Statement of Commissioner Mark P. Wetjen in Support of Adoption of Amendments to CFTC Regulation 1.22 (Residual Interest Deadline for Futures Commission Merchants)
March 17, 2015
In the fall of 2013, the Commission made some important changes to rule 1.22, to which registered futures commission merchants (FCMs) are subject. The revision to this rule, known as the “residual-interest requirement”, clarified that one customer’s funds could not be used by an FCM to cover another customer’s margin deficit, but phased in a deadline for stricter compliance with this clarified standard. The change was designed to reduce risks to those customer funds placed in the care of FCMs, and were among a host of regulatory enhancements adopted by the Commission after two failures of large, registered FCMs in 2011 and 2012 – MF Global and Peregrine Financial.
I supported those regulatory enhancements – including the revision to rule 1.22 – because of the importance of the matter addressed in each: the safekeeping of customer money, which is the most sacrosanct duty that any financial institution owes to its customers. Today, the overall framework of regulatory requirements that registered FCMs must comply with is substantially different today than in 2011. For example, FCMs are no longer permitted to use customer funds for in-house lending through repurchase agreements; they are subject to restrictions on the types of securities that customer funds can be invested in; they must pass on customer initial margin on a gross basis to the clearinghouse; through LSOC (legal segregation with operational comingling) they must legally segregate cleared swaps customer collateral on an individual basis; and they were required to significantly enhance their supervision of and accounting for customer funds. As a result, the risks posed to customers funds stewarded by FCMs have been significantly reduced.
The recent customer protection rulemakings all were well intentioned, but indisputably carried some additional costs and burdens for both FCMs and their customers. The analysis was made at the time, however, that those burdens and costs were outweighed by the benefits to FCM customers, especially against the very recent backdrop of hundreds of millions of dollars of customer funds having been stolen, or tied up in a bankruptcy proceeding, for at least a period of time.
The release before us essentially re-weighs the cost or burden on one hand, and the benefit on the other, and comes up with a slightly different, but well supported, conclusion regarding the residual-interest requirement. The costs or burdens revisited in the release: (1) uncertainty to the marketplace invited by a time-of-settlement compliance deadline that was subject to future review by the Commission staff, which suggested a change could come to the requirements, but might not; and (2) the anticipated costs to FCMs of having to finance the funding to top up their customers’ margin deficits, or the cost to customers of pre-funding their margin accounts with FCMs. And the benefit at issue in the release: the value to an FCM customer of ensuring that its funds will never be borrowed by an FCM to cover another customer’s deficit.
The inherent risk to this common practice by FCMs is that should an FCM become insolvent after it posts required margin to the clearinghouse, but before it collects margin deficits from all of its customers, the customers whose funds were used to cover a deficit might not see those funds again, or perhaps only after a protracted bankruptcy proceeding. This practice also is not technically compliant with how rule 1.22 is written, which prohibits FCMs from “using, or permitting the use of, the futures customer funds of one futures customer to purchase, margin, or settle the trades, contracts, or commodity options of, or to secure or extend the credit of, any person other than such futures customer.”
This final rule keeps the residual-interest deadline at the close of business on the day following the margin-deficit calculation and eliminates the future deadline of the time of settlement on the day following the margin-deficit calculation. The Commission staff is still required to perform a feasibility study to determine whether future, more aggressive residual-interest deadlines would be desirable.
The comment file overwhelmingly supported the change in today’s final rule – in other words, commenters took the view that the potential costs associated with the 2013 residual-interest rule appear to outweigh the risk that some of their funds could be lost in the event their FCM becomes insolvent after the time of settlement, but before an FCM collects margin deficits. Indeed, the risk that an FCM becomes insolvent during this precise timeframe without some prior notice to its customers of financial stress at the FCM is very low. Notably, many comments supporting this final rule were filed by FCM customers, the constituency rule 1.22 is designed to protect, and who appreciate the aforementioned risk. The Commission must respect the comment process and the FCM-customer viewpoint that today’s rule better balances the cost and benefits of rule 1.22.
Another relevant factor that supports the change to rule 1.22 is the risk of concentration within the FCM community as a whole, and what that means for the costs to customers of trading in derivatives and its related impacts on liquidity in those markets. The number of registered FCMs has decreased in recent years, which may make it more difficult for customers to manage their risk by limiting their ability to access the markets, or by making it more difficult for them to allocate funds between multiple FCMs to minimize concentration risk.
The results of the public comment process, when considered in the context of the overall stronger regulatory framework for FCMs and the concentration in the FCM community described above, give me the comfort needed to support the changes to 1.22 contained in today’s release.
On the other hand, without the five-year phase-in period, we might see a reluctance by the industry to move as swiftly to streamline margin-collection practices and to take advantage of any technological solutions that may be developed. Some recent technology advances hold the promise to reduce the very sorts of risks addressed by rule 1.22 by facilitating real-time margin collection and settlement. To be sure, those advances would have been more seriously and expeditiously tested and – if they demonstrate merit – embraced without the change to rule 1.22 we are releasing today. In other words, just as in 2013 when the existing rule was finalized, I continue to believe that the most costly solutions for complying with rule 1.22 that were anticipated by many commenters should not be the ones ultimately embraced by the marketplace. Moreover, given regulatory requirements imposed by other regulators, today members of the clearing ecosystem are exploring a variety of solutions to new compliance and capital burdens that also would ease and enable stricter compliance with rule 1.22, thus minimizing further the likelihood that pre-funding customer margin accounts with FCMs will become the preferred solution to compliance.
Finally, I note that a study and roundtable to review these advancements, and how they might lower risks and related costs, still are mandated by law, and I ask the Chairman to direct staff to move swiftly to comply with these regulatory requirements so that the Commission may act appropriately when and if it needs to. I look forward to continuing to collaborate with staff and market participants as we work towards enhancing the safety and efficiency of our markets.
Last Updated: March 17, 2015