[Federal Register: August 7, 1997 (Volume 62, Number 152)]
[Rules and Regulations]
[Page 42398-42401]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]



17 CFR Part 1

Securities Representing Investment of Customer Funds Held in
Segregated Accounts by Futures Commission Merchants

AGENCY: Commodity Futures Trading Commission.

ACTION: Final Rules.


SUMMARY: The Commodity Futures Trading Commission (''Commission'') is
amending Rules 1.23 and 1.25 to allow futures commission merchants
(``FCMs'') to make direct transfers into segregated accounts of
permissible, unencumbered securities of the types set forth in Section
4d(2) of the Commodity Exchange Act (``Act'') and Rule 1.25 promulgated
thereunder. This will provide FCMs a more efficient means to increase
or decrease their residual interest in funds segregated for the benefit
of commodity customers than heretofore permitted. In addition, the
revised rules will permit FCMs to deposit the proceeds from the sale or
maturity of any such investments directly into a nonsegregated bank
account, provided that the FCM maintains a sufficient residual
financial interest in the funds segregated for commodity customers to
assure that all of an FCM's obligations to its customers are covered.
The Commission's expectation is that these rule changes will reduce the
number of transactions required to manage an FCM's segregated cash and
securities balances, thus reducing operating costs for the industry. To
assure that there will be a clear audit trail for the increased types
of permitted transactions, Rule 1.27 also is being amended to require
that the description of the investment securities, required by the
rule, includes the security identification number developed by the
Committee on Uniform Security Identification Procedures (``CUSIP
Number''). Also, Rule 1.25 is being amended to require identification,
in the record of investments required to be maintained by Rule 1.27, of
the manner in which the proceeds from the sale or maturity of any
segregated securities are disposed of.

EFFECTIVE DATE: September 8, 1997.

Accountant, or Lawrence B. Patent, Associate Chief Counsel, Division of
Trading and Markets (``Division''), Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,
D.C. 20581. Telephone (202) 418-5430.


I. Investment of Customers' Segregated Funds

    At all times, an FCM is required to have sufficient funds in
segregation to meet its obligations to customers. As a consequence, to
protect against a customer account going into deficit, an FCM must
deposit funds of its own to cover any customer account deficits, and
such funds must remain in segregation until more funds are remitted to
the FCM by the customers who hold such deficit accounts. Thus,
maintaining an adequate cushion of its own in segregation is a part of
routine FCM funds management operations. FCM operational funding needs
often dictate that any unneeded excess funds in segregation be moved so
that they can be used in other aspects of the firm's operations.
Therefore, prudent and efficient funds management typically requires an
FCM to make frequent transfers of funds into and out of segregation.
    Prior to these rule changes, FCMs were only allowed to increase or
decrease their interest in customers' segregated funds by direct
transfers of cash. That is, securities owned by the FCM and held in a
non-segregated account could not be transferred to a segregated
account. Moreover, to assure an audit trail, if an FCM wished to move
funds represented by securities into segregation, the securities had to
be sold and the cash proceeds transferred into a segregated account.
The FCM could, then, use the segregated cash to purchase more
securities that would be held in segregation. The effect of these
requirements was that any segregated securities, except for securities
purchased and specifically owned and deposited by individual customers,
always had to be purchased with cash from a segregated cash account.
Likewise, the proceeds from any sale of segregated securities always
had to be deposited into a segregated account, even if there was no
longer a need for the funds to be in segregation. That is, such funds
could only be moved to a non-segregated account after the securities
were converted to cash and the cash had been deposited into a
segregated account.
    On March 21, 1997, the Commission published for comment proposed
amendments to Rules 1.23, 1.25, and 1.27.\1\ The proposed changes would
permit FCMs to transfer their own unencumbered securities from a non-
segregated account directly into a customer segregated safekeeping
account. This would enable an FCM to increase the amount of funds
segregated for the benefit of commodity customers more quickly and
economically. To be eligible for direct transfer, such securities were
required to be unencumbered and to qualify as permitted investments of
customer funds under Rule 1.25. The proposed rule amendments also would
permit an FCM to transfer such securities from a segregated customer
safekeeping account directly to the FCM's own non-segregated account,
to the extent the FCM had excess funds available in segregation. The
30-day public comment period on the proposed rule changes expired on
April 21, 1997. The Commission received one written comment letter on
this proposal from the Joint Audit Committee (``JAC'').\2\ The JAC
raised two issues.

    \1\ See 62 FR 13564 (March 21, 1997).
    \2\ JAC is comprised of representatives from each commodity
exchange and National Futures Association which coordinate the
industry's audit and ongoing surveillance activities to promote a
uniform framework of self-regulation.

    First, JAC suggested that Rule 1.25 be amended by removing the
requirement contained in the rule that the proceeds from any sale of
segregated securities be redeposited into a segregated account. JAC
indicated that by eliminating this restriction, FCMs would be able to
sell segregated securities directly out of the segregated account and
deposit the funds to a non-segregated account. Since it was the
Commission's aim to permit cash and securities to be treated the same
way, thus reducing the number of transactions required to administer
segregated funds and reduce transaction costs, the Commission agrees
with this suggestion. Therefore, to adopt the JAC's suggestion, Rule
1.25 is further amended in two respects: 1) the requirement to deposit
the proceeds from the sale of segregated securities to a segregated
account is eliminated; and 2) a requirement to identify, in the record
of investments required to be maintained by Rule 1.27, the manner in
which the proceeds from the sale or maturity of any segregated
securities are disposed of, is added to the rule. That is, if proceeds
are not redeposited in a segregated account, the record must

[[Page 42399]]

reflect that the proceeds were deposited to an identified non-
segregated account.
    These changes to the rules are achieved without any sacrifice of
the audit trail related to segregated funds transfers. Also, the rules
do not impose any significant costs or other undue burdens upon FCMs,
because the additional information required to be maintained by the
rule should be available to FCMs in the internal records they already
    The Commission's proposed amendment to Rule 1.23 would have
modified the restrictions to allow the transfer of the types of
securities set forth in Rule 1.25 between segregated and nonsegregated
accounts. These proposed changes would permit transfers between
segregated and non-segregated accounts, whether made in cash or
securities, to be treated the same way. Therefore, the Commission has
determined to adopt the amendment to Rule 1.23 as originally proposed,
but to add the amendment to Rule 1.25 to assure that the Rule 1.23 rule
changes achieve the desired result.
    In its second comment, JAC pointed out that the proposed amendments
to Rules 1.23 and 1.25 would restrict the transfer of securities to
those held in a segregated safekeeping account with a bank or trust
company. JAC's original request for the proposed rule change was to
allow FCMs the ability to transfer segregated securities held by any
permitted segregation depository, including contract market clearing
organizations and other FCMs. The Commission agrees. Therefore, the
final amendments to Rules 1.23 and 1.25, as adopted, refer to
securities held in segregated safekeeping at any permitted custodian of
segregated funds, that is a bank, trust company, contract market
clearing organization, or another FCM. It should be noted that clearing
organizations and FCMs ultimately deposit customer funds in a
segregated safekeeping account with a bank or trust company.\3\ In this
connection the Commission notes that to be considered properly
segregated, pursuant to the Act and the rules promulgated thereunder,
securities must be held in safekeeping.

    \3\ In proposing these rule amendments, the Commission noted
that their adoption would also require the Division to revise
Financial and Segregation Interpretation No. 7, which includes the
following statement:
    Under Regulations 1.23 and 1.25 such obligations must be: (1)
purchased with money deposited in an account used for the deposit of
customers' funds; (2) made through such an account; and (3) the
proceeds from any sale of such obligations must be redeposited in
such an account. Thus, all additions to and withdrawals from
customer segregated funds which represent topping up by the FCM to
cover actual or expected customer deficits must be in the form of
    1 Comm. Fut. L. Rep. (CCH) para. 7117, at 7124 (July 23, 1980).
    The Division will delete this text from the interpretation
shortly and will publish an amended interpretation on its Internet
web site (http://www.cftc.gov) and request Commerce Clearing Housng
to publish the revised interpretation in the Commodity Futures Law

    For purposes of Rules 1.26, 1.27, 1.28 and 1.29, all permissible
investments, when deposited into segregated accounts, will be deemed to
be securities and obligations which represent investments of customers'
funds until such time as the FCM withdraws or otherwise disposes of
such investments.
    Also, the Commission is adopting as proposed amendments to Rule
1.27, which require FCMs to maintain records of permissible investments
held in segregated accounts. Rule 1.27 now will require the record to
include the CUSIP number of such securities as a part of the
description of such investments, and Rule 1.25 will require the FCM's
record to indicate if securities were liquidated and the non-segregated
account where the proceeds were transferred. The Commission is not
adopting any other changes to Rule 1.27, but wants to remind FCMs that
Rule 1.27 requires them to include in the investments record, among
other information, the name of the person through whom such investments
were made and the name of the person to or through whom such
investments were disposed of. Therefore, this record should identify
permissible investments owned by the FCM which were deposited into
segregation and any investments withdrawn from segregation and
deposited in the FCM's own account. Securities owned by the FCM, used
to meet its segregation requirements, must be identified as customer
securities and properly segregated, whether physically deposited or
deposited by book entry.
    The Commission also invited comments on whether custodians for
these purposes should be limited to banks and trust companies not
affiliated with the FCM. The Commission asked this question, in part,
as a follow-up to issues raised during the Barings crisis. Many firms
had deposited their cash with affiliates of the Barings bank, which in
turn used the Barings bank as a depository for those assets. During the
Barings crisis, these firms found that their assets, notwithstanding
some interpretations that the segregation laws in the United Kingdom
impose a complete trust on customer funds, would not necessarily be
considered segregated for their benefit in any impending liquidation in
bankruptcy of the Barings group. In this connection, the Commission
notes that the International Organisation of Securities Commissions
issued guidance on client asset protection, which is contained in a
report published in August 1996, that recommends to regulatory
authorities that they should: ``. . . carefully consider the
circumstances in which authorised firms may be permitted to meet the
requirements of a client asset protection regime by holding client
assets with a related custodian.''
    In this connection, the only commenter, the JAC, stated that such a
limitation on affiliated depositories would not seem warranted. In most
jurisdictions, funds in securities held in safekeeping can be separated
from funds amenable to the claims of a creditor of the custodian, as
well as a creditor of the FCM. Amendments added to the Act in 1968, to
impose the requirement to segregate directly on the custodian, are
intended to achieve that effect.\4\ The adoption of the rules in this
release is intended to facilitate maintaining segregated funds in the
form of securities. The Commission, therefore, believes that there is
no compelling reason to impose a condition, at this time, that such
funds be held at non-affiliated custodians. The Commission notes that
it intends to keep this conclusion under review. This is because
legislative and regulatory changes in the U.S. or in other countries,
developments in risk assessment systems or cooperative arrangements
with domestic and/or international regulators and encountering new
types of custodianship problems in connection with a failed firm could
at some future time suggest that the Commission consider a change in
its current rules and policies in this connection.

    \4\ Pub. L. No. 90-258, Sec. 6, 82 Stat. 26, 28 (1968), now
codified as the concluding paragraph of Sec. 4d(2) of the Act, 7
U.S.C. 6d(2) (1994).

    Under the Act, an FCM may segregate commodity customers' funds at a
bank or trust company, another registered FCM, or a clearing
organization of a contract market. Each of these depositories is,
itself, required by the Act to treat and deal with such funds as
belonging to the FCM's customers and not as the FCM's own funds. Each
of these persons is also liable under the Act for any misuse of, or
failure to segregate, such funds. Such liability accrues whether or not
the depository is related to the FCM. When customer funds are deposited
with another FCM or contract market clearing organization, the funds,
ultimately, are deposited

[[Page 42400]]

with a bank or trust company by such FCM or clearing organization.
    With respect to net capital compliance issues, the Commission's
staff has previously informally advised the Joint Audit Committee and
individual registrants that deposits of funds with affiliates would be
deemed by staff to be returns of capital by an FCM and, therefore, such
deposits could not be treated as regulatory capital by an FCM, unless
such funds represented either: (1) Funds segregated or set aside in
safekeeping under the Commission's rules for commodity or foreign
futures or foreign options customers; (2) funds held pursuant to the
Securities and Exchange Commission's customer protection rules (17 CFR
240.15c3-3); or (3) amounts to be used for normal operating expenses.
The Commission is in agreement with that policy and does not believe
any additional limitation needs to be imposed at this time. Unusually
large amounts of cash held in segregation will be reviewed as part of
Commission and SRO audit programs.

II. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601-611 (1988),
requires that agencies, in proposing rules, consider the impact of
those rules on small businesses. The rule amendments discussed herein
would affect registered FCMs. The Commission has previously established
certain definitions of ``small entities'' to be used by the Commission
in evaluating the impact of its rules on such entities in accordance
with RFA.\5\ The Commission previously determined that registered FCMs
are not small entities for the purpose of the RFA.\6\

    \5\ 47 FR 18618-18621 (April 30, 1982).
    \6\ 47 FR 18619-18620.

    Further, the amendments discussed herein do not impose any
significant new burdens upon FCMs. These amendments facilitate the use
of firm-owned obligations to enhance funds segregated for commodity
customers by allowing the direct transfer of said obligations into and
out of segregated accounts. As a result, the Commission anticipates
that adoption of the amendments will reduce the burden of compliance
with segregation requirements by FCMs. Accordingly, when these rule
amendments were proposed, the Chairperson, on behalf of the Commission,
certified, pursuant to 5 U.S.C. 605(b), that the rule amendments would
not have a significant economic impact on a substantial number of small
entities. The Commission, nonetheless, invited comment from any
registered FCM that believed these rules would have a significant
impact on its operations, but none was received.

B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (Pub. L. No. 104-13, May 13,
1995) (``PRAct'') imposes certain requirements on federal agencies
(including the Commission) in connection with their conducting or
sponsoring any collection of information, as defined by the PRAct.
While these rule amendments have no burden, the group of rules (3038-
0024) of which the rules proposed to be amended are a part has the
following burden:

Average burden hours per response.................................18.00
Number of Respondents..........................................1,662.00
Frequency of response.............................................19.00
    Copies of the OMB approved information collection package
associated with these rules may be obtained from the Desk Officer,
CFTC, Office of Management and Budget, Room 10202, NEOB, Washington, DC
20503, (202) 395-7340.

List of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and
Recordkeeping requirements, Segregation requirements.
    In consideration of the foregoing and pursuant to the authority
contained in the Act and, in particular, Sections 4d, 4g and 8a (5)
thereof, 7 U.S.C. 6d, 6g and 12a(5), the Commission hereby amends
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 1.23 is revised to read as follows:

Sec. 1.23  Interest of futures commission merchant in segregated funds;
additions and withdrawals.

    The provision in section 4d(2) of the Act and the provision in
Sec. 1.20(c), which prohibit the commingling of customer funds with the
funds of a futures commission merchant, shall not be construed to
prevent a futures commission merchant from having a residual financial
interest in the customer funds, segregated as required by the Act and
the rules in this part and set apart for the benefit of commodity or
option customers; nor shall such provisions be construed to prevent a
futures commission merchant from adding to such segregated customer
funds such amount or amounts of money, from its own funds or
unencumbered securities from its own inventory, of the type set forth
in Sec. 1.25, as it may deem necessary to ensure any and all commodity
or option customers' accounts from becoming undersegregated at any
time. The books and records of a futures commission merchant shall at
all times accurately reflect its interest in the segregated funds. A
futures commission merchant may draw upon such segregated funds to its
own order, to the extent of its actual interest therein, including the
withdrawal of securities held in segregated safekeeping accounts held
by a bank, trust company, contract market clearing organization or
other futures commission merchant. Such withdrawal shall not result in
the funds of one commodity and/or option customer being used to
purchase, margin or carry the trades, contracts or commodity options,
or extend the credit of any other commodity customer, option customer
or other person.
    3. Section 1.25 is revised to read as follows:

Sec. 1.25  Investment of customer funds.

    No futures commission merchant and no clearing organization shall
invest customer funds, except in obligations of the United States, in
general obligations of any State or of any political subdivision
thereof, or in obligations fully guaranteed as to principal and
interest by the United States. This shall not prohibit a futures
commission merchant 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, clearing organization of a
contract market, or other registered futures commission merchant.
Furthermore, for purposes of Secs. 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

[[Page 42401]]

customer funds until such investments are withdrawn from segregation.
    4. Section 1.27 is amended by revising paragraphs (a)(4) and (b)(2)
to read as follows:

Sec. 1.27  Record of investments.

    (a) * * *
    (4) A description of the obligations in which such investments were
made, including the CUSIP numbers;
* * * * *
    (b) * * *
    (2) A description of such documents, including the CUSIP numbers;
* * * * *
    Issued in Washington D.C. on July 28, 1997, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-20766 Filed 8-6-97; 8:45 am]

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