CFTC Amends Customer Funds Investment Rules
Thursday, December 08, 2011

Following the failure on October 31 of MF Global with a shortfall in segregated customer funds of some USD900m, the United States Commodities Futures Trading Commission (CFTC) has approved a rule to enhance customer protections regarding where foreign futures and options brokers can invest such funds.

The Commodity Exchange Act prescribes that customer funds can only be placed in a set list of permitted investments. From 2000 to 2005, the CFTC gradually granted exemptions to this list, loosening the rules for their investment. Those exemptions allowed brokers to invest customer funds in AAA-rated sovereign debt, as well as to lend customer money to another side of the firm through repurchase agreements.

The new rules prevent such in-house lending through repurchase agreements, as it is now believed that there is an inherent conflict of interest between parts of a firm doing these transactions. The rule will prohibit such trades by brokers, who earn interest income by investing funds from their customers’ segregated accounts, but will still allow deals with third-parties.

It was said that the CFTC “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 to enable investments to be quickly converted to cash at a predictable value in order to avoid systemic risk."

Therefore, while the new rule retains the brokers’ ability to invest customer funds in US agency obligations, it imposes limitations on their investments in debt issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), and removes foreign sovereign debt and corporate debt obligations not guaranteed by the United States from the list of permitted investments.

In addition, the rule fulfils a Dodd-Frank Act requirement that the CFTC should remove all reliance on credit ratings from its regulations.

The CFTC first proposed the rule in October 2010, but it was withdrawn due to lack of support. CFTC’s Chairman Gary Gensler confirmed that “segregation of funds is the core foundation of customer protection,” and he had “consistently felt the CFTC needed to finalize it to ensure customer funds are protected”.

In supporting the rule, CFTC Commissioner Scott D. O’Malia stressed that, “as recent events have highlighted, the protection and preservation of customer funds is fundamental to our markets. By limiting investments of customer funds to a subset of instruments that currently have minimal risk, this final rule is a step towards enhancing customer protection. However, as I emphasized in a statement on MF Global, the CFTC must not become complacent. It must take additional action to bolster public confidence in our customer protection regime.”

In fact, as Gensler added, “this rule is important, but the agency will look at additional ways to enhance customer protections. Among the possibilities we’re reviewing are: brokers audits, their monthly and daily reporting to regulators, how they are examined for compliance, the brokers’ relationship with self-regulatory organizations, custodial arrangements, and increasing the transparency of brokers to customer communication regarding how customer funds are invested.”