Concept Release on the Denomination of Customer Funds and the Location of Depositories

COMMODITY FUTURES TRADING COMMISSION

Concept Release on the Denomination of Customer Funds and the

Location of Depositories

AGENCY: Commodity Futures Trading Commission.

ACTION: Request for comment.

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

publishing this release to obtain the views of the public on how to

address risks related to holding segregated funds offshore or in

foreign currencies. The Commission wishes to consider how to update and

otherwise to revise existing regulatory standards to avoid inhibiting

transnational commodity futures activities or causing undue costs or

operational inconvenience, without increasing risks to market

participants. This initiative is part of the Commission's recently

adopted strategic plan, which includes ensuring ``sound financial

practices of clearing organizations and firms holding customer funds''

and facilitating ``the continued development of an effective, flexible,

regulatory environment responsive to evolving market conditions.''

1

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\1\ See Vision and Strategies for the Future: Facing the

Challenges of 1997 through 2002, published by the Commission

(September 1997).

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The Commodity Exchange Act (``Act'') 2 requires that all

money, securities and property received by futures commission merchants

(``FCMs'') to margin, guarantee, or secure customer trades or contracts

on domestic contract markets, or accruing to customers as a result of

these trades or contracts, be segregated. Until 1988, the Commission

generally required that such money, securities and property

(hereinafter collectively referred to as ``customer funds'') be held in

the United States (``U.S.'') with the exception of certain funds held

on behalf of non-U.S.-domiciled customers.3

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\2\ 7 U.S.C. 1 et seq.

\3\ See Commodity Exchange Authority Administrative

Determination No. 238 (September 4, 1974).

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In November 1988, the Commission issued Financial and Segregation

Interpretation No. 12, ``Deposit of Customer Funds in Foreign

Depositories'' (``Interpretation No. 12'').4 Interpretation

No. 12 permits customer funds to be held in depositories located

outside of the U.S., subject to limitations and conditions intended for

the protection of these funds. At the time Interpretation No. 12 was

issued, the Commission stated its intention to ``monitor experience

under this interpretation * * * to alter or supplement the conditions

for keeping segregated funds offshore as such experience renders

advisable.'' Various developments since 1988 make it appropriate to

revisit this area.

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\4\ 53 FR 46911 (November 21, 1988).

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Date: Comments must be received on or before March 2, 1998.

FOR FURTHER INFORMATION CONTACT: France M.T. Maca, Special Counsel,

Division of Trading and Markets, Commodity Futures Trading Commission,

Three Lafayette Center, 1155 21st Street, N.W. Washington, D.C. 20581.

Telephone: (202) 418-5482.

Table of Contents

I. Background

A. Current Regulatory Requirements

1. Commodity Regulation

2. Bankruptcy Regulation

3. Banking Regulation

B. Developments Since the Issuance of Interpretation No. 12

II. Policy Considerations

A. Goals

B. Risks

III. Potential Approaches

A. Permissible Denominations of Obligations

1. Alternatives

2. Discussion

B. Permissible Denominations of Assets

1. Alternatives

2. Discussion

C. Permissible Locations of Segregated Funds

1. Alternatives

2. Discussion

D. Qualifications of Depositories

1. Alternatives

2. Discussion

E. Segregation and Net Capital Treatment

1. Alternatives

2. Discussion

F. Bankruptcy Treatment

1. Alternatives

2. Discussion

IV. A Specific Approach

V. Request for Comment

SUPPLEMENTARY INFORMATION:

I. Background

A. Current Regulatory Requirements

1. Commodity Regulation

The maintenance and location of customer funds is prescribed by

Section 4d of the Act which requires that each FCM:

Treat and deal with all money, securities, and property received

by such [FCM] to margin, guarantee, or secure the trades or

contracts of any customer of such [FCM], or accruing to such

customer as the result of such trades or contracts, as belonging to

such customer. Such money, securities, and property shall be

separately accounted for and shall not be commingled with the funds

of such [FCM] or be used to margin or guarantee the trades or

contracts, or to secure or extend the credit, of any customer or

person other than the one from whom the same are held.

It further provides that:

It shall be unlawful for any person, including but not limited

to any clearing agency of a contract market and any depository, that

has received any money, securities, or property for deposit in a

separate account as provided in paragraph (2) of this section, to

hold, dispose of, or use any such money, securities, or property as

belonging to the depositing [FCM] or any person other than the

customers of such [FCM].

The Commission's segregation requirements are set forth in

Regulations 1.20-1.30, 1.32 and 1.36, 17 CFR 1.20-1.30, 1.32 and 1.36.

They provide, among other things, that a customer's funds: must be

accounted for separately by the FCM; may not be commingled with the

FCM's own funds or those of any other person; must be available

immediately upon demand; and must be used only to margin or to secure

contracts traded on or subject to the rules of a designated contract

market. Neither Section 4d of the Act nor these regulations address the

holding of customer funds offshore or in foreign currencies.

Interpretation No. 12 permits the deposit of U.S. customer funds

offshore, subject to conditions intended to ensure consistency with the

segregation requirements of the Act and ``generally to prevent the

dilution of customer funds held in segregation in the United States.''

Accordingly, Interpretation No. 12 limits the circumstances under which

funds may be held offshore; requires specified qualifications for

foreign depositories; requires a certain

[[Page 67842]]

amount of funds to be held in dollars in the U.S.; and requires that

customers whose funds are deposited offshore subordinate their claims

against segregated funds to those of customers whose funds are

deposited in the U.S. or in other currencies.

More specifically, Interpretation No. 12 permits customer funds,

including funds of U.S. customers, to be held offshore subject to the

following conditions:

1. With respect to U.S.-domiciled customers, only funds held for

trading contracts that are priced and settled in a foreign currency may

be held in foreign depositories;

2. FCMs must segregate sufficient funds in dollars in the U.S. to

meet all dollar-denominated obligations to customers;

3. Customer funds may be held only in the country of origin of the

applicable currency or in a country with which the Commission has an

information sharing arrangement;

4. Foreign depositories must meet Commission Regulation 30.7(c)

criteria; 5 and

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\5\ These criteria are detailed in Part III C infra.

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5. FCMs must obtain from customers a subordination agreement

whereby the customer authorizes the deposit of its funds in a foreign

depository and subordinates its claim thereto to the claims of

customers whose accounts are denominated in U.S. dollars.6

The subordination agreement would be activated in the event the FCM is

placed in bankruptcy or receivership and there are insufficient

customer funds available for distribution to satisfy all customer

claims.

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\6\ Commission staff has interpreted this requirement to apply

with respect to funds denominated in foreign currencies, wherever

held. See, fn. 11 infra and accompanying text.

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2. Bankruptcy Regulation

Subchapter IV of Chapter 7 of the Bankruptcy Code (11 U.S.C.)

accords customers of an insolvent commodity broker priority in the

distribution of customer property:

The trustee shall distribute customer property ratably to

customers on the basis and to the extent of such customers' allowed

net equity claims, and in priority to all other claims, except

claims * * * attributable to the administration of customer

property.

In 1983, the Commission adopted Part 190 of its regulations to

implement the Bankruptcy Reform Act of 1978.7 Part 190

recognizes different account classes to permit ``the implementation of

the principle of pro rata distribution so that the differing

segregation requirements with respect to different classes of accounts

benefit customer claimants based on the class of account for which they

were imposed.'' 8 The account classes are: futures accounts,

foreign futures accounts, leverage accounts, commodity options

accounts, and delivery accounts.9 Futures and options

accounts that trade foreign currency contracts, contain foreign

currencies, or are located offshore are not recognized as a separate

account class. The subordination agreement required by Interpretation

No. 12, in effect, results in these accounts being treated as belonging

to separate account classes in the event of an FCM's bankruptcy.

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\7\ 48 FR 8716 (1983).

\8\ See Part 190 proposal, 46 Fed. Reg. 57535 (1981) (the

``Proposing Release'').

\9\ Commodity options accounts do not constitute a separate

class to the extent they relate to transactions subject to

regulation under the Act and the Commission's regulations, because

FCMs are permitted to commingle funds required to be segregated.

Section 4d(2) of the Act, 7 U.S.C. 6d(2); Commission's Regulations

190.01 and 1.3(hh).

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3. Banking Regulation

Prior to 1988, the Board of Governors of the Federal Reserve had a

policy discouraging banks in the U.S. from accepting deposits of

foreign currencies. Shortly after the Commission issued Interpretation

No. 12, in order to address the needs of contracts settled in foreign

currencies, the Board changed its policy and began to allow banks

located in the U.S. to accept foreign currency deposits.

Regulation Q (12 CFR Sec. 217) generally prohibits U.S. banks from

paying interest on demand deposits. 10 Regulation Q does not

prohibit foreign branches of U.S. banks from paying interest on demand

deposits, provided that the U.S. bank does not expressly guarantee

repayment of the deposits in the U.S.

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\10\ The Commission requirement that customer funds be

available upon demand results in these funds being categorized by

banks as demand deposits. A bill to repeal the prohibition on the

payment of interest on demand deposits was introduced by Rep.

Metcalf on July 31, 1997, and is currently pending. See H.R. 2323,

105th Cong., 1st Sess. (1997).

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B. Developments Since the Issuance of Interpretation No. 12

At the time Interpretation No. 12 was issued, the Commission stated

its intention to ``monitor experience under this interpretation * * *

to alter or supplement the conditions for keeping segregated funds

offshore as such experience renders advisable.'' Various developments

since 1988 make it appropriate to revisit this area. First, as noted

above, when Interpretation No. 12 was issued, U.S. banks generally did

not hold foreign currencies in the U.S. Therefore, Interpretation No.

12 does not explicitly address risks related to customer funds

denominated in foreign currencies and held in the U.S.11

Second, since 1988, U.S. contract markets have listed many futures and

option contracts that are priced and settled in foreign currencies. The

use of foreign currencies in connection with trading these contracts,

particularly the use of currencies of countries that are major

financial centers, has become commonplace. Third, trading volume in the

competing offshore and over-the-counter markets has increased

dramatically since 1988, raising competitiveness concerns in the

industry. Fourth, industry sources have expressed the view to

Commission staff that the subordination requirement of Interpretation

No. 12 is cumbersome, unnecessarily penalizes customers who deposit

foreign currencies with FCMs, and is an impediment to access to the

U.S. futures markets for non-U.S. customers who may be reluctant to

subordinate their claims.12

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\11\ However, Commission staff has interpreted the subordination

requirement of Interpretation No. 12 to be applicable to customer

funds denominated in foreign currencies, wherever held.

\12\ Interpretation No. 12 ``has the effect of making overseas

customers less willing to use U.S. futures markets because it

imposes a subordination requirement on foreign currency deposits

that is obsolete in today's global economy * * *.'' (Letter dated

November 4, 1997, to the Commission from the Chicago Mercantile

Exchange). A number of brokerage firms interviewed by Commission

staff in connection with reviewing the requirements of

Interpretation No. 12 expressed the same view.

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Finally, several FCMs and a clearing organization have requested

permission to maintain in offshore accounts customer funds denominated

in foreign currencies. The FCMs represented that holding funds offshore

would better serve the needs of their foreign-domiciled clientele. The

clearing organization contended that it could draw interest on customer

funds held offshore, which would permit it to be more competitive.

Interpretation No. 12 allows customer funds to be held offshore only if

``such funds are used to margin, guarantee, or secure positions in a

contract traded on a domestic contract market that is priced and

settled in a foreign currency'' and only with the express consent and

subordination of the customer. Moreover, Interpretation No. 12 clearly

states the Commission's belief that ``some constraints are necessary to

prevent the transfer of funds overseas for reasons unrelated to trading

in the relevant contracts.'' Accordingly, a clearing organization could

not move and maintain customer funds offshore except as permitted by

Interpretation No. 12 or unless it

[[Page 67843]]

obtained relief from the requirements thereof.13

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\13\ Indeed, on a case by case basis, the Division of Trading

and Markets has permitted customer funds to be maintained by

clearing organizations in London and Mexico City.

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II. Policy Considerations

A. Goals

The protection of customer funds is a cornerstone of the Act and

the Commission's regulations. Typically, U.S. market participants

deposit dollars or dollar-denominated assets with their FCM. These

assets are held in segregation in the U.S. Increasingly, however, there

appears to be a need or desire to hold customer funds overseas or in

non-U.S. dollar denominations.

Historically, the Commission has proceeded with caution in allowing

customer funds to be held offshore or denominated in foreign currencies

and intends to continue to do so. Nevertheless, at this juncture, the

Commission wishes to take a comprehensive look at the needs and

practices of the industry in evaluating possible revisions of its

requirements. Three distinct questions must be considered: (1) Whether

and under what circumstances customers may choose to have segregated

funds deposited offshore or denominated in foreign currencies; (2)

whether and under what circumstances FCMs may choose to hold segregated

funds offshore or in foreign currencies; and (3) whether and under what

circumstances clearing organizations may choose to hold segregated

funds offshore or in foreign currencies.

In each case, the extent of the need or desire for holding customer

funds offshore or in foreign currencies must be assessed against the

related risks. Risk limiting measures must be considered, and the

question of who should bear the risks that cannot be eliminated must be

explored. One of the premises of Interpretation No. 12 is that

customers whose accounts are denominated in U.S. dollars must be

insulated from the risks resulting from an FCM holding funds offshore

or in foreign currencies. The continuing viability of this premise has

been questioned by some industry participants.

The Commission encourages commenters to describe their current

practices and to provide a detailed analysis of the reasons for their

desire or need to keep segregated funds offshore. Commenters should

discuss related risks and how these risks should be addressed for the

protection of customers. Commenters should also explain how revisions

to the current requirements could affect their business.

B. Risks

Holding segregated funds offshore or in foreign currencies creates

three types of risk:

--currency risk;

--depository risk; and

--sovereign risk.

Currency risk arises when an obligation is denominated in one

currency and the asset held to meet that obligation is in another

currency. Fluctuations in exchange rates can cause the amount of the

obligation to change at a different rate than the value of the asset,

thereby resulting in insufficient funds in segregation to meet the

obligation.

Depository risk is the danger that a depository holding customer

funds may be unable or unwilling to release those funds on demand. This

risk, of course, exists with domestic depositories but contains

additional elements overseas, particularly insofar as the Commission's

knowledge of, or authority over, foreign depositories may be less.

Sovereign risk is the chance that a foreign government might take

action preventing a depository or an FCM from releasing customer funds

despite the requirements of Section 4d of the Act.

III. Potential Approaches

This part of the concept release sets forth a number of possible

methods to address the risks described above and the issues that have

arisen since Interpretation No. 12 was issued. Some of the listed

methods are existing requirements; others are measures suggested by

industry members or devised by Commission staff. The listing of

potential approaches in this concept release is designed only to elicit

public comment. It is not intended as an endorsement or to indicate a

willingness on the part of the Commission to adopt these approaches or

to abandon existing provisions.

The Commission requests commenters to indicate their preferred

alternatives from among those listed or to suggest other methods. The

alternatives are organized into six categories. These categories

represent potential avenues for dealing with the risks described above.

They are:

--the permissible denominations of FCMs' obligations to their

customers;

--the permissible denominations of assets held in segregation;

--the permissible locations of segregated funds;

--the qualifications of non-U.S. depositories;

--the segregation and net capital treatment of customer funds held

offshore or in foreign currencies; and

--the bankruptcy treatment of these funds.

The first five categories above primarily involve steps that could

reduce risks. The last category involves steps that could be taken to

allocate losses equitably in the event that shortfalls in segregated

funds nevertheless occur. The list of potential choices in each area of

intervention generally proceeds from most restrictive to least

restrictive. Each option may address more than one type of risk, and

choices within one section are not necessarily mutually exclusive.

Moreover, a choice under one area may affect a choice in another. For

example, choices under section C, relating to countries where

segregated funds may be held, must be made in conjunction with related

requirements under section E, regarding the segregation treatment of

customer funds. Each section is followed with a brief discussion of the

potential impact of listed choices. A variety of overall approaches can

be constructed by selecting different combinations.

Because the Commission generally favors an approach that emphasizes

prophylactic measures, most listed choices are intended to reduce

relevant risks. However, the Commission recognizes that all risks

cannot be prevented. Accordingly, possible procedures also are included

to alleviate the consequences of residual risks, i.e., any risks that

cannot be effectively eliminated.

A. Permissible Denominations of Obligations

1. Alternatives

An FCM's obligation to a customer may be denominated in a currency

other than U.S. dollars:

a. In connection with contracts priced and settled in that

currency.

b. (i) In connection with contracts priced and settled in that

currency; or (ii) if the customer is domiciled overseas.

c. If the currency is acceptable for margin purposes on a U.S.

contract market.

d. With the customer's written authorization.

e. Other, please specify.

2. Discussion

As noted above, because currencies fluctuate at different rates,

where obligations are denominated in one currency and assets held to

meet these obligations are denominated in another,

[[Page 67844]]

an imbalance may result between assets and obligations resulting in

insufficient funds in segregation to meet the obligations. Accordingly,

the denomination of both assets and obligations to customers must be

considered.

Discussions with participants in the industry indicate that, under

current practices, the agreement signed by a customer opening an

account with an FCM usually specifies either that obligations to the

customer are in U.S. dollars, unless otherwise agreed, or that the

customer will be paid in the currency it deposits or in which any

earnings are accrued. The discussions also indicate, however, that

these principles are not uniformly applied and indeed that some FCMs

may not have a clear agreement with their customers regarding the

currencies in which customers are to be paid. This should be clarified

as it may ultimately dictate whether gains and losses resulting from

currency fluctuations will accrue to, or be borne by, the FCM or its

customers. The choices made for this section must be considered in

close conjunction with those made for the next section relating to

permissible denomination of assets.

B. Permissible Denominations of Assets

1. Alternatives

Assets held in segregation may be denominated in a foreign currency

only:

a. In connection with contracts priced and settled in that

currency.

b. (i) In connection with contracts priced and settled in that

currency; or (ii) if the customer is domiciled overseas.

c. If the currency is acceptable for margin purposes on a U.S.

contract market.

d. With the customer's written authorization.

e. Other, please specify.

2. Discussion

Current Interpretation No. 12 permits the deposit offshore of funds

``used to margin, guarantee, or secure positions in a contract traded

on a domestic contract market that is priced and settled in a foreign

currency or accrue to such a customer as a result of positions in such

contracts.'' Provided that FCMs recompute the asset/obligation balance

on a daily basis, any choice above would effectively address currency

risk. Absent a requirement to rebalance asset/obligations daily, only

choice (a) could result in a ``natural'' balance. The other choices

would not ensure the continuous balance of assets and

obligations.14 Commenters should indicate whether

alternatives (b), (c), and (d) should be limited further to specific

currencies.

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\14\ However, potential imbalances would be mitigated by other

measures such as a requirement that FCMs take a haircut in their net

capital computation for any unhedged foreign currencies. See Part

III E infra.

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C. Permissible Locations of Segregated Funds

1. Alternatives

Segregated funds may be held at an approved depository in any of

the following geographic locations (commenters should choose the

appropriate combination):

a. The U.S.

b. The country of origin of the currency in which the related

contract is priced and settled.

c. A country with which the Commission has an information sharing

arrangement.15

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\15\ The Act enables the Commission to enter into various types

of cooperative arrangements with foreign futures authorities. See,

e.g., Sections 8(a)(1) and 12(f)(2) of the Act.

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d. For a limited period of time, the country in which the customer

is domiciled, and only for operational ease in receiving and disbursing

funds from and to customers living in foreign countries and trading on

U.S. contract markets.

e. Without time limitation, the country of domicile of the

customer.

f. The G7 countries (plus Switzerland).16

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\16\ The G7 is a group of industrialized countries. It includes:

the U.S., Canada, France, Germany, Italy, Japan and the United

Kingdom. For purposes of determining major money centers,

Switzerland is often added to the list.

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g. Some or all of the twenty-four countries that the Securities and

Exchange Commission (``SEC'') considers as major money

centers.17

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\17\ SEC no action letter from Michael Macchiaroli to Douglas

Preston of the Securities Industry Association [1992 Transfer

Binder], SEC Rep. (CCH) para. 76,245 (August 21, 1992). Subject to

certain conditions, the Market Regulation Division would not

recommend any enforcement action against broker dealers who hold

money market instruments in a ``major money market'' if they do not

take a one hundred percent haircut on these instruments in

calculating net capital under Rule 15c3-1 of the Securities Exchange

Act of 1934. The letter lists twenty-four countries that are

considered as major money markets. These countries are: Australia;

Austria; Belgium; Canada; Denmark; Finland; France; Germany; Greece;

Hong Kong; Ireland; Italy; Japan; Luxembourg; the Netherlands; New

Zealand; Norway; Portugal; Singapore; Spain; Sweden; Switzerland;

the United States; the United Kingdom.

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h. Other, please specify.

2. Discussion

Choice (a), requiring funds to be held in the U.S., is more

restrictive than the current Interpretation No. 12 approach. This

choice is more viable now than it was at the time Interpretation No. 12

was issued because, as noted above, in the interim, the Federal Reserve

changed its policy concerning foreign currency deposits in the U.S.

Nevertheless, the Commission recognizes that it could impose additional

costs on the industry. The requirement that segregated funds be held in

the country of origin of the currency (choice (b)) is a current

Interpretation No. 12 requirement. Under choice (b), an increase in the

number of currencies in which contracts traded in U.S. contract markets

settle would automatically trigger additional countries as permissible

segregated funds locations.18 This choice may result in

countries being added and taken off the list of permissible locations

based on contract designations at any given time.

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\18\ When Interpretation No. 12 was issued, no contracts priced

and settled in a foreign currency were traded on U.S. contract

markets. However, two applications were pending before the

Commission for designation of such contracts. Currently, many

contracts that margin and settle in foreign currencies are traded on

U.S. contract markets.

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Choice (c) also reflects current Interpretation No. 12. In 1988,

the Commission had an information sharing arrangement with the

Australian National Companies and Securities Commission and with the

United Kingdom Securities and Investments Board. The Commission

currently has information sharing or cooperation arrangements with

regulators of over fifteen foreign jurisdictions. While the existence

of a framework of cooperation with the Commission is a positive factor,

other factors, such as economic and political soundness of the country,

also are important. Choices (f) and (g) would limit possible depository

countries to countries generally considered to be secure and to have

sophisticated regulatory regimes. Alternative (e) would permit FCMs to

hold customer funds offshore for operational convenience in any country

where an FCM's customer is domiciled.

D. Qualifications of Depositories

1. Alternatives

To qualify to hold segregated funds, a depository must provide the

depositing FCM the segregation acknowledgment required by Commission

Regulation 1.20 and:

a. Must be located in the U.S.

b. If located offshore, must have a branch or correspondent in the

U.S. which guarantees repayment in the U.S. in the event the foreign

depository fails to fulfill its obligation for any reason.

[[Page 67845]]

c. If located offshore, must have a branch or correspondent in the

U.S. which guarantees repayment in the U.S. in the event the foreign

depository fails to fulfill its obligation for any reason other than

sovereign action.

d. If located offshore, must be an FCM or a designated bank or

trust company as defined in Advisory 87-5.19

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\19\ Pursuant to CFTC Advisory 87-5 (1987-1990 CCH Transfer

Binder para. 23,997), FCMs are required to disclose on their Form 1-

FR the identity of offshore depositories. Any bank or trust company

located outside the U.S. whose commercial paper or long term debt is

rated in one of the two highest rating categories by Standard &

Poors Corporation or Moody's Investors Service, Inc. is deemed

automatically recognized. FCMs must submit an application for

recognition of other non-U.S. located banks and trust companies not

meeting this standard. Such banks or trust companies are deemed

recognized unless the Division gives the FCM notice to the contrary

within 60 days following receipt of the application. No such

application has been received.

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e. Some combination of the elements of alternatives (a) through d.

f. Other, please specify.

2. Discussion

Alternative (d), which relies on the commercial paper or long term

debt rating of foreign depositories, is the current Interpretation No.

12 requirement. Alternative (b) would effectively address location risk

(both sovereign and depository risks) by requiring a repayment

guarantee in the U.S. whatever the cause of the shortfall. However, as

noted above, it appears that banks would not be allowed to pay interest

if an unconditional guarantee were given. Accordingly, choice (b) would

be unsatisfactory where customer funds are held offshore for the

purpose of yielding interest. Alternative (c) would address only

depository risk.

E. Segregation and Net Capital Treatment

1. Alternatives

a. Customer funds must be segregated only in accounts payable in

the U.S. No account located or payable outside the U.S. is considered

an acceptable segregated deposit.

b. A percentage of excess segregated funds on deposit in non-U.S.

locations (e.g., ten to twenty-five percent) may be recognized as good

segregated assets.

c. Only funds received from foreign-domiciled customers may be held

offshore. However, they will not be considered to be properly

segregated.

Segregated funds may be held offshore and/or in foreign currencies:

d. Provided that sufficient funds are held in each currency to meet

all obligations in that currency, as computed daily.

e. Provided that sufficient U.S. dollars are segregated in a U.S.

depository to meet all U.S. dollar obligations. To the extent other

currencies are segregated in foreign depositories, excess U.S. dollars

(e.g., 10%) must be held in the U.S. as a cushion.

f. Provided that alternative sources of funding such as dedicated

lines of credit, in a form acceptable to the Commission, are available

to cover shortfalls or delays in payment.

g. Some combination of the elements of alternatives (c) through

(e).

h. Other, please specify.

2. Discussion

Under alternative (a), funds deposited by customers for trading on

U.S. contract markets would be held in the U.S. only. This is founded

on the proposition that futures and options positions are carried in

the U.S., and therefore, the need for these funds, for variation

settlements and for standing margin is in the U.S. Having these funds

in the U.S. ensures that the funds will be available and subject to

U.S. law in the event of insolvency and that they will be distributed

according to the Bankruptcy Code and the regulations thereunder.

Alternative (b) would recognize a percentage of excess segregated

funds held offshore as properly segregated. All other segregated funds

would be required to be held in the U.S. Alternative (c) would set no

limit on the amount of foreign-domiciled customer funds held in

offshore locations; however, these funds would not be recognized as

good segregated funds. Under alternative (d) customer funds could be

properly segregated offshore, subject to daily balancing of assets and

obligations in each currency. This would address currency risk, but not

location risk. Under alternative (e), all dollar obligations would be

matched by U.S. dollars held in segregation in the U.S. An FCM could

hold foreign currencies in segregation. As a protection against

currency rate fluctuations, however, the FCM would be required to hold

additional U.S. dollars in the U.S. Alternatives (a) through (e) all

are intended to prevent the occurrence of shortfalls. Alternative (f)

provides a method to cover shortfalls should they occur. As noted,

these alternatives are not necessarily mutually exclusive.

F. Bankruptcy Treatment \20\

1. Alternatives

a. Customers whose funds are held offshore or in foreign currencies

must subordinate their claims against these funds to those of customers

whose funds are segregated in the U.S. and in U.S. dollars in the same

manner as under current Interpretation No. 12.

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\20\ As noted above, the special provisions of the Bankruptcy

Code applicable to the bankruptcy of commodity brokers generally

require that in the event of the bankruptcy or insolvency of an FCM

all segregated funds be distributed on a pro rata basis to customers

of the same class.

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b. Customers whose funds are held offshore or in foreign currencies

must subordinate their claims against these funds to those of customers

whose funds are segregated in the U.S. and in U.S. dollars in the same

manner as in Appendix B to the Commission's Bankruptcy

regulations.21

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\21\ 17 C.F.R. 190 Appendix B. Appendix B, which governs the

distribution of property where a bankrupt FCM holds cross-margin

funds, while intended to assure that non-cross-margining customers

of such an FCM will not be adversely affected by a shortfall in the

pool of cross-margining funds, modified the applicable

distributional rules such that the required subordination is more

limited.

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c. Customers whose funds are held offshore or in foreign currencies

must subordinate their claims against these funds to claims of

customers whose funds are segregated in the U.S. and in U.S. dollars in

the event there are shortfalls as a result of sovereign action.

22

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\22\ Some industry members believe that the risk that a foreign

government would freeze deposits within its borders is ``remote,

especially when dealing with the major global currencies.'' They

recommend that the Commission exempt deposits of the major

currencies, wherever held, from all aspects of Interpretation No.

12. See letter dated October 16, 1997, to Chairperson Born from the

Chicago Board of Trade.

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d. In the event of bankruptcy of an FCM or foreign depository,

segregated funds in each currency will constitute a separate pool, and

each customer will recover to the extent that there are funds in the

pool against which the customer holds a claim.

e. In the event of bankruptcy of an FCM or foreign depository, all

segregated funds will constitute a single pool and will be distributed

pro rata without regard to the location or denomination of these funds.

f. Other, please specify.

2. Discussion

The majority of measures considered earlier in this release were

intended to minimize risks. This section deals with apportioning losses

should they occur. Alternative (a) is the requirement of current

Interpretation No. 12. As noted

[[Page 67846]]

above, to ensure that in the event of an FCM bankruptcy customers whose

funds are held in the U.S. and in U.S. dollars will not share pro rata

in possible shortfalls in customer funds held offshore, Interpretation

No. 12 requires that customers who deposit funds denominated in a

foreign currency subordinate their claims to those of customers with

U.S. dollar claims. Alternative (b) would use the same device in a

manner that would be less adverse to customers with funds denominated

in foreign currencies. Under alternative (c), the subordination would

be activated only in the event shortfalls resulted from sovereign

action. Other losses would be shared pro rata.

Alternative (d) would pay each customer a pro rata share of the

currency pool(s) against which it had a claim. In certain

circumstances, this alternative could be inequitable to customers with

foreign-denominated claims. For example, the bankruptcy of a depository

could result in shortfalls in foreign currencies of the type held by

the depository. Under this alternative, the shortfalls would be shared

only by customers with claims against those currencies. However, some

of these customers may not have had funds in that depository or any

responsibility for its selection.

As noted above, the Bankruptcy Code and regulations require pro

rata sharing among customers in each account class. Accordingly, this

alternative would require the Commission to amend its bankruptcy

regulations to define each currency pool as a separate account class.

By sharing all available customer funds among all customers without

regard to the segregation locations, alternative (e) furthers the view

that shortfalls should be shared among all customers without regard to

the denomination or location of customer funds.

IV. A Specific Approach

To illustrate the interrelationship of choices under the various

headings and to assist the Commission further in reaching a resolution

of the issues, staff has prepared a specific formulation combining

choices from each category.23 The Commission is not

endorsing this approach at this time, but the Commission believes that

receiving comments on it would provide a valuable supplement to the

other comments. This approach would address the concern that current

regulatory standards may impede access to the U.S. futures market by

eliminating the subordination agreement currently required by

Interpretation No. 12. To facilitate the receipt of funds from offshore

customers, this approach, however, would permit FCMs to maintain

operating accounts in non-U.S. depositories. Under this approach:

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\23\ This approach combines, with some modifications, choices

(A)(1)(c), (B)(1)(c), (C)(1)(a), (D)(1)(a), (E)(1)(a), and

(F)(1)(a).

--Funds used by an FCM to meet its obligations to customers who trade

on U.S. contract markets must be segregated in accounts payable in the

U.S. That is, no account located or payable outside of the U.S. would

be considered an acceptable segregated depository. In addition:

--As an operational convenience, an FCM would be permitted to receive

commodity margin funds into non-U.S. accounts from customers located

outside the U.S. However, funds in these accounts would not be

recognized as segregated assets. This means that customer funds in

accounts located outside of the U.S. would not have to be transferred

to the U.S. An FCM would be considered in compliance with the

segregation rules as long as there were sufficient funds segregated in

the U.S. to cover its obligations to all of its customers, including

the non-U.S. customers whose funds had not yet been transferred to the

U.S.

--A deposit of any customers' funds into an account outside of the U.S.

would result in an increase in the FCM's segregated liability to its

customers. The FCM's excess segregated funds would be used to cover the

credit to the customer's account. This coverage must be made

immediately upon receipt of the funds in the non-U.S. account.

--An FCM would be permitted to recognize as segregated assets foreign

currencies credited to the FCM in segregated foreign currency accounts

with banks located in the U.S. as long as the account balances were

payable in the U.S. The non-U.S. currencies which would be recognized

as segregated assets would be limited to those foreign currencies which

would have been identified as acceptable for margin purposes by the

contract markets on which the FCM's customers trade.

--An FCM must take appropriate action to maintain a balance between the

currencies it had in segregated accounts and its obligations to

customers denominated in the same foreign currency. To achieve this, an

FCM must perform a daily calculation of the balance between its foreign

currency deposits and its obligations to its customers in those

currencies, including U.S. dollars. This calculation must be performed

as part of the daily segregation calculation. Imbalances must be

corrected by the day following the ``as of'' date of the calculation.

An appropriate capital charge must be taken on any imbalances, pursuant

to the Commission's net capital rule, regardless of any rebalancing

achieved the following day.

This approach would not compel an FCM to transfer any funds into

the U.S., provided the FCM had sufficient excess segregated assets in

the U.S. FCMs could maintain accounts in non-U.S. locations and use

such accounts to take in deposits from foreign-domiciled customers and

to make disbursements. However, the funds contained in these accounts

would not count towards meeting the FCM's segregated liability.

Although funds in these accounts would not qualify as good segregated

funds, they could qualify for net capital purposes, provided the

accounts met the requirements of the net capital rule, which are less

stringent than those of the segregation rule.

V. Request for Comment

The Commission requests comment on the need for and effectiveness

of the various alternatives and, in particular, on the ``specific

approach.'' In formulating their choices, commenters should consider

the following factors: (a) FCMs increasingly have a customer base

offshore; (b) U.S. banks are currently prohibited by the Board of

Governors of the Federal Reserve from paying interest on demand

deposits while unguaranteed offshore deposits may yield interest; (c)

some U.S. depositories are reluctant to hold a substantial amount of

foreign currencies; (d) as the volume of contracts that are priced and

settled in foreign currencies increases, the need to deposit customer

funds denominated in foreign currencies also increases; (e) the

enforceability of the subordination agreement has not been tested and

is not clear in the event of a bankruptcy adjudicated by a non-U.S.

court; and (f) other steps outside the Commission's purview could help

reduce the risks related to customer funds held offshore or in foreign

currencies, such as steps to facilitate the movement of foreign

currencies through the Fedwire.

The Commission encourages commenters to provide information on

their current business practices and how they could be affected by the

methods listed in this release and any additional

[[Page 67847]]

methods they propose. The Commission also requests comment on the

practicality of the various methods.

Finally, the Commission requests comment on whether it is

appropriate to allow exchanges and/or clearing organizations to hold

customer funds offshore without the customers' express authorization

and without a direct operational necessity. If so, commenters should

indicate what conditions and limitations should be imposed. The

Commission welcomes any cost-benefit analysis commenters care to

provide in support of their choices.

The Commission requests that commenters, in making their choice

among the proposed alternatives or in indicating other alternatives,

clearly indicate whether the provision should apply at the FCM level

and/or at the clearing level. The Commission will give serious

consideration to the comments in determining an appropriate manner in

which to revise the requirements set forth in Interpretation No. 12.

The Commission wishes: (a) To facilitate access to the United States

markets for the growing international customer base using them; (b) to

reduce the regulatory burden, where practicable, on FCMs and clearing

organizations that accept customer deposits in foreign denominations

and use foreign depositories; and (c) to maintain the safety of

customer funds.

Issued in Washington, DC on December 23, 1997, by the

Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97-33955 Filed 12-29-97; 8:45 am]

BILLING CODE 6351-01-P