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[Federal Register: February 10, 2004 (Volume 69, Number 27)]
[Rules and Regulations]
[Page 6140-6146]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10fe04-3]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 1

RIN 3038-AC01


Investment of Customer Funds

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'') is
amending its regulations to allow futures commission merchants
(``FCMs'') and derivatives clearing organizations (``DCOs'') to engage
in repurchase agreements (``repos'') with securities deposited by
customers, subject to certain conditions, and to modify the portfolio
time-to-maturity requirements for securities deposited in connection
with certain collateral

[[Page 6141]]

management programs of DCOs, pursuant to certain conditions.

EFFECTIVE DATE: March 11, 2004.

FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director and
Chief Counsel, or Phyllis P. Dietz, Special Counsel, Division of
Clearing and Intermediary Oversight, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, NW, Washington,
DC 20581. Telephone (202) 418-5450.

SUPPLEMENTARY INFORMATION:

I. Background

    Commission Rule 1.25 (17 CFR 1.25) sets forth the types of
instruments in which FCMs and DCOs are permitted to invest customer
segregated funds. Rule 1.25 was substantially amended in December 2000
to expand the list of permitted investments.\1\ In connection with that
expansion, the Commission added several provisions intended to minimize
the credit, liquidity, and volatility risks associated with the
additional investments.
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    \1\ See 65 FR 77993 (Dec. 13, 2000) (publishing final rules); 65
FR 82270 (Dec. 28, 2000) (making technical corrections and
accelerating effective date of final rules from February 12, 2001 to
December 28, 2000).
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    On June 30, 2003, the Commission published for public comment
proposed amendments to some of those provisions and further requested
comment on several other provisions of the rule.\2\ The Commission
received comment letters from the Futures Industry Association
(``FIA''), National Futures Association (``NFA''), Chicago Mercantile
Exchange (``CME''), Federal Home Loan Mortgage Corporation (``Freddie
Mac''), and Lehman Brothers. In light of the comments received, the
Commission has determined to adopt amendments to Rule 1.25
substantially as proposed and to further clarify certain provisions of
the rule.\3\
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    \2\ See 68 FR 38654 (June 30, 2003). In a separate release, the
Commission will address comments received on aspects of Rule 1.25
that were not related to textual amendments proposed in the June 30,
2003 Federal Register release.
    \3\ The Commission is also making technical revisions in that
the final rules consistently use the term ``derivatives clearing
organization,'' rather than the terms ``clearing organization'' or
``registered clearing organization,'' as had appeared in the text of
the proposed rules.
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II. Discussion of the Final Rules

A. Repurchase Agreements Involving Collateral Deposited by Customers

    CFTC Staff Letter 84-24 (``Letter 84-24'') \4\ permits FCMs to
enter into repos with collateral deposited by customers (``customer
collateral''), subject to certain terms and conditions. When the
Commission adopted the amendments to Rule 1.25 in December 2000, it
included provisions governing repos and reverse repos involving
investments purchased with customer funds (``permitted investments''),
subject to terms and conditions that differ in a number of ways from
those in Letter 84-24.\5\ The Commission did not, however, specifically
address Letter 84-24 at that time.
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    \4\ CFTC Staff Letter No. 84-24, [1984-1986 Transfer Binder]
Comm. Fut. L. Rep. (CCH) ] 22,449 (Dec. 5, 1984).
    \5\ See Rule 1.25(a)(2) and Rule 1.25(d).
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    The Commission proposed to amend Rule 1.25(a)(2) to permit FCMs and
DCOs to engage in repos of customer-deposited securities subject to
certain terms and conditions. The proposed amendments did not include a
requirement that the FCM provide written disclosure of the mechanics of
the repo transaction and obtain prior written authorization from the
customer. In contrast, Letter 84-24 does include such a requirement.
The Commission requested public comment on whether it is appropriate to
permit repos of customer collateral without prior written consent, and,
if so, whether the limitations set forth in the proposal are
appropriate. The Commission further requested comment on whether one-
way notice disclosure to the customer should be required, or whether an
``opt-out'' mechanism should be provided.
    The Commission received three comments on the disclosure issue. The
FIA pointed out that the securities used in the repos would have to be
highly liquid and any loss incurred as a result of a counterparty
default would be borne by the FCM. The FIA therefore concluded that the
Commission should not require an FCM to provide one-way disclosure or
obtain a customer's written consent prior to engaging in a repo
transaction with the customer's securities. It further stated its view
that all customers are presumed to be aware of the rules and
regulations governing their accounts.\6\
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    \6\ Lehman Brothers stated in its comment letter that it fully
supports the views set forth in the FIA's comment letter.
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    The NFA observed that because the Commission's proposed amendments
exclude specifically identifiable property from repo transactions, it
is not necessary to provide an opt-out mechanism whereby a customer
could instruct an FCM not to subject collateral to a repo. The NFA
expressed its belief that an opt-out provision would be costly and
burdensome for FCMs that would have to revise their existing customer
agreements without a corresponding regulatory benefit.
    Freddie Mac expressed the contrary view that the written disclosure
and customer consent requirements of Letter 84-24 are appropriate, and
should be retained. It pointed out that, in posting margin to its
clearing firms, Freddie Mac may transfer securities, which may include
mortgage-related securities that are not fungible. In certain cases, it
may be necessary to have the same security returned in order to achieve
the company's asset/liability management goals or for other risk
management purposes. Freddie Mac stated that, at a minimum, customers
and FCMs should be permitted to provide contractually for disclosure
and notice.
    The Commission has determined to amend Rule 1.25(a)(2) as proposed,
without a requirement for written disclosure and customer consent. The
Commission believes that in light of the stringent safeguards discussed
below, it is appropriate to provide FCMs and DCOs this additional
flexibility in performing collateral management. The Commission wishes
to emphasize, however, that the absence of disclosure and consent
requirements does not preclude any customer of an FCM from requiring on
its own initiative, by written agreement (e.g., the customer
agreement), that the FCM obtain the customer's prior consent in order
to engage in repo transactions with securities deposited by the
customer. As in other instances where disclosure and customer
authorization are not expressly required by regulation, a customer and
its FCM are always free to negotiate terms and conditions of disclosure
and consent, and to enter into a binding agreement accordingly.\7\
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    \7\ The Commission believes that a customer's ability to
negotiate arrangements for disclosure and consent adequately
addresses Freddie Mac's concerns. It notes, however, that it is not
making any determination as to whether the instruments identified in
the Freddie Mac letter would satisfy the standards set forth under
paragraph (a)(2)(ii)(A)-(D) (discussed below), thereby making them
suitable for repurchase.
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    With respect to the criteria for engaging in repos with customer
collateral under proposed paragraphs (a)(2)(ii)(A)-(D), the FIA
expressed the view that those requirements, in combination with the
requirements of paragraph (d), ``will be more than sufficient to
safeguard both the customer-owned securities specifically as well as
the customer segregated account generally.'' Similarly, the NFA
observed that the safeguards included in the proposal provide ``ample
protection'' for customer-deposited securities.

[[Page 6142]]

    Proposed paragraph (a)(2)(ii)(A) would provide that, to be eligible
for repurchase, securities would have to meet the marketability
requirements of Rule 1.25(b)(1).\8\ Application of this standard is
intended to ensure that, if a repo counterparty should default, the FCM
or DCO could use the cash proceeds from the repo to buy the securities
elsewhere. Both the NFA and FIA supported the marketability
requirement. The Commission has determined to adopt paragraph
(a)(2)(ii)(A) as proposed.
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    \8\ Under Rule 1.25(b)(1), except for interests in money market
mutual funds, investments must be ``readily marketable'' as defined
in 17 CFR 240.15c3-1 (the net capital rule of the Securities and
Exchange Commission). Paragraph (c)(11)(i) of that rule provides
that ``[t]he term ready market shall include a recognized
established securities market in which there exists independent bona
fide offers to buy and sell so that a price reasonably related to
the last sales price or current bona fide competitive bid and offer
quotations can be determined for a particular security almost
instantaneously and where payment will be received in settlement of
a sale at such price within a relatively short time conforming to
trade custom.''
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    Proposed paragraph (a)(2)(ii)(B) would provide that securities
subject to repos must not be ``specifically identifiable property'' as
defined in Rule 190.01(kk) (17 CFR 190.01(kk)). Such property is
generally not eligible for repurchase. The NFA expressed the opinion
that the exclusion of specifically identifiable property eliminates the
need to require the FCM to replace the securities in the event of a
counterparty default. The NFA further stated its belief that, in the
event of a default, it would be acceptable for an FCM to make the
customer whole by giving the customer the cash equivalent of the
securities plus any transaction costs that might be incurred in
replacing the securities. This topic is discussed in connection with
paragraph (a)(2)(ii)(D), below. The Commission has determined to adopt
paragraph (a)(2)(ii)(B) as proposed.
    Proposed paragraph (a)(2)(ii)(C) would provide that the terms and
conditions of a repo involving customer-deposited securities must be in
accordance with the requirements of Rule 1.25(d).\9\ As noted above,
the FIA commented that application of the requirements of paragraph
(d), combined with the additional requirements of proposed paragraph
(a)(2)(ii), will more than sufficiently safeguard both the customer-
owned securities and the customer segregated account. The Commission
believes that these safeguards, currently applicable to repos for
permitted investments, are appropriate to apply to customer-deposited
securities as well. The Commission, therefore, has determined to adopt
paragraph (a)(2)(ii)(C) as proposed.
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    \9\ Rule 1.25(d) specifies criteria for repos and reverse repos
involving permitted investments. Those criteria address, among other
things, identification of securities, permissible counterparties,
applicability of concentration limits, duration of the agreement,
substitution and transfer of securities, documentation and
confirmation requirements, and bookkeeping requirements.
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    Proposed paragraph (a)(2)(ii)(D) would provide that, in the
unlikely event of a default by a counterparty to a repo, the FCM or DCO
``must take steps to ensure'' that the default does not result in ``any
cost or expense'' to the customer. The Commission requested comment on
how an FCM might fulfill its obligations to its customer in the event a
repo counterparty fails to perform. In this regard, the Commission
asked commenters to consider whether it is sufficient for the FCM to
give the customer the cash equivalent of the securities, plus any
transaction costs that might be incurred in replacing the securities,
or whether the FCM should be required to replace the securities. The
Commission recognized the possibility that cash compensation might be
insufficient if a customer needed the particular securities to maintain
the risk profile of its portfolio.
    The FIA observed that, among other things, because the customer-
owned securities used for repos must be highly liquid, an FCM should
have little difficulty using the cash proceeds of the repo held in the
customer segregated account to buy the same securities elsewhere. The
FIA stated its belief that if a counterparty fails to perform, an FCM
should make every reasonable effort to replace the customer-owned
securities that are the subject of the repo. The FIA added that ``[o]f
course, any loss incurred as a result of such difficulty would be borne
by the FCM.'' In response to the Commission's specific request for
comments on whether there are tax implications that should be
considered in connection with the proposal, the FIA stated its
understanding that the failure of a counterparty to return the
customer-owned securities could, in certain circumstances, have tax
implications. Given the remoteness of counterparty default, the FIA
said it does not believe the Commission should consider potential tax
implications in adopting final rules. The Commission received no other
comments on tax implications.
    As noted above, the NFA stated its view that in the event of a
counterparty default, it would be acceptable for an FCM to make the
customer whole by giving the customer the cash equivalent of the
securities plus any transaction costs that might be incurred in
replacing the securities. It noted, however, that replacing the
securities may be the preferable course of action.
    Freddie Mac, in pointing out that it posts margin in the form of
securities that are not fungible, explained that in certain cases, it
may be necessary to have the same security returned in order to achieve
the company's asset/liability management goals or for other risk
management purposes. Based on this concern, Freddie Mac requested that
the Commission make more explicit, and specifically state, that an FCM
is responsible for losses arising from a customer's inability to
maintain the risk profile of a portfolio or otherwise replicate
necessary positions (e.g., ``breakage''), transactional costs, and
similar consequential losses resulting from the repo transaction.
    The Commission has determined that in the unlikely event of a
counterparty default involving customer-deposited securities, the FCM
or DCO must make the customer economically whole and must do so in a
timely manner. The FCM or DCO will not be required to replace the
securities; rather, it may exercise its discretion in determining the
means for making the customer whole in light of the relevant facts and
circumstances. Making the customer ``whole'' includes, but is not
limited to replacing the securities that were the subject of the repo,
paying the customer the cash equivalent of the securities, reimbursing
the customer for any commissions or other transactional costs incurred
by the customer in replacing the securities, compensating the customer
for any adverse tax consequences accruing to the customer,\10\ or
covering any other losses that arise from the counterparty's failure to
return the securities deposited by the customer.
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    \10\ While the FIA has suggested that the Commission need not
consider possible tax consequences in its deliberations, the
Commission wishes to make clear that adverse tax consequences for
customers as a result of a repo counterparty default are the type of
cost or expense that must be covered by the FCM. The Commission
agrees that it is not necessary to engage in an analysis of specific
factual situations that may give rise to adverse tax consequences,
but it is necessary to point out that the Commission contemplates
that adverse tax consequences are the type of cost or expense for
which the customer must be compensated.
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    Accordingly, the proposed language of 1.25(a)(2)(ii)(D), which
would have obligated the FCM or DCO ``to take steps to ensure'' that
the default by a repo counterparty does not result in ``any cost or
expense to the customer,'' has been revised to read ``[u]pon the
default by a counterparty to a repurchase

[[Page 6143]]

agreement, the futures commission merchant or derivatives clearing
organization shall act promptly to ensure that the default does not
result in any direct or indirect cost or expense to the customer.''
This modified language is intended to clarify: (1) The FCM or DCO has
an unconditional responsibility to make the customer whole; (2) the FCM
or DCO must act promptly; and (3) making the customer whole includes
compensation for a wide range of costs and expenses, both direct and
indirect, as discussed above.
    In its proposal, the Commission requested comment on whether the
terms and conditions applicable to DCOs engaging in repos should differ
in any way from those applicable to FCMs. The Commission received no
comments on this topic. The Commission has determined to apply the same
rules to both FCMs and DCOs engaging in repo transactions with
customer-deposited securities because the same economic risks apply to
both situations.
    The Commission also requested comment on whether customer
collateral that is subject to repo should be treated for concentration
purposes like permitted investments under paragraph (b)(4)(ii)
(repurchase agreements) or continue to be treated under paragraph
(b)(4)(v) (treatment of customer-owned securities). Only the FIA
touched on this. In footnote 3 of its letter, the FIA recommends that
the concentration limit requirements in paragraph (b)(4)(i) (permitted
investments) apply to all transactions. The Commission notes that under
current paragraph (b)(4)(v), there is no concentration requirement for
customer-deposited securities because changes in the value of such
securities accrue to the customer, not the FCM.\11\ The final rules in
no way limit or alter the fact that changes in the value of such
securities accrue to the customer and not the FCM. As discussed above,
however, if an FCM engaged in a repo with a customer-deposited security
and the counterparty defaulted, the FCM would bear the cost. Thus, the
FCM would incur price risk. Accordingly, consistent with the FIA
comment, the concentration requirements of direct investments apply.
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    \11\ See 65 FR at 78002 (Dec. 13, 2000) (discussion accompanying
the Commission's adoption of the concentration requirements).
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    In light of the Commission's adoption of amendments to Rule
1.25(a)(2), as discussed above, Rule 1.25, as amended, supersedes
Letter 84-24.

B. Time-to-Maturity Requirements for Certain Collateral

    Rule 1.25(b)(5) establishes a time-to-maturity requirement for the
portfolio of permitted investments. In order to encourage development
of innovative collateral management programs, and thereby facilitate
the efficient use of capital, the Commission proposed to amend Rule
1.25(b)(5) to permit certain instruments to be treated as if they had a
time-to-maturity of one day, if certain terms and conditions were
satisfied.\12\
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    \12\ The proposed amendments to Rule 1.25(b)(5) were intended to
address the CME's Interest Earning Facility 3 program (``IEF 3''),
and any similar programs, whereby FCMs could deposit certain
collateral on an overnight basis to meet concentration margin
requirements. Absent amendment of the rule, the deposit of such
collateral could cause the FCM's portfolio to exceed the time-to-
maturity limits of Rule 1.25(b)(5).
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    The Commission proposed the following criteria for such treatment:
first, under proposed paragraph (b)(5)(ii)(A), the instrument must be
deposited with a DCO solely on an overnight basis, pursuant to the
terms and conditions of a collateral management program. Second, under
proposed paragraph (b)(5)(ii)(B), the instrument must be one that the
FCM owns or has the unqualified right to pledge, is free of any lien,
and is deposited by the FCM into a segregated account at a DCO.\13\
Third, under proposed paragraph (b)(5)(ii)(C), the instrument must be
used only for the purpose of meeting concentration margin or other
similar charges that are in addition to the basic margin requirement
established by the DCO. Fourth, under proposed paragraph (b)(5)(ii)(D),
the DCO must price the instrument each day based on the current mark-
to-market value. Fifth, under proposed paragraph (b)(5)(ii)(E), the DCO
must haircut the instrument by at least two percent.
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    \13\ Instruments given to an FCM by a customer for deposit in a
segregated account currently are not subject to the time-to-maturity
provisions of Rule 1.25, and this remains the case under the final
rules. Instruments purchased by an FCM with customer funds and held
in a segregated account currently are subject to those provisions.
This generally will remain the case under the final rules. The final
rules provide relief with regard to instruments that are held by an
FCM in its non-segregated inventory and that are deposited on an
overnight basis into a segregated account at a DCO. So long as an
FCM has an unqualified right to pledge the instruments, it may
include instruments obtained through reverse repos, or otherwise.
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    The Commission requested comment on the appropriateness of the
proposed terms and conditions. In particular, the Commission requested
comment on whether the relief should be limited to instruments
deposited to meet concentration and similar margin requirements, as
proposed, or whether the modified treatment should be extended to apply
to initial margin generally. If the latter, the Commission requested
comment on whether alternative safeguards should be developed. The
Commission also requested comment on whether the proposed haircut is
appropriate.
    The Commission received two comment letters on the proposed
amendments to Rule 1.25(b)(5). With respect to the permitted categories
of margin (proposed paragraph (b)(5)(ii)(C)), the CME requested
clarification that the proposed language would not restrict it from
applying assets in the IEF 3 program to reserve and/or core performance
bond requirements. The CME stated that it performs its own conservative
risk management and stress testing functions on a daily basis,
establishing a prudent and flexible program that benefits market
participants. It asserted that by expanding the list of permitted
margin categories, industry participants and DCOs would realize greater
benefits. The CME stated its belief that it is important to have the
flexibility to expand the IEF 3 program to satisfy other classes of
performance bond requirements.
    Similarly, the FIA expressed the view that certain of the proposed
terms and conditions would unnecessarily restrict the scope of the
relief. In particular, the FIA stated its belief that the benefits of
the amendment should not be limited to those circumstances in which the
securities are used only for the purpose of meeting concentration
margin or other similar charges. Referring to the IEF 3 program, the
FIA noted that although it is limited to the deposit of concentration
margin, ``we see no reason why, if a clearing organization desired, a
comparable program could not be designed for initial margin deposits
generally.''
    With respect to the proposed minimum haircut of two percent
(proposed paragraph (b)(5)(ii)(E)), the CME expressed the view that the
rule should allow either a DCO or a qualified custodian to perform the
pricing and haircutting functions. It indicated that it plans to use
third party custodians to price and haircut securities that qualify for
the one-day time-to-maturity benefit, but would like the ability to
perform these functions if it obtains the necessary expertise. The CME
did not object to the two percent minimum haircut.
    The FIA opposed the minimum haircut, expressing the view that the
DCO core principles support the authority of DCOs to exercise
discretion in managing risks in setting haircuts on

[[Page 6144]]

deposited securities. The FIA requested that the Commission defer to
the DCO's judgment in establishing such haircuts, until the Commission
has reason to believe that the DCO is not complying with a core
principle.
    The Commission has carefully considered the views expressed by the
CME and FIA. The Commission has determined to adopt the amendments to
Rule 1.25(b)(5), as proposed, with two exceptions. First, the
Commission has decided not to adopt proposed paragraph (b)(5)(ii)(C),
which would have limited the one-day time-to-maturity treatment to
instruments deposited to meet concentration margin or similar charges.
The Commission believes that the other provisions of the rule
constitute prudent safeguards and that it is appropriate to give DCOs
the flexibility to apply the rule to other classes of performance bond.
    Second, in the final rules, the Commission has added language to
proposed paragraph (b)(5)(ii)(A) to make clear that the DCO's
collateral management program must have become effective in accordance
with the notice procedures of Rule 39.4.\14\ The notice procedures,
which apply generally to DCO rules,\15\ provide the Commission with a
mechanism for maintaining an appropriate level of oversight to ensure
that the relief granted in paragraph (b)(5) is applied consistent with
core principles and the Commission's regulations. The Commission notes
that rather than adopt prescriptive rules for collateral management
programs that incorporate the one-day time-to-maturity treatment, the
Commission has taken a more flexible approach in permitting DCOs to
exercise discretion in developing such programs.
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    \14\ Rule 39.4(a) provides that DCOs may request Commission
approval for rules and rule amendments under Rule 40.5, and Rule
39.4(b) provides that DCOs may self-certify new or amended rules
under Rule 40.6.
    \15\ The Commission broadly defines the term ``rule'' to
include, among other things, rules, regulations, interpretations,
and stated policies, in whatever form adopted, and any amendment or
addition thereto, made or issued by a DCO. See Rule 40.1.
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    With regard to the CME's comment on performance of the pricing and
haircutting function, the Commission confirms that a DCO could
outsource the daily execution of these functions to a third party
custodian. Under the rule, however, the DCO would remain ultimately
responsible for compliance.
    With regard to the FIA's comment on the haircut, the Commission has
decided to impose a minimum two percent haircut, as proposed. The
effect of new paragraph (b)(5)(ii) will be to give relief from the
time-to-maturity requirement of paragraph (b)(5)(i) that would
otherwise apply. The Commission believes that in light of this relief,
the two percent haircut is a prudent substitute safeguard. The
Commission understands that two percent is the standard haircut
generally used in the repo market.
    Finally, the FIA concluded its comments on (b)(5) with a request
for the Commission to confirm that, to the extent the concentration
limits in Rule 1.25 apply to deposits of securities with DCOs under
1.25(b)(2), the applicable limits will be the limits for direct
investments. The Commission hereby confirms this.

III. Section 4(c) Findings

    The final rules allowing FCMs and DCOs to engage in repos with
securities deposited by customers are promulgated under section
4d(a)(2) of the Commodity Exchange Act (``Act''),\16\ which governs
investment of customer funds, and Section 4(c) of the Act,\17\ which
grants the Commission broad exemptive authority. Section 4d(a)(2)
provides that customer funds may be invested in obligations of the
United States, in general obligations of any State or of any political
subdivision thereof, and in obligations fully guaranteed as to
principal and interest by the United States. It further provides that
such investments must be made in accordance with such rules and
regulations and subject to such conditions as the Commission may
prescribe.
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    \16\ 7 U.S.C. 6d(a)(2).
    \17\ 7 U.S.C. 6(c).
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    Section 4(c) of the Act provides that, in order to promote
responsible economic or financial innovation and fair competition, the
Commission, by rule, regulation or order, may exempt any class of
agreements, contracts or transactions, including any person or class of
persons offering, entering into, rendering advice or rendering other
services with respect to, the agreement, contract, or transaction, from
the contract market designation requirement of section 4(a) of the Act,
or any other provision of the Act other than section 2(a)(1)(C)(ii) or
(D), if the Commission determines that the exemption would be
consistent with the public interest. For the reasons stated below, the
Commission believes that issuing the exemptive relief as set forth in
these final rules is consistent with the public interest.
    The Commission is expanding the range of instruments in which FCMs
may invest customer funds beyond those listed in section 4d(a)(2) of
the Act, to enhance the yield available to FCMs, DCOs, and their
customers without compromising the safety of customer funds. These
final rules should enable FCMs and DCOs to remain competitive globally
and domestically, while maintaining safeguards against systemic risk.
In light of the foregoing, the Commission has determined that the
adoption of the final rules regarding the expansion of permitted
instruments for the investment of customer funds will be consistent
with the ``public interest,'' as that term is used in section 4(c) of
the Act. When that provision was enacted, the Conference Report
accompanying the Futures Trading Practices Act of 1992 \18\ stated that
the ``public interest'' in this context would ``include the national
public interests noted in the Act, the prevention of fraud and the
preservation of the financial integrity of the markets, as well as the
promotion of responsible economic or financial innovation and fair
competition.'' \19\
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    \18\ Pub. L. No. 102-546, 106 Stat. 3590 (1992).
    \19\ H.R. Conf. Rep. No. 102-978 (1992). The Conference Report
also states that the reference in Section 4(c) to the ``purposes of
the Act'' is intended to ``underscore [the Conferees'] expectation
that the Commission will assess the impact of a proposed exemption
on the maintenance of the integrity and soundness of markets and
market participants.'' Id.
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IV. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'')\20\ requires federal
agencies, in promulgating rules, to consider the impact of those rules
on small businesses. The rule amendments adopted 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.\21\ The Commission has previously determined that registered
FCMs \22\ and DCOs \23\ are not small entities for the purpose of the
RFA. Pursuant to 5 U.S.C. 605(b), the Chairman, on behalf of the
Commission, certifies that the final rules will not have a significant
economic impact on a substantial number of small entities.
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    \20\ 5 U.S.C. 601 et seq.
    \21\ 47 FR 18618 (Apr. 30, 1982).
    \22\ Id. at 18619.
    \23\ 66 FR 45604, 45609 (Aug. 29, 2001).
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B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \24\ imposes certain
requirements on federal agencies

[[Page 6145]]

(including the Commission) in connection with their conducting or
sponsoring any collection of information as defined by the PRA. The
final rule amendments that have been adopted do not require a new
collection of information on the part of any entities subject to these
rules.
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    \24\ 44 U.S.C. 3507.
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C. Cost-Benefit Analysis

    Section 15(a) of the Act requires that the Commission, before
promulgating a regulation under the Act or issuing an order, consider
the costs and benefits of its action. By its terms, section 15(a) does
not require the Commission to quantify the costs and benefits of a new
rule or determine whether the benefits of the rule outweigh its costs.
Rather, section 15(a) simply requires the Commission to ``consider the
costs and benefits'' of its action.
    Section 15(a) further specifies that costs and benefits shall be
evaluated in light of the following considerations: (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. Accordingly, the Commission could, in its discretion,
give greater weight to any one of the five considerations and could, in
its discretion, determine that, notwithstanding its costs, a particular
rule was necessary or appropriate to protect the public interest or to
effectuate any of the provisions or to accomplish any of the purposes
of the Act.
    The Commission has evaluated the costs and benefits of the final
rules in light of the specific considerations identified in section
15(a) of the Act, as follows:
    1. Protection of market participants and the public. The final
rules facilitate greater capital efficiency on the part of FCMs and
DCOs, while protecting customers by establishing prudent standards for
repos with customer-deposited collateral and requirements for
adjustment to time-to-maturity calculations for certain collateral
management programs.
    2. Efficiency and competition. The final rules provide FCMs and
DCOs with greater flexibility in using repos to maximize returns on
direct investment of customer funds. They also facilitate the
implementation of collateral management programs, which can also serve
to maximize capital efficiency. The rules should enable FCMs and DCOs
to remain competitive globally and domestically, while maintaining
safeguards against systemic risk.
    3. Financial integrity of futures markets and price discovery. The
final rules will not affect the financial integrity of futures markets
and price discovery.
    4. Sound risk management practices. The final rules impose sound
risk management practices for FCMs and DCOs that elect to invest
customer funds under the rules. The rules regarding repos with
customer-deposited securities make clear that FCMs and DCOs, not
customers, will bear the costs of any default by a repo counterparty.
DCOs acting pursuant to the one-day time-to-maturity relief must
satisfy the requirements set forth in the final rules, which include a
requirement that the governing collateral management program must have
been filed with the Commission.
    5. Other public considerations. The final rules are expected to
enhance the ability of FCMs and DCOs to earn revenue from the
investment of customer funds, while protecting the safety of such funds
and preserving the rights of customers. FCMs and DCOs are not obligated
to enter into repos with customer-deposited collateral under Rule
1.25(a)(2), and, similarly, DCOs are not obligated to implement
collateral management programs applying the relief granted in Rule
1.25(b)(5). Therefore, any costs to FCMs and DCOs in connection with
the implementation of these rules are voluntarily incurred. With
respect to customer costs, the rules clarify that, in the case of a
default by a repo counterparty, the customer must be made whole,
promptly. The requirements that must be satisfied in order for
collateral to be used for a repo (including ready marketability) will
make prompt replacement of the securities or payment of replacement
costs readily feasible solutions.

List of Subjects in 17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Reporting and
recordkeeping requirements.

0
Accordingly, the Commission amends part 1 as follows:

PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

0
1. The authority citation for Part 1 continues to read as follows:

    Authority: 7 U.S.C.

0
2. Section 1.25 is amended by revising paragraphs (a)(2) and (b)(5) to
read as follows:


Sec. 1.25  Investment of customer funds.

    (a) * * *
    (2)(i) In addition, a futures commission merchant or derivatives
clearing organization may buy and sell the permitted investments listed
in paragraphs (a)(1)(i) through (viii) of this section pursuant to
agreements for resale or repurchase of the instruments, in accordance
with the provisions of paragraph (d) of this section.
    (ii) A futures commission merchant or a derivatives clearing
organization may sell securities deposited by customers as margin
pursuant to agreements to repurchase subject to the following:
    (A) Securities subject to such repurchase agreements must meet the
marketability requirement of paragraph (b)(1) of this section.
    (B) Securities subject to such repurchase agreements must not be
``specifically identifiable property'' as defined in Sec. 190.01(kk) of
this chapter.
    (C) The terms and conditions of such an agreement to repurchase
must be in accordance with the provisions of paragraph (d) of this
section.
    (D) Upon the default by a counterparty to a repurchase agreement,
the futures commission merchant or derivatives clearing organization
shall act promptly to ensure that the default does not result in any
direct or indirect cost or expense to the customer.
    (b) * * *
    (5) Time-to-maturity. (i) Except for investments in money market
mutual funds, the dollar-weighted average of the time-to-maturity of
the portfolio, as that average is computed pursuant to Sec. 270.2a-7 of
this title, may not exceed 24 months.
    (ii) For purposes of determining the time-to-maturity of the
portfolio, an instrument that is set forth in paragraphs (a)(1)(i)
through (vii) of this section may be treated as having a one-day time-
to-maturity if the following terms and conditions are satisfied:
    (A) The instrument is deposited solely on an overnight basis with a
derivatives clearing organization pursuant to the terms and conditions
of a collateral management program that has become effective in
accordance with Sec. 39.4 of this chapter;
    (B) The instrument is one that the futures commission merchant owns
or has an unqualified right to pledge, is not subject to any lien, and
is deposited by the futures commission merchant into a segregated
account at a derivatives clearing organization;
    (C) The derivatives clearing organization prices the instrument
each day based on the current mark-to-market value; and
    (D) The derivatives clearing organization reduces the assigned
value

[[Page 6146]]

of the instrument each day by a haircut of at least 2 percent.
* * * * *

    Issued in Washington, DC on February 4, 2004, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 04-2752 Filed 2-9-04; 8:45 am]

BILLING CODE 6351-01-P
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