Compromise on Customer Protection Rule Will Have 5-Year Residual Interest Phase-In
By Richard Hill
Oct. 30 –The Commodity Futures Trading Commission adopted a customer protection rule Oct. 30 that includes a compromise on the controversial topic of how futures commission merchants will collect and maintain “residual interest” from their customers.
The rule was proposed in October 2012 in the wake of two large-scale FCM failures that left the firms’ customers–many of them small agribusiness depositors–scrambling to recoup more than $1 billion they had on deposit with the financial entities.
The rule was adopted 3-1; Commissioner Scott O’Malia voted against the rule, citing opposition to the compromise on residual interest.
Under the rule, FCMs will be required to maintain residual interest that is at least equal to its customers’ aggregate undermargined amounts for the prior trade date. According to a staff document, the rule “shifts[s] the risk of loss in the event of a double default away from customers with excess margin.”
In a change from the proposed rule, the residual interest requirement will be phased in over five years, beginning one year after the rule is published. At that time, FCMs will have to hold the required residual interest by 6 p.m. on the next business day after a trade in question rather than “at all times,” as proposed.
Commission staff then will report within 30 months of the rule’s publication “the practicality” of changing the 6 p.m. deadline, including associated costs and benefits. If the commission decides not to amend the rule, the phase-in period will expire on Dec. 31, 2018, at which time FCMs will have to hold the required residual interest prior to daily settlement with a clearinghouse.
The 6 p.m. compromise was floated by CME Group Inc. (CME) Executive Chairman and President Terrence Duffy at a hearing of the House Agriculture General Farm Commodities and Risk Management Subcommittee earlier in October. The Futures Industry Association agreed.
O’Malia voted against the rule after commissioners opposed an amendment he offered that would have eliminated the requirement that FCMs hold residual margin at the end of the daily settlement cycle after the five-year phase in. The commissioner said he would have supported the rule if commissioners had accepted his amendment.
O’Malia said his amendment would “not bias the [CFTC staff] study with an outcome that has been previously determined.” He reasoned that in five years, the agency would have analyzed the staff data and decided how to proceed.
Among other objections, O’Malia said residual interest rule would be too expensive and would lead to “a drastic increase” in margin funding. Now, “many small agribusiness hedgers will have to consider alternative risk management tools or, even worse, will be forced out of the market,” according to O’Malia.
Gensler: Phase-In ‘Smooths Transition.’
CFTC Chairman Gary Gensler had pushed for residual interest to be funded at FCMs “at all times,” but said the phase-in period is meant to “smooth implementation.” Nevertheless, he said, “[i]t is important that we look very closely at the law and ensure that one customer’s funds or property are not used in some way to secure or guarantee other people’s accounts.”
Commissioner Mark Wetjen said the commission heeded industry concerns that requiring residual interest at all times would be too expensive for FCMs and their customers. “Many contended,” he said, “that this would be too high a price to pay when measured against the corresponding benefit of mitigating fellow-customer risks.”
He said that the phase-in period was “a critical component” in reaching an agreement to adopt the rule.
For his part, Commissioner Bart Chilton disagreed “that this rule will have the perverse effect of funding customer protections on the back of America’s farmers and ranchers. Nothing could be further from the truth.” Instead, according to Chilton, the rule will ensure that agribusinesses do not suffer losses in the case of fraud or poor business practices at an FCM.
Meanwhile, the rule also institutes several other new protections. For instance, FCMs must adopt risk management programs that address potential risks related to operations, capital and customer fund segregation. One part of that program will require that customer funds be segregated from the firms’ and accounted for separately.
Regulators, including the CFTC and designated self-regulatory organizations, will have daily, electronic access to the segregated accounts. Meanwhile, SROs will be required to conduct their examinations of FCMs “in conformance with relevant auditing standards” established by the Public Company Accounting Oversight Board. Also, outside FCM auditors will be required to conduct their audits using PCAOB-promulgated standards and be PCAOB-registered and inspected.
In addition, FCMs will be required to make new disclosures to customers, including information about their business operations, and the general risks involved in futures trading.
Gensler told reporters after the hearing that “we will have failures of financial firms in the future. We haven’t repealed the business cycle.” However, when they fail, “as they will from time to time,” customer funds will be protected, he said.
The rules generally will become effective 60 days after publication. However, some rules will become effective 90 days after that date and some 180 days after. For instance, auditors will not have to be inspected by the PCAOB until Dec. 31, 2015.
Two Other Rules
Meanwhile, prior to its public meeting, commissioners voted seriatim Oct. 30 to adopt rules on segregation of margin for uncleared swaps, and ownership and control reports. The votes were unanimous.
The uncleared segregation rule requires swap dealers and major swap participants to notify uncleared swaps counterparties of a counterparty’s right to have any initial margin held in a segregated account maintained by an independent custodian.
The ownership and control rule requires new, electronic reporting to the commission regarding accounts that surpass certain trading volume thresholds. Staff said the rule will enable it to “more easily identify relationships between trading accounts, special accounts, reportable positions and market activity.” It also will help identify high-frequency traders.
At the open meeting, Gensler said he has asked commissioners to be available the second or third week of December to vote on adopting a Volcker rule. He stressed, however, that such a vote might not occur at that time.
Nonetheless, O’Malia complained to Gensler that commissioners still do not have an updated copy of a proposed Volcker rule, which is being marked up by staff at several agencies, inluding the Securities and Exchange Commission and banking regulators. “I will share the document when I think it is appropriate,” Gensler said.
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