[Federal Register: February 3, 2005 (Volume 70, Number 22)]
[Proposed Rules]
[Page 5577-5593]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr03fe05-6]

=======================================================================
-----------------------------------------------------------------------

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AC15


Investment of Customer Funds and Record of Investments

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rule.

-----------------------------------------------------------------------

SUMMARY: The Commodity Futures Trading Commission (``Commission'') is
proposing to amend its regulations regarding investment of customer
funds and related recordkeeping requirements. The proposed amendments
address standards for investing in instruments with embedded
derivatives, requirements for adjustable rate securities (including
auction rate securities), concentration limits on reverse repurchase
agreements (``reverse repos''), transactions by futures commission
merchants (``FCMs'') that are also registered as securities broker-
dealers (``FCM/BDs''), rating standards and registration requirement
for money market mutual funds (``MMMFs''), auditability standard for
investment records, and certain technical changes. Among those
technical changes is an amendment to the Commission's recordkeeping
rules in connection with repurchase agreements (``repos'') and proposed
transactions by FCM/BDs.

DATES: Comments must be received on or before March 7, 2005.

ADDRESSES: Comments on the proposed amendments should be sent to Jean
A. Webb, Secretary, Commodity Futures Trading Commission, Three
Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. Comments

 href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov. Reference should be made to ``Proposed Amendments

to Rule 1.25.''

FOR FURTHER INFORMATION CONTACT: Phyllis P. Dietz, Special Counsel,
Division of Clearing and Intermediary Oversight, Commodity Futures
Trading Commission, Three Lafayette Centre, 1155 21st Street, NW.,
Washington, DC 20581. Telephone (202) 418-5430.

Table of Contents

I. Background
II. Discussion of the Proposed Rules
    A. Instruments With Embedded Derivatives
    B. Adjustable Rate Securities
    1. Permitted Benchmarks
    2. Supplemental Requirements
    3. Technical Amendments
    4. Auction Rate Securities
    C. Reverse Repos--Concentration Limits
    D. Transactions by FCM/BDs
    E. Rating Standards for MMMFs
    F. Registration Requirement for MMMFs
    G. Auditability Standard for Investment Records
    H. Additional Technical Amendments
    1. Clarifying and Codifying MMMF Redemption Requirements
    (i) Next-Day Redemption Requirement
    (ii) Exceptions to the Next-Day Redemption Requirement
    2. Clarifying Rating Standards for Certificates of Deposit
    3. Clarifying Corporate Bonds as Permitted Investments
    4. Clarifying References to Transferred Securities
    5. Clarifying Payment and Delivery Procedures for Reverse Repos
and Repos
    6. Changing Paragraph (a)(1) ``Customer Funds'' to ``Customer
Money''
    7. Conforming Reference to ``Marketability'' Requirement
    8. Conforming Terminology for ``Derivatives Clearing
Organizations''
    9. Conforming Terminology for ``Government Sponsored
Enterprise''
    10. Conforming Terminology for ``Futures Commission Merchant''
    11. Clarifying the Meaning of ``NRSRO''
III. Time to Maturity--Treasury Portfolio
IV. Section 4(c)
V. Related Matters
    A. Regulatory Flexibility Act
    B. Paperwork Reduction Act

[[Page 5578]]

    C. Costs and Benefits of the Proposed Rules
Text of Rules

SUPPLEMENTARY INFORMATION:

I. Background

    Commission Rule 1.25 (17 CFR 1.25) sets forth the types of
instruments in which FCMs and derivatives clearing organizations
(``DCOs'') are permitted to invest customer assets that are required to
be segregated under the Commodity Exchange Act \1\ (``Act''). The
Commission believes that it is important to have customer funds
invested in a manner that minimizes their exposure to credit,
liquidity, and market risks not only because they are customer assets,
but also because, to the extent they represent a performance bond
against customer obligations under derivatives contracts, these assets
must be capable of being quickly converted to cash at a predictable
value to minimize systemic risk.
---------------------------------------------------------------------------

    \1\ Section 4d(a)(2) of the Act, 7 U.S.C. 6d(a)(2), requires
segregation of customer funds. It provides, in relevant part, that
customer-deposited ``money, securities, and property shall be
separately accounted for and shall not be commingled with the funds
of [the FCM] or be used to margin or guarantee the trades or
contracts, or to secure or extend the credit, of any customer or
person other than the one for whom the same are held.''
---------------------------------------------------------------------------

    Rule 1.25 was substantially amended in December 2000 to expand the
list of permitted investments beyond the Treasury and municipal
securities that are expressly permitted by the Act.\2\ In connection
with that expansion, the Commission added several provisions intended
to control exposures to credit, liquidity, and market risks associated
with the additional investments.
---------------------------------------------------------------------------

    \2\ See 65 FR 77993 (Dec. 13, 2000) (publishing final rules);
and 65 FR 82270 (Dec. 28, 2000) (making technical corrections and
accelerating effective date of final rules from February 12, 2001 to
December 28, 2000).
---------------------------------------------------------------------------

    On June 30, 2003, the Commission published for public comment
proposed amendments to two provisions of Rule 1.25, and it further
requested comment (without proposing specific amendments) on several
other provisions of the rule.\3\ In February 2004, the Commission
adopted final rule amendments regarding repos with customer-deposited
securities and modified time-to-maturity requirements for securities
deposited in connection with certain collateral management programs of
DCOs.\4\ The Commission did not, however, take any action on the other
matters raised in its June 30, 2003 release.
---------------------------------------------------------------------------

    \3\ 68 FR 38654 (June 30, 2003).
    \4\ 69 FR 6140 (Feb. 10, 2004).
---------------------------------------------------------------------------

    The Commission is now proposing specific rule amendments related to
the remaining issues raised in its June 30, 2003 request for public
comment. These proposed amendments, discussed in section II.A. through
C. of this release, relate to standards for investing in instruments
with embedded derivatives, permitted benchmarks for adjustable rate
securities,\5\ and concentration limits on reverse repos. The
discussion of these issues incorporates comments submitted by the
Futures Industry Association (``FIA''), National Futures Association
(``NFA''), and Lehman Brothers, in 2003.\6\
---------------------------------------------------------------------------

    \5\ In addition to addressing the issues raised in its June 30,
2003 release, the Commission is also proposing two supplemental
requirements for adjustable rate securities, as well as technical
amendments relating to terminology. Among the technical amendments
is a proposal to substitute the term ``adjustable rate security''
for the term ``variable-rate security,'' as the latter term is
currently used. See Section II.B.3. of this release for a discussion
of proposed changes in terminology.
    \6\ These comment letters are available in the comment file
accompanying the June 30, 2003 release, at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov.

---------------------------------------------------------------------------

    The Commission is also proposing amendments that address several
new issues, as discussed in section II.D. through G. of this release.
In this regard, the Commission is proposing an amendment requested by
the FIA regarding certain transactions by FCM/BDs,\7\ an amendment to
eliminate the rating requirement for MMMFs, an amendment to require
that all permitted MMMFs be registered with the Securities and Exchange
Commission (``SEC''), and an amendment establishing an auditability
standard for investment records.
---------------------------------------------------------------------------

    \7\ In connection with this proposal, the Commission is also
proposing technical amendments to Rule 1.27 to clarify the
recordkeeping requirements applicable to repos and proposed
transactions by FCM/BDs.
---------------------------------------------------------------------------

    Further, in Section II.H. of this release, the Commission is
proposing technical amendments to Rule 1.25 to clarify the following:
(1) The next-day redemption requirement for MMMFs (also codifying
previously published exceptions to that requirement); (2) the rating
standards for certificates of deposit; (3) the permissibility of
investing in corporate bonds; (4) the inapplicability of segregation
rules to securities transferred pursuant to a repo; (5) payment and
delivery procedures for repos and reverse repos; and (6) the
distinction between investment of customer money and investment of
customer-deposited securities. The technical amendments would also
conform references to applicable marketability standards, update and
conform the terminology referring to a DCO, conform the terminology
referring to a government sponsored enterprise (``GSE''), conform the
terminology referring to an FCM, and clarify the meaning of the term
``NRSRO.''
    The Commission solicits comment on all aspects of the proposed
amendments to Rules 1.25 and 1.27. Commenters are welcome to offer
their views regarding any other matters that are raised by the proposed
rules.

II. Discussion of the Proposed Rules

A. Instruments With Embedded Derivatives

    Rule 1.25(b)(3)(i) expressly prohibits investment of customer funds
in instruments with embedded derivatives.\8\ Some market participants
have suggested that there are certain instruments containing embedded
derivatives that have a level of risk similar to or lower than some of
the other investments permitted under the rule and that embedded
derivatives may otherwise have risk-neutral or even risk-mitigating
effects. In June 2003, the Commission requested comment on whether Rule
1.25(b)(3)(i) should be amended to modify the prohibition on
investments in securities that contain an embedded derivative. In this
regard, commenters were asked to describe how the level of risk of such
securities could be limited.
---------------------------------------------------------------------------

    \8\ Rule 1.25(b)(3)(i) currently provides that ``[w]ith the
exception of money market mutual funds, no permitted investment may
contain an embedded derivative of any kind, including but not
limited to a call option, put option, or collar, cap, or floor on
interest paid.''
---------------------------------------------------------------------------

    The FIA commented that many GSE securities contain caps, floors,
puts, and calls. The FIA recommended that the Commission permit FCMs to
invest in securities with such features, provided they are directly
related to the interest rate characteristics of the security. The FIA
stated that this standard is similar to one found in Generally Accepted
Accounting Principles Statement of Financial Accounting Standards No.
133, under which embedded derivatives that are ``clearly and closely
related'' to the ``host contract'' are accounted for together with the
underlying instrument. The FIA further stated that caps, floors, puts
and calls would all be considered ``clearly and closely related'' as
long as they are a function of the same rate in the underlying
security.
    Since the FIA submitted its comment letter, FIA representatives
have held further discussions with Commission staff to consider the
establishment of more specific criteria that could provide greater
clarity for FCMs and DCOs, as well as designated self-regulatory
organization and Commission auditors. Such standards would be more
readily auditable, furthering the goal of ensuring compliance.

[[Page 5579]]

    As the Commission has previously stated, it believes that expanding
the list of permitted investments can enhance the yield available to
FCMs, DCOs, and their customers, without compromising the ability of
FCMs to quickly convert such investments to cash at a predictable
value.\9\ In light of discussions with market participants, the
Commission acknowledges that there are some embedded derivatives that,
at a minimum, do not appear to heighten the material risks of permitted
investments and may serve to mitigate risks under certain
circumstances.
---------------------------------------------------------------------------

    \9\ See 65 FR at 39014.
---------------------------------------------------------------------------

    The Commission, having carefully considered the merits of
permitting investment of customer money in a limited selection of
instruments with embedded derivatives, proposes to amend Rule
1.25(b)(3)(i) to permit FCMs and DCOs to invest in instruments with
certain embedded derivatives, subject to certain express standards.
Commission staff have worked with market participants to develop these
standards, with the goal of excluding inappropriate instruments while
including instruments that offer an attractive yield at an acceptable
level of risk.
    As a preliminary matter, the Commission proposes a technical
amendment to paragraph (b)(3)(iii), to clarify its continued intent to
maintain an express prohibition against any instrument that, itself,
constitutes a derivative instrument. This was the original intent of
paragraph (b)(3)(iii) which already prohibits payments linked to any
underlying commodity except as expressly permitted by paragraph
(b)(3)(iv) with respect to adjustable rate securities.
    Proposed paragraph (b)(3)(i) would continue to generally prohibit
investments in instruments with embedded derivatives, carving out an
exception only for two categories of embedded derivatives that may be
contained in instruments that meet specified criteria.
    Proposed paragraph (b)(3)(i) sets forth the types of embedded
derivatives that would be permissible. First, proposed paragraph
(b)(3)(i)(A) permits an instrument to have a call feature, in whole or
in part, at par, on the principal amount of the instrument before its
stated maturity date. The Commission notes that the issuer's right to
call an instrument prior to maturity does not jeopardize the principal
amount, but merely accelerates the maturity of the instrument. Because
the issuer of a callable instrument typically offers a higher return to
investors in return for the right to call the issue if prevailing
interest rates fall, or for other reasons, a callable instrument can
afford its holders the opportunity to achieve a higher yield without
exposing themselves to greater credit risk by seeking higher yields
from other issuers that may be less creditworthy. That is, the
reinvestment risk presented by callable instruments is of far less
supervisory concern, if any, than the credit risk that may be presented
by a shifting of investments to less creditworthy issuers, even within
the population permitted by the credit rating requirements and other
requirements of Rule 1.25.
    Second, proposed paragraph (b)(3)(i)(B) addresses permissible
interest rate features. The proposed revision now would permit caps,
floors, or collars on the interest paid pursuant to the terms of an
adjustable rate instrument. Upper and/or lower limits on interest do
not jeopardize the principal amount payable at maturity. Although upper
limits (caps) on adjustable rates may constrain the yield achieved if
prevailing rates rise substantially, lower limits (floors) may protect
the yield achieved if prevailing rates fall significantly.
    Proposed paragraph (b)(3)(i) further provides that the terms of the
instrument must obligate the issuer to fully repay the principal amount
of the instrument at not less than par value, upon maturity. The
preservation of principal is a fundamental premise upon which the
Commission has based its policies regarding permitted investments. It
is important to ensure that principal is protected, especially as
instruments become more complex in their structure.

B. Adjustable Rate Securities

1. Permitted Benchmarks
    Rule 1.25(b)(3)(iv) currently permits investment in ``variable-rate
securities,'' \10\ provided that the interest rates thereon correlate
closely and on an unleveraged basis to a benchmark of either the
Federal Funds target or effective rate, the prime rate, the three-month
Treasury Bill rate, or the one-month or three-month LIBOR rate. Market
participants have noted that the benchmarks used in the marketplace
evolve over time. In its June 30, 2003 release, the Commission
requested comment on whether the provision on permitted benchmarks
should be amended and, if so, what the applicable standard should be.
---------------------------------------------------------------------------

    \10\ See Section II.B.3. of this release for a discussion of the
Commission's proposed amendments to clarify use of the terms
``adjustable rate,'' ``floating rate,'' and ``variable rate.''
---------------------------------------------------------------------------

    The FIA recommended that Rule 1.25(b)(3)(iv) be amended to provide
that permissible benchmarks can include any fixed rate instrument that
is a ``permitted investment'' under the rule. The FIA reasoned that, if
an FCM is authorized to purchase a fixed rate instrument, e.g., a six-
month Treasury bill, and continuously roll that instrument over, then
it should be able to purchase an instrument benchmarked to that fixed
rate security. This would allow FCMs to respond to new benchmarks as
they evolve. In this regard, the FIA noted its understanding that, in
Europe, the Euribor has become more popular than LIBOR as a benchmark
in many instruments.
    The Commission agrees that it is appropriate to afford greater
latitude in establishing benchmarks for floating rate securities,
thereby enabling FCMs and DCOs to more readily respond to changes in
the market. The Commission therefore proposes to amend Rule
1.25(b)(3)(iv), proposing new paragraph (b)(3)(iv)(A)(2), to provide
that, in addition to the benchmarks already enumerated in the rule,
floating rate securities may be benchmarked to rates on any fixed rate
instruments that are ``permitted investments'' under Rule 1.25(a). It
should be noted that any resulting interest payment must be determined
solely by reference to one or more permissible interest rates or
relationships between a constant and one or more permissible interest
rates.
    In addition, the Commission believes it appropriate to clarify that
neither the existing text requiring that the interest payments on
variable rate securities ``correlate closely and on an unleveraged
basis'' to certain benchmark rates, nor the proposed text requiring
that the interest payments on floating rate securities ``be determined
solely by reference, on an unleveraged basis,'' to those and other
benchmarks, should be read to foreclose interest payments that include
some fixed arithmetic spread added to the benchmark rate itself,
provided that no such spread may constitute any multiple of the
benchmark rate. This reflects the original intent of this provision,
and should eliminate potential errors or ambiguities in interpreting
what is meant by the phrase ``unleveraged basis.''
2. Supplemental Requirements
    The Commission is proposing to amend paragraph (b)(3)(iv) by adding
two supplemental requirements that it believes are prudent and
necessary in light of the increasing number and

[[Page 5580]]

complexity of adjustable rate securities that could qualify as
permitted investments for FCMs and DCOs. Under proposed paragraph
(b)(3)(iv)(A)(3), any benchmark rate would have to be expressed in the
same currency as the adjustable rate security referencing it. This
eliminates the need to calculate and account for changes in applicable
currency exchange rates. Under proposed paragraph (b)(3)(iv)(A)(4), the
periodic coupon payments could not be a negative amount. This is
designed to prevent FCMs and DCOs from investing in instruments that
the Commission believes do not reflect an acceptable level of risk.
3. Technical Amendments
    The Commission is proposing to revise certain terminology used in
paragraph (b)(3)(iv) for the purpose of clarifying, not changing, the
meaning of this provision. Paragraph (b)(3)(iv) currently uses the term
``variable-rate securities'' without distinguishing between securities
for which periodic interest payments vary by formula or other reference
calculation any time a specified interest rate changes (termed a
``floating rate security'' by the SEC),\11\ and those for which
periodic interest payments are adjusted on set dates (termed a
``variable rate security'' by the SEC).\12\ For purposes of clarity and
to ensure consistency with the paragraph (b)(5) time-to-maturity
provision,\13\ the Commission is proposing to amend paragraph
(b)(3)(iv) to distinguish the terms ``floating rate security'' and
``variable rate security'' and, where appropriate, to use the term
``adjustable rate security,'' to refer to either or both of the
foregoing.
---------------------------------------------------------------------------

    \11\ See SEC Rule 2a-7(a)(13), 17 CFR 270.2a-7(a)(13).
    \12\ See SEC Rule 2a-7(a)(29), 17 CFR 270.2a-7(a)(29).
    \13\ Under Rule 1.25(b)(5), the portfolio time-to-maturity
calculation is computed pursuant to SEC Rule 2a-7.
---------------------------------------------------------------------------

    In this regard, the Commission proposes to add a new paragraph
(b)(3)(iv)(B), defining the above terms for purposes of paragraph
(b)(3)(iv). Proposed paragraph (b)(3)(iv)(B)(1) defines ``adjustable
rate security'' as described above. Using the SEC's definition,
proposed paragraph (b)(3)(iv)(B)(2) defines ``floating rate security''
as a security, the terms of which provide for the adjustment of its
interest rate whenever a specified interest rate changes and that, at
any time until the final maturity of the instrument or the period
remaining until the principal amount can be recovered through demand,
can reasonably be expected to have a market value that approximates its
amortized cost. Also using the SEC's definition, proposed paragraph
(b)(3)(iv)(B)(3) defines ``variable rate security'' as a security, the
terms of which provide for the adjustment of its interest rate on set
dates (such as the last day of a month or calendar quarter) and that,
upon each adjustment until the final maturity of the instrument or the
period remaining until the principal amount can be recovered through
demand, can reasonably be expected to have a market value that
approximates its amortized cost.
4. Auction Rate Securities
    The Commission received an inquiry from an FCM interested in
investing customer funds in certain auction rate securities (``ARS'').
The specific instruments described by this FCM were issued by a quasi-
governmental corporate entity established in the Commonwealth of
Massachusetts. Such an issuer cannot be considered to be a political
subdivision of a State as described in the Act and in paragraph (a)(ii)
of Rule 1.25 but, rather, must be considered to be a corporate issuer
under paragraph (a)(vi).
    Currently, paragraph (a)(vi) uses the term ``corporate notes,''
which may create some uncertainty as to the Commission's intent
regarding the duration of such instruments. In particular, the specific
instruments that were the subject of the inquiry have maturity dates
many years in the future. As discussed in section II.H.3. of this
release, the Commission is proposing a technical change to now use the
term ``corporate notes or bonds,'' for clarity. Accordingly, an ARS
that had an initial term to maturity exceeding five or even ten years
would not be prohibited outright, but would, as with all other
securities in the portfolio, be subject to the portfolio time-to-
maturity requirements consistent with paragraph (b)(5), which focuses
on the remaining time to maturity.
    This inquiry also raises the separate question of whether the
process by which the periodic interest payments are determined for ARS
is permissible. It appears that the typical process is to reset the
interest rate through ``Dutch auctions'' held on relatively short
cycles, such as 7, 14, 28, or 35 days, with interest paid at the end of
each auction period. The full principal is due at a set maturity date,
typically years from the date of issue. In such an auction, broker-
dealers submit bids to an auction agent (typically a large money center
bank). The interest rate for the next period is set by identifying the
lowest rate that will clear the total outstanding amount of securities.
The ``auctions'' are for the purpose of rate-setting and, absent other
express terms of the agreement, do not constitute an opportunity either
for the holders to put the securities to the issuer or for the issuer
to call the securities from the holders. As with other debt securities,
holders of ARS may attempt to resell them by contacting broker-dealers
or other potential buyers, but there is no continuous bid/offer stream,
although bids and offers may be available upon request from major
dealers active in the market.
    It has been represented to the Commission that the interest
payments on the particular issue which was the subject of the inquiry,
and those of many other ARS issues, demonstrate close historical
correlation to key short-term interest rates. As described, therefore,
the process of establishing periodic interest payments in such a manner
would not violate the requirements of current paragraph (b)(3)(iv) or
proposed paragraph (b)(3)(iv)(A)(1), if, in fact, they are closely
correlated to a permitted benchmark.

C. Reverse Repos--Concentration Limits

    Rule 1.25(b)(4)(iii) establishes concentration limits for reverse
repos.\14\ These restrictions, which were adopted in response to public
comment, take into consideration the identity of both the issuer of the
securities and the counterparty to the reverse repo. Consideration as
to counterparty was based on the counterparty having direct control
over which specific securities would be supplied in a transaction.\15\
Given industry experience over the past several years, however, it has
been brought to the attention of the Commission that the ability of
FCMs and DCOs to monitor compliance with this two-prong standard has
proven to be operationally unworkable. As a result, in June 2003, the
Commission requested comment on market participants' experience with
the current provisions relating to reverse repos and suggestions on how
best to address the risks of these transactions.
---------------------------------------------------------------------------

    \14\ As used in this release, the term ``reverse repo'' means an
agreement under which an FCM or DCO buys a security that is a
permitted investment from a qualified counterparty, with a
commitment to resell that security to the counterparty at a later
date. A ``repo'' is an agreement under which an FCM or DCO sells a
security to a qualified counterparty, with a commitment to
repurchase that security at a later date.
    \15\ See 65 FR 77993, 78002 (Dec. 13, 2000).
---------------------------------------------------------------------------

    The FIA commented that, although the concentration limits for
reverse repos were imposed to remove restrictions that commenters
previously

[[Page 5581]]

had identified as inhibiting their use of reverse repos, as a practical
matter, an FCM cannot monitor such transactions by security, size and
counterparty except through manual processing. As a result, this
investment alternative has not proved to be viable. The FIA expressed
the view that all securities held by an FCM, either through an
investment of customer funds or through a reverse repo, should be
subject to the concentration limits for direct investments.
    The Commission proposes to amend paragraph (b)(4)(iii) to make
reverse repos subject to the concentration limits for direct
investments under Rule 1.25(b)(4)(i). In re-evaluating the existing
concentration limits, the Commission has concluded that imposing
issuer-based concentration limits, as originally proposed for permitted
investments including securities obtained through reverse repos, is an
appropriate and adequate safeguard.\16\ The Commission's primary
regulatory concern focuses on the actual holdings in the customer
segregated account (i.e., cash, securities, or other property) at any
given time. Accordingly, under the proposal, all investment securities
in the account, whether obtained pursuant to direct investment or
reverse repo, would be subject to the same concentration limits.
---------------------------------------------------------------------------

    \16\ See 65 FR 39008, 39020 (June 22, 2000).
---------------------------------------------------------------------------

D. Transactions by FCM/BDs

    In its comment letter responding to the Commission's June 30, 2003
request for public comment, the FIA proposed adding a new provision to
Rule 1.25 that would permit an FCM/BD to engage in transactions that
involve the exchange of customer money or customer-deposited securities
for securities that are held by the FCM in its capacity as a securities
broker-dealer (``in-house transactions'').\17\ Lehman Brothers also
submitted a comment letter in support of the FIA's proposal.
---------------------------------------------------------------------------

    \17\ Since the submission of its comment letter, the FIA has
further requested that the provision also address transactions in
which customer-deposited securities are exchanged for cash.
---------------------------------------------------------------------------

    The FIA recommended that the Commission authorize an FCM/BD that,
in its capacity as a broker-dealer, owns or has the unqualified right
to pledge securities that are ``permitted investments,'' to invest
customer money by effecting a transfer of such securities to the
customer segregated account. Similarly, in lieu of using customer-
deposited securities in a repo with a third party, the FIA proposed
that an FCM/BD should be authorized to effect similar transactions by
means of a transfer of customer-owned securities in exchange for
permitted investments that the FCM/BD holds in its capacity as a
broker-dealer. The FIA further proposed that the FCM/BD transactions be
subject to the recordkeeping requirements of Commission rules 1.25,
1.26, 1.27, 1.28, and 1.36, as well as applicable SEC rules. With
respect to transactions involving customer-owned securities, the FIA
stated that the records should reflect the customer's continued
ownership interest in those securities.
    The FIA proposed to apply to in-house transactions certain
standards that currently apply to repos and reverse repos under Rule
1.25(d), i.e., the identification of securities by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number
(paragraph (d)(1)); the ability to unwind a transaction within one
business day or on demand (paragraph (d)(5)); and the recognition of an
accomplished transaction only when the securities are actually received
by the custodian of the FCM's customer segregated account (paragraph
(d)(8)). The FIA proposed to apply the concentration requirements
applicable to direct investments (paragraph (b)(4)(i)) and to treat the
securities deposited in the customer segregated account as a result of
the in-house transaction as having a one-day time-to-maturity.
    Lehman Brothers asserted its belief that such transactions are
permissible under Section 4d(a)(2) of the Act \18\ and Rule 1.25, and
do not present any unique customer protection concerns. Lehman Brothers
described the proposed transactions as an alternative to reverse repos
and repos entered into between an FCM/BD and a third party.
---------------------------------------------------------------------------

    \18\ 7 U.S.C. 6d(a)(2).
---------------------------------------------------------------------------

    In considering issues related to the investment of customer money
or securities by an FCM, the Commission's primary interest is in
preserving the integrity of the customer segregated account. Not only
must there be sufficient value in the account at all times, but the
quality of investments must reflect an acceptable level of credit,
market, and liquidity risk. In this regard, it is important that non-
cash assets can be quickly converted to cash at a predictable value.
    The in-house transactions proposed by FIA and Lehman Brothers are
intended to provide the economic equivalent of repos and reverse repos
with third parties. A key benefit that the in-house transactions offer
is that they can assist an FCM both in achieving greater capital
efficiency and in accomplishing important risk management goals,
including internal diversification targets. For example, customer-
deposited securities that are not acceptable as collateral for DCO
performance bond requirements could be exchanged for securities that
are acceptable. This would permit the more efficient use of an FCM/BD's
total holdings. There also would be certain operational efficiencies
given the ability to readily substitute forms of collateral prior to
delivering that collateral to a DCO.
    The Commission recognizes that all permitted investments under Rule
1.25(a)(1) do not have the same risk profile, and that substitution of
one type of permitted investment for another could alter the risk
profile of a customer segregated account. However, the Commission has
previously determined that all of the instruments that are permitted
investments are appropriate investments for customer money, subject to
specified requirements. Thus, the substitution of one permitted
investment for another in an in-house transaction will not present an
unacceptable level of risk to the customer segregated account.
    In light of the above considerations, the Commission is proposing
to amend Rule 1.25 by adding new paragraphs (a)(3) and (e) \19\ to
permit FCM/BDs to engage in in-house transactions subject to specified
requirements.
---------------------------------------------------------------------------

    \19\ The current paragraph (e) would be redesignated as
paragraph (f).
---------------------------------------------------------------------------

    Proposed paragraph (a)(3)(i) provides that customer money may be
exchanged for securities that are permitted investments and are held by
an FCM/BD in connection with its securities broker or dealer
activities. Proposed paragraph (a)(3)(ii) provides that securities
deposited by customers as margin may be exchanged for securities that
are permitted investments and are held by an FCM/BD in connection with
its securities broker or dealer activities. Proposed paragraph
(a)(3)(iii) provides that securities deposited by customers as margin
may be exchanged for cash that is held by an FCM/BD in connection with
its securities broker or dealer activities.
    The authority granted under paragraph (a)(3) would be subject to
the requirements of proposed new paragraph (e), which incorporates many
of the same restrictions currently imposed on repo and reverse repo
transactions under paragraph (d). Certain provisions of paragraph (e)
have been adapted to reflect the operational differences between an in-
house transaction and a third-party transaction.
    Proposed paragraph (e)(1) requires that the FCM, in connection with
its

[[Page 5582]]

securities broker or dealer activities, must own or have the
unqualified right to pledge the securities that are exchanged for
customer money or securities held in the customer segregated account.
The securities may be held as part of the broker-dealer inventory or
may have been deposited with the broker-dealer by its customers.
    Proposed paragraph (e)(2) requires that the transaction can be
reversed within one business day or upon demand. This standard also
applies to repos and reverse repos under Rule 1.25(d)(5), with the goal
of establishing investment liquidity.
    Proposed paragraph (e)(3) incorporates the Rule 1.25(d)(1)
requirement that the securities transferred from and to the customer
segregated account be specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
    Proposed paragraph (e)(4) establishes two general requirements for
the types of customer-deposited securities that can be used in the in-
house transactions. These same requirements apply to customer-deposited
securities used in repos under Rule 1.25(a)(2)(ii). Paragraph (e)(4)(i)
incorporates the Rule 1.25(a)(2)(ii)(A) requirement that the securities
must be ``readily marketable'' as defined in SEC Rule 15c3-1.\20\
Paragraph (e)(4)(ii) incorporates the Rule 1.25(a)(2)(ii)(B)
requirement that the securities not be ``specifically identifiable
property'' as defined in Rule 190.01(kk).
---------------------------------------------------------------------------

    \20\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    Proposed paragraph (e)(5) establishes requirements for securities
that will be transferred to the customer segregated account as a result
of the in-house transaction, clarifying the treatment of these
securities once they are held in the customer segregated account.
Proposed paragraph (e)(5)(i) requires that the securities be priced
daily based on the current mark-to-market value. Proposed paragraph
(e)(5)(ii) provides that the securities will be subject to the
concentration limit requirements applicable to direct investments, as
provided in proposed Rule 1.25(b)(4)(iv) (discussed below). This is the
same treatment that the Commission is proposing to apply to repos and
reverse repos.\21\ Proposed paragraph (e)(5)(iii) provides that the
securities transferred to the customer segregated account must be held
in a safekeeping account with a bank, a DCO, or the Depository Trust
Company in an account that complies with the requirements of Rule 1.26.
This same requirement is applied to repos and reverse repos under Rule
1.25(d)(6).\22\
---------------------------------------------------------------------------

    \21\ See section II.C. of this release.
    \22\ Note that the Commission has not included in this paragraph
the FIA's proposed one-day time-to-maturity treatment for securities
transferred to the customer segregated account. Although an in-house
transaction could be reversed within one day, the rule would not
require that it be reversed within that time frame. Effectively,
these instruments would be subject to the same risks associated with
the price sensitivity of direct investments and, accordingly, should
be subject to the same standards in order to maximize the protection
of principal. Special treatment would undermine the purpose of the
time-to-maturity requirement.
---------------------------------------------------------------------------

    Proposed paragraph (e)(5)(iv) incorporates the Rule 1.25(d)(7)
restrictions on the subsequent use of the securities. It provides that
the securities may not be used in another similar transaction and may
not otherwise be hypothecated or pledged, except such securities may be
pledged on behalf of customers at another FCM or a DCO. It permits
substitution of securities if: (1) The securities being substituted and
the original securities are specifically identified by date of
substitution, market values substituted, coupon rates, par amounts,
maturity dates and CUSIP or ISIN numbers; (2) substitution is made on a
``delivery versus delivery'' basis; and (3) the market value of the
substituted securities is at least equal to that of the original
securities.
    Proposed paragraph (e)(6) sets forth the payment and delivery
procedures for in-house transactions. Adapted from Rule 1.25(d)(8), the
provisions are designed to ensure that in-house transactions are
carried out in a manner that does not jeopardize the adequacy of funds
held in the customer segregated account.
    Proposed paragraph (e)(6)(i) governs transactions under proposed
paragraph (a)(3)(i). It provides that the transfer of securities to the
customer segregated custodial account must be made simultaneously with
the transfer of money from the customer segregated cash account. Money
held in the customer segregated cash account cannot be disbursed prior
to the transfer of securities to the customer segregated custodial
account. Any transfer of securities to the customer segregated
custodial account cannot be recognized as accomplished until the
securities are actually received by the custodian of such account. Upon
unwinding of the transaction, the customer segregated cash account must
receive same-day funds credited to such account simultaneously with the
delivery or transfer of securities from the customer segregated
custodial account.
    Proposed paragraph (e)(6)(ii) governs transactions under proposed
paragraph (a)(3)(ii). It provides that the transfer of securities to
the customer segregated custodial account must be made simultaneously
with the transfer of securities from the customer segregated custodial
account. Securities held in the customer segregated custodial account
cannot be released prior to the transfer of securities to that account.
Any transfer of securities to the customer segregated custodial account
cannot be recognized as accomplished until the securities are actually
received by the custodian of such account. Upon unwinding of the
transaction, the customer segregated custodial account must receive the
securities simultaneously with the delivery or transfer of securities
from the customer segregated custodial account.
    Proposed paragraph (e)(6)(iii) governs transactions under proposed
paragraph (a)(3)(iii). It provides that the transfer of money to the
customer segregated cash account must be made simultaneously with the
transfer of securities from the customer segregated custodial account.
Securities held in the customer segregated custodial account cannot be
released prior to the transfer of money to the customer segregated cash
account. Any transfer of money to the customer segregated cash account
cannot be recognized as accomplished until the money is actually
received by the custodian of such account. Upon unwinding of the
transaction, the customer segregated custodial account must receive the
securities simultaneously with the disbursement of money from the
customer segregated cash account.
    Proposed paragraph (e)(7) provides that the FCM must maintain all
books and records with respect to the in-house transactions in
accordance with Rules 1.25, 1.27, 1.31, and 1.36, as well as the
applicable rules and regulations of the SEC. This clarifies the pre-
existing obligations of the FCM, and it is adapted from Rule
1.25(d)(10).
    Proposed paragraph (e)(8) incorporates the requirements of Rule
1.25(d)(11). It provides that an actual transfer of securities by book
entry must be made consistent with Federal or State commercial law, as
applicable. Moreover, at all times, securities transferred to the
customer segregated account are to be reflected as ``customer
property.''
    Proposed paragraph (e)(9) provides that, for purposes of Rules
1.25, 1.26, 1.27, 1.28 and 1.29, securities transferred to the customer
segregated account will be considered to be customer funds until the
money or securities for which they were exchanged are transferred back
to the customer segregated account. As a

[[Page 5583]]

result, in the event of the bankruptcy of the FCM, any securities
transferred to and held in the customer segregated account as a result
of an in-house transaction could be immediately transferred to another
FCM. This provision adapts, in part, the provisions set forth in Rule
1.25(d)(12).
    Proposed paragraph (e)(10) addresses the failure to return
customer-deposited securities to the customer segregated account.
Adapted from Rule 1.25(a)(2)(ii)(D), it provides that in the event the
FCM is unable to return to the customer any customer-deposited
securities used in an in-house transaction the FCM must act promptly to
ensure that there is no resulting direct or indirect cost or expense to
the customer.
    As explained above, under proposed paragraph (e)(5)(ii), the
Commission would apply the concentration limits for direct investments
to securities transferred to the customer segregated account as a
result of an in-house transaction. To effect this treatment, the
Commission proposes to amend Rule 1.25(b)(4) by adding a new paragraph
(iv) to provide that, for purposes of determining compliance with
applicable concentration limits, securities transferred to a customer
segregated account pursuant to Rule 1.25(a)(3) will be combined with
securities held by the FCM as direct investments. In adding this new
provision, the Commission would also redesignate existing paragraphs
(b)(4)(iv) and (v) as (b)(4)(v) and (vi), respectively.
    The Commission also proposes an additional technical amendment to
Rule 1.27 to clarify the applicability of recordkeeping requirements to
securities transferred to and from the customer custodial account
pursuant to repos and in-house transactions. Rule 1.27 provides that
each FCM that invests customer funds and each DCO that invests customer
funds of its clearing members' customers or option customers must keep
a record showing specified information. Among the items to be recorded
are the amount of money so invested (paragraph (a)(3)) and the date on
which such investments were liquidated or otherwise disposed of and the
amount of money received of such disposition, if any (paragraph
(a)(6)). The Commission proposes to insert, after the reference to
``amount of money'' the phrase ``or current market value of
securities.'' This would clarify that amounts recorded must include the
value of securities, as well as cash.

E. Rating Standards for MMMFs

    Rule 1.25 permits FCMs and DCOs to invest customer funds in MMMFs,
subject to certain standards set forth in the rule. Among those
standards is the requirement that MMMFs that are rated by a nationally
recognized statistical rating organization (``NRSRO'') must be rated at
the highest rating of the NRSRO.\23\ While the rule does not permit
investments in lower rated MMMFs, it does not prohibit investments in
unrated MMMFs. As a result, a rated MMMF that does not have the highest
rating is not acceptable as a permitted investment, but an unrated MMMF
is acceptable.\24\
---------------------------------------------------------------------------

    \23\ See Rule 1.25(b)(2)(i)(E).
    \24\ The Commission notes that a substantial percentage of
customer money invested in MMMFs is invested in unrated funds.
---------------------------------------------------------------------------

    The Commission has been asked to consider eliminating the rating
requirement for MMMFs. In particular, Federated Investors, Inc.,
(``Federated'') has expressed the view that the rating requirement
creates a competitive inequity for rated MMMFs that have yield and
portfolio characteristics similar to the unrated funds that are
commonly used by FCMs for investment of customer funds.\25\ According
to Federated, lower rated MMMFs, like many unrated MMMFs, do not
qualify for the highest rating by an NRSRO because they hold split-
rated and other securities in their portfolios, which are not approved
by the NRSROs for triple-A rated funds, and because the average
maturity of their portfolios may exceed 60 days.
---------------------------------------------------------------------------

    \25\ See letter from Melanie L. Fein, Goodwin Proctor LLP, on
behalf of Federated, dated April 8, 2004, available in the comment
file accompanying this proposed rulemaking, at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov.

---------------------------------------------------------------------------

    As an example of the competitive inequity, Federated points to its
Federated Prime Value Obligations Fund, a single-A rated fund that it
describes as having essentially the same yield and portfolio
characteristics as unrated competitors. Like unrated competitors, the
fund cannot receive a triple-A rating because it holds split-rated and
other securities in its portfolio, which are not approved by the NRSROs
for triple-A rated funds, and because the average maturity of its
portfolio may exceed 60 days. Because of the single-A rating, however,
the Prime Value Obligations Fund, unlike competing unrated funds,
cannot be used for investment of customer funds. Federated believes
that the fact that the fund is rated should make it a more acceptable
investment than an unrated fund.
    Federated asserts that the rating limitation does not provide
additional investor protections. It further argues that the investor
protections afforded by SEC Rule 2a-7 \26\ make the rating requirement
unnecessary. In this regard, Federated observes that the rule imposes
strict portfolio quality, diversification, and maturity standards,
which greatly limit the possibility of significant deviation between
the share price of a fund and its per share net asset value.
Additionally, Federated notes that MMMFs are subject to board oversight
regarding credit quality requirements and investment procedures.
---------------------------------------------------------------------------

    \26\ 17 CFR 270.2a-7.
---------------------------------------------------------------------------

    Rule 1.25(c) sets forth additional requirements for MMMFs.
Paragraph (c)(1) establishes SEC Rule 2a-7 as a basic standard of
adequacy. More specifically, paragraph (c)(1) provides that, generally,
the MMMF must be an investment company that is registered with the SEC
under the Investment Company Act of 1940 and that holds itself out to
investors as an MMMF in accordance with SEC Rule 2a-7.\27\
---------------------------------------------------------------------------

    \27\ A fund sponsor may petition for exemption from this
requirement, and the Commission may grant an exemption, if the fund
can demonstrate that it will operate in a manner designed to
preserve principal and to maintain liquidity. As discussed in
Section II.F. of this release, however, the Commission is proposing
to eliminate this exemption provision.
---------------------------------------------------------------------------

    It appears that the rating requirement for MMMFs under Rule
1.25(b)(2)(i)(E) is not essential in light of the other risk-limiting
provisions applicable to MMMFs under Rule 1.25 and SEC Rule 2a-7. In
consideration of the anomalous situation created by the use of unrated
funds as permitted investments, the Commission is proposing to amend
Rule 1.25(b)(2)(i)(E) to eliminate the rating requirement for MMMFs.

F. Registration Requirement for MMMFs

    As discussed above, Rule 1.25(c)(1) provides that, generally, an
MMMF must be an investment company that is registered with the SEC
under the Investment Company Act of 1940 and that holds itself out to
investors as an MMMF in accordance with SEC Rule 2a-7. Paragraph (c)(1)
further provides that an MMMF sponsor may petition the Commission for
an exemption from this requirement, and the Commission may grant such
an exemption if the MMMF can demonstrate that it will operate in a
manner designed to preserve principal and to maintain liquidity. The
exemption request must include a description of how the fund's
structure, operations and financial reporting are expected to differ
from the requirements in SEC Rule 2a-7 and applicable risk-limiting
provisions contained in Rule 1.25. In addition, the MMMF must specify
the information that it would

[[Page 5584]]

make available to the Commission on an on-going basis.
    The Commission has not received any formal exemption requests under
paragraph (c)(1), but it has received several informal inquiries. In
evaluating these inquiries, Commission staff have explored alternative
standards that could be used to ascertain whether an MMMF will operate
in a manner designed to preserve principal and to maintain liquidity
and, therefore, could be exempted. As a result of this exercise, it has
become apparent that establishing such standards presents substantial
practical and policy issues.
    For example, from a practical standpoint, granting an exemption
would require that the Commission, on a case-by-case basis, review a
particular MMMF's risk-limiting policies and procedures and determine
that, notwithstanding deviations from the Rule 2a-7 requirements, those
policies and procedures will operate to preserve principal and to
maintain liquidity. Moreover, if an exemption were granted, Commission
staff would have to maintain oversight over the exempt MMMF to
ascertain that it continues to operate in accordance with the
Commission's standards. The Commission believes that it would be
inefficient to devote substantial resources to the exemption process.
In addition, the Commission is concerned that this process could
produce inconsistent results and give rise to an uncertain framework
for regulatory oversight.
    From a policy standpoint, the Commission is concerned that by
granting an exemption, the Commission may be perceived as expressing a
view about the adequacy of an MMMF's overall risk-limiting policies and
procedures and, ultimately, upon the investment quality of any
particular MMMF. The Commission does not wish to provide, or be
perceived as providing, any such assurances to FCMs or DCOs that might
be interested in investing customer money in an exempt MMMF.
    In light of the above considerations, the Commission believes that
the exemptive process, in this situation, does not serve the best
interests of the futures industry or the public. Accordingly, the
Commission is proposing to amend paragraph (c)(1) to eliminate the
availability of an exemption for unregistered funds.\28\ While this
removes the possibility of adding certain MMMFs to the pool of
qualifying permitted investments, the Commission believes that this
potential loss would be mitigated by the availability of additional
MMMF investments under the Commission's proposed amendment to permit
investments in MMMFs that are rated below the top rating of an
NRSRO.\29\ The requirement that all MMMFs be registered and qualify as
SEC Rule 2a-7 funds, without exception, is consistent with the
Commission's reliance on SEC Rule 2a-7 standards in its proposal to
eliminate rating requirements for MMMFs.
---------------------------------------------------------------------------

    \28\ Related to this, the Commission also proposes a technical
amendment that would delete the reference to ``a fund exempted in
accordance with paragraph (c)(1) of this section'' at the end of
paragraph (c)(2).
    \29\ See discussion in Section II.E. of this release.
---------------------------------------------------------------------------

G. Auditability Standard for Investment Records

    Rule 1.27 sets forth recordkeeping requirements for FCMs and DCOs
in connection with the investment of customer funds under Rule 1.25.
More specifically, the rule lists the types of information that an FCM
or DCO must retain, subject to the further recordkeeping requirements
of Rule 1.31.
    The Commission proposes to amend Rule 1.27 by adding a new
provision to establish an auditability standard for pricing information
related to all instruments acquired through the investment of customer
funds. Such a standard will facilitate the maintenance of reliable and
readily available valuation information that can be properly audited.
This is particularly important with respect to instruments for which
historical valuation information may not be retrievable from third
party sources at the time of an audit.
    Accordingly, the Commission proposes to amend Rule 1.27 by adding a
new paragraph (a)(8), to require FCMs and DCOs to maintain supporting
documentation of the daily valuation of instruments acquired through
the investment of customer funds, including the valuation methodology
and third party information. Such supporting documentation must be
sufficient to enable auditors to verify information to external sources
and recalculate the valuation for a given instrument.
    The Commission requests comment on the practices and procedures
that FCMs and DCOs would have to implement in order to comply with such
a standard and whether compliance would require substantial operational
changes. To the extent that there may be issues regarding
implementation of procedures to facilitate auditability, the Commission
requests comment on how it should address those issues.

H. Additional Technical Amendments

1. Clarifying and Codifying MMMF Redemption Requirements
    The Commission currently permits FCMs and DCOs to invest customer
money in MMMFs in accordance with the standards set forth in Rule
1.25(c). Among those standards is the requirement that the MMMF be able
to redeem the interest of the FCM or DCO by the business day following
a redemption request. The Commission proposes to amend paragraph (c)(5)
to clarify that the MMMF must be legally obligated to redeem the
interest and make payment in satisfaction thereof by the business day
following the redemption request. In addition, the Commission proposes
a further amendment to codify previously articulated exceptions to the
next-day redemption requirement.
(i) Next-Day Redemption Requirement
    In response to inquires from participants in the futures and mutual
fund industries, the Commission proposes to amend paragraph (c)(5) to
clarify that next-day redemption and payment is mandatory. To effect
this, the Commission proposes to eliminate the language requiring that
the MMMF ``must be able to redeem an interest by the next business day
following a redemption request'' and to substitute in its place a
provision that requires the fund to ``be legally obligated to redeem an
interest and make payment in satisfaction thereof by the business day
following a redemption request.'' The revised language unambiguously
establishes the mandatory nature of the redemption obligation and also
clarifies the distinction between redemption (valuation) of MMMF
interests and actual payment for those redeemed interests.
    The Commission recognizes that the phrase, ``able to redeem,'' on
its face, could be interpreted to mean the MMMF must have the
capability to redeem, but need not have the obligation to redeem.
However, this is not the intended meaning of the provision.
    In adopting the next-day redemption requirement in December 2000,
the Commission responded to a public comment recommending that the one-
day liquidity requirement be extended to seven days to be consistent
with SEC requirements and the longer settlement time frames associated
with direct investments.\30\ The Commission explained its position as
follows:

    \30\ See 65 FR at 78003.

---------------------------------------------------------------------------

[[Page 5585]]

The Commission believes the one-day liquidity requirement for
investments in MMMFs is necessary to ensure that the funding
requirements of FCMs will not be impeded by a long liquidity time
frame. Since a material portion of an FCM's customer funds could well
be invested in a single MMMF, this is an important provision of the
rule. The Commission notes that, although sales of directly-owned
securities settle in longer than one-day time-frames, an FCM or
clearing organization could obtain liquidity by entering into a
repurchase transaction. Therefore, the Commission has retained the one-
day liquidity requirement imposed on investments in MMMFs and, in view
of the importance of this provision, has clarified that demonstration
that this requirement has been met may include either an appropriate
provision in the offering memorandum of the fund or a separate side
---------------------------------------------------------------------------
agreement between the fund and an FCM or clearing organization.\31\

    \31\ Id.
---------------------------------------------------------------------------

Thus, the next-day redemption requirement is not met even if an MMMF,
as a matter of practice, offers same-day or next-day redemption if
there is no binding obligation to do so.
    The second provision of paragraph (c)(5) suggests two ways in which
an FCM or DCO may demonstrate compliance with the next-day redemption
requirement, i.e., an appropriate provision in the fund's offering
memorandum or a separate side agreement between the fund and the FCM or
DCO. In view of the proposed changes in the first provision of
paragraph (c)(5), the Commission believes that it is not necessary to
specify ways in which an FCM or DCO can demonstrate that the
requirement has been met. The Commission therefore proposes to
eliminate the second provision and to substitute in its place a
provision that requires the FCM or DCO to retain documentation
demonstrating compliance with the next-day redemption requirement. Such
documentation can then be produced for audit purposes.
(ii) Exceptions to the Next-Day Redemption Requirement
    In response to an inquiry from the Board of Trade Clearing
Corporation in 2001, the Commission's Division of Trading and Markets
issued a letter stating that it would raise no issue in connection with
MMMFs that provide for certain exceptions to the practice of next-day
redemption.\32\
---------------------------------------------------------------------------

    \32\ See CFTC Staff Letter No. 01-31, [2000-2002 Transfer
Binder] Comm. Fut. L. Rep. (CCH) ]28,521 (Apr. 2, 2001).
---------------------------------------------------------------------------

    The letter specifically identified circumstances in which next-day
redemption could be excused: (1) Non-routine closure of the Fedwire or
applicable Federal Reserve Banks; (2) non-routine closure of the New
York Stock Exchange or general market conditions leading to a broad
restriction of trading on the New York Stock Exchange, i.e., a
restriction of trading due to market-wide events; or (3) declaration of
a market emergency by the SEC. The letter also included a catch-all
provision that included emergency conditions set forth in Section 22(e)
of the Investment Company Act of 1940.\33\
---------------------------------------------------------------------------

    \33\ 15 U.S.C. 80a-22(e).
---------------------------------------------------------------------------

    The Commission proposes to codify these exceptions in new paragraph
(c)(5)(ii) and, in so doing, to redesignate the existing paragraph
(c)(5), as amended, as paragraph (c)(5)(i). The Commission recognizes
that there is some overlap between the enumerated exceptions and those
contained in Section 22(e), but it believes that this is appropriate
given the need to provide for all relevant circumstances.
2. Clarifying Rating Standards for Certificates of Deposit
    Rule 1.25(b)(2)(i)(B) sets forth the rating requirements for
municipal securities, GSE securities, commercial paper, corporate notes
that are not asset-backed, and certificates of deposit.\34\ The
Commission notes that certificates of deposit, unlike the other
instruments listed in that paragraph, are not directly rated by an
NRSRO.
---------------------------------------------------------------------------

    \34\ More specifically, Rule 1.25(b)(2)(i)(B) provides as
follows: ``Municipal securities, government sponsored agency
securities, certificates of deposit, commercial paper, and corporate
notes, except notes that are asset-backed, must have the highest
short-term rating of an NRSRO or one of the two highest long-term
ratings of an NRSRO.''
---------------------------------------------------------------------------

    Because NRSRO ratings reflect the financial strength of the issuer
of an instrument, they offer a useful standard, among others, for
determining whether an instrument can be a permitted investment for
customer money. Although certificates of deposit are not rated by
NRSROs, it is possible to apply a rating standard by using, as a proxy,
the ratings of other instruments issued by the issuers of certificates
of deposit. For example, the Commission has previously taken this
approach in establishing standards for foreign depository institutions
that may hold customer funds. In this regard, Rule 1.49(d)(3)(i)
provides that, in order to hold customer funds, a bank or trust company
located outside the United States must satisfy either of the following
requirements: (1) It must have in excess of $1 billion of regulatory
capital; or (2) the bank or trust company's commercial paper or long-
term debt instrument, or if the institution is part of a holding
company system, its holding company's commercial paper or long-term
debt instrument, must be rated in one of the two highest rating
categories by at least one NRSRO.
    Consistent with this approach, the Commission believes that it is
appropriate to use, as a proxy for a certificate of deposit rating,
NRSRO ratings for the commercial paper or long-term debt instrument of
the issuer of the certificate of deposit or such issuer's parent
holding company. Accordingly, the Commission proposes to delete the
reference to certificates of deposit in paragraph (b)(2)(i)(B) of Rule
1.25 and insert a new paragraph (E) that would apply the same standard
contained in paragraph (b)(2)(i)(B) to the commercial paper or long-
term debt instrument issued by the certificate of deposit issuer or its
holding company.
3. Clarifying Corporate Bonds as Permitted Investments
    Paragraph (a)(vi) currently uses the term ``corporate note,'' which
may be interpreted by some market participants to mean obligations
whose original term to maturity does not exceed five years or perhaps
ten years. However, the Commission proposes to clarify that this is not
its intent by amending paragraphs (a)(1)(vi), (b)(2)(i)(B) and (C), and
(b)(4)(i)(C) to use the term ``corporate notes or bonds.'' Rather than
constrain the types of permitted investments on the basis of their
original term to maturity, the Commission has addressed the issue of
the greater price sensitivity of longer-term and fixed rate instruments
to changes in prevailing interest rates by adopting the portfolio time-
to-maturity requirements of paragraph (b)(5); thus, it is the remaining
term to maturity that is relevant.
4. Clarifying References to Transferred Securities
    Rule 1.25(a)(2) permits FCMs and DCOs to enter into repos using
customer-deposited securities and securities that are permitted
investments purchased with customer money. Such transactions are
subject to the provisions of paragraph (d) of Rule 1.25. Among those
provisions is paragraph (d)(6), which requires that the ``securities
transferred under the

[[Page 5586]]

agreement'' must be held in a safekeeping account with a bank, a DCO,
or the Depository Trust Company in an account that complies with the
requirements of Rule 1.26.
    The Commission has been asked whether the reference to ``securities
transferred under the agreement'' is intended to include not only in-
coming securities, but out-going securities as well. Such an
interpretation would mean that any out-going securities, in addition to
any in-coming cash, would have to be held in a customer segregated
account in accordance with Rule 1.26.\35\ This is not the intended
outcome, and the Commission therefore is proposing to amend paragraph
(d)(6) to clarify that Rule 1.26 applies only to securities transferred
to (not from) an FCM or DCO.\36\
---------------------------------------------------------------------------

    \35\ Rule 1.26 addresses the treatment of instruments purchased
with customer funds, but does not address the treatment of cash
received by an FCM or DCO pursuant to a repo. The Commission
believes that it is not necessary to specify in Rule 1.26 that cash
acquired in exchange for securities under a repo must be held in a
customer segregated cash account because this requirement is clear
from the language of Section 4d(a)(2) of the Act.
    \36\ The Commission notes that with respect to the in-house
transactions discussed in Section II.D. of this release, proposed
Rule 1.25(e)(5)(iii) specifically provides that securities
transferred to the customer segregated account as a result of the
transaction must be held in a safekeeping account with a bank, a
DCO, or the Depository Trust Company in an account that complies
with the requirements of Rule 1.26.
---------------------------------------------------------------------------

    The Commission also is proposing technical amendments to paragraphs
(d)(3) and (d)(11) to similarly clarify that the securities referred to
in those provisions are securities transferred to (not from) the
customer segregated custodial account of an FCM or DCO.
5. Clarifying Payment and Delivery Procedures for Reverse Repos and
Repos
    The Commission is proposing to amend paragraph (d)(8) to clarify
payment and delivery procedures for reverse repos and repos. Paragraph
(d)(8) currently provides that the ``transfer of securities'' must be
made on a delivery versus payment basis in immediately available funds.
The Commission proposes to amend this provision to clarify that the
delivery versus payment requirement applies to the transfer of
securities to (not from) the customer segregated custodial account, as
would be the case in a reverse repo. The Commission further proposes to
add a sentence clarifying that the transfer of funds to the customer
segregated cash account, as would be the case in a repo, must be made
on a payment versus delivery basis.
    The Commission requests comment on whether these amendments
accurately reflect the current practices of FCMs and DCOs and, if not,
how existing business practices operate to otherwise enable FCMs and
DCOs engaging in repurchase transactions to maintain the proper amount
of funds in segregated accounts at all times.
6. Changing Paragraph (a)(1) ``Customer Funds'' to ``Customer Money''
    Rule 1.25(a)(1) authorizes FCMs and DCOs to invest ``customer
funds'' in enumerated permitted investments. Paragraph (a)(1) uses the
term ``customer funds'' to describe customer money deposited with an
FCM or a DCO to margin futures or options positions. Because the term
``customer funds'' is otherwise defined in Rule 1.3(gg) to include more
than customer money, the Commission proposes to amend paragraph (a)(1)
to substitute the term ``customer money'' for the term ``customer
funds.''
    The word ``money'' is used in Section 4d(a)(2) of the Act with
reference to permitted investments, and the term ``customer money'' was
originally used in Rule 1.25. The term was changed to ``customer
funds'' in 1968 when the Commission's predecessor agency, the Commodity
Exchange Authority, adopted revisions to conform the rule to amendments
to Section 4d of the Act.\37\ No explanation was given for the change
in terminology.
---------------------------------------------------------------------------

    \37\ 33 FR 14455 (Sept. 26, 1968).
---------------------------------------------------------------------------

    Subsequently, in 1981, the Commission adopted a definition of
``customer funds'' in Rule 1.3(gg), when it adopted rules related to
futures options.\38\ That term encompasses more than money, and
includes securities and other property belonging to the customer.
---------------------------------------------------------------------------

    \38\ 46 FR 33312 (June 29, 1981).
---------------------------------------------------------------------------

    Substituting the term ``customer money'' for the term ``customer
funds'' in paragraph (a)(1) conforms the language of that paragraph to
the language of Section 4d(a)(2) of the Act and clarifies the meaning
of the term in relation to other provisions of Rule 1.25. The need for
this proposed change in terminology arises in the context of
distinguishing between customer money and customer-deposited
securities, which are the subject of Rule 1.25(a)(2)(ii) (repos with
customer-deposited securities) and proposed Rule 1.25(a)(3)(ii) and
(iii) (in-house transactions with customer-deposited securities).
7. Conforming Reference to ``Marketability'' Requirement
    Rule 1.25(a)(2)(ii), which permits FCMs and DCOs to sell customer-
deposited securities pursuant to repos, sets forth various requirements
for such transactions. Among them is the requirement, under paragraph
(a)(2)(ii)(A), that securities subject to repurchase must meet the
marketability requirement contained in paragraph (b)(1) of Rule 1.25.
Paragraph (b)(1), in turn, cross-references the marketability
requirement contained in SEC Rule 15c3-1. For purposes of clarity, the
Commission proposes to amend Rule 1.25(a)(2)(ii)(A) to eliminate the
cross-reference to paragraph (b)(1) and substitute that paragraph's
direct cross-reference to SEC Rule 15c3-1.
8. Conforming Terminology for ``Derivatives Clearing Organizations''
    Rule 1.25 uses the term ``clearing organization'' to describe an
entity that performs clearing functions. The Act, as amended by the
Commodity Futures Modernization Act of 2000,\39\ now provides that a
clearing organization for a contract market must register as a
``derivatives clearing organization'' and must comply with core
principles set forth in the statute.\40\ The Commission proposes
technical amendments to Rule 1.25 to change the term ``clearing
organization'' to ``derivatives clearing organization.'' This will
conform the language of Rule 1.25 to the language of the Act, more
accurately reflecting the current statutory framework.
---------------------------------------------------------------------------

    \39\ Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).
    \40\ See Section 5b of the Act, 7 U.S.C. 7a-1. See also Section
1a(9) of the Act, 7 U.S.C. 1a(9) (defining the term ``derivatives
clearing organization'').
---------------------------------------------------------------------------

    As an additional matter, in connection with its proposed technical
amendments to Rule 1.27,\41\ the Commission also proposes to change the
term ``clearing organization'' to ``derivatives clearing organization''
in that rule.
---------------------------------------------------------------------------

    \41\ See Section II.D. of this release.
---------------------------------------------------------------------------

9. Conforming Terminology for ``Government Sponsored Enterprise''
    The Commission is also proposing a technical amendment to Rule 1.25
to change terminology referring to government sponsored ``agency''
securities to government sponsored ``enterprise'' securities. This
would conform the language in the rule to the terminology commonly used
in the marketplace. This change would be reflected in the list of
permitted investments (paragraph (a)(1)(iii)), the rating requirements
(paragraph

[[Page 5587]]

(b)(2)(i)(B)), and the concentration limits (paragraph (b)(4)(i)(B)).
10. Conforming Terminology for ``Futures Commission Merchant''
    The Commission is proposing a technical amendment to Rule 1.25 to
substitute the term ``futures commission merchant'' for the acronym,
``FCM,'' as used in paragraph (c)(3). This would provide conformity in
the use of the term futures commission merchant throughout the rule.
11. Clarifying the Meaning of ``NRSRO''
    Rule 1.25(b)(2) sets forth the rating requirements for permitted
investments. The rule refers to ratings by an ``NRSRO,'' the acronym
for a ``nationally recognized statistical rating organization.'' The
Commission proposes to amend paragraph (b)(2)(i) to formally set forth
the acronym as a defined term and to cross-reference the definition of
that term contained in SEC Rule 2a-7.

III. Time to Maturity--Treasury Portfolio

    Rule 1.25(b)(5) limits the dollar-weighted average of the time to
maturity for permitted investments to no longer than 24 months. In
expanding the range of permitted investments in December 2000, the
Commission added this requirement as a means for addressing the greater
market risk associated with longer-term and fixed rate instruments.
    In June 2003, the Commission requested comment on the applicability
of time-to-maturity requirements for an FCM that invests solely in
obligations of the U.S. Treasury. It had been suggested that, because
Treasury securities do not pose the same credit risks as other
permitted investments, the time-to-maturity limitation should not
apply. The Commission requested comment specifically on whether an
alternate safeguard to limit risk, such as appropriate haircuts, would
be more meaningful than the time-to-maturity requirement of Rule
1.25(b)(5).
    Both the FIA and NFA supported the elimination of the time-to-
maturity requirement for a portfolio of securities consisting solely of
Treasury instruments. The FIA observed that, prior to the adoption of
the December 2000 amendments to Rule 1.25, an FCM could invest customer
money exclusively in Treasury securities without regard to the dollar-
weighted time to maturity of such instruments. Acknowledging that a
portfolio consisting solely of long-dated Treasury instruments is not
without (market) risk, the FIA concluded that these risks are addressed
by the Commission's minimum financial requirements, pursuant to which
the haircuts on Treasury instruments increase as the time to maturity
increases.\42\ However, the Commission believes that a situation in
which an FCM would have to turn to its own capital to meet its
obligations to a clearing organization or customers is far less
desirable than one in which an FCM is able to quickly convert assets
acquired with customer funds into cash at a predictable value.
---------------------------------------------------------------------------

    \42\ See 17 CFR 1.17(c)(5)(v).
---------------------------------------------------------------------------

    The NFA, while noting that Treasury instruments do not pose the
same (credit) risks as other permitted investments, stated its belief
that these instruments should be subject to haircuts. However, the
introduction of haircut requirements into the segregation calculations
would be unprecedented, could involve substantial operational
challenges or costs for FCMs, and has not otherwise been proposed or
determined to be appropriate.
    The Commission believes that the time-to-maturity requirement added
by the December 2000 amendments remains an important constraint on the
greater market risk inherent with longer-term and fixed rate
instruments in a portfolio of customer funds. Rule 1.25(b)(5) requires
the calculation of portfolio time-to-maturity as that average is
computed pursuant to SEC Rule 2a-7 for MMMFs.\43\ It should be noted
that this calculation addresses floating rate government securities and
variable rate government securities that are adjusted at least every
two years by deeming the time to maturity for such instruments to be,
respectively, either one day or the time remaining to the next variable
rate adjustment.\44\ The Commission believes this approach properly
considers the lower relative price sensitivities of short-term versus
long-term instruments and adjustable rate (floating or variable) versus
fixed rate instruments.
---------------------------------------------------------------------------

    \43\ See 17 CFR 270.2a-7.
    \44\ See discussion of the terms ``floating rate security'' and
``variable rate security'' in Section II.B.3. of this release.
---------------------------------------------------------------------------

    Accordingly, the Commission continues to believe that application
of this requirement to all portfolios, including those consisting
solely of Treasuries or other government securities, does not unduly or
improperly restrict an FCM's investment flexibility under Rule 1.25.
Thus, the Commission has determined that it will not propose any
changes to its time-to-maturity requirement for portfolios consisting
solely of Treasury securities. The Commission would be pleased to
receive comments on this decision from any interested persons.

IV. Section 4(c)

    Section 4(c) of the Act \45\ provides that, in order to promote
responsible economic or financial innovation and fair competition, the
Commission, by rule, regulation or order, after notice and opportunity
for hearing, may exempt any agreement, contract, or transaction, or
class thereof, including any person or class of persons offering,
entering into, rendering advice or rendering other services with
respect to, the agreement, contract, or transaction, from the contract
market designation requirement of Section 4(a) of the Act, or any other
provision of the Act other than Section 2(a)(1)(C)(ii) or (D), if the
Commission determines that the exemption would be consistent with the
public interest.
---------------------------------------------------------------------------

    \45\ 7 U.S.C. 6(c).
---------------------------------------------------------------------------

    The proposed rules would be promulgated under Section 4d(a)(2) of
the Act,\46\ which governs investment of customer funds. Section
4d(a)(2) provides that customer money may be invested in obligations of
the United States, in general obligations of any State or of any
political subdivision thereof, and in obligations fully guaranteed as
to principal and interest by the United States. It further provides
that such investments must be made in accordance with such rules and
regulations and subject to such conditions as the Commission may
prescribe.
---------------------------------------------------------------------------

    \46\ 7 U.S.C. 6d(a)(2).
---------------------------------------------------------------------------

    The Commission proposes to expand the range of instruments in which
FCMs may invest customer funds beyond those listed in Section 4d(a)(2)
of the Act (i.e., securities with embedded derivatives and MMMFs rated
below the highest rating of an NRSRO), to enhance the yield available
to FCMs, DCOs, and their customers without compromising the safety of
customer funds. These proposed rules should enable FCMs and DCOs to
remain competitive globally and domestically, while maintaining
safeguards against systemic risk.
    In light of the foregoing, the Commission believes that the
adoption of the proposed rules regarding the expansion of permitted
instruments for the investment of customer funds would promote
responsible economic and financial innovation and fair competition, and
would be consistent with the ``public interest,'' as that term is used
in Section 4(c) of the Act.
    The Commission solicits public comment on whether the proposed
rules

[[Page 5588]]

satisfy the requirements for exemption under Section 4(c) of the Act.

V. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') \47\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small businesses. The rule amendments adopted herein will affect
FCMs and DCOs. The Commission has previously established certain
definitions of ``small entities'' to be used by the Commission in
evaluating the impact of its rules on small entities in accordance with
the RFA.\48\ The Commission has previously determined that registered
FCMs \49\ and DCOs \50\ are not small entities for the purpose of the
RFA. Accordingly, pursuant to 5 U.S.C. 605(b), the Acting Chairman, on
behalf of the Commission, certifies that the proposed rules will not
have a significant economic impact on a substantial number of small
entities.
---------------------------------------------------------------------------

    \47\ 5 U.S.C. 601 et seq.
    \48\ 47 FR 18618 (Apr. 30, 1982).
    \49\ Id. at 18619.
    \50\ 66 FR 45604, 45609 (Aug. 29, 2001).
---------------------------------------------------------------------------

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') imposes certain
requirements on Federal agencies (including the Commission) in
connection with their conducting or sponsoring any collection of
information as defined by the PRA. The proposed rule amendments do not
require a new collection of information on the part of any entities
subject to the proposed rule amendments. Accordingly, for purposes of
the PRA, the Commission certifies that these proposed rule amendments,
if promulgated in final form, would not impose any new reporting or
recordkeeping requirements.

C. Costs and Benefits of the Proposed Rules

    Section 15(a) of the Act requires that the Commission, before
promulgating a regulation under the Act or issuing an order, consider
the costs and benefits of its action. By its terms, Section 15(a) does
not require the Commission to quantify the costs and benefits of a new
rule or determine whether the benefits of the rule outweigh its costs.
Rather, Section 15(a) simply requires the Commission to ``consider the
costs and benefits'' of its action.
    Section 15(a) further specifies that costs and benefits shall be
evaluated in light of the following considerations: (1) Protection of
market participants and the public; (2) efficiency, competitiveness,
and financial integrity of futures markets; (3) price discovery; (4)
sound risk management practices; and (5) other public interest
considerations. Accordingly, the Commission could, in its discretion,
give greater weight to any one of the five considerations and could, in
its discretion, determine that, notwithstanding its costs, a particular
rule was necessary or appropriate to protect the public interest or to
effectuate any of the provisions or to accomplish any of the purposes
of the Act.
    The Commission has evaluated the costs and benefits of the proposed
rules in light of the specific considerations identified in Section
15(a) of the Act, as follows:
    1. Protection of market participants and the public. The proposed
rules facilitate greater capital efficiency for FCMs and DCOs, while
protecting customers by establishing prudent standards for investment
of customer funds. Several of the proposed amendments narrow and refine
earlier standards based on industry and Commission experience since the
December 2000 rulemaking in which Rule 1.25 was substantially revised
and expanded. In this regard, for example, the proposed amendments
relating to the mandatory registration requirement for MMMFs and
auditability standard for investment records establish stricter
standards. Similarly, proposed amendments that expand investment
opportunities for FCMs and DCOs, such as those permitting investment in
instruments with embedded derivatives, carefully circumscribe the
activity in order to protect the customer segregated account.
    2. Efficiency, competitiveness, and financial integrity of futures
markets. The proposed rules will facilitate greater efficiency and
competitiveness for FCMs and DCOs, but they will not affect the
efficiency and competitiveness of futures markets. The proposed
amendments will not affect the financial integrity of futures markets.
    3. Price discovery. The proposed amendments will not affect price
discovery.
    4. Sound risk management practices. The proposed amendments impose
sound risk management practices upon FCMs and DCOs that invest customer
funds under the rules. They balance the need for investment flexibility
with the need to preserve customer funds. For example, while proposing
to permit FCM/BDs to engage in in-house transactions, the Commission
sets forth specific requirements for such transactions. These include
standards relating to the type of securities that may be transferred to
the customer segregated account, treatment of those securities when
held in the account, and procedures for effecting transactions.
Proposed requirements are designed to ensure that at no time will in-
house transactions cause the customer segregated account to fall below
a sufficient level. Certain other proposed amendments, such as the
registration requirement for MMMFs and clarification as to mandatory
next-day redemption and payment for MMMF interests, strengthen risk
management standards that are already in place.
    5. Other public considerations. The proposed amendments reflect
industry and Commission experience with Rule 1.25 since the rule was
expanded in December 2000. They provide FCMs and DCOs with greater
flexibility in making investments with customer funds, while
strengthening the rules that protect the safety of such funds and
preserve the rights of customers. For example, the proposed amendments
governing in-house transactions provide FCM/BDs with an efficient and
cost-effective method for maximizing investment opportunities within
the confines of strict risk management requirements. Similarly, the
proposed amendments expand the range of investments to include certain
instruments with embedded derivatives and MMMFs of any rating, and
enable FCMs and DCOs to consider a broader range of investment
possibilities within prescribed limitations.
    The proposed amendments are expected to enhance the ability of FCMs
and DCOs to earn revenue from the investment of customer funds, while
maintaining safeguards against systemic risk. FCMs and DCOs choosing to
make such investments will bear all costs associated with their
investments.
    Accordingly, after considering the five factors enumerated in the
Act, the Commission has determined to propose the rules and rule
amendments set forth below. The Commission invites public comment on
its application of the cost-benefit provision. Commenters also are
invited to submit, with their comment letters, any data that quantifies
the costs and benefits of the proposal.

Lists of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.

    In consideration of the foregoing and pursuant to the authority
contained in the Commodity Exchange Act, in particular, Sections 4d,
4(c), and 8a(5) thereof, 7 U.S.C. 6d, 6(c) and 12a(5), respectively,
the Commission hereby proposes to amend Chapter I of Title 17

[[Page 5589]]

of the Code of Federal Regulations as follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

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

    Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h,
6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a,
13a-1, 16, 16a, 19, 21, 23, and 24, as amended by the Commodity
Futures Modernization Act of 2000, Appendix E of Public Law 106-554,
114 Stat. 2763 (2000).

    2. Section 1.25 is proposed to be revised to read as follows:


Sec.  1.25  Investment of customer funds.

    (a) Permitted investments. (1) Subject to the terms and conditions
set forth in this section, a futures commission merchant or a
derivatives clearing organization may invest customer money in the
following instruments (permitted investments):
    (i) Obligations of the United States and obligations fully
guaranteed as to principal and interest by the United States (U.S.
government securities);
    (ii) General obligations of any State or of any political
subdivision thereof (municipal securities);
    (iii) General obligations issued by any enterprise sponsored by the
United States (government sponsored enterprise securities);
    (iv) Certificates of deposit issued by a bank (certificates of
deposit) as defined in section 3(a)(6) of the Securities Exchange Act
of 1934, or a domestic branch of a foreign bank that carries deposits
insured by the Federal Deposit Insurance Corporation;
    (v) Commercial paper;
    (vi) Corporate notes or bonds;
    (vii) General obligations of a sovereign nation; and
    (viii) Interests in money market mutual funds.
    (2)(i) In addition, a futures commission merchant or derivatives
clearing organization may buy and sell the permitted investments listed
in paragraphs (a)(1)(i) through (viii) of this section pursuant to
agreements for resale or repurchase of the instruments, in accordance
with the provisions of paragraph (d) of this section.
    (ii) A futures commission merchant or a derivatives clearing
organization may sell securities deposited by customers as margin
pursuant to agreements to repurchase subject to the following:
    (A) Securities subject to such repurchase agreements must be
``readily marketable'' as defined in Sec.  240.15c3-1 of this title.
    (B) Securities subject to such repurchase agreements must not be
``specifically identifiable property'' as defined in Sec.  190.01(kk)
of this chapter.
    (C) The terms and conditions of such an agreement to repurchase
must be in accordance with the provisions of paragraph (d) of this
section.
    (D) Upon the default by a counterparty to a repurchase agreement,
the futures commission merchant or derivatives clearing organization
shall act promptly to ensure that the default does not result in any
direct or indirect cost or expense to the customer.
    (3) In addition, subject to the provisions of paragraph (e) of this
section, a futures commission merchant that is also registered with the
Securities and Exchange Commission as a securities broker or dealer
pursuant to section 15(b)(1) of the Securities and Exchange Act of 1934
may enter into transactions in which:
    (i) Customer money is exchanged for securities that are permitted
investments and are held by the futures commission merchant in
connection with its securities broker or dealer activities;
    (ii) Securities deposited by customers as margin are exchanged for
securities that are permitted investments and are held by the futures
commission merchant in connection with its securities broker or dealer
activities; or
    (iii) Securities deposited by customers as margin are exchanged for
cash that is held by the futures commission merchant in connection with
its securities broker or dealer activities.
    (b) General terms and conditions. A futures commission merchant or
a derivatives clearing organization is required to manage the permitted
investments consistent with the objectives of preserving principal and
maintaining liquidity and according to the following specific
requirements:
    (1) Marketability. Except for interests in money market mutual
funds, investments must be ``readily marketable'' as defined in Sec.
240.15c3-1 of this title.
    (2) Ratings. (i) Initial requirement. Instruments that are required
to be rated by this section must be rated by a nationally recognized
statistical rating organization (NRSRO), as that term is defined in
Sec.  270.2a-7 of this title. For an investment to qualify as a
permitted investment, ratings are required as follows:
    (A) U.S. government securities and money market mutual funds need
not be rated;
    (B) Municipal securities, government sponsored enterprise
securities, commercial paper, and corporate notes or bonds, except
notes or bonds that are asset-backed, must have the highest short-term
rating of an NRSRO or one of the two highest long-term ratings of an
NRSRO;
    (C) Corporate notes or bonds that are asset-backed must have the
highest ratings of an NRSRO;
    (D) Sovereign debt must be rated in the highest category by at
least one NRSRO; and
    (E) With respect to certificates of deposit, the commercial paper
or long-term debt instrument of the issuer of a certificate of deposit
or, if the issuer is part of a holding company system, its holding
company's commercial paper or long-term debt instrument, must have the
highest short-term rating of an NRSRO or one of the two highest long-
term ratings of an NRSRO.
    (ii) Effect of downgrade. If an NRSRO lowers the rating of an
instrument that was previously a permitted investment on the basis of
that rating to below the minimum rating required under this section,
the value of the instrument recognized for segregation purposes will be
the lesser of:
    (A) The current market value of the instrument; or
    (B) The market value of the instrument on the business day
preceding the downgrade, reduced by 20 percent of that value for each
business day that has elapsed since the downgrade.
    (3) Restrictions on instrument features. (i) With the exception of
money market mutual funds, no permitted investment may contain an
embedded derivative of any kind, except as follows:
    (A) The issuer of an instrument otherwise permitted by this section
may have an option to call, in whole or in part, at par, the principal
amount of the instrument before its stated maturity date; or
    (B) An instrument that meets the requirements of paragraph
(b)(3)(iv) of this section may provide for a cap, floor, or collar on
the interest paid; provided, however, that the terms of such instrument
obligate the issuer to repay the principal amount of the instrument at
not less than par value upon maturity.
    (ii) No instrument may contain interest-only payment features.
    (iii) No instrument may provide payments linked to a commodity,
currency, reference instrument, index, or benchmark except as provided
in paragraph (b)(3)(iv) of this section, and it may not otherwise
constitute a derivative instrument.
    (iv) (A) Adjustable rate securities are permitted, subject to the
following requirements:

[[Page 5590]]

    (1) The interest payments on variable rate securities must
correlate closely and on an unleveraged basis to a benchmark of either
the Federal Funds target or effective rate, the prime rate, the three-
month Treasury Bill rate, or the one-month or three-month LIBOR rate;
    (2) The interest payment, in any period, on floating rate
securities must be determined solely by reference, on an unleveraged
basis, to a benchmark of either the Federal Funds target or effective
rate, the prime rate, the three-month Treasury Bill rate, the one-month
or three-month LIBOR rate, or the interest rate of any fixed rate
instrument that is a permitted investment listed in paragraph (a)(1) of
this section;
    (3) Benchmark rates must be expressed in the same currency as the
adjustable rate securities that reference them; and
    (4) No interest payment on an adjustable rate security, in any
period, can be a negative amount.
    (B) For purposes of this paragraph, the following definitions shall
apply:
    (1) The term adjustable rate security means, a floating rate
security, a variable rate security, or both.
    (2) The term floating rate security means a security, the terms of
which provide for the adjustment of its interest rate whenever a
specified interest rate changes and that, at any time until the final
maturity of the instrument or the period remaining until the principal
amount can be recovered through demand, can reasonably be expected to
have a market value that approximates its amortized cost.
    (3) The term variable rate security means a security, the terms of
which provide for the adjustment of its interest rate on set dates
(such as the last day of a month or calendar quarter) and that, upon
each adjustment until the final maturity of the instrument or the
period remaining until the principal amount can be recovered through
demand, can reasonably be expected to have a market value that
approximates its amortized cost.
    (v) Certificates of deposit, if negotiable, must be able to be
liquidated within one business day or, if not negotiable, must be
redeemable at the issuing bank within one business day, with any
penalty for early withdrawal limited to any accrued interest earned
according to its written terms.
    (4) Concentration. (i) Direct investments. (A) U.S. Government
securities and money market mutual funds shall not be subject to a
concentration limit or other limitation.
    (B) Securities of any single issuer of government sponsored
enterprise securities held by a futures commission merchant or
derivatives clearing organization may not exceed 25 percent of total
assets held in segregation by the futures commission merchant or
derivatives clearing organization.
    (C) Securities of any single issuer of municipal securities,
certificates of deposit, commercial paper, or corporate notes or bonds
held by a futures commission merchant or derivatives clearing
organization may not exceed 5 percent of total assets held in
segregation by the futures commission merchant or derivatives clearing
organization.
    (D) Sovereign debt is subject to the following limits: A futures
commission merchant may invest in the sovereign debt of a country to
the extent it has balances in segregated accounts owed to its customers
denominated in that country's currency; a derivatives clearing
organization may invest in the sovereign debt of a country to the
extent it has balances in segregated accounts owed to its clearing
member futures commission merchants denominated in that country's
currency.
    (ii) Repurchase agreements. For purposes of determining compliance
with the concentration limits set forth in this section, securities
sold by a futures commission merchant or derivatives clearing
organization subject to agreements to repurchase shall be combined with
securities held by the futures commission merchant or derivatives
clearing organization as direct investments.
    (iii) Reverse repurchase agreements. For purposes of determining
compliance with the concentration limits set forth in this section,
securities purchased by a futures commission merchant or derivatives
clearing organization subject to agreements to resell shall be combined
with securities held by the futures commission merchant or derivatives
clearing organization as direct investments.
    (iv) Transactions under paragraph (a)(3). For purposes of
determining compliance with the concentration limits set forth in this
section, securities transferred to a customer segregated account
pursuant to paragraphs (a)(3)(i) or (a)(3)(ii) of this section shall be
combined with securities held by the futures commission merchant as
direct investments.
    (v) Treatment of securities issued by affiliates. For purposes of
determining compliance with the concentration limits set forth in this
section, securities issued by entities that are affiliated, as defined
in paragraph (b)(6) of this section, shall be aggregated and deemed the
securities of a single issuer. An interest in a permitted money market
mutual fund is not deemed to be a security issued by its sponsoring
entity.
    (vi) Treatment of customer-owned securities. For purposes of
determining compliance with the concentration limits set forth in this
section, securities owned by the customers of a futures commission
merchant and posted as margin collateral are not included in total
assets held in segregation by the futures commission merchant, and
securities posted by a futures commission merchant with a derivatives
clearing organization are not included in total assets held in
segregation by the derivatives clearing organization.
    (5) Time-to-maturity. (i) Except for investments in money market
mutual funds, the dollar-weighted average of the time-to-maturity of
the portfolio, as that average is computed pursuant to Sec.  270.2a-7
of this title, may not exceed 24 months.
    (ii) For purposes of determining the time-to-maturity of the
portfolio, an instrument that is set forth in paragraphs (a)(1)(i)
through (vii) of this section may be treated as having a one-day time-
to-maturity if the following terms and conditions are satisfied:
    (A) The instrument is deposited solely on an overnight basis with a
derivatives clearing organization pursuant to the terms and conditions
of a collateral management program that has become effective in
accordance with Sec.  39.4 of this chapter;
    (B) The instrument is one that the futures commission merchant owns
or has an unqualified right to pledge, is not subject to any lien, and
is deposited by the futures commission merchant into a segregated
account at a derivatives clearing organization;
    (C) The derivatives clearing organization prices the instrument
each day based on the current mark-to-market value; and
    (D) The derivatives clearing organization reduces the assigned
value of the instrument each day by a haircut of at least 2 percent.
    (6) Investments in instruments issued by affiliates. (i) A futures
commission merchant shall not invest customer funds in obligations of
an entity affiliated with the futures commission merchant, and a
derivatives clearing organization shall not invest customer funds in
obligations of an entity affiliated with the derivatives clearing
organization. An affiliate includes parent companies, including all
entities through the ultimate holding company, subsidiaries to the
lowest level, and companies under common ownership of such parent
company or affiliates.

[[Page 5591]]

    (ii) A futures commission merchant or derivatives clearing
organization may invest customer funds in a fund affiliated with that
futures commission merchant or derivatives clearing organization.
    (7) Recordkeeping. A futures commission merchant and a derivatives
clearing organization shall prepare and maintain a record that will
show for each business day with respect to each type of investment made
pursuant to this section, the following information:
    (i) The type of instruments in which customer funds have been
invested;
    (ii) The original cost of the instruments; and
    (iii) The current market value of the instruments.
    (c) Money market mutual funds. The following provisions will apply
to the investment of customer funds in money market mutual funds (the
fund).
    (1) The fund must be an investment company that is registered under
the Investment Company Act of 1940 with the Securities and Exchange
Commission and that holds itself out to investors as a money market
fund, in accordance with Sec.  270.2a-7 of this title.
    (2) The fund must be sponsored by a federally-regulated financial
institution, a bank as defined in section 3(a)(6) of the Securities
Exchange Act of 1934, an investment adviser registered under the
Investment Advisers Act of 1940, or a domestic branch of a foreign bank
insured by the Federal Deposit Insurance Corporation.
    (3) A futures commission merchant or derivatives clearing
organization shall maintain the confirmation relating to the purchase
in its records in accordance with Sec.  1.31 and note the ownership of
fund shares (by book-entry or otherwise) in a custody account of the
futures commission merchant or derivatives clearing organization in
accordance with Sec.  1.26(a). If the futures commission merchant or
the derivatives clearing organization holds its shares of the fund with
the fund's shareholder servicing agent, the sponsor of the fund and the
fund itself are required to provide the acknowledgment letter required
by Sec.  1.26.
    (4) The net asset value of the fund must be computed by 9 a.m. of
the business day following each business day and made available to the
futures commission merchant or derivatives clearing organization by
that time.
    (5) (i) General requirement for redemption of interests. A fund
shall be legally obligated to redeem an interest and to make payment in
satisfaction thereof by the business day following a redemption
request, and the futures commission merchant or derivatives clearing
organization shall retain documentation demonstrating compliance with
this requirement.
    (ii) Exception. A fund may provide for the postponement of
redemption and payment due to any of the following circumstances:
    (A) Non-routine closure of the Fedwire or applicable Federal
Reserve Banks;
    (B) Non-routine closure of the New York Stock Exchange or general
market conditions leading to a broad restriction of trading on the New
York Stock Exchange;
    (C) Declaration of a market emergency by the Securities and
Exchange Commission; or
    (D) Emergency conditions set forth in section 22(e) of the
Investment Company Act of 1940.
    (6) The agreement pursuant to which the futures commission merchant
or derivatives clearing organization has acquired and is holding its
interest in a fund must contain no provision that would prevent the
pledging or transferring of shares.
    (d) Repurchase and reverse repurchase agreements. A futures
commission merchant or derivatives clearing organization may buy and
sell the permitted investments listed in paragraphs (a)(1)(i) through
(viii) of this section pursuant to agreements for resale or repurchase
of the securities (agreements to repurchase or resell), provided the
agreements to repurchase or resell conform to the following
requirements:
    (1) The securities are specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
    (2) Counterparties are limited to a bank as defined in section
3(a)(6) of the Securities Exchange Act of 1934, a domestic branch of a
foreign bank insured by the Federal Deposit Insurance Corporation, a
securities broker or dealer, or a government securities broker or
government securities dealer registered with the Securities and
Exchange Commission or which has filed notice pursuant to section
15C(a) of the Government Securities Act of 1986.
    (3) The transaction is executed in compliance with the
concentration limit requirements applicable to the securities
transferred to the customer segregated custodial account in connection
with the agreements to repurchase referred to in paragraphs (b)(4)(ii)
and (iii) of this section.
    (4) The transaction is made pursuant to a written agreement signed
by the parties to the agreement, which is consistent with the
conditions set forth in paragraphs (d)(1) through (d)(12) of this
section and which states that the parties thereto intend the
transaction to be treated as a purchase and sale of securities.
    (5) The term of the agreement is no more than one business day, or
reversal of the transaction is possible on demand.
    (6) Securities transferred to the futures commission merchant or
derivatives clearing organization under the agreement are held in a
safekeeping account with a bank as referred to in paragraph (d)(2) of
this section, a derivatives clearing organization, or the Depository
Trust Company in an account that complies with the requirements of
Sec.  1.26.
    (7) The futures commission merchant or the derivatives clearing
organization may not use securities received under the agreement in
another similar transaction and may not otherwise hypothecate or pledge
such securities, except securities may be pledged on behalf of
customers at another futures commission merchant or derivatives
clearing organization. Substitution of securities is allowed, provided,
however, that:
    (i) The qualifying securities being substituted and original
securities are specifically identified by date of substitution, market
values substituted, coupon rates, par amounts, maturity dates and CUSIP
or ISIN numbers;
    (ii) Substitution is made on a ``delivery versus delivery'' basis;
and
    (iii) The market value of the substituted securities is at least
equal to that of the original securities.
    (8) The transfer of securities to the customer segregated custodial
account is made on a delivery versus payment basis in immediately
available funds. The transfer of funds to the customer segregated cash
account is made on a payment versus delivery basis. The transfer is not
recognized as accomplished until the funds and/or securities are
actually received by the custodian of the futures commission merchant's
or derivatives clearing organization's customer funds or securities
purchased on behalf of customers. The transfer or credit of securities
covered by the agreement to the futures commission merchant's or
derivatives clearing organization's customer segregated custodial
account is made simultaneously with the disbursement of funds from the
futures commission merchant's or derivatives clearing organization's
customer segregated cash account at the custodian bank. On the sale or
resale of securities, the futures commission merchant's or derivatives
clearing organization's

[[Page 5592]]

customer segregated cash account at the custodian bank must receive
same-day funds credited to such segregated account simultaneously with
the delivery or transfer of securities from the customer segregated
custodial account.
    (9) A written confirmation to the futures commission merchant or
derivatives clearing organization specifying the terms of the agreement
and a safekeeping receipt are issued immediately upon entering into the
transaction and a confirmation to the futures commission merchant or
derivatives clearing organization is issued once the transaction is
reversed.
    (10) The transactions effecting the agreement are recorded in the
record required to be maintained under Sec.  1.27 of investments of
customer funds, and the securities subject to such transactions are
specifically identified in such record as described in paragraph (d)(1)
of this section and further identified in such record as being subject
to repurchase and reverse repurchase agreements.
    (11) An actual transfer of securities to the customer segregated
custodial account by book entry is made consistent with Federal or
State commercial law, as applicable. At all times, securities received
subject to an agreement are reflected as ``customer property.''
    (12) The agreement makes clear that, in the event of the bankruptcy
of the futures commission merchant or derivatives clearing
organization, any securities purchased with customer funds that are
subject to an agreement may be immediately transferred. The agreement
also makes clear that, in the event of a futures commission merchant or
derivatives clearing organization bankruptcy, the counterparty has no
right to compel liquidation of securities subject to an agreement or to
make a priority claim for the difference between current market value
of the securities and the price agreed upon for resale of the
securities to the counterparty, if the former exceeds the latter.
    (e) Transactions by futures commission merchants that are also
registered securities brokers or dealers. A futures commission merchant
that is also registered with the Securities and Exchange Commission as
a securities broker or dealer pursuant to section 15(b)(1) of the
Securities and Exchange Act of 1934 may enter into transactions
pursuant to paragraph (a)(3) of this section, subject to the following
requirements:
    (1) The futures commission merchant, in connection with its
securities broker or dealer activities, owns or has the unqualified
right to pledge the securities that are exchanged for customer money or
securities held in the customer segregated account.
    (2) The transaction can be reversed within one business day or upon
demand.
    (3) Securities transferred from the customer segregated account and
securities transferred to the customer segregated account as a result
of the transaction are specifically identified by coupon rate, par
amount, market value, maturity date, and CUSIP or ISIN number.
    (4) Securities deposited by customers as margin and transferred
from the customer segregated account as a result of the transaction are
subject to the following requirements:
    (i) The securities are ``readily marketable'' as defined in Sec.
240.15c3-1 of this title.
    (ii) The securities are not ``specifically identifiable property''
as defined in Sec.  190.01(kk) of this chapter.
    (5) Securities transferred to the customer segregated account as a
result of the transaction are subject to the following requirements:
    (i) The securities are priced each day based on the current mark-
to-market value.
    (ii) The securities are subject to the concentration limit
requirements set forth in paragraph (b)(4)(iv) of this section.
    (iii) The securities are held in a safekeeping account with a bank,
as referred to in paragraph (d)(2) of this section, a derivatives
clearing organization, or the Depository Trust Company in an account
that complies with the requirements of Sec.  1.26.
    (iv) The securities may not be used in another similar transaction
and may not otherwise be hypothecated or pledged, except such
securities may be pledged on behalf of customers at another futures
commission merchant or derivatives clearing organization. Substitution
of securities is allowed, provided, however, that:
    (A) The qualifying securities being substituted and original
securities are specifically identified by date of substitution, market
values substituted, coupon rates, par amounts, maturity dates and CUSIP
or ISIN numbers;
    (B) Substitution is made on a ``delivery versus delivery'' basis;
and
    (C) The market value of the substituted securities is at least
equal to that of the original securities.
    (6) The transactions are carried out in accordance with the
following procedures:
    (i) With respect to transactions under paragraph (a)(3)(i) of this
section, the transfer of securities to the customer segregated
custodial account shall be made simultaneously with the transfer of
money from the customer segregated cash account. In no event shall
money held in the customer segregated cash account be disbursed prior
to the transfer of securities to the customer segregated custodial
account. Any transfer of securities to the customer segregated
custodial account shall not be recognized as accomplished until the
securities are actually received by the custodian of such account. Upon
unwinding of the transaction, the customer segregated cash account
shall receive same-day funds credited to such account simultaneously
with the delivery or transfer of securities from the customer
segregated custodial account.
    (ii) With respect to transactions under paragraph (a)(3)(ii) of
this section, the transfer of securities to the customer segregated
custodial account shall be made simultaneously with the transfer of
securities from the customer segregated custodial account. In no event
shall securities held in the customer segregated custodial account be
released prior to the transfer of securities to that account. Any
transfer of securities to the customer segregated custodial account
shall not be recognized as accomplished until the securities are
actually received by the custodian of the customer segregated custodial
account. Upon unwinding of the transaction, the customer segregated
custodial account shall receive the securities simultaneously with the
delivery or transfer of securities from the customer segregated
custodial account.
    (iii) With respect to transactions under paragraph (a)(3)(iii) of
this section, the transfer of money to the customer segregated cash
account shall be made simultaneously with the transfer of securities
from the customer segregated custodial account. In no event shall
securities held in the customer segregated custodial account be
released prior to the transfer of money to the customer segregated cash
account. Any transfer of money to the customer segregated cash account
shall not be recognized as accomplished until the money is actually
received by the custodian of the customer segregated cash account. Upon
unwinding of the transaction, the customer segregated custodial account
shall receive the securities simultaneously with the disbursement of
money from the customer segregated cash account.
    (7) The futures commission merchant maintains all books and records
with respect to the transactions in accordance

[[Page 5593]]

with Sec. Sec.  1.25, 1.27, 1.31, and 1.36 and the applicable rules and
regulations of the Securities and Exchange Commission.
    (8) An actual transfer of securities by book entry is made
consistent with Federal or State commercial law, as applicable. At all
times, securities transferred to the customer segregated account are
reflected as ``customer property.''
    (9) For purposes of Sec. Sec.  1.25, 1.26, 1.27, 1.28 and 1.29,
securities transferred to the customer segregated account are
considered to be customer funds until the customer money or securities
for which they were exchanged are transferred back to the customer
segregated account. In the event of the bankruptcy of the futures
commission merchant, any securities exchanged for customer funds and
held in the customer segregated account may be immediately transferred.
    (10) In the event the futures commission merchant is unable to
return to the customer any customer-deposited securities exchanged
pursuant to paragraphs (a)(3)(ii) or (a)(3)(iii) of this section, the
futures commission merchant shall act promptly to ensure that such
inability does not result in any direct or indirect cost or expense to
the customer.
    (f) Deposit of firm-owned securities into segregation. A futures
commission merchant shall not be prohibited from directly depositing
unencumbered securities of the type specified in this section, which it
owns for its own account, into a segregated safekeeping account or from
transferring any such securities from a segregated account to its own
account, up to the extent of its residual financial interest in
customers' segregated funds; provided, however, that such investments,
transfers of securities, and disposition of proceeds from the sale or
maturity of such securities are recorded in the record of investments
required to be maintained by Sec.  1.27. All such securities may be
segregated in safekeeping only with a bank, trust company, derivatives
clearing organization, or other registered futures commission merchant.
Furthermore, for purposes of Sec. Sec.  1.25, 1.26, 1.27, 1.28 and
1.29, investments permitted by Sec.  1.25 that are owned by the futures
commission merchant and deposited into such a segregated account shall
be considered customer funds until such investments are withdrawn from
segregation.
    3. Section 1.27 is proposed to be amended as follows:
    A. By adding the word ``derivatives'' before the term ``clearing
organization'' in paragraphs (a) and (b);
    B. By adding the phrase ``or current market value of securities''
after the phrase ``The amount of money'' in paragraph (a)(3);
    C. By removing the word ``and'' at the end of paragraph (a)(6);
    D. By removing the period at the end of paragraph (a)(7) and adding
``; and'' in its place; and
    E. By adding paragraph (a)(8) to read as follows:


Sec.  1.27  Record of investments.

    (a) * * *
    (8) Daily valuation for each instrument and documentation
supporting the daily valuation for each instrument. Such supporting
documentation must be sufficient to enable auditors to validate the
valuation and verify the accuracy of input information used in the
valuation to external sources for any instrument.
* * * * *

    Issued in Washington, DC, on January 27, 2005, by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 05-2000 Filed 2-2-05; 8:45 am]

BILLING CODE 6351-01-P