Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Proposed rule.

SUMMARY:

The Commodity Futures Trading Commission (Commission or CFTC) is proposing to amend its regulations regarding the investment of customer segregated funds and funds held in an account subject to Commission Regulation 30.7 (30.7 funds). Certain amendments reflect the implementation of new statutory provisions enacted under Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules address: Certain changes to the list of permitted investments, a clarification of the liquidity requirement, the removal of rating requirements, an expansion of concentration limits including asset-based, issuer-based, and counterparty concentration restrictions. It also addresses revisions to the acknowledgment letter requirement for investment in a money market mutual fund (MMMF), revisions to the list of exceptions to the next-day redemption requirement for MMMFs, the application of customer segregated funds investment limitations to 30.7 funds, the removal of ratings requirements for depositories of 30.7 funds, and the elimination of the option to designate a depository for 30.7 funds.

DATES:

Comments must be received on or before December 3, 2010.

ADDRESSES:

You may submit comments, identified by RIN number, by any of the following methods:

• Agency Web site, via its Comments Online process: http://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: http://www.regulations.gov . Follow the instructions for submitting comments.

All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to http://www.cftc.gov. You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that may be exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the established procedures in CFTC Regulation 145.9.

FOR FURTHER INFORMATION CONTACT:

Phyllis P. Dietz, Associate Director, 202-418-5449, pdietz@cftc.gov, or Jon DeBord, Attorney-Advisor, 202-418-5478, jdebord@cftc.gov, or Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1151 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

A. Regulation 1.25

B. Regulation 30.7

C. Advance Notice of Proposed Rulemaking

D. The Dodd-Frank Act

II. Discussion of the Proposed Rules

A. Permitted Investments

1. Government Sponsored Enterprise Securities

2. Commercial Paper and Corporate Notes or Bonds

3. Foreign Sovereign Debt

4. In-House Transactions

B. General Terms and Conditions

1. Marketability

2. Ratings

3. Restrictions on Instrument Features

4. Concentration Limits

(a) Asset-Based Concentration Limits

(b) Issuer-Based Concentration Limits

(c) Counterparty Concentration Limits

C. Money Market Mutual Funds

1. Acknowledgment Letters

2. Next-Day Redemption Requirement

D. Repurchase and Reverse Repurchase Agreements

E. Regulation 30.7

1. Harmonization

2. Ratings

3. Designation as a Depository for 30.7 Funds

III. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

C. Costs and Benefits of the Proposed Rules

Text of Rules

I. Background

A. Regulation 1.25

Under Section 4d(a)(2) of the Commodity Exchange Act (Act), the investment of customer segregated funds is limited to obligations of the United States and obligations fully guaranteed as to principal and interest by the United States (U.S. government securities), and general obligations of any State or of any political subdivision thereof (municipal securities). Pursuant to authority under Section 4(c) of the Act, the Commission substantially expanded the list of permitted investments by amending Commission Regulation 1.25 in December 2000 to permit investments in general obligations issued by any enterprise sponsored by the United States (government sponsored enterprise securities or GSE securities), bank certificates of deposit (CDs), commercial paper, corporate notes, general obligations of a sovereign nation, and interests in MMMFs. In connection with that expansion, the Commission included several provisions intended to control exposure to credit, liquidity, and market risks associated with the additional investments, e.g., requirements that the investments satisfy specified rating standards and concentration limits, and be readily marketable and subject to prompt liquidation.

The Commission further modified Regulation 1.25 in 2004 and 2005. In February 2004, the Commission adopted amendments regarding repurchase agreements using customer-deposited securities and time-to-maturity requirements for securities deposited in connection with certain collateral management programs of derivatives clearing organizations (DCOs). In May 2005, the Commission adopted amendments related to standards for investing in instruments with embedded derivatives, requirements for adjustable rate securities, concentration limits on reverse repurchase agreements, transactions by futures commission merchants (FCMs) that are also registered as securities brokers or dealers (in-house transactions), rating standards and registration requirements for MMMFs, an auditability standard for investment records, and certain technical changes.

The Commission has been, and continues to be, mindful that customer segregated funds 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. Toward these ends, Regulation 1.25 establishes a general prudential standard by requiring that all permitted investments be “consistent with the objectives of preserving principal and maintaining liquidity.”

In 2007, the Commission's Division of Clearing and Intermediary Oversight (Division) launched a review of the nature and extent of investments of customer segregated funds and 30.7 funds (2007 Review) in order to further its understanding of investment strategies and practices and to assess whether any changes to the Commission's regulations would be appropriate. As part of this review, all registered DCOs and FCMs carrying customer accounts provided responses to a series of questions. As the Division was conducting follow-up interviews with respondents, the market events of September 2008 occurred and changed the financial landscape such that much of the data previously gathered no longer reflected current market conditions. However, much of that data remains useful as an indication of how Regulation 1.25 was implemented in a more stable financial environment, and recent events in the economy have underscored the importance of conducting periodic reassessments and, as necessary, revising regulatory policies to strengthen safeguards designed to minimize risk.

B. Regulation 30.7

Regulation 30.7 governs an FCM's treatment of customer money, securities, and property associated with positions in foreign futures and foreign options. Regulation 30.7 was issued pursuant to the Commission's plenary authority under Section 4(b) of the Act. Because Congress did not expressly apply the limitations of Section 4d of the Act to 30.7 funds, the Commission historically has not subjected those funds to the investment limitations applicable to customer segregated funds.

The investment guidelines for 30.7 funds are general in nature. Although Regulation 1.25 investments offer a safe harbor, the Commission does not currently limit investments of 30.7 funds to permitted investments under Regulation 1.25. Appropriate depositories for 30.7 funds currently include certain financial institutions in the United States, financial institutions in a foreign jurisdiction meeting certain capital and credit rating requirements, and any institution not otherwise meeting the foregoing criteria, but which is designated as a depository upon the request of a customer and the approval of the Commission.

C. Advance Notice of Proposed Rulemaking

In May 2009, the Commission issued an advance notice of proposed rulemaking (ANPR) to solicit public comment prior to proposing amendments to Regulations 1.25 and 30.7. The Commission stated that it was considering significantly revising the scope and character of permitted investments for customer segregated funds and 30.7 funds. In this regard, the Commission sought comments, information, research, and data regarding regulatory requirements that might better safeguard customer segregated funds. It also sought comments, information, research, and data regarding the impact of applying the requirements of Regulation 1.25 to investments of 30.7 funds.

The Commission received twelve comment letters in response to the ANPR, and it has considered those comments in formulating its proposal. Eleven of the 12 letters supported maintaining the current list of permitted investments and/or specifically ensuring that MMMFs remain a permitted investment. Five of the letters were dedicated solely to the topic of MMMFs, providing detailed discussions of their usefulness to FCMs. Several letters addressed issues regarding ratings, liquidity, concentration, and portfolio weighted average time to maturity. The alignment of Regulation 30.7 with Regulation 1.25 was viewed as non-controversial.

The FIA's comment letter expressed its view that “all of the permitted investments described in Rule 1.25(a) are compatible with the Commission's objectives of preserving principal and maintaining liquidity.” This opinion was echoed by MF Global, Newedge and FC Stone. CME asserted that only “a small subset of the complete list of Regulation 1.25 permitted investments are actually used by the industry. * * *” NFA also wrote that investments in instruments other than U.S. government securities and MMMFs are “negligible” and recommended that the Commission eliminate asset classes not “utilized to any material extent.”

D. The Dodd-Frank Act

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Title IX of the Dodd-Frank Act was promulgated in order to increase investor protection, promote transparency and improve disclosure.

Section 939A of the Dodd-Frank Act obligates federal agencies to review their respective regulations and make appropriate amendments in order to decrease reliance on credit ratings. The Dodd-Frank Act requires the Commission to conduct this review within one year after the date of enactment. The Commission is proposing amendments to Regulations 1.25 and 30.7 that include removal of provisions setting forth credit rating requirements. Separate rulemakings proposed today address the elimination of credit ratings from Regulations 1.49 and 4.24 and the removal of Appendix A to Part 40 (which contains a reference to credit ratings).

The Commission is now proposing amendments to Regulations 1.25 and 30.7 and requests comment on all aspects of the proposed rules, as well as comment on the specific provisions and issues highlighted in the discussion below. In addition, commenters are welcome to offer their views regarding any other related matters that are raised by the proposed amendments.

II. Discussion of the Proposed Rules

A. Permitted Investments

In proposing amendments to Regulation 1.25, the Commission seeks to simplify the regulation and impose requirements that can better ensure the preservation of principal and maintenance of liquidity. The Commission has endeavored to tailor its proposal to achieve these goals while retaining an appropriate degree of investment flexibility and opportunities for attaining capital efficiency for DCOs and FCMs investing customer segregated funds.

The Commission seeks to simplify Regulation 1.25 by narrowing the scope of investment choices in order to eliminate the potential use of instruments that may pose an unacceptable level of risk. In their July 2009 comment letters, both NFA and CME suggested contracting the scope of permitted investments by eliminating asset classes used negligibly as investment vehicles.

The Commission seeks to increase the safety of Regulation 1.25 investments by promoting diversification. For example, issuer-specific concentration limits control how much exposure an FCM or DCO has to the credit risk of any one investment. The Commission believes that greater diversification can be achieved through instituting two additional types of concentration limits. First, asset-based concentration limits, suggested by the FIA, MF Global and Newedge in their comment letters, reduce market risk by limiting how much of any one class of instrument an FCM or DCO can have in its portfolio at any one time. Second, repurchase agreement counterparty concentration limits serve to cap an FCM or DCO's exposure to the credit risk of a counterparty.

Below, the Commission details its proposal to remove government sponsored enterprise (GSE) securities that are not backed by the full faith and credit of the United States, corporate debt obligations not guaranteed by the United States, general obligations of a sovereign nation (foreign sovereign debt), and in-house transactions from the list of permitted investments. These proposed changes reflect the position of the Commission that the safety of a particular instrument or transaction must be viewed through the lens of its likely performance during a period of market volatility and financial instability.

1. Government Sponsored Enterprise Securities

The Commission proposes to amend paragraph (a)(1)(iii) to expressly add U.S. government corporation obligations to GSE securities (together, U.S. agency obligations) and to add the requirement that the U.S. agency obligations must be fully guaranteed as to principal and interest by the United States. GSEs are chartered by Congress but are privately owned and operated. Securities issued by GSEs do not have an explicit federal guarantee although they are considered by some to have an “implicit” guarantee due to their federal affiliation. Obligations of U.S. government corporations, such as the Government National Mortgage Association (known as Ginnie Mae), are explicitly backed by the full faith and credit of the United States. Although the Commission is not aware of any GSE securities that have an explicit federal guarantee, it believes that GSE securities should remain on the list of permitted investments in the event this status changes in the future.

The failure of two GSEs during the financial crisis has moved the Commission to view the securities of such GSEs as inappropriate for investments of customer funds. In 2008, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) failed due to problems in the subprime mortgage market. While Fannie Mae and Freddie Mac were bailed out in 2008, the U.S. government had no obligation to do so and investors cannot rely on another bailout should a GSE fail in the future.

In consideration of the above, the Commission proposes to amend paragraph (a)(1)(iii) of Regulation 1.25 by permitting investments in only those U.S. agency obligations that are fully guaranteed as to principal and interest by the United States. The Commission requests comment on whether GSE securities should remain as permitted investments under Regulation 1.25, either subject to a Federal guarantee requirement or not.

2. Commercial Paper and Corporate Notes or Bonds

In order to simplify the regulation by eliminating rarely-used instruments, and in light of the credit, liquidity, and market risks posed by corporate debt securities, the Commission proposes to limit investments in “commercial paper” and “corporate notes or bonds” to commercial paper and corporate notes or bonds that are federally guaranteed as to principal and interest under the Temporary Liquidity Guarantee Program (TLGP) and meet certain other prudential standards.

Information obtained during the 2007 Review indicated that commercial paper and corporate notes or bonds were not widely used by FCMs or DCOs. Consistent with this, the NFA states in its comment letter that most firms invest about 33 percent of their customer funds in government securities, 10 percent in MMMFs, and the balance maintained in bank accounts or on deposit with a carrying broker.

In the fall of 2008, the Federal Deposit Insurance Corporation (FDIC) created the TLGP, which guarantees principal and interest on certain types of corporate debt. Although the TLGP debt securities are backed by the full faith and credit of the U.S. Government and therefore pose minimal credit risk to the buyer for the period during which the guarantee is effective, initially there was concern as to whether the securities were readily marketable and sufficiently liquid so that the holders of such securities would be able to liquidate them quickly and easily without having to incur a substantial discount.

In February 2010, having evaluated the growing market for TLGP debt securities, the Division issued an interpretative letter concluding that TLGP debt securities are sufficiently liquid, and might therefore qualify as permitted investments under Regulation 1.25 if they meet the following criteria in addition to satisfying the pre-existing requirements imposed by Regulation 1.25: (1) The size of the issuance is greater than $1 billion; (2) the debt security is denominated in U.S. dollars; and (3) the debt security is guaranteed for its entire term.

Although the TLGP expires in 2012, the Commission believes it is useful to include commercial paper and corporate notes or bonds that are fully guaranteed as to principal and interest by the United States as permitted investments because this would permit continuing investment in TLGP debt securities, even though the Commission has proposed to otherwise eliminate commercial paper and corporate notes or bonds. Therefore, the Commission proposes to limit the commercial paper and corporate notes or bonds that can qualify as permitted investments to only those guaranteed as to principal and interest under the TLGP and that meet the criteria set forth in the Division's interpretation. As a result of this limitation, paragraph (b)(3)(iv), which relates to adjustable rate securities, is no longer necessary. The Commission proposes to delete current paragraph (b)(3)(iv) and replace it with language codifying the criteria for federally backed commercial paper and corporate notes or bonds. Accordingly, the Commission proposes to delete paragraph (b)(3)(i)(B) and amend paragraph (b)(3)(iii) to remove references to paragraph (b)(3)(iv). The Commission requests comment on the proscription of commercial paper and corporate notes or bonds that are not federally guaranteed under the TLGP, the liquidity of TLGP debt, and whether the removal of the requirements for adjustable rate securities will have any unintended or detrimental effects on Regulation 1.25 investments.

3. Foreign Sovereign Debt

The Commission proposes to remove foreign sovereign debt as a permitted investment in the interests of both simplifying the regulation and safeguarding customer funds. The 2007 Review revealed negligible investment in foreign sovereign debt and that fact, in combination with recent events undermining confidence in the solvency of a number of foreign countries, supports the Commission's proposed action. Removal of foreign sovereign debt from the list of permitted investments is not expected to significantly impact FCM and DCO investment strategies for customer funds. The Commission notes that, aside from general appeals to maintain the current list of permitted investments, only one commenter specifically addressed foreign sovereign debt.

Currently, an FCM or DCO can invest customer funds in foreign sovereign debt subject to two limitations: (1) The debt must be rated in the highest category by at least one nationally recognized statistical rating organization (NRSRO) and (2) the FCM or DCO may invest in such debt only to the extent it has balances in segregated accounts owed to its customers or its clearing member FCMs, respectively, denominated in that country's currency. The purpose of permitting investments in foreign sovereign debt is to facilitate investments of customer funds in the form of foreign currency without the need to convert that foreign currency to a U.S. dollar denominated asset, which would increase the FCM or DCO's exposure to currency risk. An investment in the sovereign debt of the same country that issues the foreign currency would limit the FCM or DCO's exposure to sovereign risk, i.e., the risk of the sovereign's default.

Both the lack of investment in foreign sovereign debt and the recent global financial volatility have caused the Commission to reevaluate this provision. First, as noted above, it appears that foreign sovereign debt is rarely used as an investment tool by FCMs. Second, the financial crisis has highlighted the fact that certain countries' debt can exceed an acceptable level of risk.

In consideration of the above, the Commission proposes to remove foreign sovereign debt as a permitted investment under Regulation 1.25 and renumber paragraph (a)(1) accordingly. The Commission requests comment on whether foreign sovereign debt should remain, to any extent, as a permitted investment and, if so, what requirements or limitations might be imposed in order to minimize sovereign risk.

4. In-House Transactions

The Commission proposes to eliminate in-house transactions permitted under paragraph (a)(3) and subject to the requirements of paragraph (e) of Regulation 1.25. This proposal is consistent with the Commission's proposed prohibition on an FCM or DCO entering into a repurchase or reverse repurchase agreement with a counterparty that is an affiliate of the FCM or DCO.

In 2005, two commenters recommended that the Commission permit FCMs that are dually registered as securities brokers or dealers to engage in in-house transactions. At the time, the Commission concluded that in-house transactions would allow FCMs to realize “greater capital efficiency” and further reasoned that “the substitution of one permitted investment for another in an in-house transaction [would] not present an unacceptable level of risk to the customer segregated account.” The Commission therefore amended Regulation 1.25 to allow an FCM/broker-dealer to enter into transactions that are the economic equivalent of a repurchase or reverse repurchase agreement, subject to certain requirements. More specifically, an FCM may exchange customer money for permitted investments held in its capacity as a broker-dealer, it may exchange customer securities for permitted investments held in its capacity as a broker-dealer, and it may exchange customer securities for cash held in its capacity as a broker-dealer.

Recent market events have, however, increased concerns about the concentration of credit risk within the FCM/broker-dealer corporate entity in connection with in-house transactions. Therefore, consistent with the Commission's proposal to prohibit FCMs from entering into repurchase and reverse repurchase agreements with affiliates, the Commission is proposing to eliminate in-house transactions as permitted investments for customer funds under paragraph (a)(3) of Regulation 1.25 and rescind paragraph (e), which sets forth the requirements for in-house transactions. Accordingly, paragraph (f) will be redesignated as new paragraph (e).

The Commission requests comment on the impact of this proposal on the business practices of FCMs and DCOs. Specifically, the Commission requests that commenters present scenarios in which a repurchase or reverse repurchase agreement with a third party could not be satisfactorily substituted for an in-house transaction.

The Commission requests comment on any other aspect of the proposed changes to paragraph (a) of Regulation 1.25. In particular, the Commission solicits comment on whether MMMFs should be eliminated as a permitted investment. In discussing whether MMMF investments satisfy the overall objective of preserving principal and maintaining liquidity, the Commission specifically requests comment on whether changes in the settlement mechanisms for the tri-party repo market might impact a MMMF's ability to meet the requirements of Regulation 1.25.

B. General Terms and Conditions

FCMs and DCOs may invest customer funds only in enumerated permitted investments “consistent with the objectives of preserving principal and maintaining liquidity * * *.” In furtherance of this general standard, paragraph (b) of Regulation 1.25 establishes various specific requirements designed to minimize credit, market, and liquidity risk. Among them are a requirement that the investment be “readily marketable,” that it meet specified rating requirements, and that it not exceed specified issuer concentration limits. The Commission is proposing to amend these standards to facilitate the preservation of principal and maintenance of liquidity by establishing clear, prudential standards that further investment quality and portfolio diversification. The Commission notes that an investment that meets the technical requirements of Regulation 1.25 but does not meet the overarching prudential standard cannot qualify as a permitted investment.

1. Marketability

Regulation 1.25(b)(1) states that “[e]xcept for interests in money market mutual funds, investments must be `readily marketable' as defined in § 240.15c3-1 of this title.” The Commission proposes to remove the “readily marketable” requirement from paragraph (b)(1) and substitute in its place a “highly liquid” standard. The Commission did not receive any comment letters specifically discussing the meaning and application of the “readily marketable” requirement.

The term “ready market” is borrowed from the Securities and Exchange Commission (SEC) capital rules and is interpreted by the SEC. That standard is used in setting appropriate haircuts for the purpose of calculating capital. Although its inclusion in Regulation 1.25 was intended to be a proxy for the concept of liquidity, it is not a concept that is otherwise easily applied as a prudential standard in determining the appropriateness of a debt instrument for investment of customer funds.

It is the Commission's view that the “readily marketable” language should be eliminated as it creates an overlapping and confusing standard when applied in the context of the express objective of “maintaining liquidity.” While “liquidity” and “ready market” appear to be interchangeable concepts, they have distinctly different origins and uses: The objective of “maintaining liquidity” is to ensure that investments can be promptly liquidated in order to meet a margin call, pay variation settlement, or return funds to the customer upon demand. As noted above, the SEC's “ready market” standard is intended for a different purpose and is easier to apply to exchange traded equity securities than debt securities.

Although Regulation 1.25 requires that investments be consistent with the objective of maintaining liquidity, the Commission has not articulated an explanation or a definition of the concept of “liquidity.” The Commission therefore proposes to define “highly liquid” functionally, as having the ability to be converted into cash within one business day, without a material discount in value. This approach focuses on outcome rather than process, and the Commission believes it will be easier to apply to debt securities than the current “readily marketable” standard.

An alternative to using a materiality standard in the definition of highly liquid is to employ a more formulaic and measurable approach. An example of a calculable standard would be one that provides that an instrument is highly liquid if there is a reasonable basis to conclude that, under stable financial conditions, the instrument has the ability to be converted into cash within one business day, without greater than a 1 percent haircut off of its book value.

The Commission proposes to amend paragraph (b)(1) to eliminate the marketability standard and in its place establish a requirement that permitted investments be highly liquid. The Commission requests comment on whether the proposed definition of “highly liquid” accurately reflects the industry's understanding of that term, and whether the term “material” might be replaced with a more precise or, perhaps, even calculable standard. The Commission welcomes comment on the ease or difficulty in applying the proposed or alternative “highly liquid” standards.

2. Ratings

The Commission proposes to remove all rating requirements from Regulation 1.25. This proposal is mandated by Section 939A of the Dodd-Frank Act. Further, the proposal reflects the Commission's views that ratings are not sufficiently reliable as currently administered, that there is reduced need for a measure of credit risk given the proposed elimination of certain permitted investments, and that FCMs and DCOs should bear greater responsibility for understanding and evaluating their investments.

The original purpose of imposing rating requirements was to mitigate credit risk associated with permitted investments which included commercial paper and corporate notes. Recent events in the financial markets, however, revealed significant weaknesses in the ratings industry.

Eliminating or restricting rating requirements has been considered by Congress and regulators with some frequency during the past two years. This has been motivated, at least in part, by public sentiment that credit rating agencies did not accurately rate debt in the months and years leading up to the financial crisis, worsening the financial crisis and increasing investors' losses. The SEC, in September 2009, adopted rule amendments that removed references to NRSROs from a variety of SEC rules and forms promulgated under the Securities Exchange Act of 1934 and from certain rules promulgated under the Investment Company Act of 1940 (Investment Company Act). In November 2009, the SEC adopted rules imposing enhanced disclosure and conflict of interest requirements for NRSROs. The SEC also has opened comment periods on other proposed amendments, including one that would remove references to NRSROs from its net capital rule.

The Dodd-Frank Act contains several measures that focus both on decreasing reliance on NRSROs and improving the performance of NRSROs when they must be relied upon. Section 939 of the Dodd-Frank Act mandates the removal of certain references to NRSROs in several statutes, and Section 939A requires all Federal agencies to review references to NRSROs in their regulations, to remove reliance on credit ratings and, if appropriate, to replace such reliance with other standards of credit-worthiness.

The Commission, therefore, intends to remove credit rating requirements from Regulation 1.25. Alternative standards of credit-worthiness are not being proposed. Evidence that rating agencies have not reliably gauged the safety of debt instruments in the past and the fact that other Regulation 1.25 proposed amendments published in this notice obviate much of the need for credit ratings, have helped to shape the Commission's decision.

While some might argue that imperfect information is better than none at all, several factors outweigh the possible risks associated with removing rating requirements. First, eliminating commercial paper and corporate notes or bonds as permitted investments would take away a large class of potentially risky investments for which ratings would be relevant. Second, the issuer concentration limits and proposed asset-based concentration limits should reduce the likelihood that one problem investment would destabilize an entire investment portfolio. Finally, removing rating requirements would not absolve FCMs and DCOs from investing in safe, highly liquid investments; rather it would shift to FCMs and DCOs more of the responsibility to diligently research their investments.

In light of the above analysis, the Commission proposes to eliminate paragraph (b)(2) of Regulation 1.25 and renumber the subsequent provisions of paragraph (b) accordingly.

3. Restrictions on Instrument Features

Currently, both non-negotiable and negotiable CDs are permitted under Regulation 1.25. Paragraph (b)(3)(v) details the required redemption features of both types of CDs.

Non-negotiable CDs represent a direct obligation of the issuing bank to the purchaser. The CD is wholly owned by the purchaser until early redemption or the final maturity of the CD. To be permitted under Regulation 1.25, the terms of the CD must allow the purchaser to redeem the CD at the issuing bank within one business day, with any penalty for early withdrawal limited to any accrued interest earned. Therefore, other than in the event of a bank default, an investor is assured of the return of its principal.

Negotiable CDs are considerably different than non-negotiable CDs in that they are typically purchased by a broker on behalf of a large number of investors. The large size of the purchase by the broker results in a more favorable interest rate for the purchasers, who essentially own shares of the negotiable CD. Unlike a non-negotiable CD, the purchaser of a negotiable CD cannot redeem its interest from the issuing bank. Rather, an investor seeking redemption prior to a CD's maturity date must liquidate the CD in the secondary market. Depending on the negotiated CD terms (interest rate and duration) and the current economic conditions, the market for a given CD can be illiquid and can result in the inability to redeem within one business day and/or a significant loss of principal.

Therefore, the Commission proposes to amend paragraph (b)(3)(v) by restricting CDs to only those instruments which can be redeemed at the issuing bank within one business day, with any penalty for early withdrawal limited to accrued interest earned according to its written terms.

4. Concentration Limits

Paragraph (b)(4) of Regulation 1.25 currently sets forth issuer-based concentration limits for direct investments, securities subject to repurchase or reverse repurchase agreements, and in-house transactions. The Commission proposes to adopt asset-based concentration limits for direct investments and a counterparty concentration limit for reverse repurchase agreements in addition to amending its issuer-based concentration limits and rescinding concentration limits applied to in-house transactions.

(a) Asset-based concentration limits. Asset-based concentration limits would dictate the amount of funds an FCM or DCO could hold in any one class of investments, expressed as a percentage of total assets held in segregation. In their comment letters, the FIA, MF Global and Newedge specifically suggested the incorporation of asset-based concentration limits. The Commission agrees that such limits could increase the safety of customer funds by promoting diversification.

Specifically, the Commission proposes the following asset-based limits in light of its evaluation of credit, liquidity, and market risk:

• No concentration limit (100 percent) for U.S. government securities;
• A 50 percent concentration limit for U.S. agency obligations fully guaranteed as to principal and interest by the United States;
• A 25 percent concentration limit for TLGP guaranteed commercial paper and corporate notes or bonds;
• A 25 percent concentration limit for non-negotiable CDs;
• A 10 percent concentration limit for municipal securities; and
• A 10 percent concentration limit for interests in MMMFs.

Asset-based concentration limits are consistent with the Commission's historical view that not all permitted investments have identical risk profiles. In its efforts to increase the safety of permitted investments on a portfolio basis, the Commission has decided to assign to each permitted investment an asset-based concentration limit that correlates to its level of risk and liquidity relative to other permitted investments.

U.S. government securities are backed by the full faith and credit of the U.S. government, are highly liquid, and are the safest of the permitted investments. As such, the Commission proposes a 100 percent concentration limit, allowing an FCM or DCO to invest all of its segregated funds in U.S. government securities.

U.S. agency obligations, as proposed, must be fully guaranteed as to principal and interest by the United States. The Commission views these as sufficiently safe but potentially not as liquid as a Treasury security. Because of this concern, and in the interest of promoting diversification, the Commission proposes a 50 percent concentration limit.

The Commission categorizes TLGP debt securities as corporate securities, which are riskier than U.S. government securities. While TLGP debt securities have an explicit FDIC guarantee, which provides confidence for TLGP debt investors that they will receive the full amount of principal and interest in the event of an issuer default, the timing of such a payment is uncertain. Additionally, while TLGP debt securities that meet the Commission's requirements have a liquid secondary market, that might not always be the case. The Commission therefore proposes to apply a 25 percent concentration limit for TLGP debt securities as well.

CDs are safe for relatively small amounts, but the risk increases for larger sums. The rise in bank failures since 2008 is a cause for concern with regard to CDs because they are FDIC insured to a maximum of only $250,000. As a result, the Commission proposes to apply a 25 percent concentration limit to CDs.

In evaluating possible asset-based concentration limits for TLGP debt securities and CDs, the Commission determined that the same concentration limit should apply to both, even though the risk profiles of the asset classes are different. The Commission recognizes that TLGP debt securities pose no risk to principal, unlike bank CDs which are subject to the possible default of the issuing bank. However, a CD which must be redeemable within one business day under Regulation 1.25(b)(3)(v) could prove to be more liquid than TLGP debt securities during a time of market stress. The Commission requests comment on whether there should be differentiation between asset-based concentration limits for TLGP debt securities and CDs and, if so, what those different concentration limits should be.

Municipal securities are backed by the state or local government that issues them, and they have traditionally been viewed as a safe investment. However, municipal securities have been volatile and, in some cases, increasingly illiquid over the past two years. Therefore, the Commission proposes to apply a 10 percent concentration limit to municipal securities.

MMMFs have been widely used as an investment for customer segregated funds. As discussed in the next section, their portfolio diversification, administrative ease, and heightened prudential standards recently imposed by the SEC, continue to make MMMFs an attractive investment option. However, their volatility during the 2008 financial crisis, which culminated in one fund “breaking the buck” and many more funds requiring infusions of capital, underscores the fact that investments in MMMFs are not without risk. To mitigate these risks, the Commission proposes to assign a 10 percent concentration limit for MMMFs. The Commission believes that this concentration limit is commensurate with the risks posed by MMMFs. The Commission solicits comment regarding whether 10 percent is an appropriate asset-based concentration limit for MMMFs. The Commission welcomes opinions on what alternative asset-based concentration limit might be appropriate for MMMFs and, if such asset-based concentration limit is higher than 10 percent, what corresponding issuer-based concentration limit should be adopted.

(b) Issuer-based concentration limits. The Commission has considered the current concentration limits and proposes to amend its issuer-based limits for direct investments to include a 2 percent limit for an MMMF family of funds, expressed as a percentage of total assets held in segregation. Currently, there is no concentration limit applied to MMMFs and the Commission believes that it is prudent to require FCMs and DCOs to diversify their MMMF portfolios. The 25 percent issuer-based limitation for GSEs (now U.S. agency obligations) and the 5 percent issuer-based limitation for municipal securities, commercial paper, corporate notes or bonds, and CDs will remain in place.

(c) Counterparty concentration limits. Finally, the Commission proposes a counterparty concentration limit of 5 percent of total assets held in segregation for securities subject to reverse repurchase agreements. Under Regulation 1.25(b)(4)(iii), concentration limits for reverse repurchase agreements are derived from the concentration limits that would have been assigned to the underlying securities had the FCM or DCO made a direct investment. Therefore, under current rules, an FCM or DCO could have 100 percent of its segregated funds subject to one reverse repurchase agreement. The obvious concern in such a scenario is the credit risk of the counterparty. This credit risk, while concentrated, is significantly mitigated by the fact that in exchange for cash, the FCM or DCO is holding Regulation 1.25-permissible securities of equivalent or greater value. However, a default by the counterparty would put pressure on the FCM or DCO to convert such securities into cash immediately and would exacerbate the market risk to the FCM or DCO, given that a decrease in the value of the security or an increase in interest rates could result in the FCM or DCO realizing a loss. Even though the market risk would be mitigated by asset-based and issuer-based concentration limits, a situation of this type could seriously jeopardize an FCM or DCO's overall ability to preserve principal and maintain liquidity with respect to customer funds.

In accordance with the above discussion, the Commission proposes to amend paragraph (b)(4) to add a new paragraph (i) setting forth asset-based concentration limits for direct investments; amend and renumber as new paragraph (ii) issuer-based concentration limits for direct investments; amend and renumber as new paragraph (iii) concentration limits for reverse repurchase agreements; delete the existing paragraph (iv) due to the Commission's proposed elimination of in-house transactions; renumber as a new paragraph (iv) the provision regarding treatment of customer-owned securities; and add a new paragraph (v) setting forth counterparty concentration limits for reverse repurchase agreements.

The Commission requests comment on any and all aspects of the proposed concentration limits, including whether asset-based concentration limits are an effective means for facilitating investment portfolio diversification and whether there are other methods that should be considered. In addition, the Commission requests comment on whether the proposed concentration levels are appropriate for the categories of investments to which they are assigned and whether there should be different standards for FCMs and DCOs.

C. Money Market Mutual Funds

The continued use of MMMFs was the sole focus of five comment letters, a substantial focus of one, and referenced positively by an additional four. Taken together, the letters conveyed a consensus that MMMFs are both safe and administratively efficient. In their respective comment letters, Federated noted that MMMFs are subject to the overlapping regulatory regimes overseen by the SEC, and ICI highlighted the quality, liquidity and diversity of an MMMF's holdings. Further, TSI noted that out of 700-800 MMMFs, only one failed during the September 2008 financial turmoil, a crisis which Dreyfus likened to a “1,000 year flood.”

While the Commission appreciates the benefits of MMMFs, it also is cognizant of their risks. Reserve Primary Fund, the September 2008 failure referenced by TSI, was an MMMF that satisfied the enumerated requirements of Regulation 1.25 and at one point was a $63 billion fund. The Reserve Primary Fund's breaking the buck called attention to the risk to principal and potential lack of sufficient liquidity of any MMMF investment. In the wake of the Reserve Primary Fund problem, the Commission has been forced to consider the possibility that any number of MMMFs that meet the technical requirements of Regulation 1.25(c) might not meet the Regulation 1.25 objective of preserving principal and maintaining liquidity, particularly during volatile market conditions. Lending credence to such concerns, the SEC has estimated that, in order to avoid breaking the buck, nearly 20 percent of all MMMFs received financial support from their money managers or affiliates from mid-2007 through the end of 2008.

In response to the potential risks posed by investments in MMMFs, the Commission is proposing to institute the concentration limits discussed above. However, the Commission has decided to refrain from further restricting investments in MMMFs at this time. The Commission is hopeful that the combination of its asset-based limitations, issuer-based limitations applied to a single family of funds, and the SEC's recent MMMF reforms will adequately address the risks associated with MMMFs.

The Commission requests comment on whether MMMF investments should be limited to Treasury MMMFs, or to those MMMFs that have portfolios consisting only of permitted investments under Regulation 1.25.

The Commission is proposing two technical amendments to paragraph (c) of Regulation 1.25. First, the Commission is proposing to clarify the acknowledgment letter requirement under paragraph (c)(3); and second, the Commission is proposing to revise and clarify the exceptions to the next-day redemption requirement under paragraph (c)(5)(ii).

1. Acknowledgment Letters

The Commission is proposing to amend Regulation 1.25(c)(3) to clarify the appropriate party to provide an acknowledgment letter where customer funds are invested in MMMFs. Regulation 1.26 requires an FCM or DCO which invests customer funds in instruments permitted under Regulation 1.25 to create a segregated account at a depository for such instruments and to obtain an acknowledgment letter from the depository. Because interests in MMMFs generally are not held at a depository in the first instance, like other permitted investments, Regulation 1.25(c)(3) currently provides an exception to the Regulation 1.26 requirement that an acknowledgment letter be provided by a depository. Regulation 1.25(c)(3) requires the “sponsor of the fund and the fund itself” to provide an acknowledgment letter when the MMMF shares are held by a fund's shareholder servicing agent.

The Commission has received a number of inquiries regarding the meaning of this provision and the definition of “sponsor,” a term that is not defined in the Investment Company Act. While the term is not defined, it is nonetheless used throughout the Investment Company Act and is generally understood to refer to the entity that organizes the fund. Such an entity typically provides seed capital to the investment company and may be an affiliated investment adviser or underwriter to the investment company.

The Commission seeks to clarify that the intent of Regulation 1.25(c)(3) is to require an acknowledgment letter from a party that has substantial control over the fund's assets and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds invested in shares of an MMMF. The Commission has concluded that in many circumstances, the fund sponsor, the investment adviser, or fund manager would satisfy this requirement. To the extent there are circumstances where an entity such as the Administrator would be in this position, proposed Regulation 1.25(c)(3) encompasses such an entity. The Commission requests comment on whether the proposed standard is appropriate and whether there are other entities that could serve as examples.

The Commission is also proposing to 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. This revision is designed to eliminate any confusion as to whether the acknowledgment letter requirement is applied differently based on the presence or absence of a shareholder servicing agent. The Commission requests comment on whether removal of this language helps clarify the intent of Regulation 1.25(c)(3).

The Commission is accordingly proposing to amend Regulation 1.25(c)(3) to set forth a functional definition accompanied by specific examples. The proposed amendment would require an FCM or DCO to obtain the acknowledgment letter required by Regulation 1.26 from an entity that has substantial control over the fund's assets and has the knowledge and authority to facilitate redemption and payment or transfer of the customer segregated funds. The proposed language would specify that such an entity may include the fund sponsor or investment adviser.

2. Next-Day Redemption Requirement

Regulation 1.25(c) requires that “[a] fund shall be legally obligated to redeem an interest and to make payment in satisfaction thereof by the business day following a redemption request.” This “next-day redemption” requirement is a significant feature of Regulation 1.25 and is meant to ensure adequate liquidity. Regulation 1.25(c)(5)(ii) lists four exceptions to the next-day redemption requirement, and incorporates by reference the emergency conditions listed in Section 22(e) of the Investment Company Act (Section 22(e)). The Commission has received questions from FCMs regarding Regulation 1.25(c)(5), particularly because the exceptions listed in paragraph (c)(5)(ii) overlap with some of those appearing in Section 22(e).

Recently, as part of its MMMF reform initiative, the SEC adopted a rule that provides the basis for another exception to the next-day redemption requirement. Promulgated under Section 22(e), Rule 22e-3 permits MMMFs to suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund. Before Rule 22e-3 may be invoked, the fund's board, including a majority of its disinterested directors, must determine that the extent of the deviation between the fund's amortized cost per share and its current net asset value per share may result in material dilution or other unfair results, and the board, including a majority of its disinterested directors, must irrevocably approve the liquidation of the fund. In addition, prior to suspending redemption, the fund must notify the SEC of its decision.

In order to expressly incorporate Rule 22e-3 into the permitted exceptions for purposes of clarity, and to otherwise clarify the existing exceptions to the next-day redemption requirement, the Commission has decided to amend paragraph (c)(5)(ii) of Regulation 1.25 by more closely aligning the language of that paragraph with the language in Section 22(e) and specifically including Rule 22e-3. Section 22(e) will, however, continue to be incorporated by reference so as to provide for any future amendment or regulatory actions by the SEC.

The Commission will include, as Appendix A to the rule text, safe harbor language that can be used by MMMFs to ensure that their prospectuses comply with Regulation 1.25(c)(5). The proposed language tracks the proposed paragraph (c)(5).

The Commission requests comment on all aspects of its proposed amendments to paragraph (c). The Commission seeks comment specifically on any proposed regulatory language that commenters believe requires further clarification. In addition, commenters are invited to submit views on the usefulness and substance of the proposed safe harbor language contained in proposed Appendix A.

D. Repurchase and Reverse Repurchase Agreements

The Commission proposes to eliminate repurchase and reverse repurchase transactions with affiliate counterparties. This amendment forwards the interests of both protecting customer funds as well as establishing consistency within the regulation, which would no longer permit in-house transactions and currently prohibits investments in instruments issued by affiliates.

Repurchase and reverse repurchase transactions were originally included as permitted investments to increase the liquidity in the portfolio of segregated funds. By entering into repurchase agreements with unaffiliated counterparties, FCMs can convert securities holdings into cash or alternatively supply cash to market participants in exchange for liquid securities. In the event that a counterparty receiving cash defaults, the other party is protected due to its holding of the counterparty's securities. Reverse repurchase and repurchase agreements contribute generally to increased market liquidity and are not inconsistent with the required safety of customer funds.

The benefits of such an arrangement are diminished, however, when repurchase agreements are between affiliates. In particular, the concentration of credit risk increases the likelihood that the default of one party could exacerbate financial strains and lead to the default of its affiliate. While such a scenario would be unexpected in calm markets, during periods of financial turbulence such problems are considerably more likely to occur. It should be noted that the actions of market participants suggest that even possession and control of liquid securities may be insufficient to alleviate concerns relating to transactions with financially troubled counterparties.

Further, the interests of consistency of the regulation weigh in favor of disallowing repurchase agreements between affiliates. Currently, a repurchase agreement between affiliates is allowed under Regulation 1.25(d), while investments in debt instruments issued by an affiliate—effectively a collateralized loan between affiliates—is prohibited by paragraph (b)(6). A repurchase agreement is functionally equivalent to a short-term collateralized loan. In both transactions, one party provides cash to another party, secured by assets owned by the other party, and, in return, the other party repays the cash, plus interest, and its assets are returned. The similarity of the two transactions would seem to require similar treatment under Regulation 1.25.

Therefore, the Commission proposes to amend paragraph (d) by adding new paragraph (3) prohibiting repurchase and reverse repurchase agreements with affiliates. Current paragraphs (3) through (12) will be renumbered as (4) through (13), accordingly. The Commission seeks comment on its proposal to eliminate repurchase and reverse repurchase transactions with affiliate counterparties.

E. Regulation 30.7

1. Harmonization

The Commission proposes to harmonize Regulation 30.7 with the investment limitations of Regulation 1.25. As noted above, the Commission has not previously restricted investments of 30.7 funds to the permitted investments under Regulation 1.25, although Regulation 1.25 limitations can be used as a safe harbor for such investments. The Commission now believes that it is appropriate to align the investment standards of Regulation 30.7 with those of Regulation 1.25 because many of the same prudential concerns arise with respect to both segregated customer funds and 30.7 funds. Such a limitation should increase the safety of 30.7 funds and provide clarity for the FCMs, DCOs, and designated self-regulatory organizations.

The Commission anticipates that the impact of this amendment will be slight, as it appears that using Regulation 1.25 standards in 30.7 investments is a common industry practice. For example, Newedge commented that the harmonization of Regulations 1.25 and 30.7 “would reflect current market practice * * *” since, in its opinion, “* * * many if not most FCMs currently invest Part 30.7 funds in the same products and transactions in which they invest Rule 1.25 funds.” FIA also noted that its “member firms generally follow the Rule 1.25 investment guidelines” when investing 30.7 funds. In addition to adding new paragraph (g) to Regulation 30.7 to reflect this amendment, the Form 1-FR-FCM instruction manual would be revised accordingly.

The Commission solicits comment on applying the requirements of Regulation 1.25 to 30.7 funds. In this regard, the Commission seeks comment on any differences between customer segregated funds and 30.7 funds that would warrant the continuing application of different standards.

2. Ratings

The Commission proposes to remove all rating requirements from Regulation 30.7. This proposal is required by Section 939A of the Dodd-Frank Act and further reflects the Commission's views on the unreliability of ratings as currently administered and its interest in aligning Regulation 30.7 with Regulation 1.25.

The only reference to credit ratings in Regulation 30.7 is in paragraph (c)(1)(ii)(B). Paragraph (c)(1)(ii) permits 30.7 funds to be kept in an account with a depository outside the United States if the depository meets any of three alternative standards: (1) The depository has in excess of $1 billion of regulatory capital, (2) the depository or its parent's “commercial paper or long-term debt instrument * * * is rated in one of the two highest rating categories by at least one” NRSRO, or (3) if it does not meet either of the first two criteria, the depository has been permitted to hold 30.7 funds upon the request of a customer.

The use of the credit rating of the commercial paper or long-term debt of the depository institution is comparable to the standard used to gauge the safety of an issuer of a CD. The Commission has viewed credit ratings as unreliable to gauge the safety of an issuer of a CD and proposed, in Section II.B.2 of this notice, to remove this requirement from Regulation 1.25. The Commission now proposes to remove paragraph (c)(1)(ii)(B) in Regulation 30.7 as it views an NRSRO rating as similarly unreliable to gauge the safety of a depository institution for 30.7 funds. This proposal also serves to align Regulation 30.7 with Regulation 1.25 on the topic of NRSROs.

The Commission requests comment on whether there is a standard or measure of solvency and credit-worthiness that can be used as an additional test of a bank's safety. Specifically, the Commission seeks comment on whether a leverage ratio or a capital adequacy ratio requirement consistent with or similar to those in the Basel III accords would be an appropriate additional safeguard for a bank or trust company located outside the United States.

3. Designation as a Depository for 30.7 Funds

Under Regulation 30.7(c)(1)(ii)(C), a bank or trust company that does not otherwise meet the requirements of paragraph (c)(1)(ii) may still be designated as an acceptable depository by request of its customer and with the approval of the Commission. The Commission proposes to no longer allow a customer to request that a bank or trust company located outside the United States be designated as a depository for 30.7 funds. The Commission has never allowed a bank or trust company located outside the United States to be a depository through these means, and believes that it is appropriate to require that all depositories meet the regulatory capital requirement under paragraph (c)(1)(ii)(A).

Therefore, the Commission proposes to amend Regulation 30.7 by deleting paragraph (c)(1)(ii)(C). The Commission requests comment on whether an exception of any kind to Regulation 30.7(c)(1)(ii) is appropriate.

III. Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (RFA) requires federal agencies, in promulgating rules, to consider the impact of those rules on small businesses. The rule amendments proposed herein will affect FCMs and DCOs. The Commission has previously established certain definitions of “small entities” to be used by the Commission in evaluating the impact of its rules on small entities in accordance with the RFA. The Commission has previously determined that registered FCMs and DCOs are not small entities for the purpose of the RFA. Accordingly, pursuant to 5 U.S.C. 605(b), the Chairman, on behalf of the Commission, certifies that the proposed rules will not have a significant economic impact on a substantial number of small entities.

B. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (PRA) imposes certain requirements on federal agencies (including the Commission) in connection with their conducting or sponsoring any collection of information as defined by the PRA. The proposed rule amendments do not require a new collection of information on the part of any entities subject to the proposed rule amendments. Accordingly, for purposes of the PRA, the Commission certifies that these proposed rule amendments, if promulgated in final form, would not impose any new reporting or recordkeeping requirements.

C. Costs and Benefits of the Proposed Rules

Section 15(a) of the CEA requires the Commission to consider the costs and benefits of its actions before issuing a rulemaking under the Act. By its terms, section 15(a) does not require the Commission to quantify the costs and benefits of a rule or to determine whether the benefits of the rulemaking outweigh its costs; rather, it requires that the Commission “consider” the costs and benefits of its actions. Section 15(a) further specifies that the costs and benefits shall be evaluated in light of five broad areas of market and public concern: (1) Protection of market participants and the public; (2) efficiency, competitiveness and financial integrity of futures markets; (3) price discovery; (4) sound risk management practices; and (5) other public interest considerations. The Commission may in its discretion give greater weight to any one of the five enumerated areas and could in its discretion determine that, notwithstanding its costs, a particular rule is necessary or appropriate to protect the public interest or to effectuate any of the provisions or accomplish any of the purposes of the Act.

Summary of proposed requirements. The proposed rules would facilitate greater protection of customer funds and 30.7 funds and reduction of systemic risk by establishing stricter prudential standards for investment of such funds. The proposed amendments restrict the scope of permitted investments to reflect the current economic environment. During the prior ten-year period, starting with the December 2000 rulemaking, Regulation 1.25 was substantially revised and expanded. The more restrictive proposals contained herein are based on the Commission's experience over the course of the past decade and, in particular, since September 2008, during which certain permitted investments under Regulation 1.25 were shown to present potentially unacceptable levels of risk. In narrowing the scope of Regulation 1.25 (as to both type and characteristics of permitted investments), the Commission's primary purpose is to safeguard the funds of customers and, in so doing, to help ease the chain reaction of negative effects that can come about during a financial crisis in the broader financial marketplace.

Costs. With respect to costs, the Commission has determined that any costs associated with the proposal are outweighed by its benefits. The Commission recognizes that scaling back on the type and form of permitted investments could result in certain FCMs and DCOs earning less income from their investments of customer funds. This, in turn, could reduce an FCM or DCO's overall profits and create an incentive for them to charge higher fees to customers. The Commission believes, however, that the potential loss of income for those FCMs and DCOs whose investment strategies will be materially affected by the proposed amendments will be outweighed by the reduction in potential risk associated with the current regulatory standards for permitted investments. To the extent that customers may bear the cost of the proposed changes, the customers will nonetheless benefit from greater protection of their funds. Eliminating the option of a customer to designate, with the Commission's permission, a foreign depository for 30.7 funds would potentially limit the choices of suitable depositories. However, the presence of alternative depositories would mitigate any adverse impact. The proposed amendments would not affect the efficiency or competitiveness of futures markets, and the proposed amendments will not affect price discovery.

Benefits. With respect to benefits, the Commission has determined that the proposal will result in several benefits. First, the risk-reducing nature of the proposed amendments would facilitate greater financial integrity of FCMs and DCOs and, as a result, futures markets more generally. Essential to the proper functioning of futures markets is the financial integrity of the clearing process, which is dependent upon the immediate availability of sufficient funds for daily pays and collects and default management.

The proposed amendments would also raise the standards for risk management practices of FCMs and DCOs that invest customer funds. They balance the need for investment flexibility and capital efficiency with the need to preserve principal and maintain liquidity. In particular, the proposal both narrows the scope of permitted investments to only those that the Commission considers the safest, and mandates diversification well beyond previous requirements. The Commission believes that these structural safeguards will decrease the credit, market, and liquidity risk exposures of FCMs and DCOs. Moreover, the revised requirements will more closely align with the investment restrictions contained in Section 4d of the Act.

Also, the Commission recognizes that many, if not most, FCMs and DCOs are already engaging in sound risk management practices and are pursuing responsible investment strategies under the existing regulatory regime. However, the Commission believes that in an environment where many of its previous economic assumptions are called into question, it becomes necessary to establish new bright line requirements to better ensure proper risk management in connection with the investment of customer segregated and 30.7 funds.

The proposed amendments retain an appropriate degree of flexibility in making investments with customer segregated and 30.7 funds, while significantly strengthening the rules that protect the safety of such funds. In addition, eliminating the option of a customer to designate, with the Commission's permission, a foreign depository for 30.7 funds that otherwise would not meet the requirements of Regulation 30.7 both closes a loophole that might have allowed for a less financially sound depository to hold 30.7 funds and eliminates the need for the Commission to individually review the safety and soundness of foreign depositories.

Public Comment. The Commission invites public comment on its cost-benefit considerations. Commenters are also are invited to submit any data or other information that they may have quantifying or qualifying the costs and benefits of the Proposal with their comment letters.

Lists of Subjects

17 CFR Part 1

• Brokers
• Commodity futures
• Consumer protection
• Reporting and recordkeeping requirements

17 CFR Part 30

• Commodity futures
• Consumer protection
• Currency
• Reporting and recordkeeping requirements

In consideration of the foregoing and pursuant to the authority contained in the Commodity Exchange Act, in particular, Sections 4d, 4(c), and 8a(5) thereof, 7 U.S.C. 6d, 6(c) and 12a(5), respectively, the Commission hereby proposes to amend Chapter I of Title 17 of the Code of Federal Regulations as follows:

PART 1—GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

1. The authority citation for Part 1 is revised to read as follows:

Authority: 7 U.S.C. 1a, 2, 5, 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, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010).

2. Revise § 1.25 to read as follows:

PART 30—FOREIGN FUTURES AND FOREIGN OPTIONS TRANSACTIONS

3. The authority citation for part 30 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 6, 6c, and 12a, unless otherwise noted.

4. In § 30.7, revise paragraph (c) and add paragraph (g) to read as follows:

Note:

The following statement will not appear in the Code of Federal Regulations.

Statement of Chairman Gary Gensler

Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions

October 26, 2010

I support today's Commission vote on the proposed rulemaking regarding the investment of customer segregated and secured amount funds. This rulemaking fulfills part of the Dodd-Frank Act's requirement that the Commission remove all reliance on credit ratings from its regulations. In addition, the rule enhances protections regarding where derivatives clearing organizations (DCOs) and futures commission merchants (FCMs) can invest customer funds. The market events of the last two years have underscored the importance of prudent investment standards to ensure the financial integrity of DCOs and FCMs and of maximizing protection of customer funds.