[Federal Register: August 14, 2002 (Volume 67, Number 157)]
[Rules and Regulations]
[Page 53145-53180]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14au02-31]
[[Page 53145]]
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Part IV
Commodity Futures Trading Commission
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17 CFR Part 41
Securities and Exchange Commission
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17 CFR Part 242
Customer Margin Rules Relating to Security Futures; Joint Final Rules
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 41
RIN 3038-AB71
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-46292; File No. S7-16-01]
RIN 3235-AI22
Customer Margin Rules Relating to Security Futures
AGENCIES: Commodity Futures Trading Commission and Securities and
Exchange Commission.
ACTION: Joint final rules.
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SUMMARY: The Commodity Futures Trading Commission ("CFTC") and the
Securities and Exchange Commission ("SEC") (collectively,
"Commissions") are adopting rules to establish margin requirements
for security futures. The final rules preserve the financial integrity
of markets trading security futures, prevent systemic risk, and require
that the margin requirements for security futures be consistent with
the margin requirements for comparable exchange-traded option
contracts.
EFFECTIVE DATE: September 13, 2002.
FOR FURTHER INFORMATION CONTACT:
CFTC: Phyllis P. Dietz, Special Counsel; or Michael A. Piracci,
Attorney, Division of Clearing and Intermediary Oversight, Commodity
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,
NW, Washington, DC 20581. Telephone: (202) 418-5000. E-mail:
(PDietz@cftc.gov); or (MPiracci@cftc.gov).
SEC: Onnig Dombalagian, Attorney Fellow, at (202) 942-0737;
Theodore R. Lazo, Senior Special Counsel, at (202) 942-0745; Hong-anh
Tran, Special Counsel, at (202) 942-0088; and Lisa Jones, Attorney, at
(202) 942-0063, Division of Market Regulation, Securities and Exchange
Commission, 450 Fifth Street, NW, Washington, DC 20549-1001.
SUPPLEMENTARY INFORMATION: The CFTC is adopting Rules 41.42 through
41.49, 17 CFR 41.42 through 41.49, and the SEC is adopting Rules 400
through 406, 17 CFR 242.400 through 242.406, (the "Final Rules")
under authority delegated by the Federal Reserve Board pursuant to the
Securities Exchange Act of 1934 ("Exchange Act").
I. Background
A. Statutory Provisions
B. Proposed Rules
C. Overview of the Comment Letters
D. Overview of the Final Rules
II. Discussion of the Final Rules
A. Who is Covered by the Final Rules
B. Exclusions from Coverage
1. Financial Relations between a Customer and a Security Futures
Intermediary under a Portfolio Margining System
2. Financial Relations between a Security Futures Intermediary
and a Foreign Person
3. Margin Requirements Imposed by Clearing Agencies or
Derivatives Clearing Organizations
4. Financial Relations between Security Futures Intermediaries
and Broker-Dealers, and Certain Members of National Securities
Exchanges
a. Financial Relations with an Exempted Person
b. Margin Arrangements with a Borrower Otherwise Excluded
Pursuant to Section 7(c)(3) of the Exchange Act
c. Financial Relations between a Security Futures Intermediary
and a Member of a National Securities Exchange or Association in
Connection with Market Making Activities
C. Interpretation of, and Exemptions from, the Final Rules
D. Definitions
E. Application of Regulation T to Security Futures
F. Account Administration Rules
1. Separation and Consolidation of Accounts
2. Accounts of Partners
3. Contribution to a Joint Venture
4. Extensions of Credit
G. Customer Margin Levels for Security Futures
1. Definition of Current Market Value
2. Margin Levels for Unhedged Positions
3. Margin Offsets
4. Higher Margin Levels
5. Procedures for Certain Margin Level Adjustments
H. Satisfaction of Required Margin
1. Type, Form and Use of Collateral
a. Acceptable Collateral Deposits
b. Use of Money Market Mutual Funds
2. Computation of Equity
a. Security Futures
b. Option Value
c. Open Trade Equity
d. Margin Equity Securities
e. Other Securities
f. Foreign Currency
g. Other Components of Equity
h. Guarantees
3. Satisfaction of Required Margin for Positions Other than
Security Futures
I. When Margin May Be Withdrawn
1. Withdrawal of Margin by the Customer
2. Withdrawal of Margin by the Security Futures Intermediary
J. Consequences of Failure to Collect Required Margin
K. CFTC Procedures for Notification of Proposed Rule Changes Related
to Margin
III. Paperwork Reduction Act
A. CFTC
B. SEC
IV. Costs and Benefits of the Final Rules
A. CFTC
B. SEC
1. Costs
a. Compliance with Regulation T
b. Levels of Margin
c. Computation of Margin
d. Undermargined Accounts
2. Benefits
a. Benefits to Security Futures Intermediaries
b. Benefits to Customers
V. Consideration of Burden on Competition, Promotion of Efficiency, and
Capital Formation
VI. Regulatory Flexibility Act
A. CFTC
B. SEC
VII. Statutory Basis
Text of Rules
I. Background
A. Statutory Provisions
The Commodity Futures Modernization Act of 2000 ("CFMA"),\1\
which became law on December 21, 2000, lifted the ban on single stock
and narrow-based stock index futures ("security futures"). In
addition, the CFMA established a framework for the joint regulation of
security futures by the CFTC and the SEC.
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\1\ Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).
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As part of the statutory scheme for the regulation of security
futures, the CFMA provided for the issuance of rules governing customer
margin for transactions in security futures. Specifically, the CFMA
added a new subsection (2) to section 7(c) of the Exchange Act,\2\
which directs the Board of Governors of the Federal Reserve System
("Federal Reserve Board") to prescribe rules establishing initial and
maintenance customer margin requirements imposed by brokers, dealers,
and members of national securities exchanges for security futures
products. In addition, section 7(c)(2)(B) provides that the Federal
Reserve Board may delegate this rulemaking authority jointly to the
Commissions. On March 6, 2001, the Federal Reserve Board delegated its
authority under Section 7(c)(2)(B) to the Commissions.\3\ Pursuant to
that authority, the SEC and the CFTC have adopted customer
[[Page 53147]]
margin requirements for security futures.\4\
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\2\ 15 U.S.C. 78g(c)(2).
\3\ Letter from Jennifer J. Johnson, Secretary of the Board,
Federal Reserve Board, to James E. Newsome, Acting Chairman, CFTC,
and Laura S. Unger, Acting Chairman, SEC (March 6, 2001) ("FRB
Letter").
\4\ Because section 6(h)(6) of the Exchange Act (15 U.S.C.
78f(h)(6)) provides that options on security futures may not be
traded for at least three years after the enactment of the CFMA, the
margin requirements do not address options on security futures.
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Section 7(c)(2) provides that the customer margin requirements for
security futures must satisfy four requirements. First, they must
preserve the financial integrity of markets trading security futures
products. Second, they must prevent systemic risk. Third, they must (a)
be consistent with the margin requirements for comparable option
contracts traded on any exchange registered pursuant to section 6(a) of
the Exchange Act; and (b) provide for initial and maintenance margin
levels that are not lower than the lowest level of margin, exclusive of
premium, required for comparable exchange-traded options. Fourth, they
must be and remain consistent with the margin requirements established
by the Federal Reserve Board under Regulation T.\5\
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\5\ 12 CFR 220 et seq.
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B. Proposed Rules
On September 26, 2001, the CFTC and the SEC issued for public
comment proposed rules (the "Proposed Rules") relating to customer
margin requirements for security futures.\6\ In response to a joint
request from the Futures Industry Association ("FIA") and the
Securities Industry Association ("SIA") for an extension of the
public comment period, the Commissions granted a 30-day extension until
December 5, 2001.\7\
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\6\ Securities Exchange Act Release No. 44853 (September 26,
2001), 66 FR 50720 (October 4, 2001). The FRB Letter was attached as
Appendix B. See id. at 50741.
\7\ See Securities Exchange Act Release No. 44996 (October 29,
2001), 66 FR 55608 (November 2, 2001).
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C. Overview of the Comment Letters
The Commissions received a total of 19 comment letters from
securities and futures industry associations,\8\ exchanges,\9\ a
clearing organization,\10\ financial services firms,\11\ systems
vendors,\12\ a member of the academic community,\13\ and two members of
the public.\14\ In general, the comment letters focused on three major
issues raised by the Proposed Rules: the applicability of Regulation T
and the desirability of an account-specific margin regime; the
appropriateness of the proposed 20% margin level; and the
permissibility of portfolio margining.
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\8\ See letters from Mark E. Lackritz, President, SIA, and John
M. Damgard, President, FIA, dated December 5, 2001 ("SIA/FIA
Letter"); George Ruth, Chairman, Rules and Regulations Committee,
Securities Industry Association Credit Division, dated December 4,
2001 ("SIA Credit Division Letter"); Thomas W. Sexton, Vice
President and General Counsel, National Futures Association, dated
December 5, 2001 ("NFA Letter"); and John G. Gaine, President,
Managed Funds Association, dated January 11, 2002 ("Manager Funds
Letter").
\9\ See letters from James J. McNulty, Chicago Mercantile
Exchange Inc., and David J. Vitale, Board of Trade of the City of
Chicago, Inc., dated December 4, 2001 ("CME/CBOT Letter"); the
American Stock Exchange, Chicago Board Options Exchange, The Options
Clearing Corporation, International Securities Exchange, Pacific
Exchange, and Philadelphia Stock Exchange, dated December 5, 2001
("Options Exchanges Letter"); Kathleen M. Hamm, Director of Market
Regulation, Senior Vice President Regulation and Compliance, Nasdaq
Liffe Markets, LLC, dated December 5, 2001 ("Nasdaq Liffe
Letter"); Kenneth M. Rosenzweig, on behalf of OneChicago, LLC,
dated December 6, 2001 ("OneChicago Letter"); Michael J. Ryan,
Jr., Executive Vice President and General Counsel, American Stock
Exchange, dated December 7, 2001 ("Amex Letter"); and William J.
Brodsky, Chairman and Chief Executive Officer, Chicago Board Options
Exchange, dated December 7, 2001 ("CBOE Letter"). The CBOE also
joined in the Options Exchanges Letter.
\10\ See letter from Susan Milligan, The Options Clearing
Corporation, dated December 14, 2001 ("OCC Letter"). The OCC also
joined in the Options Exchanges Letter.
\11\ See letters from John P. Davidson III, Managing Director,
Morgan Stanley, dated December 5, 2001 ("Morgan Stanley Letter");
James A. Gary, Executive Vice President, ABN AMRO Incorporated,
dated December 5, 2001 ("ABN AMRO Letter"); and Russell R.
Wasendorf, Sr., Chairman and Chief Executive Officer, Peregrine
Financial Group, Inc., dated December 5, 2001 ("Peregrine
Letter").
\12\ See letters from John Munro, Senior Vice President, Product
Design, Rolfe and Nolan Systems Inc ("Rolfe and Nolan Letter");
and Stephen P. Auerbach, Chief Operating Officer, SunGard Futures
Systems, dated December 5, 2001 ("SunGard Letter").
\13\ See letter from Frank Partnoy, Professor of Law, University
of San Diego School of Law, dated October 29, 2001 ("Partnoy
Letter").
\14\ See letter from Robert Drinkard, dated September 28, 2001
("Drinkard Letter"); and letter from Bernard E. Klein, dated
December 18, 2001 ("Klein Letter").
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The majority of commenters expressed the view that Regulation T
should not be applied to futures accounts. They stated their concern
that application of Regulation T to security futures carried in futures
accounts would impose heavy costs on carrying firms in the form of
reprogramming of systems and training of staff. Some believed that it
would discourage futures commission merchants ("FCMs") from trading
security futures. One commenter, however, supported the application of
Regulation T to security futures, regardless of the type of account in
which they are carried. Several commenters identified specific
provisions of Regulation T that would have to be addressed in order to
accommodate carrying security futures in a securities account, e.g.,
rules for variation margin payments.
Ten of the commenters specifically endorsed the concept that the
margin rules should build on the existing regulatory infrastructure and
that, to the extent possible, the rules applicable to security futures
should be determined by the type of account in which the security
futures are carried. Under this "account-specific" approach, for
example, rules relating to acceptable collateral, collateral haircuts,
timing for collection of margin, and calculations of current market
value would be determined in accordance with the rules otherwise
applicable to a securities account or futures account, respectively.
Several commenters observed that this would be consistent with the
Commissions' proposed customer funds rules \15\ and would be the most
prudent and cost effective approach.
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\15\ See Securities Exchange Act Release No. 44854 (September
26, 2001), 66 FR 50768 (October 4, 2001).
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Most commenters found the proposed 20% minimum margin level to be
acceptable, although some thought the minimum should instead be 25%.
The SIA/FIA Letter noted that "members of the Associations are
divided" as to whether the minimum level of initial and maintenance
margin should be 20% or 25%. Another commenter expressed the view that
the 20% level could be either too high or too low depending on the
circumstances, and that for certain positions 50% initial margin would
be appropriate.
Eleven commenters supported the implementation of full portfolio
margining for security futures, as soon as possible. Two other
commenters emphasized the need for experience with a proposed pilot
program.\16\ One commenter supported portfolio margining only for
sophisticated customers, with another commenter joining in the view
that portfolio margining might not be appropriate for all customers.
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\16\ See Securities Exchange Act Release No. 45630 (March 22,
2002), 67 FR 15263 (March 29, 2002) (notice of rules proposed by the
CBOE related to customer portfolio and cross-margining
requirements).
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After carefully considering the public comments, the Commissions
have adopted Final Rules that reflect modifications to the Proposed
Rules in response to the views and concerns expressed by the
commenters. The Commissions believe that the Final Rules fulfill the
statutory requirements and that the changes made to the
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Proposed Rules will more effectively promote market efficiency and
liquidity.
D. Overview of the Final Rules
The Commissions have carefully considered the commenters' views,
and have modified the Proposed Rules in various respects. The Final
Rules, among other things:
Establish stand-alone requirements that are consistent
with Regulation T, but do not apply Regulation T in its entirety to
futures accounts.
Establish minimum initial and maintenance margin levels
for unhedged positions in security futures at 20% of their "current
market value."
Permit self-regulatory authorities to set margin levels
lower than 20% of current market value for customers with certain
strategy-based offset positions involving security futures and one or
more related securities or futures.
Identify the types of collateral acceptable as margin
deposits and establish standards for the valuation of such collateral
and other components of equity.
Establish standards for the withdrawal of margin by
customers and security futures intermediaries.
Set forth procedures applicable to undermargined accounts.
Set forth procedures for filing proposed rule changes with
the CFTC.
II. Discussion of the Final Rules
A. Who Is Covered by the Final Rules
The Commissions are adopting the Final Rules under the authority
delegated to them by the Federal Reserve Board under section 7(c)(2) of
the Exchange Act, which applies to brokers, dealers, and members of
national securities exchanges extending credit to or for customers, or
collecting margin from customers, in connection with security futures.
In the Proposed Rules, the Commissions used the term "creditor," as
defined in Regulation T, to delineate those persons who would be
subject to the margin rules.\17\ Because FCMs that effect transactions
in security future products are broker-dealers,\18\ they were included
in the definition of "creditor" under the Proposed Rules.
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\17\ Under Section 220.2 of Regulation T (17 CFR 220.2), the
term "creditor" means any broker or dealer, member of a national
securities exchange, or any person associated with a broker or
dealer other than business entities controlling or under common
control with the broker-dealer.
\18\ See sections 3(a)(4) and 3(a)(5) of the Exchange Act, 15
U.S.C. 78c(a)(4) and 78c(a)(5).
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To avoid characterizing the collection of margin for a security
futures contract as involving an extension of credit, the Final Rules
use the term "security futures intermediary" instead of the term
"creditor." \19\ The term "security futures intermediary" is
intended to include the same persons as are included in the Regulation
T definition of "creditor," but solely with respect to their
financial relations involving security futures. SEC Rule 401(a)(29)
defines security futures intermediary by reference to the term
creditor. For the sole purpose of clarifying the scope of the Final
Rules for market participants that are not subject to Regulation T, the
definition of security futures intermediary in CFTC Rule 41.43(a)(29)
specifies that the term includes FCMs and enumerated affiliated
persons.\20\
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\19\ For the same reason, the Final Rules do not use the term
"borrower" to refer to persons who deposit margin in connection
with security futures transactions.
\20\ See CFTC Rule 41.43(a)(29); SEC Rule 401(a)(29).
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The Commissions believe that the term security futures intermediary
is defined identically for all substantive purposes, and emphasize that
the difference in the language used in the two rules to define a
security futures intermediary is not intended to mean that the scope of
the two rules is different.
In addition, the term "customer" is defined under the Final Rules
as any person or persons acting jointly on whose behalf a security
futures intermediary effects a security futures transaction or carries
a security futures position, or who would be considered a customer of
the security futures intermediary according to the ordinary usage of
the trade.\21\ The definition of customer further includes (i) any
partner in a security futures intermediary that is organized as a
partnership who would be considered a customer of the security futures
intermediary absent the partnership relationship, and (ii) any joint
venture in which a security futures intermediary participates and which
would be considered a customer of the security futures intermediary if
the security futures intermediary were not a participant.\22\ This
definition is derived from the Regulation T definition of customer.\23\
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\21\ See CFTC Rule 41.43(a)(5)(i); SEC Rule 401(a)(5)(i).
\22\ See CFTC Rule 41.43(a)(5)(ii) and (iii); SEC Rule
401(a)(5)(ii) and (iii).
\23\ See 12 CFR 220.2.
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B. Exclusions From Coverage
The Final Rules include specific exclusions for certain categories
of financial relations, substantially as proposed. The exclusions are
described below.
1. Financial Relations between a Customer and a Security Futures
Intermediary Under a Portfolio Margining System
The Proposed Rules provided an exclusion for margin calculated by a
portfolio margining system that has been approved by the SEC and, as
applicable, the CFTC.\24\ The Commissions are adopting this exclusion
substantially as proposed.\25\ The Final Rules add a provision
requiring that the portfolio margining system meet the criteria set
forth in section 7(c)(2)(B) of the Exchange Act.\26\ This addition is
intended to clarify that the portfolio margining system must be
consistent with a risk-based system used for comparable exchange-traded
options. This requirement does not preclude the use of an existing
portfolio margining system that interfaces with an FCM's bookkeeping
system, so long as the portfolio margining system is modified to
produce results that comply with the Final Rules.\27\
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\24\ See Proposed CFTC Rule 41.43(b)(3)(i); Proposed SEC Rule
400(b)(3)(i).
\25\ See CFTC Rule 41.42(c)(2)(i); SEC Rule 400(c)(2)(i).
\26\ See CFTC Rule 41.42(c)(2)(i); SEC Rule 400(c)(2)(i).
Section 7(c)(2)(B) requires that the margin requirements for
security futures (i) be consistent with the margin requirements for
comparable exchange-traded security options (and that margin levels
for security futures not be lower than the levels of margin required
for comparable exchange-traded options), and (ii) be and remain
consistent with Regulation T of the Federal Reserve Board. 15 U.S.C.
78g(c)(2)(B).
\27\ Under the Final Rules, a portfolio margining system can be
used to compute required initial or maintenance margin that results
in margin levels that are equal to or higher than the margin levels
required by the Final Rules. In this regard, for example, the
minimum margin requirement for unhedged security futures positions
must be 20%, and the system cannot recognize any offset for
combination positions that is not permitted under self-regulatory
authority rules, as provided in CFTC Rule 41.45(b)(2) and SEC Rule
403(b)(2). See discussion of margin offsets, Section II.G.3. below.
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Portfolio margining establishes margin levels by assessing the
market risk of a "portfolio" of positions in securities or
commodities. Under a portfolio margining system, the amount of required
margin is determined by analyzing the risk of each component position
in a customer account (e.g., a class of option with the same expiration
date) and by recognizing any risk offsets in an overall portfolio of
positions (e.g., across options and futures on the same underlying
instrument). So that adequate margin is deposited to cover
extraordinary market events, one or more additional adjustments may be
applied in calculating a customer's required margin. A portfolio
margining system may also be used in conjunction with a risk-based
margining system,
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which assesses margin based on the historical performance of individual
instruments, rather than as a fixed percentage of current market value.
Depending upon the risks attributable to one or more positions, the
amount of required margin in a portfolio margining system may be
greater than or less than the margin levels currently required for
securities positions in a fixed-percentage, strategy-based margining
system.
The Commissions received 14 comment letters that addressed the
issue of portfolio margining, all of which supported the concept of
portfolio margining for security futures.\28\ Ten of the commenters
strongly supported the implementation of full portfolio margining for
security futures as soon as possible.\29\
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\28\ See SIA Credit Division Letter; Options Exchanges Letter;
CME/CBOT Letter; SunGard Letter; SIA/FIA Letter; OCC Letter;
Peregrine Letter; Nasdaq Liffe Letter; NFA Letter; Morgan Stanley
Letter; OneChicago Letter; ABN AMRO Letter; Rolfe and Nolan Letter;
and Managed Funds Letter.
\29\ See CME/CBOT Letter; SunGard Letter; SIA/FIA Letter;
Peregrine Letter; Nasdaq Liffe Letter; NFA Letter; OneChicago
Letter; ABN AMRO Letter; Rolfe and Nolan Letter; and Managed Funds
Letter.
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Five commenters observed that portfolio margining recognizes the
market risk associated with a specific position more accurately than a
fixed-percentage margin scheme.\30\ One commenter criticized the
Proposed Rules for limiting customers to an "archaic strategy-based
system." \31\
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\30\ See SIA/FIA Letter at 2; Morgan Stanley Letter at 3;
OneChicago Letter at 7-8; NFA Letter at 4-5; and Nasdaq Liffe Letter
at 4.
\31\ CME/CBOT Letter at 5.
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One commenter stated its opinion that portfolio margining should be
allowed immediately for security futures, and that the higher margin
levels collected under a strategy-based approach would make it
difficult for U.S. markets to attract liquidity in security
futures.\32\ This commenter raised concerns that strategy-based
margining would disadvantage U.S. markets and would encourage investors
to seek foreign markets.\33\ Another commenter supported portfolio
margining for security futures, securities, and securities options to
promote global competitiveness.\34\ It observed that portfolio
margining has become the international standard for major futures
markets and without it, the U.S. markets will be at a disadvantage.\35\
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\32\ SunGard Letter at 2.
\33\ Id.
\34\ Nasdaq Liffe Letter at 5-6.
\35\ Id.
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One commenter expressed the view that portfolio margining should
not be approved for security futures before it is approved for options,
and stated that it was critical that any portfolio margining system
applicable to security futures apply to all related products, including
options and the underlying securities.\36\ Another commenter supported
implementation of a portfolio margining framework under which the
margin requirements for portfolios comprised of securities and security
futures would be determined through a risk-based analysis.\37\
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\36\ Options Exchanges Letter at 4.
\37\ SIA/FIA Letter at 11. This commenter also recommended that
the Commissions permit FCMs to use the Standard Portfolio Analysis
of Risk ("SPAN") system for establishing the initial and
maintenance margin requirements for security futures maintained in a
futures account as long as the resulting margin levels are
consistent with the margin requirements for security futures held in
a securities account. Id. at 12.
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Two other commenters, while strongly supporting the concept of
portfolio margining, expressed the opinion that portfolio margining was
not necessarily appropriate for all investors, and that it might be
appropriate to limit the use of portfolio margining for security
futures to sophisticated investors.\38\
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\38\ See SIA Credit Division Letter at 2; Morgan Stanley Letter
at 4.
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The SEC and the CFTC have approved the use of portfolio margining
systems for certain purposes. The CFTC has approved portfolio margining
using the SPAN system for all currently traded futures contracts, at
both the clearing level and the customer level.\39\ The SEC has
approved portfolio margining using The Options Clearing Corporation's
("The OCC") Theoretical Intermarket Margin System ("TIMS") for
margin collected by The OCC for the options positions of its clearing
members.\40\ The SEC and CFTC also have approved self-regulatory
organization ("SRO") rules that permit the use of SPAN and TIMS in
connection with certain cross-margining arrangements involving futures
and securities.\41\ In addition, as noted previously, on March 22,
2002, the SEC published notice of a proposed rule change filed by the
CBOE to implement a portfolio margining system on a pilot basis for
certain customers.\42\
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\39\ The CFTC also has approved SPAN margining for all options
on futures contracts.
\40\ See Securities Exchange Act Release No. 28928 (March 1,
1991), 56 FR 9995 (March 8, 1991); Securities Exchange Act Release
No. 23167 (April 22, 1986), 51 FR 16127 (April 30, 1986).
\41\ To date, the Commissions have approved cross-margining
programs between The OCC and the following futures clearing
organizations: The Intermarket Clearing Corporation (1988); Chicago
Mercantile Exchange ("CME") (1989); Board of Trade Clearing
Corporation ("BOTCC") (1991); Kansas City Board of Trade Clearing
Corporation (1992); and Comex Clearing Association (1992). The
Commissions also have approved cross-margining programs between the
Government Securities Clearing Corporation and the following futures
clearing organizations: the New York Clearing Corporation (1999);
BOTCC (2001); and CME (2001).
\42\ See supra note 16 and accompanying text.
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Section 7(c)(2)(B)(iii) of the Exchange Act \43\ provides that the
margin requirements for security futures must be consistent with the
margin requirements for comparable exchange-traded options, and that
the initial and maintenance margin levels for security futures may not
be lower than the lowest level of margin, exclusive of premium,
required for any comparable exchange-traded option. After considerable
deliberation about the application of this standard to security futures
margin, the Commissions have determined that risk-based portfolio
margining for security futures will not be permitted until a similar
methodology is introduced for comparable exchange-traded options.
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\43\ 15 U.S.C. 78g(c)(2)(B)(iii).
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Three commenters expressed opinions regarding the future selection
and use of SPAN or TIMS as a portfolio margining system.\44\ The
Commissions will consider issues related to the use of any particular
portfolio margining system at such time as the Commissions consider the
actual implementation of portfolio margining for security futures.
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\44\ See CME/CBOT Letter at 5; SIA/FIA Letter at 12-13 and
Appendix I, Q 15; OCC Letter.
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The Commissions strongly encourage the efforts of market
participants to develop a portfolio margining proposal for security
futures, and are committed to working with these participants to
resolve any outstanding issues as quickly as feasible. Such a portfolio
margining system would be in keeping with current practices in the
futures industry and would be responsive to the Federal Reserve Board's
desire to encourage the development of more risk-sensitive, portfolio-
based approaches to margining security futures products.\45\
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\45\ In its delegation letter, the Federal Reserve Board
requested that "the Commissions provide an assessment of progress
toward adopting more risk-sensitive, portfolio-based approaches to
margining security futures products." The Federal Reserve Board
further stated that "[t]he Board has encouraged the development of
such approaches by, for example, amending its Regulation T so that
portfolio margining systems approved by the [SEC] can be used in
lieu of the strategy-based system embodied in the Board's
regulation. The Board anticipates that the creation of security
future products will provide another opportunity to develop more
risk-sensitive, portfolio based approaches for all securities,
including security options and security futures products." FRB
Letter at 2.
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[[Page 53150]]
2. Financial Relations Between a Security Futures Intermediary and a
Foreign Person
The Proposed Rules provided an exclusion from the margin
requirements for financial relations between a foreign branch of a
creditor and a foreign person involving foreign security futures.\46\
This exclusion was intended to be consistent with the way Regulation T
treats financial relations between a foreign branch of a creditor and a
foreign person involving foreign securities.\47\ The Commissions are
adopting this exclusion with two modifications.\48\
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\46\ See Proposed CFTC Rule 41.43(b)(3)(ii); Proposed SEC Rule
400(b)(3)(ii).
\47\ See 12 CFR 220.1(b)(3)(iv).
\48\ See CFTC Rule 41.42(c)(2)(ii); SEC Rule 400(c)(2)(ii).
---------------------------------------------------------------------------
First, in response to concerns raised by a commenter,\49\ the scope
of the exclusion is being expanded so that it applies to the U.S.
offices as well as foreign branch offices of a security futures
intermediary. This commenter expressed the view that the exclusion, as
proposed, would create a competitive disadvantage for U.S. firms whose
existing foreign futures customers would likely migrate to foreign
offices or competing foreign firms to obtain the margin levels
available on the foreign exchange. After considering the commenter's
view, the Commissions have concluded that expanding the exclusion is
appropriate and, in light of the potential competitive issues, is not
inconsistent with Regulation T.
---------------------------------------------------------------------------
\49\ Meeting between SEC and CFTC staff and representatives of
SIA/FIA (February 6, 2000).
---------------------------------------------------------------------------
The second modification clarifies the scope of this exclusion.
Because the Proposed Rules did not define the term "foreign security
future," the Final Rules provide that the exclusion applies to
financial relations between a security futures intermediary and a
foreign person involving "security futures traded on or subject to the
rules of a foreign board of trade." Thus, the exclusion applies
regardless of whether the underlying security is issued in the United
States or a foreign country.\50\
---------------------------------------------------------------------------
\50\ This exclusion does not address the application of Section
6(h)(1) of the Exchange Act (15 U.S.C. 78f(h)(1)) to transactions in
security futures that are traded on or subject to the rules of a
foreign board of trade.
---------------------------------------------------------------------------
3. Margin Requirements Imposed by Clearing Agencies or Derivatives
Clearing Organizations
The Proposed Rules provided an exclusion from the margin
requirements for margin collected by registered clearing agencies from
their members.\51\ The Commissions received no comments relating to
this provision. The text of the proposed exclusion has been revised to
specify that the Final Rules exclude clearing agencies registered under
section 17A of the Exchange Act and derivatives clearing organizations
registered under Section 5b of the CEA.\52\ These textual changes do
not affect the meaning of the provision and, therefore, the Commissions
have effectively adopted the provision as proposed.
---------------------------------------------------------------------------
\51\ See Proposed CFTC Rule 41.43(b)(3)(iii); Proposed SEC Rule
400(b)(3)(iii).
\52\ See CFTC Rule 41.42(c)(2)(iii); SEC Rule 400(c)(2)(iii).
---------------------------------------------------------------------------
Section 7(c)(2) of the Exchange Act directs the Federal Reserve
Board to prescribe rules regarding customer margin for security futures
products, but it does not confer authority over margin requirements for
clearing agencies and derivatives clearing organizations. Accordingly,
the Federal Reserve Board stated in its delegation letter that "[t]he
authority delegated by the Board is limited to customer margin
requirements imposed by brokers, dealers, and members of national
securities exchanges. It does not cover margin requirements imposed by
clearing agencies on their members." The margin rules of clearing
agencies registered with the SEC are approved by the SEC pursuant to
section 19(b)(2) of the Exchange Act.\53\ The CFTC has authority to
ensure compliance with core principles for derivatives clearing
organizations registered with the CFTC under Sections 5b and 5c of the
CEA.\54\ This exclusion clarifies that margin requirements that
clearing agencies registered with the SEC or derivatives clearing
organizations registered with the CFTC impose on their members are not
subject to the Final Rules.
---------------------------------------------------------------------------
\53\ 15 U.S.C. 78s(b)(2).
\54\ 7 U.S.C. 7a-1; 7 U.S.C. 7a-2.
---------------------------------------------------------------------------
4. Financial Relations Between Security Futures Intermediaries and
Broker-Dealers, and Certain Members of National Securities Exchanges
a. Financial Relations with an Exempted Person. The Proposed Rules
provided an exclusion from the margin requirements for credit
arrangements between a creditor and a borrower that is a member of a
national securities exchange or is a registered broker-dealer
(including an FCM registered as a broker-dealer under section 15(b)(11)
of the Exchange Act) if the creditor made a good faith determination
that the borrower was an "exempted borrower" under Regulation T.\55\
The Regulation T criteria for an "exempted borrower" establish
standards for the exception from federal margin regulation for exchange
members and registered brokers and dealers, a substantial portion of
whose business consists of transactions with persons other than brokers
or dealers.\56\ In addition, the Proposed Rules provided that a person
that ceased to qualify for the exempted borrower exclusion would be
required to notify the creditor of this fact before establishing any
new security futures positions.\57\ Any security futures positions
subsequently established by that person would be subject to the
Commissions' customer margin requirements.
---------------------------------------------------------------------------
\55\ See Proposed CFTC Rule 41.43(b)(3)(iv)(A); Proposed SEC
Rule 400(b)(3)(iv)(A).
\56\ The term "exempted borrower" is defined in Section 220.2
of Regulation T as a member of a national securities exchange or a
registered broker or dealer, a substantial portion of whose business
consists of transactions with persons other than brokers or dealers,
and includes a borrower who: (1) Maintains at least 1,000 active
accounts on an annual basis for persons other than brokers, dealers,
and persons associated with a broker or dealer; (2) earns at least
$10 million in gross revenues on an annual basis from transactions
with persons other than brokers, dealers, and persons associated
with a broker or dealer; or (3) earns at least 10% of its gross
revenues on an annual basis from transactions with persons other
than brokers, dealers, and persons associated with a broker or
dealer. 12 CFR 220.2. section 7(c)(3)(A) of the Exchange Act (15
U.S.C. 78g(c)(3)(A)) provides an exception from federal margin
regulation for members of national securities exchanges and
registered broker-dealers, "a substantial portion of whose business
consists of transactions with persons other than brokers or
dealers."
\57\ See Proposed CFTC Rule 41.45(e); Proposed SEC Rule 402(e).
---------------------------------------------------------------------------
One commenter addressed the exclusion, asserting that an FCM or
floor broker whose only securities business consists of trading
security futures would not likely qualify as an exempted borrower under
Regulation T.\58\ The commenter asked the Commissions to clarify that
the scope of the exclusion includes FCMs or floor brokers that do not
have a substantial securities or security futures business, as long as
they have a substantial customer futures business.
---------------------------------------------------------------------------
\58\ OneChicago Letter at 8-9.
---------------------------------------------------------------------------
After considering the commenter's view, the Commissions have
adopted the exclusion with several modifications to clarify the
application of the exclusion.\59\ As a preliminary matter, the
Commissions are replacing the term "exempted borrower" with the new
term, "exempted person," to avoid characterizing the collection of
margin for a security futures contract as involving an extension of
credit.
---------------------------------------------------------------------------
\59\ See CFTC Rule 41.42(c)(2)(iv); SEC Rule 400(c)(2)(iv).
---------------------------------------------------------------------------
Consequently, the Commissions are also adding to the Final Rules a
definition of "exempted person." The Commissions believe that the
definition of exempted person is consistent with
[[Page 53151]]
the definition of exempted borrower in Regulation T. More specifically,
the Final Rules define an exempted person as a member of a national
securities exchange, a registered broker or dealer, or a registered
futures commission merchant, a substantial portion of whose business
consists of transactions in securities, commodity futures, or commodity
options with persons other than brokers, dealers, futures commission
merchants, floor brokers, or floor traders, including a person who:
Maintains at least 1000 active accounts on an annual basis
for persons other than brokers, dealers, persons associated with a
broker or dealer, futures commission merchants, floor brokers, floor
traders, and persons affiliated with a futures commission merchant,
floor broker, or floor trader that are effecting transactions in
securities, commodity futures, or commodity options;
Earns at least $10 million in gross revenues on an annual
basis from transactions in securities, commodity futures, or commodity
options with persons other than brokers, dealers, persons associated
with a broker or dealer, futures commission merchants, floor brokers,
floor traders, and persons affiliated with a futures commission
merchant, floor broker, or floor trader; or
Earns at least 10 percent of its gross revenues on an
annual basis from transactions in securities, commodity futures, or
commodity options with persons other than brokers, dealers, persons
associated with a broker or dealer, futures commission merchants, floor
brokers, floor traders, and persons affiliated with a futures
commission merchant, floor broker, or floor trader.\60\
---------------------------------------------------------------------------
\60\ See CFTC Rule 41.43(a)(9); SEC Rule 401(a)(9).
---------------------------------------------------------------------------
Although the commenter recommended that floor brokers as well as
FCMs be permitted to qualify as exempted borrowers, the Commissions
have not included floor brokers in the definition of exempted person.
This is because the exemption cannot readily be applied to floor
brokers given that they do not carry the type of customer accounts
contemplated by the Regulation T exempted borrower provision. The
Commissions note that, although floor brokers are not included in the
definition of exempted person, they may still qualify for an exclusion
from the security futures margin requirements if they meet the criteria
for a market maker under the Final Rules, as discussed below.\61\
---------------------------------------------------------------------------
\61\ See CFTC Rule 41.42(c)(2)(v); SEC Rule 400(c)(2)(v).
---------------------------------------------------------------------------
The Final Rules also set forth an express definition of "persons
affiliated with" a futures commission merchant, floor broker, or floor
trader,\62\ which parallels the definition in the Exchange Act of
"person associated with a broker or dealer." \63\ The purpose of this
definition is to establish consistency with the Regulation T definition
of exempted borrower, which excludes transactions with "persons
associated with a broker or dealer," as that term is defined in
section 3(a)(18) of the Exchange Act.\64\ The phrase "persons
affiliated with" has been used in the definition with respect to
transactions with FCMs, floor brokers and floor traders, and the phrase
"persons associated with" has been used with respect to transactions
with brokers and dealers. This is not intended to create a substantive
difference in the provisions applicable to the securities and futures
industries. Rather, it is intended to avoid confusion insofar as the
CFTC's definition of "affiliated person" (which includes corporate
affiliates) \65\ more closely matches the Exchange Act definition of
"persons associated with a broker or dealer," than does the CFTC
definition of "associated person," which is a registration
category.\66\
---------------------------------------------------------------------------
\62\ See CFTC Rule 41.43(a)(9)(ii); SEC Rule 401(a)(9)(ii).
\63\ See CFTC Rule 41.43(a)(23); SEC Rule 401(a)(23).
\64\ 15 U.S.C. 78c(a)(18).
\65\ See 17 CFR 155.1; Section 4f(c)(1)(i) of the CEA, 7 U.S.C.
6f(c)(1)(i).
\66\ See 17 CFR 1.3(aa).
---------------------------------------------------------------------------
The Final Rules clarify that a person may qualify as an exempted
person based on transactions in commodity futures and commodity
options, as well as securities. For purposes of the "1000 active
accounts" threshold, an FCM or broker or dealer that clears a bona
fide customer omnibus account for another FCM or broker or dealer may
treat that account as a single customer account. For purposes of the
$10 million and 10% thresholds, the gross revenues from transactions
for bona fide customer omnibus accounts may be included in the
computation. An omnibus account will not be considered a bona fide
customer account if it is used to clear transactions for market
professionals that would otherwise be excluded from the exempted person
computation. A fully disclosed customer account will be considered a
single customer account of the clearing firm, as well as the
introducing firm.
The exempted person provision further states that a member of a
national securities exchange or a registered broker, dealer, or futures
commission merchant that has been in existence for less than one year
may meet the definition of exempted person based on a six-month
period.\67\ This incorporates the standard set forth in Regulation
T.\68\
---------------------------------------------------------------------------
\67\ See CFTC Rule 41.43(a)(9)(iii); SEC Rule 401(a)(9)(iii).
\68\ See 12 CFR 220.3(j)(1).
---------------------------------------------------------------------------
In response to one commenter's suggestion,\69\ the Commissions are
also defining the term "good faith," consistent with the definition
of that term in Regulation T,\70\ for the purposes of determining what
steps a security futures intermediary must take to assure itself that a
person is an exempted person.\71\ The Final Rules further provide that
a person who ceases to qualify as an exempted person must notify the
security futures intermediary of that fact, and become subject to the
provisions of the Final Rules, but only before entering into any new
security futures transaction or related transaction that would require
additional margin to be deposited.\72\ This would permit a person to
enter into new offsetting transactions that reduce the required margin
in an account without triggering higher margin requirements.
---------------------------------------------------------------------------
\69\ Meeting between SEC and CFTC staff and representatives of
SIA/FIA (February 6, 2002).
\70\ See 12 CFR 220.2.
\71\ See CFTC Rule 41.43(a)(15); SEC Rule 401(a)(15).
\72\ See CFTC Rule 41.44(f); SEC Rule 402(f).
---------------------------------------------------------------------------
b. Margin Arrangements with a Borrower Otherwise Excluded Pursuant
to section 7(c)(3) of the Exchange Act. The Proposed Rules included an
exclusion for credit extended, maintained, or arranged by a creditor to
or for a registered broker-dealer, or member of a national securities
exchange (including an FCM registered as a broker-dealer under section
15(b)(11) of the Exchange Act) that is otherwise excluded under section
7(c)(3) of the Exchange Act.\73\ The Commissions have decided not to
adopt this exclusion.
---------------------------------------------------------------------------
\73\ See Proposed CFTC Rule 41.43(b)(3)(iv)(B); Proposed SEC
Rule 400(b)(3)(iv)(B).
---------------------------------------------------------------------------
Under section 7(c)(3)(B) of the Exchange Act,\74\ the financing of
the market making or underwriting activities of a member of a national
securities exchange or a registered broker-dealer is excluded from the
scope of federal margin regulation. The Federal Reserve Board has
expressed the view that floor traders on open-outcry futures exchanges
act as market makers and therefore would be excluded from the margin
requirements for security futures pursuant to Section 7(c)(3)(B).\75\
[[Page 53152]]
The proposed exclusion was intended to codify this view.
---------------------------------------------------------------------------
\74\ 15 U.S.C. 78g(c)(3)(B).
\75\ In its delegation letter, the Federal Reserve Board stated
that "[i]n the current open-outcry environment, the Board believes
that floor traders act as market makers and therefore would be
exempt [under section 7(c)(3) of the Exchange Act]." FRB Letter at
2.
---------------------------------------------------------------------------
One commenter addressed this exclusion and maintained that the
exclusion was confusing because the Commissions did not provide any
guidance as to the factors under which a broker-dealer would qualify
for the exclusion.\76\ The commenter asked the Commissions to clarify
the circumstances under which a floor trader on an open outcry exchange
qualifies for the market maker exclusion.
---------------------------------------------------------------------------
\76\ CBOE Letter.
---------------------------------------------------------------------------
The Commissions have not adopted the proposed exclusion. As noted
above, the Federal Reserve Board has taken the position that floor
traders on open-outcry futures exchanges qualify for the statutory
market maker exception. However, any further interpretation of section
7(c)(3) of the Exchange Act is within the purview of the Federal
Reserve Board. As a result, the Commissions would not be able to
provide specific guidance as requested by the commenter as to the
circumstances under which Section 7(c)(3) applies to floor traders on
an open-outcry futures exchange. The Commissions emphasize that any
person excluded from federal margin regulation under section 7(c)(3) of
the Exchange Act is not subject to the rules adopted by the Commissions
today. The Commissions encourage market participants to seek
interpretive guidance from the Federal Reserve Board regarding the
circumstances in which the exception under section 7(c)(3) of the
Exchange Act applies.
c. Financial Relations between a Security Futures Intermediary and
a Member of a National Securities Exchange or Association in Connection
with Market Making Activities. The Commissions proposed to exclude from
the scope of the margin requirements credit extended, maintained, or
arranged to or for members of a national securities exchange or a
national securities association in connection with market making
activities.\77\ As proposed, the exclusion had two conditions. First,
the borrower could not directly or indirectly accept or solicit
customer orders or provide advice to any customer in connection with
the trading of security futures. Second, the borrower had to be
registered with the exchange or association as a security futures
dealer, pursuant to regulatory authority rules that require the
borrower: (a) To be registered as a floor trader or floor broker with
the CFTC, or as a dealer with the SEC; (b) to comply with applicable
SEC or CFTC net capital requirements; (c) to maintain records
sufficient to demonstrate compliance with the exclusion and the rules
of the exchange or association; (d) to hold itself out as willing to
buy and sell security futures for its own account on a regular or
continuous basis; and (e) to be subject to disciplinary action if it
failed to comply with the Commissions' margin rules or the rules of the
exchange or association.\78\ The Commissions are adopting this
exclusion with modifications in light of commenters' views.\79\
---------------------------------------------------------------------------
\77\ See Proposed CFTC Rule 41.43(b)(3)(iv)(C); Proposed SEC
Rule 400(b)(3)(iv)(C).
\78\ Id.
\79\ See CFTC Rule 41.42(c)(2)(v); SEC Rule 400(c)(2)(v). The
Commissions note that the Final Rules include a definition of the
term "member," which clarifies the applicability of that term to
persons with trading privileges on an exchange, even if that
exchange does not have a "membership" structure. More
specifically, the term "member" has the meaning provided in
section 3(a)(3) of the Exchange Act and includes persons registered
under section 15(b)(11) of the Exchange Act that are permitted to
effect transactions on a national securities exchange without the
services of another person acting as executing broker. See CFTC Rule
41.43(a)(21); SEC Rule 401(a)(21).
---------------------------------------------------------------------------
The Commissions received four comments on the exclusion.\80\ These
comments generally supported the proposed exclusion, but suggested that
the Commissions clarify certain aspects of the conditions.
---------------------------------------------------------------------------
\80\ See Amex Letter; CBOE Letter; OneChicago Letter; SIA/FIA
Letter. In addition, the ABN AMRO Letter endorsed the comments in
the SIA/FIA Letter.
---------------------------------------------------------------------------
One commenter expressed the view that a person is a market maker in
security futures if it provides liquidity on a regular basis, even if
it is not under an affirmative obligation to do so.\81\ Based on that
view, the commenter suggested two alternatives to the Commissions'
proposal to determine whether a trader is a liquidity provider. First,
the commenter recommended that the Commissions consider a person to be
a liquidity provider solely because that person is registered with
either the SEC or the CFTC as a trading professional (e.g., as a
broker-dealer or FCM) and is a member of an exchange. In the
alternative, the commenter recommended that the Commissions consider a
trader to be a liquidity provider if that person can demonstrate
through its business activity that it is a professional liquidity
provider, regardless of its regulatory status or membership in an
exchange.\82\ This commenter further stated that the net capital
requirements for persons acting as market makers in security futures
should be uniform in order to prevent security futures market makers
subject to CFTC financial responsibility rules from obtaining an unfair
competitive advantage over security futures market makers (or security
options market makers) subject to SEC financial responsibility
rules.\83\
---------------------------------------------------------------------------
\81\ CBOE Letter at 2-3.
\82\ Id. at 4.
\83\ Id. at 5-6.
---------------------------------------------------------------------------
Another commenter asked the Commissions to modify the condition to
the exclusion for exchange members that requires that the member "hold
itself out as being willing to buy and sell security futures for its
own account on a regular or continuous basis." \84\ The commenter
maintained that market makers on a screen-based trading system either
should have an enforceable obligation to provide liquidity or should
meet an objective standard for supplying liquidity.\85\ Specifically,
the commenter suggested that the condition be narrowed further with
respect to members of screen-based trading systems so that it would
apply only to members of such systems that: (1) have a continuous,
affirmative obligation to quote a two-sided market; or (2) effect more
than two-thirds of their security futures trades on that exchange with
persons other than registered market makers on that exchange.\86\
---------------------------------------------------------------------------
\84\ Amex Letter.
\85\ Id. at 2, 4.
\86\ Id. at 4.
---------------------------------------------------------------------------
A third commenter asked the Commissions to eliminate the condition
to the exclusion for exchange members that requires that the member not
"directly or indirectly accept or solicit orders from any customer or
provide advice to any customer in connection with the trading of
security futures." \87\ The commenter maintained that a broker-dealer
acting as a market maker should not be precluded from also carrying out
a customer securities business.
---------------------------------------------------------------------------
\87\ SIA/FIA Letter at 14, n.25; Appendix I, Q 17(a).
---------------------------------------------------------------------------
The fourth commenter asked the Commissions to confirm that
registered floor brokers and floor traders would qualify for the
exclusion even if they are not subject to a net capital requirement
under CFTC rules.\88\ In support of this request, the commenter stated
that market makers in options are exempt from the SEC's net capital
rule.\89\
---------------------------------------------------------------------------
\88\ OneChicago Letter at 9.
\89\ Id.
---------------------------------------------------------------------------
After considering the commenters' views, the Commissions have
adopted the exclusion with certain modifications. First, the
Commissions are clarifying that the provision relating
[[Page 53153]]
to accepting or soliciting customer orders was not intended to bar a
member from engaging in such activities. That provision was intended to
limit the exclusion from the margin requirements to circumstances where
the member was trading for its own account, not for the account of
others. Accordingly, the rule has been modified to make clear that the
exclusion is available to a member only with respect to trading
activity for its own account.\90\ Thus, the member may conduct a
customer business and still qualify for the exclusion from the
Commissions' margin requirements for security futures with regard to
its market making activity.
---------------------------------------------------------------------------
\90\ See CFTC Rule 41.42(c)(2)(v); SEC Rule 400(c)(2)(v).
---------------------------------------------------------------------------
The Commissions have also decided that it is unnecessary to restate
the applicability of existing net capital requirements under CFTC and
SEC rules, or to impose additional net capital requirements, as a
condition of the exclusion for persons acting as market makers. Firms
will continue to be subject to applicable CFTC or SEC net capital
requirements. Further, even if a member is not subject to net capital
requirements, the member's carrying firm will be subject to the
treatment provided in existing SEC or CFTC net capital rules, whichever
are applicable, with respect to the member's security futures
transactions.
As noted above, the Commissions received several comments regarding
the circumstances under which an exchange member should be considered a
market maker for purposes of the margin rules, other than in
circumstances that fall within the exception in Section 7(c)(3) of the
Exchange Act. These comments largely refer to the requirement that the
exchange member "hold itself out as being willing to buy and sell
security futures for its own account on a regular or continuous basis'
in order to qualify for the exclusion. The Commissions do not believe
that registration with the SEC or CFTC is, by itself, sufficient to
show that a market participant is holding itself out as willing to buy
and sell security futures. However, the Commissions believe that there
are a number of different ways that an exchange member could satisfy
this condition. For example, an exchange's or association's rules could
require the member to effect a certain percentage of its security
futures trades on that exchange or association with persons other than
registered market makers on that exchange or association.\91\
---------------------------------------------------------------------------
\91\ National securities exchanges registered under section 6(a)
of the Exchange Act require their options market makers to conduct
at least 50% of their total contract volume in option classes to
which they have been appointed. See Amex Rule 958; Philadelphia
Stock Exchange ("Phlx") Rule 1014. In some cases, market makers
are required to conduct at least 75 percent of their total contract
volume in option classes to which they have been appointed. See CBOE
Rule 8.7.03; International Securities Exchange Rule 805; Pacific
Exchange ("PCX") Rule 6.37.
---------------------------------------------------------------------------
Alternatively, such rules could require that a large majority of
such exchange member's revenue is derived from business activities or
occupations from trading listed financial-based derivatives (i.e.,
security futures, stock index futures, stock and index options, foreign
currency futures and options, and interest rate futures and options) on
any exchange in the capacity of a member. As another alternative, the
exchange member could be subject to rules that impose on it an
affirmative obligation to quote on a regular or continuous basis in
security futures.
C. Interpretations of, and Exemptions From, the Final Rules
The Commissions are adopting two provisions in the Final Rules to
clarify the Commissions' authority to respond to issues that arise in
connection with the implementation of the Final Rules. First, the
Commissions are adding a provision regarding the interpretation of the
security futures margin rules. The Final Rules provide that the
Commissions shall jointly interpret the margin rules, consistent with
the criteria set forth in clauses (i) through (iv) of section
7(c)(2)(B) of the Exchange Act and Regulation T.\92\
---------------------------------------------------------------------------
\92\ See CFTC Rule 41.42(b); SEC Rule 400(b).
---------------------------------------------------------------------------
Second, the Final Rules add a provision providing that each
Commission may issue an exemption from any provision of the Final
Rules.\93\ CFTC Rule 41.42(d) provides that the CFTC may grant an
exemption with respect to any provision of CFTC Rules 41.42 through
41.49, provided that the CFTC finds that the exemption is consistent
with the public interest and the protection of customers. Similarly,
SEC Rule 400(d) provides that the SEC may grant an exemption with
respect to any provision of SEC Rules 400 through 406, provided that
the exemption is necessary or appropriate in the public interest and
consistent with the protection of investors. Because financial
relations involving security futures are subject to the Final Rules as
adopted by both the CFTC and the SEC, any person seeking an exemption
under these rules must request and obtain the same exemption from both
the CFTC and SEC. The Commissions intend to work together on exemption
requests to establish uniform policies for security futures trading.
---------------------------------------------------------------------------
\93\ See CFTC Rule 41.42(d); SEC Rule 400(d). The SEC and CFTC
exemption standards contained in the Final Rules are the same as
those set forth in the recently adopted rules relating to cash
settlement and regulatory halt requirements for security futures
products. See Securities Exchange Act Release No. 45956 (May 17,
2002), 67 FR 36740 (May 24, 2002). As noted in connection with those
rules, the SEC version of the exemption provision refers to the
protection of "investors," and the CFTC version of the provision
refers to the protection of "customers." Id. at 36745, n.64. The
difference in terminology is not intended to have any substantive
significance. Rather, the terms are used for purposes of conformity
with terminology used in the Exchange Act and CEA.
---------------------------------------------------------------------------
D. Definitions
The definition section of the Proposed Rules has been expanded to
include all applicable defined terms. Under the Proposed Rules, many of
these definitions and provisions would have been incorporated through
the application of Regulation T.
The terms "contract multiplier," "daily settlement price," and
"Regulation T" are defined in the Final Rules as proposed.\94\ The
Proposed Rules defined the terms "examining authority," "initial
margin," and "maintenance margin." \95\ These terms are not,
however, included in the Final Rules because modifications made to the
Proposed Rules make them unnecessary. The Final Rules also define the
term "self-regulatory authority," \96\ instead of the term
"regulatory authority" as proposed,\97\ and its definition has been
revised to include a reference to registration under the CEA. In
addition, the Final Rules define the term "current market value" with
respect to a security other than a security future consistently with
the Regulation T definition.\98\ Some of the defined terms incorporate
by reference definitions from the CEA, the Exchange Act, or CFTC or SEC
rules.\99\
---------------------------------------------------------------------------
\94\ See CFTC Rules 41.43(a)(3), (a)(6), and (a)(24); SEC Rules
401(a)(3), (a)(6), and (a)(24).
\95\ See Proposed CFTC Rules 41.44(a)(3), (a)(4), and (a)(5);
Proposed SEC Rules 401(a)(3), (a)(4), and (a)(5).
\96\ See CFTC Rule 41.43(a)(30); SEC Rule 401(a)(30). The
terminology was modified to eliminate confusion as to a "regulatory
authority" being a governmental regulator rather than an SRO.
\97\ See Proposed CFTC Rule 41.44(a)(7); Proposed SEC Rule
401(a)(7).
\98\ See CFTC Rule 41.43(a)(4); SEC Rule 401(a)(4); see also 12
CFR 220.2.
\99\ See, e.g., definitions of "broker," CFTC Rule 41.43(a)(2)
and SEC Rule 401(a)(2); "dealer," CFTC Rule 41.43(a)(7) and SEC
Rule 401(a)(7); "exempted security," CFTC Rule 41.43(a)(10) and
SEC Rule 401(a)(10); "futures account," CFTC Rule 41.43(a)(13) and
SEC Rule 401(a)(13); "futures commission merchant," CFTC Rule
41.43(a)(14) and SEC Rule 401(a)(14); and "securities account,"
CFTC Rule 41.43(a)(28) and SEC Rule 401(a)(28).
---------------------------------------------------------------------------
[[Page 53154]]
Terms that are not otherwise defined in the definition section of
the Final Rules will have the meaning set forth in the margin rules
applicable to the account.\100\ Terms that are neither defined in the
definition section nor in the margin rules applicable to the account
will have the meaning set forth in the Exchange Act and the CEA.\101\
If the definitions of a term in the Exchange Act and the CEA are
inconsistent as applied in particular circumstances, such term shall
have the meaning set forth in rules, regulations, or interpretations
jointly promulgated by the SEC and the CFTC.
---------------------------------------------------------------------------
\100\ See CFTC Rule 41.43(b); SEC Rule 401(b). See also infra
notes 125-126 and accompanying text.
\101\ See CFTC Rule 41.43(c); SEC Rule 401(c).
---------------------------------------------------------------------------
E. Application of Regulation T to Security Futures
Section 7(c)(2)(B)(iv) of the Exchange Act requires that the margin
requirements for security futures (other than levels of margin),
including the type, form, and use of collateral, must be consistent
with the requirements of Regulation T.\102\ To carry out that statutory
mandate, the Commissions proposed that Regulation T would apply to all
transactions in security futures, to the extent consistent with the
Proposed Rules. Thus, under the Proposed Rules, Regulation T would have
applied both to securities accounts (which are already subject to
Regulation T) and to futures accounts (which are not otherwise subject
to Regulation T) that carry security futures.\103\ This approach also
would have applied existing and future Federal Reserve Board
interpretations of Regulation T to the margin requirements for security
futures and kept the margin requirements consistent with Regulation T
without the need for amendments to the Final Rules.
---------------------------------------------------------------------------
\102\ 15 U.S.C. 78g(c)(2)(B)(iv).
\103\ See Proposed CFTC Rule 41.43(b)(1); Proposed SEC Rule
400(b)(1).
---------------------------------------------------------------------------
The Commissions, however, also recognized that there could be more
than one approach to prescribing rules that are "consistent" with
Regulation T. Accordingly, the Commissions specifically requested
commenters' views on alternative approaches to establishing consistency
with Regulation T. In particular, the Commissions solicited comment on
the approach of issuing comprehensive "stand-alone" margin rules that
would parallel Regulation T requirements for securities to the extent
that such requirements are relevant to security futures. Under that
approach, the stand-alone rules would apply to security futures and any
related securities or futures contracts that are used to offset
positions in such security futures. However, the stand-alone rules
would not apply to any other securities or futures transactions.
The Commissions received a total of 12 comment letters on the
application of Regulation T to security futures transactions.\104\ One
commenter supported the Commissions' proposed approach regarding
Regulation T.\105\ Nine commenters opposed general application of
Regulation T to security futures carried in futures accounts,\106\ and
two other commenters specifically opposed applying the Regulation T
account structure to FCMs.\107\
---------------------------------------------------------------------------
\104\ See NFA Letter; SIA/FIA Letter; Nasdaq Liffe Letter; ABN
AMRO Letter; CME/CBOT Letter; OneChicago Letter; Morgan Stanley
Letter; Peregrine Letter; SunGard Letter; Options Exchanges Letter;
Managed Funds Letter; and Rolfe and Nolan Letter.
\105\ Options Exchanges Letter at 3.
\106\ NFA Letter at 2-3; SIA/FIA Letter at 2, 4-7; ABN AMRO
Letter at 1; CME/CBOT Letter at 2-3; OneChicago Letter at 3-7;
Morgan Stanley Letter at 2, 5-6; Peregrine Letter at 2; Managed
Funds Letter at 1; and Rolfe and Nolan Letter at 1-2.
\107\ Nasdaq Liffe Letter at 6-7; and SunGard Letter at 2-3.
---------------------------------------------------------------------------
The commenter that supported application of Regulation T to all
security futures transactions believed that the alternative approach of
stand-alone rules would not satisfy the statutory requirement that the
margin requirements for security futures (other than levels of margin)
be "consistent" with those imposed on securities.\108\ The commenter
expressed the view that the term "consistent" should mean that there
is no appreciable difference between rules applicable to exchange-
traded options and rules applicable to security futures. In addition,
the commenter noted that if the Commissions adopt stand-alone margin
rules there is a risk that over time such rules will vary materially
from Regulation T because of the difficulty of promptly incorporating
the Federal Reserve Board's future interpretations of Regulation T into
stand-alone rules.
---------------------------------------------------------------------------
\108\ Options Exchanges Letter at 3.
---------------------------------------------------------------------------
Commenters opposing the general application of Regulation T to
security futures did not believe that the CFMA required such
application. One commenter contended that application of Regulation T
to futures accounts "is impractical and unnecessary" and "not
required," and that the CFMA's "consistent" standard did not
necessarily require rules "identical" or "equivalent" to the rules
applicable to exchange-traded options.\109\ Rather, this commenter
argued, Regulation T permits commodity futures to be recorded in an
account other than a margin account (a "good faith" account) and, as
a result, permitting security futures to be carried in a futures
account (not a margin account) is "consistent" with Regulation
T.\110\ Another commenter observed that while "consistency requires
reasonable comparability * * * [, i]f Congress had meant `consistent'
to mean `identical,' however, it would have used that word" or would
have clearly directed that Regulation T be applied to security
futures.\111\ Similarly, another commenter pointed out that "the CFMA
did not mandate the application of Reg[ulation] T to security futures
maintained in a futures account" and that the "imposition of
Reg[ulation] T with respect to security futures is inconsistent with
Congress's goal of facilitating trading in security futures." \112\
---------------------------------------------------------------------------
\109\ OneChicago Letter at 3.
\110\ Id. at 3-4.
\111\ NFA Letter at 2.
\112\ SIA/FIA Letter at 5.
---------------------------------------------------------------------------
Commenters that disagreed with the Commissions' proposed approach
generally urged the Commissions to adopt "stand-alone" margin rules
for security futures.\113\ All of these commenters maintained that the
programming changes necessary to enable FCMs to comply with Regulation
T would be overly costly.\114\ Generally, those commenters believed
that it would be operationally difficult or impossible to carry
security futures in a standard futures account without costly and time-
consuming reprogramming.\115\ Commenters were concerned that this would
place FCMs at a considerable disadvantage in comparison to broker-
dealers and would discourage them from trading security futures. One
commenter pointed out that a broker-dealer "would need to do little,
relative to an FCM, to bring itself into compliance with the Proposed
Rules." \116\ Another commenter expressed concern that FCMs would have
to undertake a substantial development project requiring `the
[[Page 53155]]
restructuring of FCMs' accounts and related systems changes." \117\
The commenter estimated that this would result in the expenditure of
"several thousands of personnel hours," \118\ while another commenter
believed that costs would "run well into six figures." \119\
---------------------------------------------------------------------------
\113\ See NFA Letter at 2; SIA/FIA Letter at 5; Nasdaq Liffe
Letter at 7; ABN AMRO Letter at 1; CME/CBOT Letter at 10; OneChicago
Letter at 7; SunGard Letter at 3; and Peregrine Letter at 2.
\114\ See NFA Letter at 3; SIA/FIA Letter at 4; Nasdaq Liffe
Letter at 6; ABN AMRO Letter at 1; CME/CBOT Letter at 3; OneChicago
Letter at 5; SunGard Letter at 1; and Peregrine Letter at 2.
\115\ See NFA Letter at 2; SIA/FIA Letter at 4-5; Nasdaq Liffe
Letter at 6; ABN AMRO Letter at 1; CME/CBOT Letter at 3; OneChicago
Letter at 4; SunGard Letter at 1; Peregrine Letter at 2.
\116\ OneChicago Letter at 5.
\117\ SIA/FIA Letter at 4.
\118\ Id.
\119\ Rolfe and Nolan Letter at 1.
---------------------------------------------------------------------------
Eight commenters recommended the adoption of an account-specific
margin regime for purposes of account administration.\120\ The adoption
of an account-specific margin regime was effectively endorsed by two
other commenters that advocated retention of specific existing
practices \121\ and one other that believed the imposition of
Regulation T on FCMs would be highly burdensome.\122\ One commenter
argued against the adoption of an account-specific margin regime,
stating that FCMs will have to revise a number of their operating
procedures and there is no compelling reason to make an exception for
margin procedures.\123\
---------------------------------------------------------------------------
\120\ See NFA Letter at 1-2; SIA/FIA Letter at 3-4; Nasdaq Liffe
Letter at 6-7; ABN AMRO Letter at 1; OneChicago Letter at 6-7;
Peregrine Letter at 2; Morgan Stanley Letter at 1; and Managed Funds
Letter at 2.
\121\ See Rolfe and Nolan Letter at 2; and CME/CBOT Letter at
10.
\122\ SunGard Letter at 2.
\123\ Options Exchanges Letter at 3-4.
---------------------------------------------------------------------------
After considering the commenters' suggestions, the Commissions have
determined that it is not necessary to apply Regulation T in its
entirety to security futures transactions to satisfy the requirements
under section 7(c)(2) of the Exchange Act.\124\ Given the relative
infrequency of the Federal Reserve Board adopting amendments to
Regulation T and issuing formal regulatory guidance, the Commissions do
not believe that it will be unduly burdensome or impractical to amend
these rules to maintain consistency with Regulation T. Accordingly, the
Commissions have adopted stand-alone margin rules that include certain
requirements of Regulation T. The Commissions believe that the
inclusion of these requirements in the Final Rules satisfies the
statutory requirement that margin requirements for security futures be
and remain consistent with Regulation T.
---------------------------------------------------------------------------
\124\ 15. U.S.C. 78g(c)(2).
---------------------------------------------------------------------------
The Commissions believe that many of the rules governing margin for
positions carried in securities accounts are similar enough to the
rules governing margin for positions carried in futures accounts that
the differences do not, by themselves, create an incentive for
customers either to trade security futures instead of options, or to
hold security futures in a futures account rather than a securities
account. Accordingly, the Commissions are adopting an "account-
specific" approach for those aspects of account administration that
need not be conformed to satisfy the requirement that the margin rules
for security futures be consistent with Regulation T. Thus, the Final
Rules provide that security futures held in a securities account are
subject to the Final Rules, Regulation T, and to the margin
requirements of the self-regulatory authorities of which the security
futures intermediary is a member.\125\ Security futures held in a
futures account, on the other hand, will be subject to the Final Rules
and the margin requirements of the self-regulatory authorities of which
the security futures intermediary is a member.\126\
---------------------------------------------------------------------------
\125\ See CFTC Rule 41.44(a)(1); SEC Rule 402(a)(1).
\126\ See CFTC Rule 41.44(a)(2); SEC Rule 402(a)(2).
---------------------------------------------------------------------------
Notwithstanding the Commissions' determination not to apply
Regulation T in its entirety to security futures, the Final Rules
include certain uniform provisions that govern account administration,
type, form, and use of collateral, calculation of equity, withdrawals
from accounts, and treatment of undermargined accounts. The Commissions
believe that the inclusion of these provisions in the Final Rules
satisfies the statutory requirement that the margin rules for security
futures be consistent with Regulation T.
F. Account Administration Rules
1. Separation and Consolidation of Accounts
Regulation T establishes specific types of accounts for recording
different types of customer transactions (e.g., a margin account, a
cash account, a good faith account).\127\ Regulation T generally
provides that a customer can have only one margin account.\128\ While a
margin account may be divided into separate parts for bookkeeping
purposes, as authorized by the customer, all parts must be considered
as one unit in determining whether or not any transaction is
permissible under Regulation T.\129\ The determination as to whether an
account satisfies the requirements of Regulation T, moreover, may not
take into consideration items in any other account; bookkeeping entries
must be made whenever cash or securities in one account are used for
purposes of meeting requirements in another account.\130\ Consistent
with Regulation T, the Final Rules provide that the margin requirements
for one account may not be met by considering items in another account,
except where excess margin is transferred using appropriate bookkeeping
entries.\131\ To facilitate the enforcement of this general
prohibition, this provision also requires that if withdrawals of cash,
securities, or other assets deposited as margin are permitted under the
Final Rules, a security futures intermediary must make and keep
accurate bookkeeping entries when those assets are used to meet
requirements in another account.\132\ This provision parallels Section
220.3(b)(1) of Regulation T, and is intended to be consistent with
existing futures account practices under Section 4d of the CEA,\133\
CFTC Rules 1.20 and 1.22, and applicable futures exchange rules.
---------------------------------------------------------------------------
\127\ See 12 CFR 220.4(a)(1).
\128\ See 12 CFR 220.4(a)(2).
\129\ Fed. Res. Reg. Serv. Sec. 5-634.11 (Staff Op. May 15,
1978).
\130\ See 12 CFR 220.3(b)(1).
\131\ See CFTC Rule 41.44(b)(1); SEC Rule 402(b)(1).
\132\ See CFTC Rule 41.44(b)(1); SEC Rule 402(b)(1); see also
section 17(a) of the Exchange Act (15 U.S.C. 78q-1(a)), and the
rules thereunder; Section 4g of the CEA (7 U.S.C. 6g), and the rules
thereunder; National Association of Securities Dealers ("NASD")
Rule 3110; and NFA Rule 2-10.
\133\ 7 U.S.C. 6d.
---------------------------------------------------------------------------
Currently, futures exchange rules or practices similarly recognize
accounts of different types for different customer transactions (e.g.,
customer segregated, customer secured, nonsegregated). Customers may
maintain multiple accounts of the same regulatory classification or
account type, although futures exchange rules provide that identically
owned accounts within the same regulatory classification or account
type should be combined for margin purposes.\134\ Moreover, an FCM may
not apply free funds in an account under identical ownership but of a
different regulatory classification or account type to an account's
margin deficiency.\135\ As is the case under Regulation T, however, the
Final Rules require the FCM to actually document through bookkeeping
entries the transfer of funds from one account to satisfy the margin
deficiency in another account. The Commissions do not believe that this
provision will create any substantial operational burdens for FCMs
carrying security futures in futures accounts.
---------------------------------------------------------------------------
\134\ See Joint Audit Committee Handbook, Chapter 9 (June 1999),
available at <http://www.nfa.futures.org/compliance/publications/
Margins/MarginsHandbook.pdf>.
\135\ See id.
---------------------------------------------------------------------------
The Final Rules provide that all futures accounts of the same
regulatory
[[Page 53156]]
type or classification that carry security futures shall be considered
a single account for purposes of the Regulation.\136\ The Final Rules
also permit a securities futures intermediary to further consolidate
all futures accounts of the same regulatory classification or account
type, regardless of whether they carry security futures, for purposes
of determining whether the required margin for all of a customer's
futures positions (including security futures) is satisfied.\137\
---------------------------------------------------------------------------
\136\ See CFTC Rule 41.44(b)(2); SEC Rule 402(b)(2).
\137\ Id.
---------------------------------------------------------------------------
2. Accounts of Partners
The Final Rules provide that if a partner of a security futures
intermediary (organized as a partnership) has an account with the
security futures intermediary in which security futures or related
positions are held, the security futures intermediary must disregard
the partner's financial relations with the firm (as shown in the
partner's capital and ordinary drawing accounts) in calculating the
margin or equity of any such account.\138\ This provision parallels
Section 220.4(b)(5) of Regulation T,\139\ and is consistent with
current futures exchange practices. The provision is intended to
reinforce the principle of "separation of accounts" with respect to
partners in a security futures intermediary organized as a partnership,
when a partner maintains a trading account with the firm.
---------------------------------------------------------------------------
\138\ See CFTC Rule 41.44(c); SEC Rule 402(c).
\139\ 12 CFR 220.4(b)(5).
---------------------------------------------------------------------------
3. Contribution to a Joint Venture
Under the Final Rules, if an account in which security futures or
related positions are held is the account of a joint venture in which
the security futures intermediary participates, any interest of the
security futures intermediary in the joint account in excess of the
interest which the security futures intermediary would have on the
basis of its right to share in the profits must be margined in
accordance with the Final Rules.\140\ This provision parallels Section
220.4(b)(6) of Regulation T,\141\ which is intended to prevent firms
from indirectly extending credit to customers in circumstances where
the customer does not deposit equity in the account corresponding to
its share of the profits in the account (e.g., if the customer is
entitled to 90% of the profits in an account, but only deposits 40% of
the equity at the outset, the broker-dealer is effectively extending
credit to the customer in the amount of 50% of the equity in the
account).
---------------------------------------------------------------------------
\140\ See CFTC Rule 41.44(d); SEC Rule 402(d).
\141\ 12 CFR 220.4(b)(6).
---------------------------------------------------------------------------
4. Extensions of Credit
The Final Rules prohibit any extension of credit with respect to
security futures, if the extension of credit is designed to evade or
circumvent the security futures margin requirements.\142\ Among other
things, this provision is intended to prevent security futures
intermediaries from extending unsecured credit to customers, or
extending credit secured by securities or other assets in excess of the
value such assets would have under the Final Rules,\143\ to satisfy or
maintain the required margin for security futures carried in the
customer's account.\144\ For example, a security futures intermediary
may not lend a customer $100 in cash secured by less than $200 in
margin equity securities to meet a margin call for a security future.
This provision does not, however, preclude a security futures
intermediary from advancing funds to a customer to meet variation
settlement calls on behalf of an undermargined customer account, in the
ordinary course of business, provided that the security futures
intermediary issues a margin call for the funds advanced.
---------------------------------------------------------------------------
\142\ See CFTC Rule 41.44(e); SEC Rule 402(e). CFTC Rule 1.30
permits FCMs to lend their own funds to customers on pledged
securities; the proceeds of such loans are treated as customer funds
for purposes of the CEA. 17 CFR 1.30. Extensions of credit by
brokers and dealers with respect to securities are governed by
Regulation T and the margin rules of the national securities
exchanges and securities associations.
\143\ See CFTC Rule 41.46(c); SEC Rule 404(c).
\144\ Futures exchange rules also impose certain restrictions on
the financing of futures positions. See, e.g., CME Rule 930.G
("Clearing members may not extend loans to account holders for
performance bond purposes unless such loans are secured as defined
in [17 CFR] 1.17(c)(3)"); New York Mercantile Exchange ("NYMEX")
Rule 4.03 ("Clearing Members shall not be permitted to make loans
to any customers for the purpose of financing margins on NYMEX
Division contracts unless such loans are secured, as such term is
defined in [17 CFR] 1.17").
---------------------------------------------------------------------------
The Final Rules permit a security futures intermediary to arrange
for an extension of credit to or for a customer by a person, provided
that the extension of credit would not constitute a violation of
Regulations T, U, or X by such person.\145\ In this connection, the
Commissions believe that credit extended for the purpose of satisfying
or maintaining the required margin for a security future is "purpose
credit" for purposes of the Federal Reserve Board's credit
regulations. For example, a security futures intermediary may not
arrange for a Regulation T creditor to extend credit to a customer
against securities or other assets in a nonpurpose or nonsecurities
credit account to enable the customer to meet a margin requirement with
respect to a security future. Likewise, a security futures intermediary
may not arrange for a bank or other Regulation U lender to extend
credit secured directly or indirectly by margin stock in excess of the
maximum loan value of the collateral (i.e., 50% of current market
value) securing the credit for the purpose of purchasing or carrying a
security future. Similarly, a security futures intermediary may not
arrange for a Regulation X borrower to obtain an extension of credit
within or from outside the United States for the purpose of effecting
or carrying a security futures transaction unless the credit conforms
to the Federal Reserve Board's margin regulations, as provided in
Regulation X.
---------------------------------------------------------------------------
\145\ See CFTC Rule 41.44(e)(2); SEC Rule 402(e)(2).
---------------------------------------------------------------------------
G. Customer Margin Levels for Security Futures
The Commissions proposed to require both the seller and the buyer
of a security future to provide and maintain, on a daily basis, cash or
other acceptable assets equal to a percentage of the "current market
value" of the security future. The Commissions are adopting those
requirements substantially as proposed.
1. Definition of Current Market Value
The Commissions proposed to define the term "current market
value" of a security future as the product of the daily settlement
price of the security future (as shown by any regularly published
reporting or quotation service) and either the applicable number of
shares per contract (when the underlying instrument is a single stock),
or the applicable contract multiplier (when the underlying instrument
is a narrow-based security index).\146\ The Commissions also proposed
to define the term "current market value" with respect to a narrow-
based security index future to mean the product of the daily settlement
price of such security future, as shown by any regularly published
reporting or quotation service, and the applicable contract
multiplier.\147\
The Commissions received one comment on these definitions, which
suggested that the pricing convention for determining current market
value need not be the same for security futures held in a security
account and for
[[Page 53157]]
security futures held in a futures account.\148\ The Commissions,
however, believe that a uniform definition of current market value is
necessary to ensure that identical contracts are not subject to
different margin requirements based on the type of account in which
they are carried.
---------------------------------------------------------------------------
\146\ See Proposed CFTC Rule 41.44(a)(2)(i); Proposed SEC Rule
401(a)(2)(i).
\147\ See Proposed CFTC Rule 41.44(a)(2)(ii); Proposed SEC Rule
401(a)(2)(ii).
\148\ SIA/FIA Letter at Appendix I, Q 18.
---------------------------------------------------------------------------
As noted above, section 7(c)(2)(B)(3)(I) of the Exchange Act \149\
requires that the margin requirements for security futures be
consistent with the margin requirements for comparable exchange-traded
options. The Commissions believe that using the daily settlement price
\150\ at the end of each trading day to calculate margin requirements
for security futures on that day is consistent with the use of the
closing price of the option and the underlying security for determining
maintenance margin for equity options.\151\ In addition, the
Commissions continue to believe that using the daily settlement price
of a security future on the day of a transaction to calculate the
initial margin (rather than the daily settlement price on the day
preceding the transaction) is consistent with using the underlying
stock's closing price on the preceding business day. The daily
settlement price of a security future on the preceding business day,
for example, may not exist if such security future were not available
for trading on the preceding business day. Accordingly, the Commissions
are adopting the definition of "current market value" as proposed.
---------------------------------------------------------------------------
\149\ 15 U.S.C. 78g(c)(2)(B)(3)(I).
\150\ Under the Final Rules, the term "daily settlement price"
means, with respect to a security future, the settlement price of
such security future determined at the close of trading each day, as
determined by the rules of the applicable exchange, clearing agency
or derivatives clearing organization. See CFTC Rule 41.43(a)(6); SEC
Rule 401(a)(6).
\151\ Currently, the computation of the margin required on the
sale of an uncovered option is based on the value of the security
underlying the option. The initial margin on the sale of an
uncovered option is based on the price at which the underlying
security closed at the end of the business day before the day on
which the option is sold. The maintenance margin on an uncovered
short option is based on the closing price of the underlying
security at the end of each business day.
---------------------------------------------------------------------------
2. Margin Levels for Unhedged Positions
The Commissions proposed that the minimum initial and maintenance
margin levels required of customers for each security future carried in
a long or short position be 20% of the current market value of such
security future.\152\ This proposed level was based on the requirement
under section 7(c)(2) of the Exchange Act that the initial and
maintenance margin levels for a security future not be lower than the
lowest level of margin, exclusive of premium, required for any
comparable option contracts traded on any exchange registered pursuant
to section 6(a) of the Exchange Act.\153\
---------------------------------------------------------------------------
\152\ See Proposed CFTC Rule 41.45(b); Proposed SEC Rule 402(b).
\153\ 15 U.S.C. 78g(c)(2)(B)(iii)(II).
---------------------------------------------------------------------------
Twelve commenters commented on this aspect of the Proposed
Rules.\154\ Six commenters found 20% to be an acceptable level.\155\
Two commenters advocated a 25% margin level,\156\ and one commenter,
joined by a second, stated that its members could not reach a consensus
as between 20% and 25%.\157\ One commenter expressed the view 20% could
be either too high or low, and suggested that for certain positions,
50% initial margin would be appropriate.\158\
---------------------------------------------------------------------------
\154\ See SIA Credit Division Letter; Morgan Stanley Letter;
Drinkard Letter; Partnoy Letter; Klein Letter; SIA/FIA Letter; One
Chicago Letter; NFA Letter; Peregrine Letter; Options Exchanges
Letter; Nasdaq Liffe Letter; and Managed Funds Letter.
\155\ See NFA Letter at 4; Nasdaq Liffe Letter at 5; Options
Exchanges Letter at 5; OneChicago Letter at 2; Peregrine Letter at
2; Managed Funds Letter at 3.
\156\ See Morgan Stanley Letter at 6; SIA Credit Division Letter
at 1.
\157\ See SIA/FIA Letter at 2-3, 10-11; ABN AMRO Letter at 1.
\158\ Partnoy Letter at 10-14.
---------------------------------------------------------------------------
One commenter considered the 20% level to be consistent with the
margin requirements for exchange-traded options, but "more than
adequate" in terms of preserving the financial integrity of the market
and preventing systemic risk.\159\ Another commenter stated that it
"does not oppose" the 20% level, but favors portfolio margining.\160\
---------------------------------------------------------------------------
\159\ NFA Letter at 4.
\160\ Nasdaq Liffe Letter at 5.
---------------------------------------------------------------------------
One commenter said that its members were split between recommending
20% and 25%.\161\ Those supporting the 20% level believed that it was
consistent with the levels applicable to exchange-traded options and
consistent with the intent of the CFMA. This margin level in
combination with a T+1 settlement period and the fact that the Proposed
Rules permit higher margin levels, made some members conclude that 20%
is a prudent minimum level.\162\ Other members thought that 20% is too
low, failing to take into account the varying volatility/share price
profiles of equity securities and the credit risk implications of those
differences. Those members favored a 25% minimum, finding this to be
"consistent" with margin levels for options.\163\ They further noted
that a comparable option position consists of a long (short) call/short
(long) put option pair struck at the forward price of the underlying
security.\164\
---------------------------------------------------------------------------
\161\ SIA/FIA Letter at 2.
\162\ Id. at 10.
\163\ Id.
\164\ Id.
---------------------------------------------------------------------------
Finally, one commenter urged the Commissions to adopt a 25% margin
level, citing historical data and stating that this level is consistent
with the minimum margin level applied under SRO rules to long equity
positions.\165\ It argued that the 20% level would create an advantage
for security futures as compared to listed option put/call pairs,
noting margin levels in excess of 30% for combinations based on
relatively high volatility stocks, and margin levels in excess of 20%
for combinations based on relatively low volatility stocks.\166\
---------------------------------------------------------------------------
\165\ Morgan Stanley Letter at 6-8.
\166\ Id. at 7.
---------------------------------------------------------------------------
After considering the commenters' views, the Commissions have
adopted the margin levels as proposed. The Commissions believe that a
security future is comparable to a short, at-the-money option, as
discussed in the release accompanying the Proposed Rules ("Proposing
Release").\167\ Currently, the margin requirement for a short, at-the-
money option, where the underlying instrument is either an equity
security (such as a stock or an instrument immediately convertible into
a stock) or an index, is 100% of the option proceeds plus 20% of the
value of the underlying security or index.\168\
---------------------------------------------------------------------------
\167\ See Securities Exchange Act Release No. 44853 (September
26, 2001), 66 FR at 50776 (October 4, 2001).
\168\ See, e.g., Amex Rule 462; CBOE Rule 12.3; NASD Rule 2520;
New York Stock Exchange ("NYSE") Rule 431; PCX Rule 2.16; and Phlx
Rule 722.
---------------------------------------------------------------------------
Unlike an options contract, however, a futures contract involves
obligations of both parties to perform in the future: The buyer (long)
to purchase the asset underlying the future, and the seller (short) to
deliver the asset. As a result, both the buyer and the seller of a
futures contract must post and maintain margin on a daily basis to
assure contract performance and the integrity of the marketplace. In
addition, all market participants pay or receive daily variation
settlement as a result of all open futures positions being marked to
current market value. Accordingly, the margin levels apply equally for
both buyers and sellers of security futures.
The Commissions have considered the comments, and have determined
that a minimum margin level of 20% satisfies the comparability standard
of section 7(c)(2) of the Exchange Act.\169\ In addition, the
Commissions note that the Final Rules permit self-regulatory
[[Page 53158]]
authorities and security futures intermediaries to establish higher
margin levels or to take appropriate action to preserve their own
financial integrity.\170\ As a result, the Commissions are adopting the
minimum initial and maintenance margin levels for unhedged positions,
as proposed.
---------------------------------------------------------------------------
\169\ See 15 U.S.C. 78g(c)(2).
\170\ See CFTC Rule 41.42(c)(1); SEC Rule 400(c)(1).
---------------------------------------------------------------------------
3. Margin Offsets
The Proposed Rules included a provision to allow national
securities exchanges and national securities associations to adopt
rules that reduce the margin levels below 20% of current market value
for customers with certain positions in securities or futures that
offset the risk of their positions in security futures.\171\ The
Proposed Rules provided further that the resulting margin levels could
not be lower than the lowest customer margin levels required for
comparable offset positions involving exchange-traded options.\172\ In
addition, the Commissions published a table that included offsets for
security futures that the Commissions had preliminarily identified as
consistent with those permitted for comparable offset positions
involving options and that would qualify for reduced margin
levels.\173\
---------------------------------------------------------------------------
\171\ See Proposed CFTC Rule 41.45(d); Proposed SEC Rule 402(d).
\172\ Id.
\173\ See Securities Exchange Act Release No. 44853 (September
26, 2001), 66 FR at 50727-29 (October 4, 2001).
---------------------------------------------------------------------------
The Commissions received three comments with respect to the
proposed offsets.\174\ One of the commenters stated that offsets
involving security futures and options should be recognized only if the
risk from the security future is completely offset by the option.\175\
Another commenter expressed concern that the offsets would produce
margin levels that did not accurately reflect the risk of the positions
and suggested that the Commissions adopt general provisions regarding
margin levels for offsetting positions instead of providing specific
examples. \176\ Finally, one commenter suggested modifying the existing
strategy-based rules to put security futures on a par with cash
equities in connection with offsetting strategies involving listed
options and to reduce the margin requirements for certain calendar and
basket spreads involving security futures.\177\ This commenter also
suggested that the Commissions address the treatment of spreads
involving non-fungible security futures.\178\
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\174\ See Options Exchanges Letter; Partnoy Letter; SIA/FIA
Letter.
\175\ Options Exchanges Letter at 6.
\176\ Partnoy Letter at 14.
\177\ SIA/FIA Letter at Appendix I, Q 19.
\178\ Meeting between SEC and CFTC staff and representatives of
SIA/FIA (February 6, 2002).
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After considering the commenters' views, the Commissions have
adopted, substantially as proposed, rules that permit self-regulatory
authorities to establish margin levels for offset positions involving
security futures that are lower than the required margin levels for
unhedged positions.\179\ Under the Final Rules, a self-regulatory
authority may set the required initial or maintenance margin level for
an offsetting position involving security futures and related positions
at a level lower than the level that would be required if the positions
were margined separately. Such rules must meet the criteria set forth
in section 7(c)(2)(B) of the Exchange Act \180\ and must be effective
in accordance with section 19(b)(2) of the Exchange Act \181\ and, as
applicable, Section 5c(c) of the CEA.\182\
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\179\ See CFTC Rule 41.45(b)(2); SEC Rule 403(b)(2).
\180\ 15 U.S.C. 78g(c)(2)(B).
\181\ 15 U.S.C. 78s(b)(2).
\182\ 7 U.S.C. 7a-2(c).
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The Commissions have retained, with certain revisions, the table of
offsets that they deem to be consistent with offsets recognized for
comparable exchange-traded options. In particular, the revised table of
offsets reflects an adjustment in the level of margin required for
certain calendar and basket spreads involving security futures to more
accurately reflect the risk of such positions relative to comparable
spreads involving exchange-traded options. An offset position for
spreads involving non-fungible security futures also has been added to
the table.
When it approved strategy-based offsets for options, the SEC found
that it was appropriate for the SROs to recognize the hedged nature of
certain combined options strategies and prescribe margin requirements
that better reflect the risk of those strategies.\183\ The SEC also
found that the SROs' proposals relating to strategy-based offsets
involving options contracts were carefully crafted as they were based
on the SROs' experiences in monitoring the credit exposures of options
strategies. In particular, the SEC noted that the SROs regularly
examine the coverage of options margin as it relates to price movements
in the underlying securities and index components. Moreover, the SROs'
proposals were thoroughly reviewed by the NYSE Rule 431 Review
Committee, which is comprised of securities industry participants who
have extensive experience in margin and credit matters. As a result of
these factors, the SEC was confident that the SROs' proposed margin
requirements were consistent with investor protection and properly
reflected the risks of the underlying options positions.
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\183\ See Securities Exchange Act Release Nos. 41658 (July 27,
1999), 64 FR 42736 (August 5, 1999) (order approving SR-CBOE-97-67
amending CBOE Rule 12.3); 42011 (October 14, 1999), 64 FR 57172
(October 22, 1999) (order approving SR-NYSE-99-03 amending NYSE Rule
431); 43582 (November 17, 2000), 65 FR 70854 (November 28, 2000)
(order approving SR-Amex-99-27 amending Amex Rule 462); and 43581
(November 17, 2000), 65 FR 71151 (November 29, 2000) (order
approving SR-NASD-00-15 amending NASD Rule 2520).
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The table of offsets reflects a reduction in the minimum initial
and maintenance margin requirement for calendar spreads \184\ and
basket spreads,\185\ in response to the comment that the risk posed by
certain spreads involving security futures is lower than the risk posed
by comparable spreads involving exchange-traded options. \186\ In light
of the observation that security futures are not subject to early
exercise and therefore do not exhibit the same price volatility as
options, the minimum initial and maintenance margin requirement
recognized for calendar spreads and basket spreads has been reduced to
5% of the current market value of the long or short position.\187\ The
Commissions deliberated as to whether risk-based margin computations
using SPAN could be applied to these strategies, so long as the
offsetting positions were the only positions included in the margin
computation. The Commissions have decided not to permit risk-based
margin computations for these offsets at this time.
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\184\ A calendar spread is an offset position consisting of a
long security future and short security future on the same
underlying security, each contract expiring in a different month.
See table of offsets, item 10.
\185\ A basket spread is an offset consisting of a security
future based on an index and a basket of security futures that
replicates the index, i.e., a basket that contains the same
securities, and in the same proportion, as the index. See table of
offsets, items 17 and 18.
\186\ Meeting between SEC and CFTC staff and representatives of
SIA/FIA (February 6, 2002).
\187\ By way of comparison, the minimum margin required for
offsetting long and short positions in the same security under the
rules of the national securities exchanges is 5% of the current
market value of the long position. See, e.g., NYSE Rule 431(e)(1).
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The table of offsets, likewise, reflects a reduction in the
required margin recognized for spreads involving a long or short
security future and a short or long position in the same security
underlying the security future, given that these spreads are
economically
[[Page 53159]]
analogous to calendar spreads.\188\ The Commissions intend to review
the margin levels for the offsets discussed above after six months of
security futures trading to determine whether the margin levels have
resulted in regulatory arbitrage with comparable positions involving
exchange-traded options, and may jointly undertake appropriate action.
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\188\ See table of offsets, items 4 and 13.
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Based on the same commenter's suggestion, the Commissions believe
that an additional offset should be recognized for spreads involving
identical, non-fungible security futures.\189\ Because there is a
possibility that certain security futures may not be fungible across
markets, a customer may simultaneously hold a long security future and
a short security future on the same underlying security even when those
security futures have identical contract terms. As a result, the
customer will be economically neutral but will be required to hold both
positions to expiration and meet daily variation settlement calls with
respect to each contract. The commenter expressed the view that a
minimum margin level of 1% would be appropriate.\190\ The Commissions
recognize that the rules of a clearing agency or derivatives clearing
organization may effectively net the two contracts at final settlement.
However, due to potential differences in daily settlement prices across
markets or other market-specific events, the Commissions have
determined that such offset positions will be subject to a minimum
margin requirement of 3%.
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\189\ See table of offsets, item 19.
\190\ Meeting between SEC and CFTC staff and representatives of
SIA/FIA (February 6, 2002).
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The Commissions believe that the offsets identified in the
following table are consistent with the strategy-based offsets
permitted for comparable offset positions involving exchange-traded
options. The Commissions expect that self-regulatory authorities
seeking to permit trading in security futures will submit to the
Commissions proposed rules that impose levels of required margin for
offsetting positions involving security futures in accordance with the
minimum margin requirements identified in the following table of
offsets.
----------------------------------------------------------------------------------------------------------------
Security underlying the Initial margin Maintenance margin
Description of offset security future requirement requirement
----------------------------------------------------------------------------------------------------------------
1. Long security future or short Individual stock or 20% of the current 20% of the current
security future. narrow-based security market value of the market value of the
index. security future. security future.
2. Long security future (or Individual stock or 20% of the current The lower of: (1) 10% of
basket of security futures narrow-based security market value of the the aggregate exercise
representing each component of a index. long security future, price \3\ of the put
narrow-based securities index plus pay for the long plus the aggregate put
\1\) and long put option \2\ on put in full. out-of-the-money \4\
the same underlying security (or amount, if any; or (2)
index). 20% of the current
market value of the
long security future.
3. Short security future (or Individual stock or 20% of the current 20% of the current
basket of security futures narrow-based security market value of the market value of the
representing each component of a index. short security future, short security future,
narrow-based securities index plus the aggregate put plus the aggregate put
\1\) and short put option on the in-the-money amount, if in-the-money amount, if
same underlying security (or any. Proceeds from the any.\5\
index). put. Proceeds from the
put sale may be applied.
4. Long security future and short Individual stock or The initial margin 5% of the current market
position in the same security narrow-based security required under value as defined in
(or securities basket \1\) index. Regulation T for the Regulation T of the
underlying the security future. short stock or stocks. stock or stocks
underlying the security
future.
5. Long security future (or Individual stock or 20% of the current 20% of the current
basket of security futures narrow-based security market value of the market value of the
representing each component of a index. long security future, long security future,
narrow-based securities index plus the aggregate call plus the aggregate call
\1\) and Short call option on in-the-money amount, if in-the-money amount, if
the same underlying security (or any. Proceeds from the any.
index). call sale may be
applied.
6. Long a basket of narrow-based Narrow-based security 20% of the current 20% of the current
security futures that together index. market value of the market value of the
tracks a broad based index \1\ long basket of narrow- long basket of narrow-
and short a broad-based security based security futures, based security futures,
index call option contract on plus the aggregate call plus the aggregate call
the same index. in-the-money amount, if in-the-money amount, if
any. Proceeds from the any.
call sale may be
applied.
7. Short a basket of narrow-based Narrow-based security 20% of the current 20% of the current
security futures that together index. market value of the market value of the
tracks a broad-based security short basket of narrow- short basket of narrow-
index \1\ and short a broad- based security futures, based security futures,
based security index put option plus the aggregate put plus the aggregate put
contract on the same index. in-the-money amount, if in-the-money amount, if
any. Proceeds from the any.
put sale may be applied.
8. Long security a basket a Narrow-based security 20% of the current The lower of: (1) 10% of
narrow-based securities futures index. market value of the the aggregate exercise
that together tracks a broad- long basket of narrow- price of the put, plus
based security index \1\ and based security futures, the aggregate put out-
long a broad-based security plus pay for the long of-the-money amount, if
index put option contract on the put in full. any; or (2) 20% of the
same index. current market value of
the long basket of
security futures.
[[Page 53160]]
9. Short a basket of narrow-based Narrow-based security 20% of the current The lower of: (1) 10% of
security futures that together index. market value of the the aggregate exercise
tracks a broad-based security short basket of narrow- price of the call, plus
index \1\ and long a broad-based based security futures, the aggregate call out-
security index call option plus pay for the long of-the-money amount, if
contract on the same index. call in full. any; or (2) 20% of the
current market value of
the short basket of
security futures
10. Long security future and Individual stock or The greater of: 5% of The greater of: 5% of
short security future on the narrow-based security the current market the current market
same underlying security (or index. value of the long value of the long
index). security future; or 2) security future; or (2)
5% of the current 5% of the current
market value of the market value of the
short security future. short security future.
11. Long security future, long Individual stock or 20% of the current 10% of the aggregate
put option and short call narrow-based security market value of the exercise price, plus
option. The long security index. long security future, the aggregate call in-
future, long put and short call plus the aggregate call the-money amount, if
must be on the same underlying in-the-money amount, if any.
security and the put and call any, plus pay for the
must have the same exercise put in full. Proceeds
price. (Conversion). from the call sale may
be applied.
12. Long security future, long Individual stock or 20% of the current The lower of: (1) 10% of
put option and short call narrow-based security market value of the the aggregate exercise
option. The long security index. long security future, price of the put plus
future, long put and short call plus the aggregate call the aggregate put out-
must be on the same underlying in-the-money amount, if of-the-money amount, if
security and the put exercise any, plus pay for the any; or (2) 20% of the
price must be below the call put in full. Proceeds aggregate exercise
exercise price. (Collar). from call sale may be price of the call, plus
applied. the aggregate call in-
the-money amount, if
any.
13. Short security future and Individual stock or The initial margin 5% of the current market
long position in the same narrow-based security required under value, as defined in
security (or securities basket index. Regulation T for the Regulation T, of the
\1\) underlying the security long stock or stocks. long stock or stocks.
future.
14. Short security future and Individual stock or The init