Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies, 75162-75168 [2010-29836]

Agencies

• Commodity Futures Trading Commission

[Federal Register Volume 75, Number 231 (Thursday, December 2, 2010)]
[Proposed Rules]
[Pages 75162-75168]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-29836]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 190

RIN 3038-AD99


Protection of Cleared Swaps Customers Before and After Commodity 
Broker Bankruptcies

AGENCY: Commodity Futures Trading Commission.

ACTION: Advanced notice of proposed rulemaking; request for comments.

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SUMMARY: The Commodity Futures Trading Commission (the ``CFTC'' or 
``Commission'') seeks comment on possible models for implementing new 
statutory provisions enacted by Title VII of the Dodd-Frank Wall Street 
Reform and Consumer Protection Act (``Dodd-Frank'') concerning the 
protection of collateral posted by customers clearing swaps.

DATES: Submit comments on or before January 18, 2011.

ADDRESSES: You may submit comments, identified by RIN number 3038-AD99, 
by any of the following methods:
     Agency Web site, via its Comments Online process: https://comments.cftc.gov. Follow the instructions for submitting comments 
through the Web site.
     Mail: David A. Stawick, Secretary of the Commission, 
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st 
Street, NW., Washington, DC 20581.
     Hand Delivery/Courier: same as mail above.
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.

Please submit your comments by only one method.

    All comments must be submitted in English, or if not, accompanied 
by an English translation. Comments will be posted as received to 
https://www.cftc.gov. You should submit only information that you wish 
to make available publicly. If you wish the Commission to consider 
information that you believe is exempt from disclosure under the 
Freedom of Information Act, a petition for confidential treatment of 
the exempt information may be submitted according to the procedures 
established in CFTC Regulation 145.9, 17 CFR 145.9.
    The Commission reserves the right, but shall have no obligation, to 
review, pre-screen, filter, redact, refuse or remove any or all of your 
submission from www.cftc.gov that it may deem to be inappropriate for 
publication, such as obscene language. All submissions that have been 
redacted or removed that contain comments on the merits of the 
rulemaking will be retained in the public comment file and will be 
considered as required under the Administrative Procedure Act and other 
applicable laws, and may be accessible under the Freedom of Information 
Act.

FOR FURTHER INFORMATION CONTACT: Robert B. Wasserman, Associate 
Director, Division of Clearing and Intermediary Oversight (DCIO), at 
202-418-5092 or rwasserman@cftc.gov; Martin White, Assistant General 
Counsel, at 202-418-5129 or mwhite@cftc.gov; or Nancy Liao Schnabel, 
Special Counsel, DCIO, at 202-418-5344 or nschnabel@cftc.gov. in each 
case, also at the Commodity Futures Trading Commission, Three Lafayette 
Centre, 1155 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Introduction

    This Advanced Notice of Proposed Rulemaking (``ANPR'') is intended 
to obtain comment from interested parties concerning the appropriate 
model for protecting the margin collateral posted by customers clearing 
swaps transactions. As discussed in more detail below, the statutory 
language in Dodd-Frank concerning the protection of swaps customer 
margin is substantially similar, though not identical, to analogous 
provisions in Section 4d(a) of the Commodity Exchange Act (``CEA'') \1\ 
applicable to the protection of collateral posted by customers with 
respect to exchange-traded futures. The Commission therefore is seeking 
comment on whether to adopt a similar model to protect the margin 
collateral posted by customers clearing swaps transactions as it 
currently employs with respect to exchange-traded futures, or whether 
another model is appropriate.
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    \1\ 7 U.S.C. 6d(a).
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    Section 4d(f)(2) of the CEA,\2\ as added by Section 724 of Dodd-
Frank, provides that ``property of a swaps customer [received to margin 
a swap]* * * shall not be commingled with the funds of the futures 
commission merchant or be used to margin, secure or guarantee any 
trades or contracts of any swaps customer or person other than the 
person for whom the same are held.\3\ Section 4d(f)(6) of the CEA makes 
it unlawful for a depository, including a derivatives clearing 
organization (``DCO''), that has received such swaps customer property 
``to hold, dispose of, or use any such * * * property as belonging to * 
* * any person other than the swaps customer of the futures commission 
merchant.'' \4\
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    \2\ 7 U.S.C. 6d(f)(2).
    \3\ Section 4d(f)(3)(A) of the CEA provides an exception 
permitting commingling ``for convenience.''
    \4\ 7 U.S.C. 6d(f)(6) (emphasis added). This section was added 
by Section 724(a) of Dodd-Frank, Public Law 111-203, 124 Stat. 1376.
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    The provisions applicable to the margin posted by exchange-traded 
futures customers are similar, but not identical. Section 4d(a)(2) 
provides that ``property received [by a futures commission merchant] to 
margin, guarantee or secure the [exchange-traded] contracts of any 
customer of such [futures commission merchant] * * * shall not be 
commingled with the funds of such commission merchant or be used to 
guarantee the trades or contracts * * * of any person other than the 
one for whom the same are held.'' \5\ Section 4d(b) makes it unlawful 
for a DCO that has received such customer property ``to hold, dispose 
of, or use any such * * * property as belonging to * * * any person 
other

[[Page 75163]]

than the customers of such futures commission merchant.''
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    \5\ Section 4d(a)(2) provides a similar exception permitting 
commingling ``for convenience.''.
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    Commission Regulation (``Reg. Sec.  '') 1.22 \6\ prohibits a 
futures commission merchant (``FCM'') from using, or permitting the 
use, of one futures' customer's funds to margin, guarantee or secure 
another customer's futures trades or contracts. Thus, if a futures 
customer sustains losses sufficient to cause it to have a debit balance 
(i.e., the customer owes the FCM money), the FCM must deposit its own 
capital to ``top up'' the loss. Pursuant to existing industry custom 
and Reg Sec.  1.20(b), however, futures commission merchants (``FCMs'') 
segregate futures customer property posted as collateral with a DCO on 
an omnibus basis: Such property is treated separately from the property 
of the FCM, but futures customers are treated as a group, rather than 
individually.
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    \6\ 17 CFR 1.22.
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    Thus, if a futures customer suffers sufficient losses that the 
customer's debit balance exceeds the FCM's available capital, and such 
customer (the ``defaulting customer'') fails to promptly pay such loss, 
the FCM may, as a practical matter, be unable to ``top up'' the loss, 
and the FCM may be unable to make a required payment to a DCO with 
respect to that FCM's customer account. Such an FCM would then be a 
defaulter to the DCO (a ``Defaulting FCM''). In case of such an FCM 
default in the futures customer account, the DCO is permitted to use 
the collateral of all customers of the Defaulting FCM to meet the net 
customer obligation of the Defaulting FCM to the DCO (including the use 
of any customer gains to meet customer losses), without regard to which 
customers gained or lost, or which customers defaulted or made full 
payment.
    In such a case, customers of the Defaulting FCM other than the 
defaulting customer may lose collateral they have posted with the 
Defaulting FCM, and/or gains on their positions. The risk these other 
customers face shall be referred to as ``fellow-customer risk.''

II. Maximizing Customer Protection and Minimizing Cost

    In considering how to implement Section 4d(f) of the Dodd-Frank 
Act, the Commission and its staff have heard countervailing concerns 
from various stakeholders. Some customers have noted that, in the 
context of uncleared swaps that they currently engage in--and may be 
obligated to clear under Dodd-Frank \7\--they are able to negotiate for 
individual segregation, with independent third parties, of collateral 
that they post for such uncleared swaps. These customers contend that 
it is inappropriate that they should be subject to an additional risk 
(fellow-customer risk) when clearing their positions.\8\ Pension funds, 
in particular, are concerned about their obligations under the Employee 
Retirement Income Security Act, and about having their collateral used 
to subsidize others.\9\
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    \7\ See generally CEA 2(h), added by Dodd-Frank 723(a).
    \8\ See, e.g., Staff Roundtable on Individual Customer 
Collateral Protection (``Roundtable'') at 20-21 (Statement of Mr. 
Szycher), 12, 79 (Statements of Mr. Kaswell), 10 (Statement of Mr. 
Thum), available at https://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_6_SegBankruptcy.html.
    \9\ Roundtable at 18 (Statement of Mr. Szycher).
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    FCMs and DCOs, on the other hand, point out that models of 
protecting swaps customer collateral that are different from the 
current model for protecting futures customer collateral would bring 
significant added costs, which they aver would ultimately be borne by 
the customers. Moreover, the use of fellow-customer collateral is 
included in existing DCO models for dealing with member defaults. The 
Commission has proposed to require DCOs to maintain default resources 
sufficient to

    [e]nable the derivatives clearing organization to meet its 
financial obligations to its clearing members notwithstanding a 
default by the clearing member creating the largest financial 
exposure for the derivatives clearing organization in extreme but 
plausible market conditions.\10\
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    \10\ See Financial Resources Requirements for Derivatives 
Clearing Organizations, 75 FR 63113, 63118 (proposed regulation 
39.11(a)(1)) (Oct. 14, 2010).

Systemically-important DCOs would be required to maintain default 
resources sufficient to cover a default by the two clearing members 
creating the largest combined financial exposure in such 
conditions.\11\
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    \11\ Id. at 63119 (proposed regulation 39.29(a)).
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    Typically, DCOs use a variety of resources in addressing defaults 
arising from a member's customer account.\12\ These resources, which 
are frequently referred to as a ``waterfall,'' typically include, in 
order, the property of the Defaulting Member, the margin posted on 
behalf of all of that members' customers, a portion of the capital of 
the DCO, and the default fund contributions of other members of the 
DCO.\13\
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    \12\ Customers would not be exposed to loss in the case of a 
default arising from their FCM's proprietary account.
    \13\ See, e.g., CME Rule 802.
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    If the collateral of non-defaulting swaps customers is not 
available as a default resource, DCOs will need to change their models 
for sizing their default waterfalls, and/or the size of the components 
of those default waterfalls. One means to do this would be to increase 
the collateral required to margin each customer's positions. One DCO 
estimated that it might need to increase collateral from a 99% 
confidence level to a 99.99% confidence level, which would cause an 
increase in required collateral of approximately 60%.\14\ These 
increases in required margin levels would be passed on to customers, as 
an FCM is required to collect margin from a customer at a level no less 
than that imposed by the clearing house on the clearing member FCM. The 
Commission requests that DCOs provide data in support of their 
assertions.
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    \14\  See, e.g., Roundtable at 137-138 (Colloquy between Ms. 
Taylor and Mr. Maguire).
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    An alternative approach to reacting to changes in the model for 
sizing default waterfalls would be to increase clearing members' 
default fund contributions. FCMs note that if they are required to 
commit added capital to clearing, they would pass such costs on to 
customers. Certain models for protecting collateral posted by customers 
clearing swaps could also cause significant added administrative costs, 
in requiring more transactions per customer every day, which costs 
would also be passed on to customers.\15\ The Commission requests that 
FCMs provide data supporting these assertions.
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    \15\  See, e.g., Roundtable at 62-73 (Statements of Ms. Burke).
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    The Commission is seeking to achieve two basic goals: Protection of 
customers and their collateral, and minimization of costs imposed on 
customers and on the industry as a whole. It is considering four models 
of achieving these goals with respect to cleared swaps. These are 
listed in order below, from most protective of customer collateral to 
least protective of customer collateral.
    Each of these various models would potentially impose different 
levels of costs upon the various parties--i.e., customers, FCMs, and 
DCOs--both pre- and post-default. Accordingly, the Commission seeks to 
obtain further information about the costs and benefits of such models.

III. Description of the Models

    The Commission seeks comment on each of the following four 
potential models, as well as any additional models that may be proposed 
by commenters:

[[Page 75164]]

    (1) Full Physical Segregation--Each customer's cleared swaps 
account, and all property collateralizing that account, is kept 
separately for and on behalf of that cleared swaps customer, at the 
FCM, at the DCO, and at each depository.
    a. Impact on Customers' Risk: Each customer is protected from 
losses on the positions or investments of any other customer.
    b. Impact on DCO Default Resources: The collateral attributable to 
any non-defaulting customer is not available as a DCO default resource
    (2) Legal Segregation With Commingling--The collateral of all 
cleared swaps customers of an FCM member of a DCO is kept on an omnibus 
basis, but is attributed to each customer based on the collateral 
requirements, as set by the clearinghouse, attributable to each 
customer's swaps.
    a. Process: Payments and collections of both initial margin and 
variation margin between the DCO and its member FCMs customer accounts 
are made on an omnibus basis. Each FCM member reports to the DCO, on a 
daily basis, the portfolio of rights and obligations attributable to 
each cleared swaps customer. The performance bond collateral required 
at the DCO for each customer's swaps is a function, defined by the DCO, 
of that portfolio of rights and obligations. The collateral required 
for all of an FCM member's customers is the sum of the collateral 
requirements for each of such customers.
    b. Posting Collateral:
    i. The FCM may post the total required customer margin on an 
omnibus basis, without regard to the customer to whom any particular 
item of collateral (e.g., a particular security) belongs.
    ii. If the FCM loans to a customer any portion of the property 
necessary to margin that customer's positions, that collateral is 
treated at the DCO as belonging to the customer, and at the FCM as a 
debt from the customer to the FCM.
    iii. The DCO may require an FCM to post its own capital as 
collateral for its guarantee of its customers.
    c. Use of Collateral in Case of Default--If the FCM defaults, the 
DCO must treat each customer's swaps positions, and related margin 
(based on the positions reported as of the day previous to the default) 
individually, debiting each customer's account with losses attributable 
to that customer's positions, and crediting each customer's account 
with gains attributable to that customer's positions. However, if the 
value of the margin account is reduced below the required level as a 
result of market fluctuations in the value of the collateral, the 
margin attributed to each customer would be adjusted accordingly on a 
pro rata basis. The DCO has recourse to any collateral posted by the 
FCM as part of its own capital.
    d. Transfer or Return of Positions and Collateral--The DCO may, at 
its election, transfer the swaps positions and related collateral of 
any or all of the defaulting FCM's customers to a willing transferee, 
or liquidate such swaps positions and return the remaining collateral 
to the FCM (or its trustee in bankruptcy).
    e. Impact on Customers' Risk--Each customer of the defaulting FCM 
is protected from losses on the positions of other customers, but bears 
some risk of loss on the value of collateral (subject to the investment 
restrictions of Commission Regulation 1.25).\16\
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    \16\ 17 CFR 1.25.
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    f. Impact on DCO Default Resources--The remaining collateral 
attributable to each of the defaulting FCM's customers is not available 
as a DCO Default Resource.
    (3) Moving Customers to the Back of the Waterfall--This model is 
similar to Model 2 above, Legal Segregation With Commingling, with two 
modifications:
    a. The DCO may use the remaining collateral attributable to each of 
the defaulting FCM's customers as a DCO default resource.
    b. Before using the remaining collateral attributable to any 
customer, however, the DCO must first apply (i) the DCO's contribution 
to its default resources from its own capital and (ii) the guarantee 
fund contributions of all members of the DCO.
    c. Impact on Customers' Risk--Each customer of the defaulting FCM 
is protected from losses on the positions of other customers, except in 
the most extreme of circumstances (a default which consumes the DCO's 
guarantee fund), in which case the customers are at risk of losing 
their collateral. Customers also bear some risk of loss on the value of 
collateral (subject to the investment restrictions of Regulation 1.25).
    d. Impact on DCO Default Resources--The remaining collateral 
attributable to each of the defaulting FCM's customers is available as 
a DCO Default Resource. Because the total required default resources 
(including the DCO's contribution and the guarantee fund) are 
substantial,\17\ the remaining collateral of customers will only be 
used in the case of an extremely large default.
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    \17\ See supra footnotes 10-11.
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    (4) Baseline Model--The current approach to futures. The rights and 
obligations arising out of the cleared swaps positions of all cleared 
swaps customers of an FCM member of a DCO, as well as the money, 
securities and other property collateralizing such rights and 
obligations, are held at the DCO on an omnibus basis. The DCO has 
recourse to all such collateral in the event of any failure of the FCM 
member to meet a margin call (initial or variation) with respect to the 
FCM's cleared swaps customer account at that DCO.
    a. Impact on Customers' Risk--Each customer of the defaulting FCM 
is exposed to loss of their collateral due to losses on the positions 
of other customers. Customers also bear some risk of loss on the value 
of collateral (subject to the investment restrictions of Regulation 
1.25).
    b. Impact on DCO Default Resources--The remaining collateral 
attributable to each of the defaulting FCM's customers is fully 
available as a DCO default resource, and may be used before the DCO's 
contribution or the default fund contributions of other clearing 
members.

IV. Cost and Benefit Questions

    The Commission seeks comment on all of the following questions from 
all members of the public, but will direct specific questions to three 
particular groups of stakeholders:
    (1) Cleared Swaps Customers, including asset management firms and 
others who may act on their behalf.
    (2) FCMs who currently intermediate swaps on behalf of customers, 
or who intend to do so in the future, or trade organizations with FCM 
members.
    (3) DCOs.

1. For Cleared Swaps Customers

    a. What are the benefits of each of the models relative to the 
baseline model and relative to other models?
    b. What costs would you expect to incur for each of the models 
relative to the baseline model? Please provide a detailed basis for 
that estimate.
    c. How should the Commission balance such costs and benefits?

2. For FCMs

    For Each Model (Other Than the Baseline Model)
    a. Compliance:
    i. What compliance activities (including gathering of information) 
would you need to perform as a result of that model that you do not 
perform now (i.e., as part of the baseline model).
    ii. What is a reasonable estimate of the initial and annualized 
ongoing cost of

[[Page 75165]]

such incremental activities (relative to the baseline model) for your 
institution? Please provide a detailed basis for that estimate.
    iii. How can such costs be estimated industry-wide? Please provide 
a detailed basis for that estimate?
    b. Risk environment:
    i. How do you see the industry adapting to the risk changes 
attendant to the model?
    ii. What types of costs would you expect your institution to incur 
if the industry adapts to that model in the most efficient manner 
feasible? How are these costs different from the costs you would incur 
under the baseline model?
    iii. What is a reasonable estimate of the initial and annualized 
ongoing incremental cost incurred by your institution? Are these costs 
the same for each FCM clearing member, or a function of activity level? 
Please provide a detailed basis for that estimate.
    iv. How can such costs be estimated industry-wide? Please provide a 
detailed basis for that estimate?
    c. What benefits does the model present relative to the baseline 
model, and relative to other models?

3. For DCOs

For Each Model (Other Than the Baseline Model)
    a. Compliance (internal):
    i. What compliance activities (including gathering of information) 
would you need to perform as a result of that model that you do not 
perform now (i.e., as part of the baseline model)?
    ii. What is a reasonable estimate of the initial and annualized 
ongoing cost of such incremental activities (relative to the baseline 
model) for your DCO? Please provide a detailed basis for that estimate.
    b. Compliance (members):
    i. What compliance activities (including gathering of information) 
would you expect each of your members to perform as a result of that 
model that they do not perform now (i.e., as part of the baseline 
model).
    ii. What is a reasonable estimate of the initial and annualized 
ongoing cost of such incremental activities (relative to the baseline 
model) for each such member? Do these costs vary with the member's 
level of activity? How? Please provide a detailed basis for your 
estimates.
    iii. What is a reasonable estimate of the initial and ongoing costs 
of such activities across your membership? May there be some members 
who do not incur these costs? Please provide a detailed basis for these 
estimates.
    c. Changes to default management structure:
    i. What changes to your default management structure (relative to 
the baseline model) would the model require?
    ii. Costs to the DCO
    1. What types of costs would these changes impose on the DCO if the 
industry adapts to that model in the most efficient manner feasible? 
How are these costs different from the costs the DCO would incur under 
the baseline model?
    2. What is a reasonable estimate of the initial and annualized 
ongoing incremental cost to the DCO? Please provide a detailed basis 
for that estimate.
    iii. Costs to members
    1. What types of costs would these changes to the DCO's default 
management impose on members if the industry adapts to that model in 
the most efficient manner feasible? How are these costs different from 
the costs the members would incur under the baseline model?
    2. What is a reasonable estimate of the initial and annualized 
ongoing incremental cost to each member? Are these costs the same for 
each member, or are they a function of activity level? Please provide a 
detailed basis for that estimate.
    3. What is a reasonable estimate of the initial and ongoing costs 
of such activities across your membership? May there be some members 
who do not incur these costs? Please provide a detailed basis for these 
estimates.
    iv. To what extent do the costs identified above represent 
increased costs to the system as a whole (i.e., customers, FCMs, and 
DCOs considered together) and to what extent do they represent a shift 
of risk and/or cost between those groups?
    b. What benefits does the model present relative to the baseline 
model, and relative to other models?
    For all commenters:
    2. Optional Models
    A point frequently raised is that individual customer protection 
should be made available on an optional basis. There are questions as 
to how such a model could be implemented, and how the costs imposed by 
a customer obtaining individual protection could be attributed to--and 
charged to--that customer. For example, in the ``Full Physical 
Segregation'' and ``Legal Segregation with Commingling'' models 
discussed above, a significant portion of the marginal costs may arise 
from the fact that the collateral posted by the opting-out customer 
would not be available in the event of a default caused by other 
customers of the same FCM. How could a payment by the opting-out 
customer be used to address the changes to the DCO's default management 
structure that would be attributable to that opting out? Considered 
from another perspective, how much cost would be avoided from an 
optional as contrasted to a mandatory implementation of each of the 
models above? Also, what would be the effect on customers of an FCM in 
bankruptcy if different DCOs of which the FCM was a member adopted 
different voluntary models? If a marketplace in which varying models 
were in use was otherwise desirable, what changes to the Regulation 
Part 190 rules regarding bankruptcy account classes could or should be 
made to accommodate such variety?
    3. Moral Hazard: Customers risk-managing their FCMs:
    Another point frequently raised is that customers should risk-
manage their FCMs, and provide market discipline by doing business with 
FCMs that pose less risk. DCOs already monitor the eligibility of their 
members, supervising the member's risk relative to collateral and 
capital, and considering members' risk management.\18\ The Commission 
is aware of concerns that, if the risk that customers will lose swaps 
collateral posted at an FCM is minimized, there will be less incentive 
for FCMs to maintain capital in excess of the minimum levels required 
by the Commission and the DCOs of which such FCMs are members. These 
concerns lead to a number of questions:
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    \18\ See Sections 5b(c)(2)(C)(i)(I), (c)(2)(C)(ii), (c)(2)(D) of 
the CEA (participant eligibility and risk management).
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    a. To what extent would each model lead to moral hazard concerns? 
How, if at all, could such concerns be addressed?
    b. Are the capital requirements currently imposed by the Commission 
on FCMs and by DCOs on their clearing members sufficient? If not, what 
steps should DCOs or the Commission take to address this insufficiency?
    c. Do the rules and procedures of DCOs currently provide adequate 
tools and incentives for DCOs to supervise their clearing members so as 
to mitigate the risk of default? If not, what steps should DCOs or the 
Commission take to address this inadequacy?
    In analyzing costs, the Commission needs to consider the additional 
cost incurred by customers risk-managing their FCMs on an initial and 
ongoing

[[Page 75166]]

basis.\19\ This leads to a number of questions:
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    \19\ Cf. Roundtable at 45-46 (Statement of Mr. Prager) (DCOs 
have advantages over clients in conducting risk management of FCMs).
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    d. What information would each customer need, on an initial and an 
ongoing basis, to effectively manage the risk posed by fellow-customers 
at an FCM?
    e. What information should be provided to each customer regarding 
the FCM's risk management policies, and how those policies are, in 
fact, implemented with respect to other customers, on both an initial 
and ongoing basis?
    f. What information should be provided to each customer regarding 
fellow-customer risk, on both an initial and ongoing basis?
    g. What is or would be the cost, per customer, on an annualized 
basis, of conducting this risk management?
    h. What is or would be the cost to the industry as a whole, on an 
annualized basis, of customer-conducted FCM risk management?

V. Other Questions

    1. Did Congress evince an intent as to whether the Commission 
should adopt any one or more of these models?
    How do commenters view Interpretation 85-3, and how should it 
inform the rulemaking on segregation of collateral for cleared swaps 
customers? (A copy of this interpretation is attached as an appendix to 
this Request for Comment.)

    Issued in Washington, DC, on November 19, 2010, by the 
Commission.
David A. Stawick,
Secretary of the Commission.

APPENDIX

Interpretative Statement, No. 85-3, Regarding the Use of Segregated 
Funds by Clearing Organizations Upon Default by Member Firms. (OGC Aug. 
12, 1985)

    Use of Segregated Funds by Clearing Organizations Upon Defaults 
By Member Firms
    The rights of a clearing organization to make use of margin 
funds deposited by a clearing member firm that has defaulted on an 
obligation to the clearing organization are defined by the rules and 
by-laws of the clearing organization subject to limitations imposed 
by the Commodity Exchange Act (``Act'') and the rules and 
regulations promulgated thereunder, 17 CFR 1, et seq. (1984). 
Clearing organization rules and by-laws commonly provide that upon 
the failure of a member firm to satisfy an obligation owed the 
clearing organization, the clearing organization may use all margin 
funds and property of the member firm within the clearing 
organization's custody to satisfy the firm's obligations to the 
clearing organization. In our view, Section 4d(2) of the Act does 
not preclude the clearing organization from applying all margin 
deposits of a defaulting firm to discharge such firm's obligations 
on behalf of the customer account for which they were deposited with 
the clearing organization. The clearing organization may be 
precluded from exercising such rights in limited circumstances, 
however, by reason of its knowledge of or participation in a 
violation of the Act or other provision of law by the defaulting 
firm or other parties that renders its rights to such funds inferior 
to those of the clearing firm's customers.
    Section 4d(2) of the Act, 7 U.S.C. 6d, defines the manner in 
which futures commission merchants (``FCMs''), clearing 
organizations, and other depositories of funds deposited by 
commodity customers to margin or settle futures transactions, or 
accruing to customers as the result of such trades, must deal with 
such funds. Section 4d(2) requires that FCMs ``treat and deal with'' 
funds deposited by a customer to margin or settle trades or 
contracts or accruing as the result of such trades or contracts ``as 
belonging to such customer,'' separately account for such funds, and 
refrain from using such funds ``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.'' Section 
4d(2) specifically authorizes FCMs to commingle such funds, for 
purposes of convenience, in the same account or accounts with any 
bank, trust company or clearing organization of a contract market. 
This provision also authorizes withdrawals from such funds of ``such 
share thereof as in the normal course of business shall be 
necessary'' to margin, guarantee, secure, transfer, adjust, or 
settle trades or contracts, ``including the payment of commissions, 
brokerage, interest, taxes, storage and other charges, lawfully 
accruing in connection with such contracts and trades.''
    The final sentence of Section 4d(2) defines the obligations of 
clearing organizations, depositories and all other recipients of 
customer margin funds and property in the following terms:
    It shall be unlawful for any person, including but not limited 
to any clearing agency of a contract market and any depository, that 
has received any money, securities, or property for deposit in a 
separate account as provided in paragraph (2) of this section, to 
hold, dispose of or use any such money, securities, or property as 
belonging to the depositing futures commission merchant or any 
person other than the customers of such futures commission merchant.
    This provision prohibits clearing organizations and all other 
depositories of customer funds from using such funds to discharge 
proprietary obligations of the depositing FCM or for any purpose 
other than to margin, guarantee, secure, transfer, adjust, or settle 
trades or contracts of the depositing firm's customers, including 
the payment of commissions and other charges ``lawfully accruing in 
connection with'' such contracts and trades.
    In our view, Section 4d(2)'s provisions with respect to clearing 
organizations' treatment of customer funds must be construed in 
light of the fact that clearing organizations' direct customers are, 
generally, clearing firms, not the ultimate ``customers'' who 
entered into the futures contracts and options positions accepted 
for clearance by the clearing organization. Margin deposits posted 
with clearing organizations by their member firms normally consist, 
at least in part, of funds belonging to clearing firm customers, 
whose margin deposits were posted with the clearing firm and 
subsequently drawn upon by the clearing firm to satisfy its margin 
obligations to the clearing organization. The clearing organization 
normally has no direct dealings with such customers and has 
knowledge neither of their specific identities nor of the extent of 
their respective ownership interests in margin funds posted by its 
clearing firms. Consequently, to the extent that Section 4d(2) of 
the Act requires that clearing organizations use margin deposits on 
behalf of the ``customers of such [depositing] futures commission 
merchant,'' we are of the view that it requires only that the 
clearing organization use such funds as the property of the clearing 
firm's customers collectively, but does not require the clearing 
organization to treat such funds as the property of the particular 
customers who deposited them or to whose positions they have 
accrued.
    This view accords with the legislative history of Section 4d(2) 
of the Act. The Act did not specifically govern the treatment of 
commodity customer funds by clearing organizations and other 
depositories of customer margin funds until the enactment of Section 
4d(2)'s final paragraph, quoted above, in 1968. The legislative 
history of this provision reflects Congress's intention to ensure 
that customer funds would not be used to discharge the general 
obligations of the FCM or otherwise diverted from their lawful 
purposes. According to the Senate Report, for example, the amendment 
was proposed ``to prohibit expressly customers' funds from being 
used to offset liabilities of the futures commission merchants or 
otherwise being misappropriated.'' S. Rep. No. 947, 90th Cong. 2d 
Sess. 7 (1968). See also H.R. Rep. No. 743, 90th Cong., 1st Sess. 4-
5 (1967).
    The Commodity Exchange Authority's Administrator described the 
1968 amendment as one which would afford additional protection 
against a situation presented in the De Angelis salad oil case ``in 
which one of the banks actually took over funds of customers of one 
of the brokerage firms to offset liabilities of the firm.'' Amend 
the Commodity Exchange Act: Hearings on H.R. 11930 and H.R. 12317 
Before the House Comm. on Agriculture 57 (1967) (Testimony of Alex 
C. Caldwell, Administrator, Commodity Exchange Authority). The 
proposed amendment would require that banks and other depositories 
``keep separate the funds of the customers and of the brokerage 
firms which they do not have to do now.'' Id. The Act's legislative 
history thus evinces an intention that depositories treat customers' 
funds as the property of the

[[Page 75167]]

customers of the depositing FCM, as distinguished from the FCM's own 
property or that of any other person.
    Our conclusion that Section 4d(2) generally allows clearing 
organizations to treat customer funds as the property of the 
depositing firm's customers, collectively, without regard to the 
respective interests of particular customers, also finds support in 
the legislative history of the Bankruptcy Reform Act of 1978. In 
recommending new provisions to govern bankruptcy liquidations of 
commodity firms, the Commission described the clearing house system 
then (and now) operant in the futures market as one in which ``a 
clearing house deals only with its clearing members'' and thus 
``does not know the specific customer on whose behalf a particular 
contract was entered into by one of its clearing members.'' 
Bankruptcy Act Revision: Hearings on H.R. 31 and H.R. 32 Before the 
Subcomm. on Civil and Constitutional Rights, House Comm. on the 
Judiciary, 94th Cong., 2d Sess. 2377, 2395 (Statement of William T. 
Bagley) (1976). The Commission explained that this system allows a 
clearing organization to use ``whatever funds are on deposit with it 
on behalf of customers to meet variation margin calls with respect 
to customers' trades or contracts'' and, following a clearing member 
default, the defaulting firm's ``original margin deposits are 
immediately available to offset any losses the clearing house might 
incur'' as a result of answering variation margin calls to the 
defaulting firm. Id. at 2397, 2405.
    The Commission's regulations are also consistent with the view 
that the clearing organization's direct obligations under Section 
4d(2) include an obligation to treat customer funds as the property 
of the depositing FCM's customers but do not include a duty to 
separately account for or to employ such funds as the property of 
particular customers. Regulation 1.20(b), 17 CFR 1.20(b) (1984), for 
example, requires that a clearing organization separately account 
for and segregate all customers' funds received from a member of the 
clearing organization to purchase, margin, guarantee, secure or 
settle the trades, contracts or commodity options of the clearing 
member's customers and all money accruing to such customers as the 
result of such trades, contracts, or commodity options ``as 
belonging to such commodity or option customers,'' and specifies 
that a clearing organization shall not hold, use or dispose of such 
customer funds ``except as belonging to such commodity or option 
customers.'' 17 CFR 1.20(b) (1984).\1\
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    \1\ To the extent that the final sentence of Regulation 1.20(a), 
17 CFR 1.20(a) (1984), may be read to require that clearing 
organizations treat customer funds as the property of the particular 
customer who deposited them, we consider it inconsistent with 
Regulation 1.20(b), which more specifically addresses the 
obligations of clearing organizations, and with this agency's view 
of clearing organizations' obligations. The current language of 
Regulation 1.20(a)'s final sentence apparently reflects an 
unintentionally broad modification of that provision made in 
connection with amendments of a number of Commission regulations to 
reflect establishment of the Commission's exchange-traded options 
program. Until these 1981 revisions of the Commission's regulations, 
Regulation 1.20(a)'s last sentence referred to ``customers'' in the 
plural, made no express reference to clearing organizations and was 
substantially consistent with the final sentence of Section 4d(2). 
The Commission's proposed rules regarding exchange-traded options 
would have modified this language only to the extent of including 
option customers within its protections: ``Nor shall any such funds 
be held, disposed of, or used as belong [sic] to the depositing 
futures commission merchant or any person other than the commodity 
or option customers of such futures commission merchant.'' 46 FR 
33315 (1981). As adopted, however, the Commission's final rules 
concerning the regulation of exchange-traded commodity options 
included Regulation 1.20(a)'s final sentence in its current form, a 
modification that apparently was not intended to be substantive. In 
the preamble to these rules, the Commission stated that it was 
adopting revised Regulations 1.20 through 1.30 ``essentially as 
proposed.'' 46 FR 54508 (1981). We suggest that a technical 
amendment to Regulation 1.20(a) be proposed in the near future to 
conform its final sentence to its intended meaning.
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    Regulation 1.22, 17 CFR 1.22 (1984), which precludes FCMs from 
using or permitting the use of ``the customer funds of one commodity 
and/or option 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 customer or option customer,'' 
refers only to FCMs and, hence, does not govern clearing 
organizations or other depositories of customer funds.\2\
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    \2\ See also Regulation 1.36, which governs recordkeeping 
concerning securities and other property received from customers and 
option customers. Regulation 1.36 requires FCMs to maintain a 
record, showing ``separately for each customer or option customer'' 
the securities or property received, name and address of the 
depositing customer and other pertinent information. By contrast, 
clearing organizations with which clearing member firms deposit 
securities or property belonging to particular customers or option 
customers of such members in lieu of cash margin are required to 
maintain records ``which will show separately for each member'' the 
date of receipt of such securities and property and other pertinent 
data but are not required to maintain records of the names of the 
particular customers of the member firm from whom such securities 
and property were received.
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    Our conclusion that Section 4d(2) does not preclude a clearing 
organization from using all margin funds deposited by a clearing 
member firm to satisfy obligations arising from the account for 
which such funds were deposited reflects the essential function of 
margin deposits in the futures markets' clearing system. Clearing 
organizations generally stand as guarantors of the net futures and 
options obligations of the member firms and require margin deposits 
as security for the performance of obligations which, in the event 
of a member's default, the clearing organization must discharge. 
Margin deposits at the clearing level thus facilitate the clearing 
organization's performance of its guarantee obligations, serving to 
confine losses stemming from a clearing firm default to the 
defaulting firm and preventing their spread to the market as a 
whole.
    In sum, we conclude that clearing organization rules and by-laws 
awarding clearing organizations the right to apply all customer 
margin funds within their custody to satisfy nonproprietary 
obligations of defaulting clearing firms are not inconsistent with 
Section 4d(2) of the Act or the Commission's regulations. Clearing 
organizations' rights with regard to the use of customer margin 
deposits of their member firms are not, however, wholly unlimited. A 
clearing organization may not use the margin deposits of one 
clearing member firm to satisfy obligations of another clearing firm 
or of any other person. In addition, as noted above, the final 
paragraph of Section 4d(2) of the Act was enacted to present use of 
customer funds to satisfy the FCM's own obligations. Consequently, 
customer margin funds deposited by a member FCM may not be used to 
margin, guarantee or settle the futures or options transactions or 
to satisfy any other proprietary obligation of the depositing firm. 
Such funds must be used to margin, guarantee, secure, or settle 
trades or contracts of the depositing FCM's customers or for charges 
``lawfully accruing in connection with'' such contracts and not for 
any other purpose.\3\ Finally, a clearing organization's rights with 
respect to the use of customer margin funds may be limited in 
particular circumstances by reason of the clearing organization's 
knowledge of or participation in a violation of the Act or other 
provision of law that precludes it from obtaining rights to such 
funds superior to those of one or more customers of the defaulting 
clearing member. Such a violation could occur, for example, in 
circumstances in which the clearing organization received particular 
margin funds with actual knowledge that the depositing firm has 
breached its duty under Section 4d(2) to segregate and separately 
account for customer funds and that the funds in question have been 
deposited with it to margin, secure, guarantee or settle the trades 
or contracts of a person other than the customer who deposited such 
funds or to whom they have accrued. The clearing organization's 
knowing participation in such use of customer funds could subject it 
to aiding and abetting liability under Section 13(a) of the Act and 
would preclude it from obtaining rights to such funds superior to 
those of the innocent customer.
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    \3\ This prohibition includes a proscription against the use of 
customer margin funds deposited in connection with futures or option 
transactions to discharge obligations, including customers' 
obligations, incurred in connection with transactions that are not 
within the purview of the Act or the rules and regulations 
promulgated thereunder.
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Statement of Chairman Gary Gensler: Protection of Cleared Swaps 
Customers Before and After Commodity Broker Bankruptcies

    I support the advance notice of proposed rulemaking concerning 
protection of collateral of customers entering into cleared swaps. 
There has been much public input into these matters, but I think it 
is appropriate to have a formal ANPR soliciting input on a number of 
options and questions on how best to protect customers' collateral 
in the event of another customer's default. This is particularly 
important as we move forward to implement Congress's mandate that 
for the first time standardized swaps

[[Page 75168]]

must be cleared. I am hopeful that we will hear from a broad range 
of market participants, including clearinghouses, futures commission 
merchants, pension funds, asset managers and other end-users, on the 
costs, benefits and feasibility of various approaches to protecting 
customers' money.

[FR Doc. 2010-29836 Filed 12-1-10; 8:45 am]
BILLING CODE 6351-01-P