to demonstrate compliance with required regulatory capital, conditions are such that it will not be able to meet liquidity requirements out a period of time not to exceed one week. This provision will allow the Commission to essentially require an FCM on demand to be able to certify its access to liquidity sufficient to continue operating as a going concern for a period not to exceed one week. The inability of the FCM to satisfy this requirement will allow the Commission to direct the FCM to transfer customer accounts and cease doing business as an FCM.

The Commission believes the ability to certify, and if requested, demonstrate with verifiable evidence, sufficient liquidity to operate as a going concern to meet immediate financial obligations, is a minimum financial requirement necessary to ensure an FCM will continue to meet its obligations as a registrant as set forth under § 4(f)(b) of the Act. The certification required must satisfy the same oath or affirmation requirements as those required for the submission of monthly financial reports under § 1.10(d)(4), to ensure that it is made by an appropriate individual and that it is in writing under oath of the individual that it is true and correct to the best knowledge and belief of such individual. If a registrant certifies to the Commission its access to liquidity, but is not able to demonstrate with sufficient evidence such liquidity (for example such evidence may include confirmations by third parties of access

to credit lines with available credit or of unrestricted cash balances available to meet projected short term cash requirements), the Commission believes it would be prudent to require the registrant to transfer customer accounts. Circumstances related to a liquidity drain could also result in a breakdown of management controls and result in an erroneous or false certification, and in such circumstances, the protection of customers must be paramount. The Commission requests comment on the proposed additional clause to § 1.17(a)(4).

Regulation 1.17 further requires an FCM to take a haircut against the value of securities the FCM holds as investments of customer funds under § 1.25. A primary purpose of these haircuts is to provide a margin of safety against losses that might be incurred by the FCM as a result of market fluctuations in the prices of, or lack of liquidity in, the security positions.

For futures positions, an FCM that is a member of the clearing organization where the positions are cleared is required to take a haircut equal to the margin required by the clearing organization on such futures positions.

For securities positions, § 1.17 incorporates by reference the securities haircuts that a BD is required to take in computing its net capital under the SEC's regulations.

The structure of the Commission's net capital rule referring to the SEC's net capital rule is a result of the Commission's determination to defer to the SEC in areas of its expertise, specifically with respect to market risk and appropriate haircuts on securities positions.

See

§ 1.17(c)(5)(x)(A).

Commission Regulations 1.17(c)(5)(v) and 1.32(b) both incorporate 17 CFR 240.15c3-1(c)(2)(vi) by reference.

See

43 FR 15072 (Apr. 10, 1978) at 15077 and 43 FR 39956 (Sept. 8, 1978) at 39963.

The SEC capital rule currently applies a general or “default” haircut of 15 percent of the market value of commercial paper, convertible debt instruments, and nonconvertible debt instruments if the securities are readily marketable, and 100 percent of the market value if the securities are not readily marketable. The SEC capital rule also provides for a lower haircut for commercial paper, convertible debt instruments, and nonconvertible debt instruments if the securities are rated in higher rating categories by at least two nationally recognized statistical rating organizations (“NRSROs”). To receive the benefit of a reduced haircut on commercial paper, the commercial paper must be rated in one of the three highest rating categories by at least two NRSROs. To receive the benefit of a reduced haircut on a nonconvertible debt security or a convertible debt security, the security must be rated in one of the four highest rating categories by at least two NRSROs.

The SEC has proposed rule amendments to implement the Dodd-Frank Act requirement to remove references to credit ratings in its regulations and substitute a standard for creditworthiness deemed appropriate, including a proposed amendment to its net capital rule for BDs at 17 CFR 240.15c3-1.

Under the SEC proposal, a BD may impose the default haircuts of 15 percent of the market value of readily marketable commercial paper, convertible debt, and nonconvertible debt instruments or 100 percent of the market value of nonmarketable commercial paper, convertible debt, and nonconvertible debt instruments. A BD, however, may impose lower haircut percentages for commercial paper, convertible debt, and nonconvertible debt instruments that are readily marketable, if the BD determines that the investments have only a minimal amount of credit risk pursuant to its written policies and procedures designed to assess the credit and liquidity risks applicable to a security.

See

76 FR 26550 (May 6, 2011).

Under the SEC proposal, the BD's written policies and procedures may assess a security's credit risk using the following factors, to the extent appropriate, instead of exclusively relying on NRSROs ratings:

• Credit spreads (

i.e.,

whether it is possible to demonstrate that a position in commercial paper, nonconvertible debt, and preferred stock is subject to a minimal amount of credit risk based on the spread between the security's yield and the yield of Treasury or other securities, or based on credit default swap spreads that reference the security);

• Securities-related research (

i.e.,

whether providers of securities-related research believe the issuer of the security will be able to meet its financial commitments, generally, or specifically, with respect to securities held by the broker-dealer);

• Internal or external credit risk assessments (

i.e.,

whether credit assessments developed internally by the broker-dealer or externally by a credit rating agency, irrespective of its status as an NRSRO, express a view as to the credit risk associated with a particular security);

• Default statistics (

i.e.,

whether providers of credit information relating to securities express a view that specific securities have a probability of default consistent with other securities with a minimal amount of credit risk);

• Inclusion on an index (

i.e.,

whether a security, or issuer of the security, is included as a component of a recognized index of instruments that are subject to a minimal amount of credit risk);

• Priorities and enhancements (

i.e.,

the extent to which a security is covered by credit enhancements, such as overcollateralization and reserve accounts, or has priority under applicable bankruptcy or creditors' rights provisions);

• Price, yield and/or volume (

i.e.,

whether the price and yield of a security or a credit default swap that references the security are consistent with other securities that the broker-dealer has determined are subject to a minimal amount of credit risk and whether the price resulted from active trading); and

• Asset class-specific factors (

e.g.,

in the case of structured finance products, the quality of the underlying assets).

A BD that maintains written policies and procedures and determines that the credit risk of a security is minimal is permitted under the SEC proposal to apply the lesser haircut requirement currently specified in the SEC capital rule for commercial paper (

i.e.,

between zero and ½ of 1 percent), nonconvertible debt (

i.e.,

between 2 percent and 9 percent), and preferred stock (

i.e.,

10 percent).

For FCMs that are dually-registered as BDs, any changes adopted by the SEC to these securities haircuts will be applicable under § 1.17(c)(5)(v) unless the Commission specifically provides an alternate treatment for FCMs.

However, FCMs that are not dual registrants would be required to take the default haircuts of 15 percent for readily marketable securities. The Commission does not believe that it is appropriate to exclude standalone FCMs from using an internal process to assess the credit risk of certain securities. Therefore, the Commission's proposed amendment to § 1.17(c)(v) will permit an FCM that is not a BD to develop the framework proposed by the SEC to establish, maintain and enforce written policies and procedures for determining creditworthiness, and upon a determination that a particular type of security has minimal credit risk, to apply lower deductions to such

securities. An FCM will be required to maintain its written policies and procedures in accordance with the general recordkeeping requirements of § 1.31, and the implementation of the policies and procedures will be subject to review by the FCM's DSRO. An FCM that elects to develop written policies and procedures will be subject to review by its DSRO.

See discussion adopting § 1.17(c)(5)(vi) for options haircuts at 43 FR 39956 at 39964, with respect to the applicability of provisions incorporating by reference and referring to the rules of the SEC for securities broker dealers also registered as futures commission merchants.

Regulation 1.17 also requires an FCM to reduce its capital (

i.e.,

take a capital charge) for customer, noncustomer, and omnibus accounts that are undermargined for more than a specified period of time. Regulation 1.17(c)(5)(viii) requires an FCM to take a capital charge if a customer account is undermargined for three business days after the margin call is issued. The capital charge is equal to the amount of funds necessary to restore the account to the initial margin requirement.

Regulation 1.17(c)(5)(ix) requires an FCM to take a capital charge for noncustomer and omnibus accounts that are undermargined for two business days after the margin call is issued. The capital requirement for undermargined noncustomer and omnibus accounts is the amount of funds necessary to restore the account to the maintenance margin level.

For purposes of these Commission regulations, a margin call is presumed to be issued by the FCM the day after an account becomes undermargined. Thus, if a customer's account is undermargined at the close of business on Monday, the FCM will issue a margin call on Tuesday, and the regulation requires the FCM to take an undermargined capital charge at the close of business on Friday if the margin call is not met. For noncustomer and omnibus accounts that were undermargined at the close of business on Monday, the FCM would take a capital charge as of the close of business on Thursday.

The Commission is proposing to amend §§ 1.17(c)(5)(viii) and (ix) to require an FCM to take capital charges for undermargined customer, noncustomer, and omnibus account that are undermargined for more than one business day after a margin call is issued. Therefore, an FCM will impose a capital charge as of the close of business on Wednesday for any customer, noncustomer, or omnibus account that did not fully satisfy a margin call that is issued by the FCM on Tuesday for an account that was undermargined as of the close of business on Monday.

The timely collection of margin is a critical component of an FCM's risk management program and is intended to ensure that an FCM holds sufficient funds deposited by account owners to meet potential obligations to a DCO. As guarantor of the financial performance of the customer, noncustomer, and omnibus accounts that it carries, the FCM is financially responsible if the owner of an account cannot meet its margin obligations to the FCM and ultimately to a DCO. The timeframe for meeting margin calls currently provided in §§ 1.17(c)(5)(viii) and (ix) may have been appropriate when the capital rules were adopted in the 1970s when the use of checks and the mail system were more prevalent for depositing margin with an FCM. The Commission believes, however, that in today's markets, with the increasing use of technology, 24-hour-a-day trading, and the use of wire transfers to meet margin obligations, that the timeframe for taking a capital charge should be reduced both to incentivize FCMs to exercise prudent risk management and to strengthen the financial protection of FCMs, their customers, and the clearing systems by requiring the FCMs to reserve capital for undermargined customer, noncustomer, and omnibus accounts that fail to meet a margin call on a timely basis.

The Commission also is proposing, as discussed in Section II.I below, to require an FCM to maintain a residual interest in customer segregated accounts in an amount sufficient to cover all customer accounts that are undermargined as of the close of business on the previous trading day, thereby ensuring that residual interest in customer segregated accounts exceeds the sum of outstanding margin calls for customers, and that the funds of one customer are not used to margin or guarantee the positions of another customer. The FCM may only maintain as residual interest cash and assets that qualify as permitted investments under § 1.25. Margin deficits will be calculated as enough to restore the customer's account equity to the maintenance margin requirement on the account.

The Commission also is proposing technical amendments to certain definitions in § 1.17 to reflect proposed changes discussed in Section II.R below concerning the § 30.7 secured amount calculation. The § 1.17(b)(2) and (7) definitions of the terms “customer” and “customer account” are being proposed to be amended, the first to include “30.7 Customer” (which is a new definition being proposed in § 30.1 to include foreign domiciled persons) and the second to remove surplus language due to the revised definition of “customer.”

The Commission requests comment on the proposed amendments to § 1.17. Specifically, the Commission requests comment on the following:

• Does the proposed amendment to require an FCM to certify that it has sufficient liquidity to operate as a going concern provide a sufficient and objective standard for FCMs to assess whether they are in compliance with the provision? Are there alternative standards or approaches that the Commission should consider to meet its objective of ensuring that an FCM has sufficient liquidity to meet its pending short-term obligations so that customer funds would not be put at risk in the event of the insolvency of the FCM?

• Should the Commission consider alternative timeframes for the imposition of a capital charge for undermargined accounts?

G. Proposed Amendments to § 1.20: Futures Customer Funds To Be Segregated and Separately Accounted for

The Commission is proposing to reorganize the structure of § 1.20 by providing additional paragraph subdivisions to the existing specific requirements, applying headings to the regulation to assist in the reading and understanding of the regulation. The Commission also is proposing to add new provisions designed to enhance the protection of customer funds.

Regulation 1.20 implements the provisions of section 4d(a)(2) of the Act, which provides, in relevant part, that an FCM must: (1) Separately account for all futures customer funds and segregate such funds as belonging to its futures customers; (2) not commingle futures customer funds with the FCM's proprietary funds; (3) not use the funds of one futures customer to margin or extend credit to any person other than to the futures customer that deposited the funds; and (4) deposit futures customer funds in any bank, trust company or DCO.

Paragraph (a) of § 1.20 sets forth the general principle under section 4d(a)(2) of the Act by requiring an FCM to separately account for all futures customer funds and to segregate such funds from the FCM's proprietary funds by depositing them under an account name that clearly shows that the funds are futures customer funds and segregated as required by the Act. Paragraph (g)(1) applies the same general principle to futures customer funds received by a DCO from its members.

Paragraph (a) also requires each FCM to perform appropriate due diligence on all depositories in accordance with its risk management policies and procedures required under proposed

§ 1.11 to ensure that the depositories holding customer funds are financially sound. The FCM must annually update its due diligence.

Paragraph (a) of § 1.20 also provides that an FCM must be in compliance with its segregation obligations at all times. It is not sufficient for an FCM to be in compliance at the end of a business day, but to fail to meet its segregation obligations on an intra-day basis. If an FCM was not in compliance with the segregation requirements on an intra-day basis that would necessarily mean that the FCM was using the funds of one customer to margin positions of another customer or to cover losses of another customer.

Paragraph (b) of § 1.20 lists the permitted depositories for futures customer funds as any bank, trust company, derivatives clearing organization, or another FCM. These permitted depositories are listed in existing § 1.20 and the Commission is not proposing to amend the list. Proposed paragraph (g)(2) lists the permitted depositories for futures funds received by a DCO as any bank or trust company, and clarifies that the term “bank” includes a Federal Reserve Bank. This proposed amendment implements section 806(a) of the Dodd-Frank Act, which provides that a Federal Reserve Bank may establish and maintain a deposit account for a “financial market utility” (in the present case, a DCO) that has been designated as systemically important.

Paragraph (c) provides that an FCM may hold futures customer funds in depositories outside of the United States only in accordance with the current provisions of § 1.49. Paragraph (g)(3) sets forth the same limitation for a DCO. Regulation 1.49 currently permits an FCM or DCO to hold futures customer funds in certain foreign depositories provided that the FCM or DCO holds sufficient funds in the United States to meet its U.S. dollar-denominated obligations to futures customers. Regulation 1.49 also requires specific futures customer authorization for an FCM or DCO to hold futures customer funds in certain foreign jurisdictions. The Commission is not proposing to amend § 1.49 as part of this rulemaking.

Proposed § 1.20(e) prohibits an FCM from commingling futures customer funds with the FCM's proprietary funds, and prohibits the FCM from commingling funds deposited by futures customers with funds deposited by 30.7 Customers or Cleared Swaps Customers. Regulation 1.20(e), however, does permit an FCM to commingle the funds of multiple futures customers in a single account or accounts for operational convenience. Similarly, proposed § 1.20(g)(5) prohibits a DCO from commingling futures customer funds with the DCO's proprietary funds or with any proprietary account of any of its clearing members, and prohibits the DCO from commingling funds held for futures customers with funds deposited by clearing members on behalf of their Cleared Swaps Customers. DCOs would be permitted to commingle the funds of multiple futures customers in a single account or accounts for operational convenience.

Proposed § 1.20(f) restricts an FCM's use of customer funds. An FCM is prohibited from using one futures customer's funds to margin or secure another futures customer's positions. An FCM also is prohibited from using a futures customer's funds to extend credit to any other person. The FCM also may obligate futures customers' funds to a DCO or another FCM solely to purchase, margin, or guarantee futures and options positions of futures customers.

The Commission is proposing a new paragraph (h) which states that all futures customer funds deposited with a bank or trust company must be available for immediate withdrawal upon demand by the FCM or DCO. Paragraph (h) codifies a long-standing interpretation of the Commission's Division of Swap Dealer and Intermediary Oversight and predecessor divisions derived from an administration determination by the Commission's predecessor, the Commodity Exchange Authority of the U.S. Department of Agriculture.

The requirement, as proposed, is a practical necessity to the effective functioning of FCMs and futures markets. Should a depository have the ability to delay an FCM from withdrawing customer funds, the FCM may not be able to meet margin obligations to DCOs, or requests by futures customers for access to their funds. In addition, an inability of an FCM to have immediate access to the futures customer funds that it holds may adversely impact the transfer of futures customers positions in the event of the FCM's insolvency.

See

Administrative Determination No. 29 of the Commodity Exchange Administration dated Sept. 28, 1937 stating, “the deposit, by a futures commission merchant, of customers' 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 by subject to withdrawal on demand.”

In the case of the bankruptcy of Lehman Brothers, for example, immediate access to customer funds allowed the commodity customer accounts to be effectively transferred to Barclays over the weekend of September 20-21, 2008, immediately following the commencement of the liquidation of the firm. This transfer was authorized in the hours immediately following the commencement of Lehman's liquidation, and was implemented in the hours immediately thereafter.

• The Commission is proposing a new paragraph (i), which mirrors what was recently adopted in Part 22 for Cleared Swaps Customers, by providing more detail implementing the Net Liquidating Equity Method of calculating segregation requirements. In addition, because a customer may have Net Liquidating Equity (

i.e.,

a credit balance) in his or her account, requiring segregation of his or her funds, and still be undermargined relative to open positions, proposed paragraph (i) requires an FCM to record in the accounts of its futures customers the amount of margin required for such customers' open positions, and to calculate margin deficits for each such customer. Moreover, the Commission is proposing to require that an FCM maintain residual interest in segregated accounts in an amount that exceeds the sum of all futures customers' margin deficits. A margin deficit occurs when the value of the futures customer funds for a futures customer's account is less than the total amount of collateral required by DCOs for that account's contracts. Currently, the Commission requires FCMs to hold sufficient funds in segregated futures customer accounts to ensure that those accounts do not become undersegregated. Proposed new paragraph (i) will affirmatively require an FCM to maintain enough funds in the futures customer accounts to cover all margin deficits as well as to ensure that the accounts are not undersegregated. The Commission requests comments on all aspects of proposed new § 1.20(i), including the costs and benefits of this proposed regulation. The Commission specifically requests comment on the following:

• Will this proposal serve to increase the protections to customer funds in the event of an FCM bankruptcy?

• To what extent would this proposal increase costs to FCMs and/or futures customers?

• To what extent would this proposal benefit futures customers and/or FCMs?

• To what extent would this proposal increase or mitigate market risk?

• To what extent would this proposal lead to FCMs requiring customers to provide margin for their trades before placing them?

• To what extent is this likely to lead to a re-allocation of costs from customers with excess margin to undermargined customers?

• For purposes of margin deficit calculations, should the Commission

address issues surrounding the timing of when an FCM must have sufficient funds in the futures customer account to cover all margin deficits? If so, how should the Commission address such issues?

In addition to the foregoing, the Commission also is proposing to revise requirements regarding the written acknowledgment letter that an FCM or DCO is required to obtain from a depository holding futures customer funds. Regulation 1.20 currently requires an FCM or DCO to obtain a written acknowledgment from each depository, unless the depository is a DCO that has rules approved by the Commission providing for the segregation of customer funds. The written acknowledgment must state that the depository was informed that the futures customer funds deposited belong to futures customers and are being held in accordance with the provisions of the Act and Commission regulations.

The Commission previously proposed amendments to the acknowledgment letter regulations. On February 20, 2009, the Commission published proposed amendments to §§ 1.20, 1.26, and 30.7 for public comment (the “Original Proposal”).

The Original Proposal set out specific representations that would have been required to be included in all acknowledgment letters in order to reaffirm and to clarify the obligations that depositories incur when accepting customer funds or secured amount funds.

74 FR 7838 (February 20, 2009).

The Commission notes that both the current and proposed definition of “customer funds” in Regulation 1.3(gg) do not include “secured amount funds” as defined in Regulation 30.7 (

i.e.,

funds deposited by foreign futures or foreign options customers). See 76 FR 33066, 33085 (June 7, 2011). However, as used in this notice, unless otherwise specified, the term “customer funds” is meant to include secured amount funds. The regulations adopted by this notice are also being amended to use the term “customer” as newly proposed (

i.e.,

in this rulemaking the Commission is deleting references to “commodity or option customers”. As necessary, the Commission distinguishes between the two types of funds in this notice by referring to “customer segregated funds” and “customer secured amount funds.”

In light of the comments on the Original Proposal, the Commission determined to re-propose the amendments with several changes made in response to comments (the “Revised Proposal”).

As part of the Revised Proposal, the Commission proposed the required use of standard template acknowledgment letters which were included as Appendix A to each of § 1.20 and 1.26, and Appendix E to Part 30 of the Commission's regulations (referred to herein as the “Template Letters” or “Acknowledgment Letters”).

75 FR 47738 (Aug. 9, 2010).

The Commission received nine comment letters on the Revised Proposal.

In general, the commenters were supportive of the Commission's Revised Proposal and, in particular, were very supportive of requiring the use of Template Letters. It was noted by certain commenters that use of a standard template will simplify the process of obtaining an Acknowledgment Letter.

In addition, it was noted by commenters that uniformity of Acknowledgment Letters will provide consistency and legal certainty across the commodities and banking industries.

Letters were submitted by: Hunton & Williams on behalf of the Working Group of Commercial Energy Firms (“Energy Working Group”); International Derivatives Clearinghouse LLC (“IDCH”); Futures Industry Association (“FIA”); Harris, N.A. (“Harris”); Katten Muchin Rosenman LLP (“Katten”); CME Group Inc. (“CME”); The Minneapolis Grain Exchange (“MGEX”); JPMorgan Chase Bank, N.A. (“JP Morgan”); and The Federal Reserve Bank of Chicago, Financial Markets Group (“FRB Chicago”).

See

MGEX CL-00007 at 1; FIA CL-00003 at 2; Harris CL-00004 at 1.

See

MGEX CL-00007 at 1; CME CL-00006 at 2; FRB Chicago CL-00010 at 1.

The Commission is proposing revised amendments to the Acknowledgment Letters in this release to address several issues that have arisen as a result of the recent MF Global and Peregrine failures and the adverse impact on customers that had funds on deposit with these FCMs. The additional amendments are discussed below. The Commission also has revised the Acknowledgment Letters to address comments to the Revised Proposal. These revisions are discussed immediately below.

1. Obligation To Obtain New Acknowledgment Letters

Under the Revised Proposal, an FCM or DCO would be required to obtain a new Acknowledgment Letter within 60 days of changes in the name of any party to the Acknowledgment Letter or changes to the account number(s) under which customer funds are held. FIA stated that it is unduly burdensome to require the parties to execute a new Acknowledgment Letter in the event of a party changing its name within 60 days of the event.

FIA recommended instead including “binding effect” language in the Template Letters to ensure parties remain subject to the applicable provisions.

If the Commission determines to adopt the amendment requirement, FIA requested that the time period be extended from 60 to 120 days because a change in name often occurs in the context of a merger or acquisition in which case the relevant party will be in the process of amending numerous agreements and related documentation.

FIA CL-00003 at page 2.

FIA suggests, for example, the following language: “The terms of this letter shall remain binding upon the parties, their successors and assigns, including for the avoidance of doubt, regardless of the change in name of any party.” FIA CL-00003 at page 2.

The Commission has determined to add to the Template Letter the “binding effect” language as proposed by FIA, as this language will ensure the continued applicability of the Acknowledgment Letter in the event of a name change to the parties. The Commission, however, is proposing to require that FCMs and DCOs file new Acknowledgment Letters in the event of a name, address, or other change as specified in the proposed rule because the Commission believes it is important to maintain current and accurate Acknowledgment Letters to provide clear legal status of the customer account, which will better protect customers in the event of a dispute regarding the legal status of the account. The Commission is proposing a 120-day time period for an FCM to obtain new Acknowledgment Letters. Given the use of the Template Letter, which is not open to negotiation, and electronic filing, the Commission believes that 120 days is a sufficient period of time for FCMs and DCOs to obtain and file the new Acknowledgment Letters.

2. Technical Amendments to Acknowledgment Letter for Omnibus Accounts; Abbreviation of Account Names

Regulation 1.20 provides that customer funds, when deposited with a depository, “shall be deposited under an account name that clearly identifies them as such and shows that they are segregated as required by the Act and [Part 1 of the CFTC Regulations].” FIA noted that the account naming convention used in the proposed forms of Template Letters

may present certain issues with respect to Acknowledgment Letters obtained by FCMs maintaining customer funds with

another FCM through a customer omnibus account relationship.

The first issue is with respect to operational limits on the number of characters available for account names. Secondly, naming conventions for such accounts typically include the words “Customer Omnibus Account” and the relevant account number. FIA accordingly requested the Commission to clarify that the Template Letters may be modified to permit the use of the words “CFTC Regulated FCM Customer Omnibus Account” to describe such accounts.

Proposed Appendix A to Regulation 1.20 provides that the Account will be entitled “[Name of Futures Commission Merchant or Derivatives Clearing Organization] CFTC Regulation 1.20 Customer Segregated Account.” 75 FR 47738, 47743 (Aug. 9, 2010); Proposed Appendix A to Regulation 1.26 provides that the Account will be entitled “[Name of Futures Commission Merchant or Derivatives Clearing Organization] CFTC Regulation 1.26 Customer Segregated Money Market Mutual Fund Account.” 75 FR 47738, 47744 (Aug. 9, 2010); and Proposed Appendix E to part 30 provides that the Account will be entitled “[Name of Futures Commission Merchant] CFTC Regulation 30.7 Customer Secured Account.” 75 FR 47738, 47745 (Aug. 9, 2010).

FIA CL-00003 at 4 and 5.

The Commission has modified the proposed Template Letters to provide an option to add the words “CFTC Regulated FCM Customer Omnibus Account” to describe such accounts when applicable. In addition, the Commission is proposing that if the name of the account as set forth in the Template Letter is too long for a depository's system to include all characters, the depository may abbreviate the name in order to accommodate its system, provided that (i) it remains clear that the account is a CFTC regulated segregated/secured account held for the benefit of customers (

e.g.,

“segregated” may be shortened to “seg;” “customer” may be shortened to “cust;” “account” to “acct;” etc.), and (ii) when completing an Acknowledgment Letter, such letter must include both the long and short versions of the account name.

3. Clarification Regarding Notice, Authentication, and Instruction Protocol for Commission Authorized Withdrawals

Four of the commenters to the Revised Proposal addressed the need for the Commission to establish specific standards with respect to the notice, authentication and instruction protocol regarding Commission instructions for the immediate release of funds from a Customer Account.

In the Revised Proposal, the Template Letter provides that “the Funds in the Account(s) shall be released immediately, * * * upon proper notice and instruction from an appropriate officer or employee * * * of the CFTC. [FCM/DCO] will not hold [depository] responsible for acting pursuant to any instruction from the CFTC upon which [depository] has relied after having taken reasonable measures to assure that such instruction was provided to [depository] by a duly authorized officer or employee of the CFTC.”

The FRB Chicago pointed out that, as the Acknowledgment Letters will have been filed electronically with the Commission, the Commission will know all of the Depositories that have signed such letters, their location, and basic contact information. In light of this, the FRB Chicago suggests that the Commission could establish for each depository a basic but unique authentication identifier. The Commission believes this suggestion has merit, and it will consider implementing this type of data collection and identification as it works to implement the operational aspects of the electronic filing of Acknowledgment Letters.

JP Morgan suggests that the Acknowledgment Letter include a notice provision with contact information for the depository so that the Commission has information on how best to contact the depository. The Commission agrees with this suggestion and has revised the Template Letters to indicate where depository contact information may be inserted as optional information. The Commission recognizes that such information may be subject to frequent change and, therefore, at this time, the Commission is not requiring that an amended Acknowledgment Letter be filed in the event there are changes to such contact information.

Katten asserts that Depositories face legal uncertainty with respect to their release of customer funds in reliance on instructions from the Commission. Katten states that the Commission's reluctance to define “proper notice” or “reasonable measures” imposes on Depositories the conflicting obligations (i) to the Commission, to release customer funds “immediately upon proper notice,” and (ii) to its customer FCM, to take “reasonable measures” first to assure that such notice was “duly authorized.”

With respect to due authorization, Katten requests that the Commission reconsider its decision to permit an instruction to transfer customer funds to be made orally, with written confirmation to follow. Katten believes that the depository's obligation to take “reasonable measures” may require it to await written confirmation in any event. In addition, Katten believes that the proposed amendments to §§ 1.20, 1.26, 30.7 and 140.91 do not limit the identity of the Commission officers and employees that may issue a notice to a depository or the process that must be followed before such a notice is issued. Katten submits that a depository would have a reasonable basis to conclude that an instruction to transfer customer funds was duly authorized if the depository could be assured that any instruction to transfer customer funds would be issued only by the Director of the Division of Clearing and Intermediary Oversight (or the Director's designee).

Katten recommends that “the Commission revise the proposed rules to confirm that any such instruction may be made only by the Commission or by the director of DCIO (or the director's designee) acting with the concurrence of the General Counsel (or Deputy General Counsel).”

FIA requests, at a minimum, that the Commission define and limit the term “appropriate officer or employee” of the Commission (for example, authorization limited to Division Directors or other senior designated personnel such as Deputy Directors or Associate Directors).

In October 2011, the Commission reorganized the Division of Clearing and Intermediary Oversight into two divisions, the Division of Clearing and Risk and the Division of Swap Dealer and Intermediary Oversight. With respect to a transfer of customer funds as contemplated in this rulemaking, instructions would come from either the Director of the Director of the Division of Clearing and Risk or the Director of the Division of Swap Dealer and Intermediary Oversight (or one of the Director's designees).

See

Katten CL-00005 at FN 3.

FIA CL-00003 at page 3.

With respect to a “duly authorized officer or employee of the CFTC,” the Commission has determined to provide that any such instruction to transfer customer funds may be made by the Director of the Division of Clearing and Risk (or the Director's designee), or by the Director of the Division of Swap Dealer and Intermediary Oversight (or the Director's designee). Accordingly, the Template Letter now specifies that such instructions may only be given by the Director of the Division of Clearing and Risk (or any successor division), the Director of the Division of Swap Dealer and Intermediary Oversight (or any successor division), or the designees of such Directors under delegated authority.

With regard to the role of the General Counsel, the General Counsel will be consulted by the Director of the Division of Clearing and Risk (or any successor division), the Director of the Division of Swap Dealer and Intermediary Oversight (or any successor division), or the designees of such Directors prior to the exercise of the delegated authority.

The Commission will publish on its Web site the identity of the Director of the Division of Clearing and Risk, the Director of the Division of Swap Dealer and Intermediary Oversight, and the individual(s) who are authorized to serve as their designees. The Template Letters do not explicitly refer to instructions provided by “the Commission” because in exigent circumstances, it is not likely that action approved by a majority of Commissioners will be feasible.

The Commission does not believe, as asserted by Katten, that “reasonable measures” may require the depository to await written confirmation. For example, due to the nature of the

exceptional circumstances that would prompt a call from the Commission, it is likely that the depository would already be aware of certain problems facing the FCM or DCO and would not be surprised to receive a phone call from a Division Director (or his or her designee). In addition, while the Commission believes it is desirable that any such instruction to release customer funds be in writing, or, if oral, to be confirmed in writing, the Commission is not limiting the manner of notice in the Template Letter given the potential exigencies of the situation and the need for flexibility in communication. For example, either the Commission or the depository could be experiencing unexpected technical problems in its respective email servers or facsimile machines. It is critical that the transfer of customer funds from a Segregated Account not be delayed as a result of technical or other operational issues.

With respect to the release of customer funds “immediately upon proper notice,” Katten commented that it appreciates the Commission's recognition of the potential practical obstacles to immediate release (

e.g.,

Fedwire is unavailable). However, Katten remains concerned that, in the absence of further guidance or clarification, the use of the term “immediately” may subject a depository to potential claims by either FCMs or the Commission in the event that there is a delay in the transfer of customer funds, even if such delay is the result of reasonable actions on the part of the depository or events beyond the control of the depository. In addition, FIA commented that it would like the Commission to confirm that its authority to require the transfer of customer funds would be expected to be used sparingly (

i.e.,

“only in exceptional circumstances”).

After considering these comments, the Commission is proposing to retain the use of the word “immediately” in the Template Letter regarding instructions to a depository for release of customer funds. First, in response to FIA's comment, the Commission clarifies that the use of its authority to require the immediate release of customer funds would be in exceptional circumstances. As stated in the Revised Proposal, “[t]he Commission would issue such an instruction only when, in the judgment of the Commission, it is necessary to do so for the protection of customer funds. For example, the prospective insolvency of the FCM could prompt an instruction from the Commission to release the customer funds.”

Next, the Commission notes that anything less than the term “immediate” could leave the timing open to interpretation, which could cause delays in the transfer of funds and have a potential impact on safety and soundness of customer funds and positions. In this regard, the Commission notes that customer funds in the Segregated Account have always been subject to withdrawal immediately upon demand by the FCM.

75 FR 47738, 47740. The Revised Proposal also noted that, as set forth in the Template Letter, in the event the FCM becomes subject to a voluntary or involuntary petition for relief under the U.S. Bankruptcy Code, the depository will have no obligation to release the customer funds except upon instruction from the bankruptcy trustee or pursuant to a court order.

Id.

See

Amended Financial and Segregation Interpretation No. 10, 70 FR 24768 (May 11, 2005) (“Thus any impediments or restrictions on the FCM's ability to obtain immediate and unfettered access to customer funds are not permitted. The immediate and unfettered access requirements is [sic] intended to prevent potential delay or interruption in securing required margin payments that, in times of significant market disruption, could magnify the impact of such market disruption and impair the liquidity of other FCMs and clearinghouses.”)

4. Limiting the “Merger” Clause in the Acknowledgment Letter

CME believes that the use of an integration clause (

i.e.,

the statement that the Acknowledgment Letter “constitutes the entire understanding of the parties with respect to its subject matter”) in the Template Letters is inappropriate and could have a number of serious and unintended consequences. For example, the parties to the Acknowledgment Letter could be prevented from relying upon and enforcing terms of applicable account (or similar) agreements that do not conflict with the Acknowledgment Letter. CME believes the term “subject matter” is ambiguous and could be interpreted very broadly thereby casting doubt on the validity and interpretation of existing agreements between the parties. The CME suggests the following more narrowly tailored language for the integration clause in the Template Letters: “This letter agreement supersedes and replaces any prior agreement between the parties in connection with the Account(s), including but not limited to any prior Acknowledgment Letter, to the extent that such prior agreement is inconsistent with the terms hereof.”

FIA agrees with the CME's comment that the scope of the “merger clause” in the Template Letters should be narrowed to make clear that these clauses do not invalidate the terms of other agreements that may have been entered into by the parties and that do not conflict with the Template Letters. The FRB Chicago also believes that this provision should be narrowed so that a bank's standard account opening agreements, corporate resolutions and other agreements incorporated by reference should govern the remainder of the account relationship, but

not

matters specific to section 4d of the Act. Should there be a conflict, the Acknowledgment Letter should govern matters specific to section 4d of the Act.

The Commission agrees with the commenters that the scope of the “merger clause” language in the Template Letter

should be narrowed. Accordingly, the Commission is replacing the clause with CME's suggested language above. In addition, in order to incorporate the comment of the FRB Chicago and to ensure that future agreements between the parties do not negate the Acknowledgment Letter, the Commission is adding the following sentence to the end of the new language: “In the event of any conflict between this letter agreement and any other agreement between the parties in connection with the Account(s), this letter agreement shall govern with respect to matters specific to section 4d of the Act and the CFTC's regulations, as amended.”

The merger clause language in the Revised Proposal's Template Letter reads as follows: “This letter agreement constitutes the entire understanding of the parties with respect to its subject matter and supersedes and replaces all prior writings, including any applicable agreement between the parties in connection with the Account(s), with respect thereto.”

5. New Proposed Amendments to Acknowledgment Letters

The Commission is also now proposing under Appendix A to § 1.26 and Appendix F to § 30.7 an additional acknowledgment letter template form for money market mutual funds (to the extent they are permissible investments under § 1.25). The template form for money market mutual funds is substantially the same as the Acknowledgment Letters. The Commission requests comment on all aspects of the template form.

In addition, the Commission is proposing to add language to its proposed Acknowledgment Letters (under § 1.20, § 1.26 and § 30.7) authorizing and requiring the depository to grant—at all times—read-only electronic access to such accounts to the Commission and, in the case of an FCM, to the FCM's DSRO. Given recent events, the Commission believes such access is crucial to the protection of customer funds. The Commission is also proposing a substantive requirement for

this access in §§ 1.20, 1.26 and 30.7 in addition to the language in the Acknowledgment Letters.

The proposal for read-only access is not intended to require a depository to have the ability to provide the Commission or an FCM's DSRO with real-time information regarding an FCM's account balance. The Commission understands that depositories may not have the capability to provide customers or any other party with real-time account balances and position information. The conditions of the proposal would be satisfied if the depository had the capability to provide read-only access to account information as of the close of the prior business day.

The Commission intends to continue to explore possible uses of technology to enhance its ability to protect customer funds. Read-only access will allow Commission staff to review an FCM's segregated account balances reported by depositories and to compare those balances to the FCM's reported account balances either as part of a review of the firm, or in circumstances where the Commission is concerned about the financial condition of the firm. The read-only access is an additional tool that Commission staff may use as part of its assessment of the financial condition of an FCM and the safety of customer funds. The Commission will continue to review how direct access to account balances and the use of technology can provide greater assurance as to the safety of customer funds held by an FCM.

The Commission requests comment on all aspects of the proposed amendments to § 1.20. Specifically, the Commission requests comment on the following:

• The proposal requires each depository to provide the Commission and an FCM's DSRO with direct, read-only access to the FCM's accounts held by the depository. What technology issues are raised by the Commission's proposal? How can the Commission adequately address such technology issues?

• What account information can depositories currently provide to the Commission and to DSROs via the internet on a read-only basis? Do all depositories (

e.g.,

banks, trust companies, derivatives clearing organizations, or other FCMs) have the capability of using the Internet to provide account access to the Commission and DSROs? Are there other options for depositories to provide read-only access to FCM accounts other than the internet?

• How should the Commission implement this requirement? What timeframe would be appropriate to make the requirement effective? Please provide analysis with your comment.

H. Proposed Amendments to § 1.22: Use of Futures Customer Funds

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM's use of one futures customer's funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

Regulation 1.22 provides that an FCM may not use the cash, securities or other property deposited by one futures customer to purchase, margin or settle the trades, contracts, or other positions of another futures customer, or to extend credit to any other person. Regulation 1.22 further provides that an FCM may not use the funds deposited by a futures customer to carry trades or positions, unless the trades or positions are traded through a designated contract market.

The proposed amendment to clarify that the prohibition on the FCM's use of one futures customer's funds to margin positions of another futures customer is intended to remove any question as to the permissibility of being undersegregated at any point in time during the day. Section 4d(a)(2) requires an FCM to segregate futures customers' funds from its own funds, and prohibits an FCM from using the funds of one customer to margin or extend credit to any other futures customer or person. The Commission believes that section 4d(a)(2) is intended to provide a maximum level of protection to futures customer funds, which would be thwarted and inconsistent with the reading of the Act if an FCM only recognized this principle at the end of the trading day. Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers. The Commission also is proposing that the sum of all margin deficits be reported on the Segregation Schedule (as discussed previously with respect to proposed amendments to § 1.10) and also required to be reported on the daily segregation calculation (as discussed further herein with respect to proposed amendments to § 1.32), so that compliance review of this mechanism can be performed.

I. Proposed Amendments to § 1.23: Interest of Futures Commission Merchant in Segregated Futures Customer Funds; Additions and Withdrawals

The Commission is proposing to amend § 1.23 to require additional safeguards with respect to an FCM withdrawing futures customer funds from segregated accounts that are part of the FCM's residual interest in such accounts.

Regulation 1.23 provides that an FCM may deposit unencumbered proprietary funds, including securities that qualify as permitted investments under § 1.25, into segregated futures customer accounts in order to ensure that the firm always maintains sufficient funds in such accounts to meet its total obligations to futures customers. FCMs, by virtue of practical necessity, must keep proprietary funds in segregated futures customer accounts in order to act as a buffer between futures customers whose funds are commingled in such accounts. In the event that any futures customer were to experience losses such that the customer has insufficient funds to meet the margin requirements at clearing organizations associated with its positions, or if all of the funds deposited by the futures customer were depleted and the account had a debit balance, without proprietary funds of the FCMs being held in such accounts to absorb the debit balance as it accrued, funds of other futures customers would be used to guarantee the undermargined amount or the debit. For this reason, FCMs are permitted to deposit their own funds into segregated accounts and to maintain a residual financial interest in such accounts. Regulation 1.23 further provides that an FCM's books and records must always reflect the firm's residual interest in the accounts of its futures customers.

In addition, an FCM is permitted to withdraw funds from futures customer accounts for the FCM's proprietary use to the extent of the FCM's actual residual interest in such accounts. The withdrawal, however, may not result in the FCM failing to hold sufficient funds to meet its obligations to its futures customers, or in the funds of one futures customer margining or securing the positions of another futures customer. The Commission also is proposing that the residual amount maintained by an FCM be required to exceed the sum of margin deficits for futures customers, as discussed previously with res

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