Alert December 20, 2011

CFTC Adopts Restrictions on Permissible Investments for Customer Segregated Accounts

The CFTC adopted final rule amendments (the “Amendments”) to its regulations regarding the types of permissible investments for customer segregated accounts (“Segregated Accounts”).  The Amendments impose certain restrictions on the types and level of investments that futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) can make with customer assets, as well as revise the general standards associated with these restrictions.  As a result of public comments submitted in response to the CFTC’s original proposal (the “Original Proposal”, as discussed in the November 16, 2010 Financial Services Alert), the Amendments provide DCOs and FCMs more flexibility in investing customer funds than under the Original Proposal.  Of particular note, the Amendments, while still placing limits on investments in money market fund (“MMFs”) by Segregated Accounts, provide greater flexibility to invest customer funds in MMFs than originally proposed.

Statutory and Regulatory Overview.  Section 4d(a)(2) of the Commodity Exchange Act and Regulation 1.25 thereunder limit the types of investments for Segregated Accounts to obligations of the United States and obligations guaranteed as to principal and interest by the United States, general obligations of States or political subdivisions thereof, investments in MMFs, obligations issued by government-sponsored enterprises, bank certificates of deposit, commercial paper, corporate notes and general obligations of sovereign nations.  Regulation 1.25 also sets forth the general standard that such investment limitations are consistent with the goal of ensuring that funds in Segregated Accounts “must be invested in a manner that minimizes their exposure to credit, liquidity, and market risks both to preserve their availability to customers and DCOs and to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk.” 

Narrowed Scope of Investment Choices and Related Restrictions (other than MMFs).  The Amendments narrow the scope of investment choices set forth above by eliminating or restricting the use of certain instruments.  The following is a brief overview of these changes, including a description of certain of the more significant differences from the Original Proposal:

  • The Amendments continue to permit investment of customer funds in government-sponsored entities (“GSEs”).  However, Segregated Accounts may only invest in the obligations of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) while these entities remain under the conservatorship or receivership of the Federal Housing Finance Authority.
  • The Amendments permit investments in corporate notes or bonds or commercial paper only if such instruments are fully guaranteed as to principal and interest by the Temporary Liquidity Guarantee Program.
  • The Amendments permit investments in CDs only if such instruments can be redeemed at the issuing bank within one business day, with a penalty for early withdrawal limited to accrued interest earned according to its written terms.
  • The Amendments prohibit investments in foreign sovereign debt; the CFTC did state, however, that it will consider exemptions from this restriction on a case-by-case basis. 

MMF Investment Limitations.  As noted above, the Amendments impose heightened restrictions on the use of MMFs by FCMs and DCOs for Segregated Accounts.  However, the Amendments significantly relax certain of the more stringent limitations that would have been imposed under the Original Proposal.  The following is a brief overview of these changes, including a discussion of the significant differences from the Original Proposal:

  • Under the Original Proposal, aggregate investments in MMFs would have been limited to 10% of the total assets in the Segregated Account and no more than 2% of the total assets in such account could have been invested in any single family of MMFs.  Under the Amendments, the CFTC distinguishes between (1) MMFs that are comprised of obligations of the U.S. government (“Treasury MMFs”) and all other MMFs (“Non-Treasury MMFs”) and (2) MMFs with at least $1 billion in assets that are managed by a management company with at least $25 billion in MMF assets under management (“Large MMFs”) and all other MMFs (“Small MMFs”).  There is no asset-based concentration limit to the aggregate amount that a Segregated Account can invest in Large Treasury MMFs.  A Segregated Account may invest up to 50% of its assets in Large Non-Treasury MMFs.  A Segregated Account may invest up to 10% of its assets in Small MMFs, regardless of whether such MMFs are Treasury or Non-Treasury.  Furthermore, there is no issuer-based concentration limit to the amount that a Segregated Account can invest in a single Treasury MMF or in a “family” of Treasury MMFs.  A Segregated Account may invest up to 10% of its assets in a single Non-Treasury MMF or 25% of its assets in Non-Treasury MMFs in the “same family of funds.”
  • The Amendments clarify the acknowledgement letter requirement in the context of MMFs.  Under Regulation 1.25, FCMs or DCOs that invest customer funds in MMFs must obtain an acknowledgement letter from the “sponsor of the fund and the fund itself” when the MMF shares are held by a shareholder servicing agent.  The Amendments clarify that the acknowledgement letter should be obtained “from a party that has substantial control over [MMF] shares purchased with customer segregated funds and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds invested in shares of the [MMF]” and remove the current language in Regulation 1.25(c)(3) relating to the issuer of the acknowledgment letter when the shares of the fund are held by the fund’s shareholder servicing agent.
  • The Amendments also provide certain additional exceptions to Regulation 1.25’s “next day redemption” requirements by accounting for Rule 22e-3 under the Investment Company Act of 1940, which permits an MMF to suspend redemptions and postpone payment of redemptions in order to facilitate an orderly liquidation, provided certain conditions are met.  

Effective and Compliance Dates.  The Amendments are effective February 17, 2012.  Compliance with the Amendments is required beginning June 18, 2012.