[Federal Register: January 14, 1998 (Volume 63, Number 9)]

[Proposed Rules]

[Page 2188-2192]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]





17 CFR Part 1

Maintenance of Minimum Financial Requirements by Futures

Commission Merchants and Introducing Brokers

AGENCY: Commodity Futures Trading Commission.

ACTION: Proposed rules.


SUMMARY: Rule 1.12 \1\ of the Commodity Futures Trading Commission

("Commission" or "CFTC") sets forth the early warning reporting

requirements for futures commission merchants ("FCMs") and

introducing brokers ("IBs"). These requirements are designed to

afford the Commission and industry self-regulatory organizations

("SROs") sufficient advance notice of a firm's financial or

operational problems to take any protective or remedial action that may

be needed to assure the safety of customer funds and the integrity of

the marketplace. The Commission has determined to propose amendments to

Rule 1.12, applicable to FCMs only, that will require immediate

notification by an FCM to the Commission and its designated self-

regulatory organization ("DSRO") if an FCM knows or should know that

it is in an undersegregated or undersecured condition: i.e., the FCM

has insufficient funds in accounts segregated for the benefit of

customers trading on U.S. contract markets or has insufficient funds

set aside for customers trading on non-U.S. markets to meet the FCM's

obligations to its customers. The term "funds" in this context

includes accrued amounts due to or from the FCM's clearing

organizations and/or carrying brokers in connection with customer-

related activities, typically, the daily or intraday variation



\1\ Commission rules are found at 17 CFR Ch. I (1997).


The Commission is also proposing to require immediate notification

of certain events pertaining to undercapitalization or failure to

satisfy margin calls, where notice is currently required within 24

hours. The Commission also proposes to codify a previous staff

interpretation that permits notices to be filed by facsimile in

addition to telegraphic means and to require immediate telephonic

notice as well.

DATES: Comments mut be received on or before March 16, 1998.

ADDRESSES: Comments on the proposed amendments should be sent to Jean

A. Webb, Secretary of the Commission, Commodity Futures Trading

[[Page 2189]]

Commission, 1155 21st Street, N.W., Washington, D.C. 20581. In

addition, comments may be sent by facsimile transmission to facsimile

number (202) 418-5221 or by electronic mail to secretary@cftc.gov.

Reference should be made to "Early Warning Amendments".


Director and Chief Accountant, Lawrence B. Patent, Associate Chief

Counsel, Lawrence T. Eckert, Attorney-Advisor, or Charles T. O'Brien,

Attorney-Advisor, Division of Trading and Markets, Commodity Futures

Trading Commission, 1155 21st Street, N.W., Washington, D.C. 20581;

Telephone (202) 418-5430.


I. Background

Rule 1.12 requires each FCM \2\ to report to the Commission and to

the FCM's DSRO certain events pertaining to the FCM's: (i) Financial

condition; and (ii) procedures for safeguarding customer and firm

assets; and (iii) ability to monitor its financial condition through an

appropriate system of records and reports. Rule 1.12's purpose is to

notify the Commission and the FCM's DSRO of circumstances that have or

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

business operations or that pose a threat to customer funds or the

FCM's financial integrity. Reportable events currently include, among

others, the FCM's adjusted net capital's falling below its "early

warning" level (i.e., 150 percent of the minimum required); \3\

failure to maintain current books and records; the existence of

material inadequacies in the FCM's accounting systems or internal

controls; and the issuance of a margin call exceeding the FCM's

adjusted net capital. Collectively, these are known as the Commission's

"early warning" reporting requirements.


\2\ Certain portions of Rule 1.12 also apply to IBs. However,

the proposed rule amendments discussed herein relate mostly to

segregated funds and the secured amount, which involves FCM's but

not IBs. Therefore, this release focuses upon Rule 1.12 as it

pertains to FCMs.

\3\ The minimum adjusted net capital requirement for an FCM is

set forth in Rule 1.17(a)(1)(i) and basically requires an FCM to

maintain adjusted net capital equal to the greatest of $250,000,

four percent of the amount of customer funds or the amount required

by an SRO of which the FCM is a member. Therefore, assuming no

higher applicable SRO requirement, the early warning reporting is

triggered if adjusted net capital is less than the greater of

$375,000 or six percent of customer funds.


The "segregation" requirements of the Commodity Exchange Act

("Act") and Commission rules are the primary safeguard against the

loss of customer funds resulting from the financial failure of an FCM.

Section 4d(2) of the Act \4\ and Rule 1.20 require that an FCM

segregate customer funds from the firm's proprietary funds and that one

customer's funds not be used to margin, guarantee or secure the trades

or contracts, or to secure or extend the credit, of another

customer.\5\ Other important elements of the segregation rules govern

the investment of customer funds \6\ and require a daily record of

segregation requirements and funds in segregation.\7\ Rule 30.7

contains similar protections relating to customers maintaining

positions on non-U.S. exchanges.\8\


\4\ 7 U.S.C. 6d(2).

\5\ Rule 1.23 states that the prohibition against commingling an

FCM's own funds with the FCM's customer funds does not prevent an

FCM from adding any of its own funds to segregated customer funds as

necessary to prevent any or all customer's accounts from becoming

undermargined. The Commission recently adopted amendments to Rule

1.23 that permit FCMs to use Treasury securities in addition to cash

to increase their interests in customer segregated accounts,

facilitating the use of FCM funds to prevent the undermargining of

customer accounts. See 62 FR 42398 (Aug. 7, 1997).

\6\ Section 4d(2) of the Act and Rules 1.25-1.29.

\7\ Rule 1.32.

\8\ A more detailed presentation concerning these protections

can be found in Chapter 12 of the Form 1-FR-FCM instructions.


Given the importance of these rules in enabling the Commission to

carry out its customer and market protection functions, it is critical

that the Commission and an FCM's DSRO be made aware at the earliest

possible moment of an FCM's failure to satisfy these requirements.\9\

The proposed CFTC rule would require an FCM to provide immediate

telephonic notice, to be confirmed immediately by facsimile or

telegram,\10\ to the Commission and the FCM's DISRO when the FCM knows

or should know that it has failed to maintain sufficient funds in

segregation or in separate set-aside accounts.\11\


\9\ The Commission notes that, in the Federal Register release

proposing the Commission's overhaul of minimum financial

requirements over twenty years ago, the Commission stated its

intention to propose an early warning notice for undersegregation of

customer funds. See 42 FR 27166, 27173 (May 26, 1997). However, the

Commission did not subsequently include such a rule as part of its

early warning requirements.

\10\ Telegraphic notification has been the traditional method of

required notice under Rule 1.12, whereby an FCM or an IB sends a

telegram to the Commission and the DSRO concerning a particular


\11\ The Chicago Mercantile Exchange ("CME") currently has a

rule requiring that FCMs for which it acts as the DSRO provide

written notice to it in such circumstances, although the CME's rule

requires such notification within twenty-four hours following such

events. Rules of the Chicago Mercantile Exchange, Rule 971

Segregation and Secured Requirements (1997).


II. Proposed Rule Amendments

FCMs occasionally have become undersegregated as a result of market

movements which cause deficits in the accounts they carry on behalf of

their customers. Generally, the undersegregated condition is corrected

the following business day with funds available from an FCM's own

proprietary funds or through collection of deficits. However, during

the market downturn on October 27, 1997, the Commission was made aware

that a few FCMs experienced undersegregation to a degree that they were

unable to make up the shortfall from their own internal proprietary

funds. Infusions of external capital were required in those cases to

correct the undersegregated conditions.

An evaluation of the Commission's current early warning

notification rules indicated that these rules, which require notice to

the Commission upon an FCM falling below the net capital early warning

level, may not result in notice to the Commission until as much as a

day or a day and a half after the occurrence of a major market event

which causes an undersegregated condition. In particular, on October

27, some firms knew they had a major problem by noon of that day, but

did not provide notice of these problems to the Commission until on or

about the close of business on October 28.

The Commission believes that it needs to be notified as soon as an

FCM knows that it may have a problem meeting segregation requirements.

The proposed rule is designed to require notice as soon as an FCM

"should know" of an undersegregated condition. Because of the linkage

between segregation and net capital, the proposed rule will also result

in the Commission knowing of a net capital impairment earlier than

under the existing rule and should facilitate a resolution of the

problem with the least harmful impact upon an FCM's customers and other

market participants.

As proposed, new Rule 1.12(h) \12\ would require an FCM to notify

the Commission and its DSRO immediately after it knows or should know

that funds segregated for customers trading on U.S. markets or set

aside for customers trading on non-U.S. markets are less than the

amount required to be segregated or set aside by the Act or Commission

rules. In this context, the term "funds" includes funds on deposit

and funds due to or from the FCM's clearing organizations or carrying

[[Page 2190]]

brokers. The Commission's proposal requires an immediate telephone call

by an FCM, to be followed immediately by telegraphic or facsimile

notice.\13\ The notification to the Commission should be directed to

the Division of Trading and Markets, to the attention of the Director

and the Chief Accountant. Notice to the DSRO should be directed to the

person or unit provided for under the DSRO's rules. For example, the

notice required by CME Rule 971 must be sent to CME's Audit Department.


\12\ The Commission is proposing to redesignate current

paragraph (h) of Rule 1.12 as paragraph (i) and to include the new

rule in a new paragraph (h).

\13\ The Division of Trading and Markets has stated that any

notice required to be transmitted to the Commission under Rule 1.12

by telegraphic notice may be transmitted by facsimile machine. See

CFTC Advisory No. 90-2, [1990-92 Transfer Binder] Comm. Fut. L. Rep.

(CCH) para. 24,599 (Feb. 6, 1990). The Commission is proposing to

codify this Advisory throughout Rule 1.12 to make clear that any

written notice can be provided either through telegraphic means or

via facsimile transmission.


In accordance with Rules 1.32 and 30.7(f), each FCM is required to

complete its daily segregation and secured amount computations by noon

of the business day following the day for which the computations are

made.\14\ The time when the Commission would expect an FCM to be aware

of an undersegregated condition or a possible undersegregated condition

would depend upon the circumstances. In this connection, both the net

capital rule and the segregation rules require compliance at all times.

Intra-day changes in the prices of contracts carried by an FCM may

require settlement variation payments. As of the close of trading each

day, there is an accrued settlement amount which is payable to or

receivable from the FCM's clearing organization. A receivable from a

clearing organization is reflected as an asset on the FCM's segregation

calculation, and conversely, a payable to a clearing organization is a

liability. It is important to note that, in the event of a major move

in the market, these amounts could be substantial and, if the move is

against the FCM's customers, it could result in an undersegregated

condition due to a deficit or deficits in the accounts of one or more



\14\ Rule 1.32 states that each FCM must compute as of the close

of each business day the total amount of customer funds on deposit

in segregated accounts on behalf of commodity and option customers

and the total amount of such funds required by the Act and

regulations to be on deposit in segregated accounts on behalf of

such customers, as well as the FCM's residual interest in such

funds. Rule 30.7(f) states that each FCM must compute as of the

close of each business day the total amount of money, securities and

property on deposit in separate accounts, the total amount of money,

securities and property required to be on deposit in separate

accounts and the amount of the FCM's residual interest in money,

securities and property on deposit in separate accounts.


In the event of a major market move, the Commission would expect an

FCM to consider the impact of that move on the values of the positions

it is carrying and how this impact would affect the accrued payable to

its clearing organizations and the deficits in customer accounts. If

the FCM has reason to believe that this impact could be material and

negative in relation to previously computed excess segregation, it

would be advisable to report a possible undersegregated condition to

the Commission.

However, in some cases losses may occur over a large number of

accounts in smaller amounts that, cumulatively, may cause an FCM to

become undersegregated. In such a circumstance, the Commission

recognizes that an FCM may not become aware of an undersegregated

condition until it performs its daily segregation computation the

following day. In any event, an FCM would be expected to notify the

Commission of a deficiency in its segregated accounts by noon of the

following business day.

Proposed new Rule 1.12(h), like the other provisions of the early

warning system, is intended to allow protective action to be taken. The

Commission wishes to emphasize that the triggering event is when an FCM

knows or should know that the FCM has a deficiency, as discussed above.

An FCM should not attempt to circumvent the rule simply by delaying

making the computations until noon of the next business day when it is

clear from market events or other factors that a deficiency likely


The Commission also wishes to note that, while Rule 1.12(h) would

require only that an FCM notify the Commission and its DSRO of a

segregation or secured amount deficiency immediately, a firm with a

notification obligation under Rule 1.12(h) may incur additional

requirements under other early warning rules or Commission regulations.

For example, a firm that is undersegregated may also be

undercapitalized and thus be required (in addition to notifying the

Commission) to comply with various filing requirements under Rule

1.12(a)(2).\15\ Although the Commission is not proposing any specific

further reporting by an FCM that files notice of a segregation or

secured amount deficiency, under Rule 1.10(b)(4) the Commission may

request in writing that an FCM also file a Form 1-FR-FCM or provide

such other additional financial information as the Commission may

require. This could include, for example, a request that the FCM file

daily segregation or secured account computations with the Commission

for a specified period, rather than simply making such records

available for inspection.\16\


\15\ Rule 1.12(a)(2) requires that an FCM whose adjusted net

capital is below the amount required under Rule 1.17 or under the

capital rule of any applicable SRO, within twenty-four hours of

giving notice of such occurrence to the Commission, file for the

period "as of" the date of the adjusted net capital deficiency, a

statement of financial condition, a statement of the computation of

the minimum capital requirements, the statements of segregation

requirements and funds in segregation, and the statement of secured

amounts and funds held in separate accounts for foreign futures and

foreign options customers.

\16\ Rule 1.31 requires that all records required by the Act or

Commission rules be maintained for five years under specified

conditions and be available for inspection by any representative of

the Commission or the United States Department of Justice.


Although the Commission's early warning rules already require an

FCM to notify the Commission if the FCM is undercapitalized, large

market moves such as those which occurred on October 19, 1987, and more

recently on October 27, 1997, can cause a firm to be undersegregated

even though it is not undercapitalized. A large market move can create

unsecured "debit/deficit" accounts, which present greater risk for an

FCM than undermargined accounts since the customer now owes the FCM

money. Accounts of this kind would generally be subject to a margin

call. In that case, absent the FCM being aware of doubts regarding its

customer's ability to pay the deficit or debit, the FCM carrying the

account has one business day from the date on which the deficit or

debit ledger balance originated before it must reclassify the account

as a "non-current asset" in computing its adjusted net capital.\17\

Likewise, the FCM must put sufficient funds from its own capital into

the segregated account to cover the deficit amount or debit ledger

balance, thus ensuring that there are sufficient segregated funds to

cover all customers with liquidating equities in their accounts. Should

the FCM not have sufficient funds to cover the debit or deficit amount,

the FCM would be undersegregated, although not necessarily

undercapitalized. The proposed rule is intended to require that notice

to the CFTC and the DSRO be provided immediately in such



\17\ Rule 1.17(c)(2) (i) and (vi).

\18\ The Commission also proposes to correct the cross-reference

in Sec. 1.12(g)(2) concerning consolidation that now refers to

`'Sec. 1.10(f)" to read "Sec. 1.17(f)".


The Commission believes that notice that an FCM is undersegregated

or undersecured should be provided immediately. In reviewing other

provisions of the early warning requirements, the Commission has

[[Page 2191]]

determined to propose that notices of events now required within 24

hours, which must be provided when an FCM or IB is undercapitalized or

when an account must be liquidated, transferred or allowed to trade for

liquidation only, now be provided immediately. Such notifications would

be required by telephone immediately, to be confirmed in writing by

telegraph or facsimile. See Rule 1.12 (a)(1), (f)(1), and (f)(2).\19\


\19\ Certain other provisions of Rule 1.12 currently require

immediate notifications. See paragraphs (e), (f)(3), (f)(4) and

(f)(5) of Rule 1.12. The Commission is also proposing that these

notifications be made by telephone as well as by telegraph or



III. Related Matters

A. Regulatory Flexibility Act

Regulatory Flexibility Act ("RFA"), 5 U.S.C. 601-611 (1994),

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

those rules on small businesses. The rule amendments discussed herein

would affect primarily FCMs. The amendment of one provision,

Sec. 1.12(f)(1), would affect clearing organizations, and the amendment

of another provision, Sec. 1.12(a)(1), would affect IBs. The Commission

has previously determined that, based upon the fiduciary nature of the

FCM/customer relationships, as well as the requirement that FCMs meet

minimum financial requirements, FCMs should be excluded from the

definition of small entity.\20\ Contract markets and their clearing

organizations have also been excluded from the definition of small



\20\ 47 FR 18618-18621 (April 30, 1982).

\21\ Id.


The proposed amendment to Sec. 1.12(a)(1) concerning notice of

undercapitalization would affect the minority of IBs that rely upon

their own capital to meet net capital rules, "independent" IBs, as

well as FCMs. The Commission is proposing to require that this notice

be provided immediately rather than within 24 hours as currently

required. The notification requirement will remain essential the same,

but the timing would be shortened by 24 hours. The Commission believes

that this rule amendment is necessary for the Commission and DSROs to

be able to carry our their overishgt and monitoring functions

concerning the financial condition of futures industry intermediaries

and to protect the customers of those firms and the markets. Therefore,

any slight increase in the burden on an independent IB caused by the

proposed amendment to Rule 1.12(a)(1) is necessary for the Commission

to fulfill its regulatory obligation.\22\


\22\ The Commission evaluates within the context of a particular

rule proposal whether all or some IBs should be considered small

entities and, if so, analyzes the impact on IBs of the proposal 48

FR 35248, 35276 (Aug. 3, 1983).


Accordingly, on behalf of the Commission, the Chairperson certifies

that these proposed rule amendments will not have a significant

economic impact on a substantial number of small entities.

B. Paperwork Reduction Act

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

seq. (1994), imposes certain requirement on federal agencies (including

the Commission) in connection with their conducting or sponsoring any

collection of information as defined by the PRA. The Commission

anticipates that fewer than 10 FCMs per year would be filing reports

under the proposed rule and thus the new rule would not constitute a

collection of information under the PRA.\23\ The group of rules (3038-

0024) of which this is a part has the following burden:


\23\ 44 U.S.C. 3502(4) 1994)


Average Burden Hours Per Response: 128.

Number of Respondents: 1366.

Frequency of Response: On occasion.

Persons wishing to comment on the estimated paperwork burden

associated with this proposed rule amendment should contact Jeff Hill,

Office of Management and Budget, Room 3228, NEOB Washington, DC 20503,

(202) 395-7340. Copies of the information collection submission to OMB

are available from the CFTC Clearance Officer, 1155 21st Street N.W.,

Washington, DC 20581, (202) 418.5160.

List of Subjects in 17 CFR Part 1

Commodity futures; minimum financial and relating reporting


In consideration of the foregoing, and pursuant to the authority

contained in the Commodity Exchange Act, and in particular, Sections

4f, fg and 8a(5) therof, 7 U.S.C. 6f, 6g and 12a(5), the Commission

hereby proposes to amend Part 1 of chapter I of title 17 of the Code of

Federal Regulations as follows:


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

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

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

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

2. Section 1.12 is amended by revising paragraph (a)(1), by

revising the first sentence of paragraph (b)(4), by adding the phrase

"or facsimile" after the word "telegraphic" in paragraphs (c) and

(d), by revising paragraph (e), by adding the phrase "telephonic,

confirmed in writing by" before the word "telegraphic," by adding

the phrase "or facsimile," after the word "telegraphic," and by

revising the phrase at the end which reads "within 24 hours" to read

"immediately" in paragraphs (f)(1) and (f)(2), by adding the phrase

"telephonic, confirmed in writing by" before the word "telegraphic"

and by adding the phrase "or facsimile," after the word

"telegraphic" in paragraph (f)(3), by adding the phrase "by

telephone, confirmed in writing immediately by telegraphic or facsimile

notice," after the word "immediately" in paragraphs (f)(4) and

(f)(5), by revising the phrase in paragraph (g)(2) which reads

"Sec. 1.10(f)" to read "Sec. 1.17(f)", by redesignating paragraphs

(h)(1) and (h)(2) as paragraphs (i)(1) and (i)(2), respectively, by

revising the last sentence of newly redesignated paragraph (i)(2), and

by adding a new paragraph (h). The additions and revisions follow:

Sec. 1.12 Maintenance of minimum financial requirements by futures

commission merchants and introducing brokers.

* * * * *

(a) * * *

(1) Give telephonic notice, to be confirmed in writing by

telegraphic or facsimile notice, as set forth in paragraph (i) of this

section that the applicant's or registrant's adjusted net capital is

less than required by Sec. 1.17 or by other capital rule, identifying

the applicable capital rule. This notice must be given immediately

after the applicant or registrant knows or should know that its

adjusted net capital is less than is required by any of the aforesaid

rules to which the applicant or registrant is subject; and

* * * * *

(b) * * *

(4) For securities brokers or dealers, the amount of net capital

specified in Rule 17a-11(b) of the Securities and Exchange Commission

(17 CFR 240.17a-11(b)), must file written notice to that effect as set

forth in paragraph (i) of this section within five (5) business days of

such event. * * *

* * * * *

(e) Whenever any self-regulatory organization learns that a member

registrant has failed to file a notice or written report as required by

this Sec. 1.12, that self-regulatory organization must immediately

report this failure by

[[Page 2192]]

telephone, confirmed in writing immediately by telegraphic or facsimile

notice, as provided in paragraph (i) of this section.

* * * * *

(h) Whenever a person registered as a futures commission merchant

knows or should know that the total amount of its funds on deposit in

segregated accounts on behalf of customers, or that the total amount

set aside on behalf of customers trading on non-United States markets,

is less than the total amount of such funds required by the Act and the

Commission's rules to be on deposit in segregated or secured amount

accounts on behalf of such customers, the registrant must report

immediately by telephone, confirmed in writing immediately by

telegraphic or facsimile notice, such deficiency to the registrant's

designated self-regulatory organization and the principal office of the

Commission in Washington, DC, to the attention of the Director and the

Chief Accountant of the Division of Trading and Markets.

(i) * * *

(2) * * * Any notice or report filed with the National Futures

Association pursuant to this paragraph shall be deemed for all purposes

to be filed with, and to be the official record of, the Commission.

Issued in Washington, D.C. on January 6, 1998 by the Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 98-665 Filed 1-13-98; 8:45 am]


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