Securities Representing Investment of Customer Funds Held in Segregated Accounts by Futures Commission Merchants

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

Securities Representing Investment of Customer Funds Held in

Segregated Accounts by Futures Commission Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Final Rules.

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SUMMARY: The Commodity Futures Trading Commission (''Commission'') is

amending Rules 1.23 and 1.25 to allow futures commission merchants

(``FCMs'') to make direct transfers into segregated accounts of

permissible, unencumbered securities of the types set forth in Section

4d(2) of the Commodity Exchange Act (``Act'') and Rule 1.25 promulgated

thereunder. This will provide FCMs a more efficient means to increase

or decrease their residual interest in funds segregated for the benefit

of commodity customers than heretofore permitted. In addition, the

revised rules will permit FCMs to deposit the proceeds from the sale or

maturity of any such investments directly into a nonsegregated bank

account, provided that the FCM maintains a sufficient residual

financial interest in the funds segregated for commodity customers to

assure that all of an FCM's obligations to its customers are covered.

The Commission's expectation is that these rule changes will reduce the

number of transactions required to manage an FCM's segregated cash and

securities balances, thus reducing operating costs for the industry. To

assure that there will be a clear audit trail for the increased types

of permitted transactions, Rule 1.27 also is being amended to require

that the description of the investment securities, required by the

rule, includes the security identification number developed by the

Committee on Uniform Security Identification Procedures (``CUSIP

Number''). Also, Rule 1.25 is being amended to require identification,

in the record of investments required to be maintained by Rule 1.27, of

the manner in which the proceeds from the sale or maturity of any

segregated securities are disposed of.

EFFECTIVE DATE: September 8, 1997.

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

Accountant, or Lawrence B. Patent, Associate Chief Counsel, Division of

Trading and Markets (``Division''), Commodity Futures Trading

Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,

D.C. 20581. Telephone (202) 418-5430.

SUPPLEMENTARY INFORMATION:

I. Investment of Customers' Segregated Funds

At all times, an FCM is required to have sufficient funds in

segregation to meet its obligations to customers. As a consequence, to

protect against a customer account going into deficit, an FCM must

deposit funds of its own to cover any customer account deficits, and

such funds must remain in segregation until more funds are remitted to

the FCM by the customers who hold such deficit accounts. Thus,

maintaining an adequate cushion of its own in segregation is a part of

routine FCM funds management operations. FCM operational funding needs

often dictate that any unneeded excess funds in segregation be moved so

that they can be used in other aspects of the firm's operations.

Therefore, prudent and efficient funds management typically requires an

FCM to make frequent transfers of funds into and out of segregation.

Prior to these rule changes, FCMs were only allowed to increase or

decrease their interest in customers' segregated funds by direct

transfers of cash. That is, securities owned by the FCM and held in a

non-segregated account could not be transferred to a segregated

account. Moreover, to assure an audit trail, if an FCM wished to move

funds represented by securities into segregation, the securities had to

be sold and the cash proceeds transferred into a segregated account.

The FCM could, then, use the segregated cash to purchase more

securities that would be held in segregation. The effect of these

requirements was that any segregated securities, except for securities

purchased and specifically owned and deposited by individual customers,

always had to be purchased with cash from a segregated cash account.

Likewise, the proceeds from any sale of segregated securities always

had to be deposited into a segregated account, even if there was no

longer a need for the funds to be in segregation. That is, such funds

could only be moved to a non-segregated account after the securities

were converted to cash and the cash had been deposited into a

segregated account.

On March 21, 1997, the Commission published for comment proposed

amendments to Rules 1.23, 1.25, and 1.27.\1\ The proposed changes would

permit FCMs to transfer their own unencumbered securities from a non-

segregated account directly into a customer segregated safekeeping

account. This would enable an FCM to increase the amount of funds

segregated for the benefit of commodity customers more quickly and

economically. To be eligible for direct transfer, such securities were

required to be unencumbered and to qualify as permitted investments of

customer funds under Rule 1.25. The proposed rule amendments also would

permit an FCM to transfer such securities from a segregated customer

safekeeping account directly to the FCM's own non-segregated account,

to the extent the FCM had excess funds available in segregation. The

30-day public comment period on the proposed rule changes expired on

April 21, 1997. The Commission received one written comment letter on

this proposal from the Joint Audit Committee (``JAC'').\2\ The JAC

raised two issues.

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\1\ See 62 FR 13564 (March 21, 1997).

\2\ JAC is comprised of representatives from each commodity

exchange and National Futures Association which coordinate the

industry's audit and ongoing surveillance activities to promote a

uniform framework of self-regulation.

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First, JAC suggested that Rule 1.25 be amended by removing the

requirement contained in the rule that the proceeds from any sale of

segregated securities be redeposited into a segregated account. JAC

indicated that by eliminating this restriction, FCMs would be able to

sell segregated securities directly out of the segregated account and

deposit the funds to a non-segregated account. Since it was the

Commission's aim to permit cash and securities to be treated the same

way, thus reducing the number of transactions required to administer

segregated funds and reduce transaction costs, the Commission agrees

with this suggestion. Therefore, to adopt the JAC's suggestion, Rule

1.25 is further amended in two respects: 1) the requirement to deposit

the proceeds from the sale of segregated securities to a segregated

account is eliminated; and 2) a requirement to identify, in the record

of investments required to be maintained by Rule 1.27, the manner in

which the proceeds from the sale or maturity of any segregated

securities are disposed of, is added to the rule. That is, if proceeds

are not redeposited in a segregated account, the record must

[[Page 42399]]

reflect that the proceeds were deposited to an identified non-

segregated account.

These changes to the rules are achieved without any sacrifice of

the audit trail related to segregated funds transfers. Also, the rules

do not impose any significant costs or other undue burdens upon FCMs,

because the additional information required to be maintained by the

rule should be available to FCMs in the internal records they already

maintain.

The Commission's proposed amendment to Rule 1.23 would have

modified the restrictions to allow the transfer of the types of

securities set forth in Rule 1.25 between segregated and nonsegregated

accounts. These proposed changes would permit transfers between

segregated and non-segregated accounts, whether made in cash or

securities, to be treated the same way. Therefore, the Commission has

determined to adopt the amendment to Rule 1.23 as originally proposed,

but to add the amendment to Rule 1.25 to assure that the Rule 1.23 rule

changes achieve the desired result.

In its second comment, JAC pointed out that the proposed amendments

to Rules 1.23 and 1.25 would restrict the transfer of securities to

those held in a segregated safekeeping account with a bank or trust

company. JAC's original request for the proposed rule change was to

allow FCMs the ability to transfer segregated securities held by any

permitted segregation depository, including contract market clearing

organizations and other FCMs. The Commission agrees. Therefore, the

final amendments to Rules 1.23 and 1.25, as adopted, refer to

securities held in segregated safekeeping at any permitted custodian of

segregated funds, that is a bank, trust company, contract market

clearing organization, or another FCM. It should be noted that clearing

organizations and FCMs ultimately deposit customer funds in a

segregated safekeeping account with a bank or trust company.\3\ In this

connection the Commission notes that to be considered properly

segregated, pursuant to the Act and the rules promulgated thereunder,

securities must be held in safekeeping.

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\3\ In proposing these rule amendments, the Commission noted

that their adoption would also require the Division to revise

Financial and Segregation Interpretation No. 7, which includes the

following statement:

Under Regulations 1.23 and 1.25 such obligations must be: (1)

purchased with money deposited in an account used for the deposit of

customers' funds; (2) made through such an account; and (3) the

proceeds from any sale of such obligations must be redeposited in

such an account. Thus, all additions to and withdrawals from

customer segregated funds which represent topping up by the FCM to

cover actual or expected customer deficits must be in the form of

cash.

1 Comm. Fut. L. Rep. (CCH) para. 7117, at 7124 (July 23, 1980).

The Division will delete this text from the interpretation

shortly and will publish an amended interpretation on its Internet

web site (http://www.cftc.gov) and request Commerce Clearing Housng

to publish the revised interpretation in the Commodity Futures Law

Reporter.

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For purposes of Rules 1.26, 1.27, 1.28 and 1.29, all permissible

investments, when deposited into segregated accounts, will be deemed to

be securities and obligations which represent investments of customers'

funds until such time as the FCM withdraws or otherwise disposes of

such investments.

Also, the Commission is adopting as proposed amendments to Rule

1.27, which require FCMs to maintain records of permissible investments

held in segregated accounts. Rule 1.27 now will require the record to

include the CUSIP number of such securities as a part of the

description of such investments, and Rule 1.25 will require the FCM's

record to indicate if securities were liquidated and the non-segregated

account where the proceeds were transferred. The Commission is not

adopting any other changes to Rule 1.27, but wants to remind FCMs that

Rule 1.27 requires them to include in the investments record, among

other information, the name of the person through whom such investments

were made and the name of the person to or through whom such

investments were disposed of. Therefore, this record should identify

permissible investments owned by the FCM which were deposited into

segregation and any investments withdrawn from segregation and

deposited in the FCM's own account. Securities owned by the FCM, used

to meet its segregation requirements, must be identified as customer

securities and properly segregated, whether physically deposited or

deposited by book entry.

The Commission also invited comments on whether custodians for

these purposes should be limited to banks and trust companies not

affiliated with the FCM. The Commission asked this question, in part,

as a follow-up to issues raised during the Barings crisis. Many firms

had deposited their cash with affiliates of the Barings bank, which in

turn used the Barings bank as a depository for those assets. During the

Barings crisis, these firms found that their assets, notwithstanding

some interpretations that the segregation laws in the United Kingdom

impose a complete trust on customer funds, would not necessarily be

considered segregated for their benefit in any impending liquidation in

bankruptcy of the Barings group. In this connection, the Commission

notes that the International Organisation of Securities Commissions

issued guidance on client asset protection, which is contained in a

report published in August 1996, that recommends to regulatory

authorities that they should: ``. . . carefully consider the

circumstances in which authorised firms may be permitted to meet the

requirements of a client asset protection regime by holding client

assets with a related custodian.''

In this connection, the only commenter, the JAC, stated that such a

limitation on affiliated depositories would not seem warranted. In most

jurisdictions, funds in securities held in safekeeping can be separated

from funds amenable to the claims of a creditor of the custodian, as

well as a creditor of the FCM. Amendments added to the Act in 1968, to

impose the requirement to segregate directly on the custodian, are

intended to achieve that effect.\4\ The adoption of the rules in this

release is intended to facilitate maintaining segregated funds in the

form of securities. The Commission, therefore, believes that there is

no compelling reason to impose a condition, at this time, that such

funds be held at non-affiliated custodians. The Commission notes that

it intends to keep this conclusion under review. This is because

legislative and regulatory changes in the U.S. or in other countries,

developments in risk assessment systems or cooperative arrangements

with domestic and/or international regulators and encountering new

types of custodianship problems in connection with a failed firm could

at some future time suggest that the Commission consider a change in

its current rules and policies in this connection.

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\4\ Pub. L. No. 90-258, Sec. 6, 82 Stat. 26, 28 (1968), now

codified as the concluding paragraph of Sec. 4d(2) of the Act, 7

U.S.C. 6d(2) (1994).

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Under the Act, an FCM may segregate commodity customers' funds at a

bank or trust company, another registered FCM, or a clearing

organization of a contract market. Each of these depositories is,

itself, required by the Act to treat and deal with such funds as

belonging to the FCM's customers and not as the FCM's own funds. Each

of these persons is also liable under the Act for any misuse of, or

failure to segregate, such funds. Such liability accrues whether or not

the depository is related to the FCM. When customer funds are deposited

with another FCM or contract market clearing organization, the funds,

ultimately, are deposited

[[Page 42400]]

with a bank or trust company by such FCM or clearing organization.

With respect to net capital compliance issues, the Commission's

staff has previously informally advised the Joint Audit Committee and

individual registrants that deposits of funds with affiliates would be

deemed by staff to be returns of capital by an FCM and, therefore, such

deposits could not be treated as regulatory capital by an FCM, unless

such funds represented either: (1) Funds segregated or set aside in

safekeeping under the Commission's rules for commodity or foreign

futures or foreign options customers; (2) funds held pursuant to the

Securities and Exchange Commission's customer protection rules (17 CFR

240.15c3-3); or (3) amounts to be used for normal operating expenses.

The Commission is in agreement with that policy and does not believe

any additional limitation needs to be imposed at this time. Unusually

large amounts of cash held in segregation will be reviewed as part of

Commission and SRO audit programs.

II. 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 rule amendments discussed herein

would affect registered FCMs. The Commission has previously established

certain definitions of ``small entities'' to be used by the Commission

in evaluating the impact of its rules on such entities in accordance

with RFA.\5\ The Commission previously determined that registered FCMs

are not small entities for the purpose of the RFA.\6\

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\5\ 47 FR 18618-18621 (April 30, 1982).

\6\ 47 FR 18619-18620.

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Further, the amendments discussed herein do not impose any

significant new burdens upon FCMs. These amendments facilitate the use

of firm-owned obligations to enhance funds segregated for commodity

customers by allowing the direct transfer of said obligations into and

out of segregated accounts. As a result, the Commission anticipates

that adoption of the amendments will reduce the burden of compliance

with segregation requirements by FCMs. Accordingly, when these rule

amendments were proposed, the Chairperson, on behalf of the Commission,

certified, pursuant to 5 U.S.C. 605(b), that the rule amendments would

not have a significant economic impact on a substantial number of small

entities. The Commission, nonetheless, invited comment from any

registered FCM that believed these rules would have a significant

impact on its operations, but none was received.

B. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (Pub. L. No. 104-13, May 13,

1995) (``PRAct'') imposes certain requirements on federal agencies

(including the Commission) in connection with their conducting or

sponsoring any collection of information, as defined by the PRAct.

While these rule amendments have no burden, the group of rules (3038-

0024) of which the rules proposed to be amended are a part has the

following burden:

Average burden hours per response.................................18.00

Number of Respondents..........................................1,662.00

Frequency of response.............................................19.00

Copies of the OMB approved information collection package

associated with these rules may be obtained from the Desk Officer,

CFTC, Office of Management and Budget, Room 10202, NEOB, Washington, DC

20503, (202) 395-7340.

List of Subjects in 17 CFR Part 1

Brokers, Commodity futures, Consumer protection, Reporting and

Recordkeeping requirements, Segregation requirements.

In consideration of the foregoing and pursuant to the authority

contained in the Act and, in particular, Sections 4d, 4g and 8a (5)

thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission hereby amends

Chapter I of Title 17 of the Code of Federal Regulations 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 1.23 is revised to read as follows:

Sec. 1.23 Interest of futures commission merchant in segregated funds;

additions and withdrawals.

The provision in section 4d(2) of the Act and the provision in

Sec. 1.20(c), which prohibit the commingling of customer funds with the

funds of a futures commission merchant, shall not be construed to

prevent a futures commission merchant from having a residual financial

interest in the customer funds, segregated as required by the Act and

the rules in this part and set apart for the benefit of commodity or

option customers; nor shall such provisions be construed to prevent a

futures commission merchant from adding to such segregated customer

funds such amount or amounts of money, from its own funds or

unencumbered securities from its own inventory, of the type set forth

in Sec. 1.25, as it may deem necessary to ensure any and all commodity

or option customers' accounts from becoming undersegregated at any

time. The books and records of a futures commission merchant shall at

all times accurately reflect its interest in the segregated funds. A

futures commission merchant may draw upon such segregated funds to its

own order, to the extent of its actual interest therein, including the

withdrawal of securities held in segregated safekeeping accounts held

by a bank, trust company, contract market clearing organization or

other futures commission merchant. Such withdrawal shall not result in

the funds of one commodity and/or option customer being used to

purchase, margin or carry the trades, contracts or commodity options,

or extend the credit of any other commodity customer, option customer

or other person.

3. Section 1.25 is revised to read as follows:

Sec. 1.25 Investment of customer funds.

No futures commission merchant and no clearing organization shall

invest customer funds, except in obligations of the United States, in

general obligations of any State or of any political subdivision

thereof, or in obligations fully guaranteed as to principal and

interest by the United States. This shall not prohibit a futures

commission merchant from directly depositing unencumbered securities,

of the type specified in this section, which it owns for its own

account, into a segregated safekeeping account or from transferring any

such securities from a segregated account to its own account, up to the

extent of its residual financial interest in customers' segregated

funds; provided, however, that such investments, transfers of

securities, and disposition of proceeds from the sale or maturity of

such securities are recorded in the record of investments, required to

be maintained by Sec. 1.27. All such securities may be segregated in

safekeeping only with a bank, trust company, clearing organization of a

contract market, or other registered futures commission merchant.

Furthermore, for purposes of Secs. 1.25, 1.26, 1.27, 1.28 and 1.29,

investments permitted by Sec. 1.25 that are owned by the futures

commission merchant and deposited into such a segregated account shall

be considered

[[Page 42401]]

customer funds until such investments are withdrawn from segregation.

4. Section 1.27 is amended by revising paragraphs (a)(4) and (b)(2)

to read as follows:

Sec. 1.27 Record of investments.

(a) * * *

(4) A description of the obligations in which such investments were

made, including the CUSIP numbers;

* * * * *

(b) * * *

(2) A description of such documents, including the CUSIP numbers;

and

* * * * *

Issued in Washington D.C. on July 28, 1997, by the Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97-20766 Filed 8-6-97; 8:45 am]

BILLING CODE 6351-01-P