Early Warning Reporting Requirements for Futures Commission Merchants

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

Early Warning Reporting Requirements for Futures Commission

Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'' or

``CFTC'') is proposing to amend Rule 1.12 to: make paragraph (g), which

requires the reporting of certain reductions in adjusted net capital,

applicable to all futures commission merchants (``FCMs''), rather than

just those FCMs subject to the risk assessment reporting requirements

of Rule 1.15; require reporting of a margin call that exceeds an FCM's

excess adjusted net capital which remains unanswered by the close of

business on the day following the issuance of the call; and require

reporting by an FCM whenever its excess adjusted net capital is less

than six percent of the maintenance margin required to support

proprietary and noncustomer positions carried by the FCM.

DATES: Comments must be received on or before January 27, 1995.

ADDRESSES: Comments on the proposed rules should be sent to Jean A.

Webb, Secretary of the Commission, Commodity Futures Trading

Commission, 2033 K Street, N.W., Washington, D.C. 20581.

FOR FURTHER INFORMATION CONTACT: Paul H. Bjarnason, Chief Accountant,

or Lawrence B. Patent, Associate Chief Counsel, Division of Trading and

Markets, Commodity Futures Trading Commission, 2033 K Street, N.W.,

Washington, D.C. 20581; telephone (202) 254-8955.

SUPPLEMENTARY INFORMATION:

Background

On March 1, 1994, the Commission proposed Risk Assessment Rules for

Holding Company Systems, 59 FR 9689. Certain portions of the rules were

adopted by the Commission and are published elsewhere in this edition

of the Federal Register. The proposed rules generally would have

required, inter alia, FCMs to notify the Commission of certain events

or transactions that would reduce or potentially reduce an FCM's net

capital. The triggering events were originally proposed to be included

in a new Rule 1.15. Several commenters suggested that the reporting of

certain of these triggering events would more appropriately be part of

the Commission's existing early warning reporting system set forth in

Rule 1.12. The Commission agrees. Therefore, although it has adopted as

part of the risk assessment rulemaking one of the triggering provisions

relating to declines in capital at the FCM, the final rule is relocated

in Sec. 1.12(g) of the Commission's early warning rules.\1\ As proposed

and adopted, this rule would require only those FCMs which are required

to file reports under Rule 1.15 also to report the triggering event

specified in Rule 1.12(g). However, certain commenters had suggested

that this triggering event should be applicable to all FCMs, not just

those subject to the risk assessment rules. The Commission agrees and

is hereby proposing to further amend Rule 1.12 to make the reporting of

capital declines applicable to all FCMs and to make certain other

changes to the early warning system as an adjunct to its risk

assessment initiative.

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\1\The balance of the proposed trigger event provisions remains

under consideration by the Commission.

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Early Warning Rule

Reportable Events

The Commission has required FCMs\2\ to report to the Commission and

to the FCMs' designated self-regulatory organization (``DSRO'') certain

situations that involve an FCM's financial position, an FCM's

procedures for safeguarding customer and firm assets, and its ability

to monitor its financial position through an appropriate system of

records and reports. The purpose of such reporting is to make the

Commission and the FCM's DSRO aware of situations that have or

potentially could have a negative impact on the FCM's ability to carry

on normal business operations consistent with the Commission's

prudential requirements and pose a potential threat to customer funds

or the FCM's financial integrity. Receipt of such notices results in a

heightened degree of surveillance over the FCM by the Commission and

the DSRO. The situations to be reported include undercapitalization,

the FCM's capital falling below its early warning level (i.e., 150

percent of the minimum required), failure to maintain current books and

records, the existence of material inadequacies in the FCM's accounting

systems or internal controls, and the issuance of a margin call

exceeding the FCM's adjusted net capital. Collectively, these are known

as the Commission's early warning reporting requirements and are set

forth in Rule 1.12.

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\2\Section 1.12 requires reports from FCMs, introducing brokers

(``IBs''), self-regulatory organizations (``SROs''), and exchange

clearing organizations depending on the nature of the matter to be

reported. The current changes relate only to reporting by FCMs.

There are no changes proposed with respect to reporting requirements

imposed on IBs, SROs, or clearing organizations.

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Reductions in adjusted Net Capital

The Commission has now added to the list of reportable events under

Rule 1.12 a new paragraph (g), requiring that certain FCMs (i.e., those

FCMs required to file risk assessment reports) report declines in

capital which may not necessarily result in the FCM being

undercapitalized or its capital declining below early warning levels,

but which are sufficiently material to the FCM's regulatory capital as

to warrant enhanced monitoring by the Commission and the FCM's DSRO.

The reporting of such an event was initially proposed as a part of the

Commission's March 1, 1994, rule proposals relating to risk management

for holding company systems (``risk assessment rules'')\3\ and included

in Sec. 1.15(b)(2)(i) of those proposed rules. Several commenters noted

that this reportable event would more appropriately be included in the

Commission's Sec. 1.12 early warning rule. The Commission has issued

final rules on certain of the proposed risk assessment rules and in

that connection, in accordance with these comments, adopted this

reporting requirement as paragraph (g) of Rule 1.12. This action of the

Commission is addressed elsewhere in this edition of the Federal

Register.

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\3\59 FR 9689.

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As adopted, Rule 1.12(g) applies only to those FCMs which are

required to file reports with the Commission under the risk assessment

rules. Several commenters, including the Futures Industry Association

and National Futures Association, suggested that the reporting

requirement now in paragraph (g) be made applicable to all FCMs, not

just those required to report under Rule 1.15. The Commission agrees

that this reporting requirement serves to alert the Commission and DSRO

to potential problems resulting from transactions that affect an FCM

directly and therefore should not be limited to those FCMs subject to

the risk assessment rules.4 Since FCMs that believed they were not

subject to the risk assessment rules may not have taken advantage of

the opportunity to comment on the Commission's March 1994 risk

assessment rule proposals, the Commission is publishing this proposed

change to Sec. 1.12(g) for comment.

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\4\Certain exchanges have a similar requirement. See Chicago

Mercantile Exchange (``CME'') Rule 972A; Chicago Board of Trade Rule

285.03; New York Mercantile Exchange Rule 2.14(d) and Clear- ing

Rule 9.22(c) (i) and (ii); Commodity Exchange, Inc. Rule 7.08(a);

Coffee, Sugar and Cocoa Exchange, Inc. Clearing Rule 302(c)(i);

Kansas City Board of Trade Rule 1311.00; Kansas City Board of Trade

Clearing Corporation Rule 8.01(c); and Minneapolis Grain Exchange

Rule 2088.00.

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The event to be reported, which is set forth in Rule 1.12(g), is

the occurrence of any transaction or condition that results in a

reduction of more than 20 percent in the adjusted net capital of the

FCM from that reported in the most recent financial report filed with

the Commission pursuant to Rule 1.10. If the decline in adjusted net

capital is due to activities in the normal course of the FCM's

business, the reduction is to be reported within two business days

following the reduction in adjusted net capital. These are events that

are not normally planned for in advance. However, where a transaction

or series of transactions is planned to be taken which will reduce

adjusted net capital by more than 20 percent, the notice must be filed

at least two business days in advance of the transaction or series of

transactions. This would permit Commission or DSRO staff to make

further inquiries concerning the transaction before the transaction is

effected to assure that the FCM has adequately considered the effect of

the transaction on its overall liquidity. The rule does not provide for

Commission approval or disapproval of the transaction prior to the FCM

effecting the transaction, nor does it provide a means for the

Commission to delay or prevent the FCM from carrying out the

transactions.5

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\5\See Securities and Exchange Commission Rule 240.15c3-1(e)(1),

17 CFR 240.15c3-1(e)(1) (1994), which requires a securities broker-

dealer to provide notice two business days prior to withdrawals of

equity capital that on a net basis exceed in the aggregate in any 30

calendar day period, 30 percent of the firm's excess net capital, or

two business days after such withdrawals during any 30 calendar day

period exceed 20 percent of the firm's excess net capital. The

Commission requests comment as to whether Rule 1.12(g) should

establish a mechanism by which the Commission could delay or prevent

an FCM from carrying out the relevant transactions.

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The Commission's early warning rules relating to an FCM's level of

capital contemplate that the FCM will have systems in place to monitor

its capital levels and its compliance with the Commission's net capital

rules on a day-to-day basis. The Commission requires each FCM to be

able to demonstrate its capital compliance at any time and not just on

a required formal computation or filing date.6 Consequently, the

effect of planned transactions on net capital should be readily

determinable.

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\6\See Commission Rules 1.17(a)(3)-(5) and 1.18(b), 17 CFR

1.17(a)(3)-(5) and 1.18(b) (1994).

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The initial filing is to be made, pursuant to redesignated Rule

1.12(h), with the regional office of the Commission with which the FCM

normally files its financial reports under Rule 1.10, with the

principal office of the Commission in Washington, D.C., with the FCM's

designated self-regulatory organization, and with the Securities and

Exchange Commission if the FCM is also registered as a securities

broker/dealer. Rule 1.12(g) also provides that, following receipt of a

notice from an FCM, the Director of the Commission's Division of

Trading and Markets, or the Director's designee, may request additional

information concerning the effect of the reported event on the FCM's

financial or operational condition. The FCM is required to provide such

additional information within three business days, or sooner if the

Commission believes prompter filing is needed to address the early

warning condition and so requests.

Unanswered Margin Calls

In its March 1994 risk assessment rule proposal, the Commission had

proposed to adopt Rule 1.15(b)(2)(iii), which would have required an

FCM to notify the Division of Trading and Markets whenever aggregate

cumulative losses in all noncustomer accounts exceeded the greater of:

(A) in any 30-day period, 10 percent of the last reported consolidated

stockholders' equity of the FCM's parent or $50 million, and (B) in any

12-month period, 20 percent of the last reported stockholders' equity

of the FCM's parent or $100 million. The proposal was opposed by a

number of commenters. Several commenters suggested that, as an

alternative, an FCM be required to notify the Commission within two

business days after a margin call to a noncustomer remains outstanding

for two business days, if the margin call exceeds 20 percent of the

FCM's adjusted net capital.

The original proposal was intended to require the reporting of

holding company group losses that could adversely affect the regulatee,

and as such the suggestions of the commenters are that a failure to pay

margin is a proxy for such losses and more readily reportable using

existing systems. The Commission therefore has determined to propose a

narrower early warning notice requirement based upon an unsatisfied

margin call on a customer, noncustomer or omnibus account that exceeds

the firm's excess adjusted net capital. This notice would augment

existing notice requirements by identifying potentially delinquent

margin payments which could affect the firm's integrity. The Commission

is therefore proposing that it be notified pursuant to paragraph (f)(4)

of Rule 1.12 if the call to the account owner is not answered by the

close of business on the day following the day the call is made. The

Commission would also take account of favorable market moves in

determining whether the margin call is required to be reported under

this rule.

For purposes of this rule, a margin call would be taken to mean any

deposit of funds required by the FCM to margin, guarantee or secure a

futures or commodity option position. Thus, if, with respect to an

exchange-traded contract, the FCM requires a deposit in excess of the

minimum required pursuant to exchange rules, that greater amount is the

amount to be used in determining whether a call has been collected from

an account holder. Although exchanges may exempt firms from the

requirements of Commission Rule 1.12(f)(3), which requires notice of

issuance of a margin call in excess of a firm's entire adjusted net

capital, such waivers would not be permitted from the Rule 1.12(f)(4)

notice requirement. The Commission also requests additional comment,

however, on the originally proposed trigger event for which this was

proposed as an alternative.

Maintenance Margin Factor

Some commenters on the Commission's risk assessment proposals also

suggested that the Commission amend Rule 1.12 to add an early warning

reporting requirement to require an FCM to report to the Commission

whenever its excess adjusted net capital is less than 6 percent of the

maintenance margin requirement applicable to positions in proprietary

and noncustomers' accounts in lieu of certain other reports of losses

in noncustomer accounts. These commenters noted that the CME imposes

such a capital requirement on an informal basis on its clearing

members. The Commission agrees that a similar provision should be

included on an industry-wide basis as a part of the Commission's early

warning rule.

For purposes of proposed paragraph (f)(5), ``maintenance margin''

includes all deposits which the FCM requires its noncustomers to

maintain in order to carry a position at the futures commission

merchant. With respect to an FCM's proprietary account positions,

maintenance margin shall mean the amount of funds the FCM is required

to maintain at the exchange's clearing organization or with its

clearing broker, or 5 percent of the value of the contract, whichever

is greater. The Commission requests comment on these standards for

calculating maintenance margin for purposes of this rule.

This requirement is intended to address the risk attendant to

positions not currently subject to the 4 percent and 6 percent factors

applied to account equity in accounts of customers to establish minimum

adjusted net capital requirements and early warning capital levels,

respectively, for an FCM. An FCM that trades for its own account and

handles accounts of noncustomers currently bears the risk of such

positions, without any incremental increase in its net capital

requirement over an FCM that does not do so. The Commission believes

that that risk should be reflected in the early warning reporting

requirement, which will represent some measure of that risk and apprise

the Commission and DSROs that an FCM is carrying positions that bear a

certain risk but are not factored into the adjusted net capital

requirement.7

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\7\The CME currently assesses clearing members an informal

capital charge based on this amount as do bank regulators for bank-

affiliated FCMs.

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Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (RFA), 5 U.S.C. 601-611 (1988),

requires that agencies, in proposing rules, consider the impact of

those rules on small businesses. The rules discussed herein will affect

FCMs. The Commission already has established certain definitions of

``small entities'' to be used by the Commission in evaluating the

impact of its rules on such small entities in accordance with the

RFA.8 FCMs have been determined not to be small entities under the

RFA. The Commission believes that the proposals, if adopted, would not

have a significant economic impact on smaller entities.

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\8\47 FR 18618-18621 (April 30, 1982).

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Accordingly, pursuant to Rule 3(a) of the RFA, 5 U.S.C. 605(b), the

Chairman, on behalf of the Commission, certifies that these proposed

rules will not have a significant economic impact on a substantial

number of small entities. The Commission nonetheless invites comment

from any registered FCM who believes that these rules would have a

significant impact on its operations.

B. Paperwork Reduction Act

The Paperwork Reduction Act of 1980 (PRA), 44 U.S.C. 3501 et seq.,

imposes certain requirements on federal agencies (including the

Commission) in connection with their conducting or sponsoring any

collection of information as defined by the PRA. In compliance with the

PRA the Commission has submitted these proposed rules and its

associated information collection requirements to the Office of

Management and Budget. The burden associated with this entire

collection, including these proposed rules, is as follows:

Average Burden Hours Per Response: 18.00

Number of Respondents: 1,782

Frequency of Response: annually, quarterly and on occasion

The burden associated with these proposed rules, is as follows:

Average Burden Hours Per Response: 1.00

Number of Respondents: 12

Frequency of Response: on occasion

Persons wishing to comment on the estimated paperwork burden

associated with this proposed rule should contact Jeff Hill, Office of

Management and Budget, room 3228, NEOB, Washington, DC 20503 (202) 395-

7340. Copies of the information collection submission to OMB are

available from Joe F. Mink, CFTC Clearance Office, 2033 K Street, NW.,

Washington, DC 20581, (202) 254-9735.

List of Subjects in 17 CFR Part 1

Commodity futures, Commodity options, Prohibited transactions.

In consideration of the foregoing, and pursuant to the authority

contained in the Commodity Exchange Act, and in particular Sections

4f(b), 4f(c), 4g and 8a, 7 U.S.C. 6f(b), 6f(c), 6g, and 12a, the

Commission hereby proposes to amend Part 1 of Chapter I of Title 17 of

the Code of Federal Regulations as amended and published as a final

rule elsewhere in this issue of the Federal Register as follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

1. The authority citation for Part 1 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,

6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a,

12c, 13a, 13a-1, 16, 16a, 19, 21, 23 and 24.

2. Section 1.12 is proposed to be amended by adding paragraphs

(f)(4) and (f)(5) and by revising the first sentence of paragraph (g)

introductory text to read as follows:

Sec. 1.12 Maintenance of minimum financial requirements by futures

commission merchants and introducing brokers.

* * * * *

(f) * * * (4) A futures commission merchant shall report

immediately whenever any commodity interest account it carries is

subject to a margin call, or call for other deposits required by the

futures commission merchant, that exceeds the futures commission

merchant's excess adjusted net capital, determined in accordance with

Sec. 1.17, and such call has not been answered by the close of business

on the day following the issuance of the call. This applies to all

accounts carried by the futures commission merchant, whether customer,

noncustomer, or omnibus, that are subject to margining, including

commodity futures and options. In addition to actual margin deposits by

an account owner, a futures commission merchant may also take account

of favorable market moves in determining whether the margin call is

required to be reported under this paragraph.

(5) A futures commission merchant shall report immediately whenever

its excess adjusted net capital is less than 6 percent of the total of:

(i) the maintenance margin required by the futures commission merchant

on all positions held in noncustomer accounts; and (ii) the maintenance

margin applicable to all positions held in the futures commission

merchant's proprietary accounts. For purposes of this paragraph,

maintenance margin shall include all deposits which the futures

commission merchant requires its noncustomers to maintain in order to

carry the position at the futures commission merchant. With respect to

a futures commission merchant's proprietary account positions,

maintenance margin shall mean the amount of funds the futures

commission merchant is required to maintain at the exchange's clearing

organization or with its clearing broker, or 5 percent of the value of

the contract, whichever is greater.

(g) A futures commission merchant shall provide written notice of

any reduction in adjusted net capital in excess of 20 percent of the

futures commission merchant's adjusted net capital as last reported in

financial reports filed with the Commission pursuant to Sec. 1.10. * *

*

* * * * *

Issued in Washington, D.C. on December 21, 1994, by the

Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 94-31827 Filed 12-27-94; 8:45 am]

BILLING CODE 6351-01-P