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[Federal Register: December 30, 1997 (Volume 62, Number 249)]
[Notices]
[Page 67841-67847]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr30de97-67]

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COMMODITY FUTURES TRADING COMMISSION


Concept Release on the Denomination of Customer Funds and the
Location of Depositories

AGENCY: Commodity Futures Trading Commission.

ACTION: Request for comment.

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SUMMARY: The Commodity Futures Trading Commission (``Commission'') is
publishing this release to obtain the views of the public on how to
address risks related to holding segregated funds offshore or in
foreign currencies. The Commission wishes to consider how to update and
otherwise to revise existing regulatory standards to avoid inhibiting
transnational commodity futures activities or causing undue costs or
operational inconvenience, without increasing risks to market
participants. This initiative is part of the Commission's recently
adopted strategic plan, which includes ensuring ``sound financial
practices of clearing organizations and firms holding customer funds''
and facilitating ``the continued development of an effective, flexible,
regulatory environment responsive to evolving market conditions.''
<SUP>1</SUP>
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    \1\ See Vision and Strategies for the Future: Facing the
Challenges of 1997 through 2002, published by the Commission
(September 1997).
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    The Commodity Exchange Act (``Act'') <SUP>2</SUP> requires that all
money, securities and property received by futures commission merchants
(``FCMs'') to margin, guarantee, or secure customer trades or contracts
on domestic contract markets, or accruing to customers as a result of
these trades or contracts, be segregated. Until 1988, the Commission
generally required that such money, securities and property
(hereinafter collectively referred to as ``customer funds'') be held in
the United States (``U.S.'') with the exception of certain funds held
on behalf of non-U.S.-domiciled customers.<SUP>3</SUP>
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    \2\ 7 U.S.C. 1 et seq.
    \3\ See Commodity Exchange Authority Administrative
Determination No. 238 (September 4, 1974).
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    In November 1988, the Commission issued Financial and Segregation
Interpretation No. 12, ``Deposit of Customer Funds in Foreign
Depositories'' (``Interpretation No. 12'').<SUP>4</SUP> Interpretation
No. 12 permits customer funds to be held in depositories located
outside of the U.S., subject to limitations and conditions intended for
the protection of these funds. At the time Interpretation No. 12 was
issued, the Commission stated its intention to ``monitor experience
under this interpretation * * * to alter or supplement the conditions
for keeping segregated funds offshore as such experience renders
advisable.'' Various developments since 1988 make it appropriate to
revisit this area.
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    \4\ 53 FR 46911 (November 21, 1988).

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     Date: Comments must be received on or before March 2, 1998.

FOR FURTHER INFORMATION CONTACT: France M.T. Maca, Special Counsel,
Division of Trading and Markets, Commodity Futures Trading Commission,
Three Lafayette Center, 1155 21st Street, N.W. Washington, D.C. 20581.
Telephone: (202) 418-5482.

Table of Contents

I. Background
    A. Current Regulatory Requirements
    1. Commodity Regulation
    2. Bankruptcy Regulation
    3. Banking Regulation
    B. Developments Since the Issuance of Interpretation No. 12
II. Policy Considerations
    A. Goals
    B. Risks
III. Potential Approaches
    A. Permissible Denominations of Obligations
    1. Alternatives
    2. Discussion
    B. Permissible Denominations of Assets
    1. Alternatives
    2. Discussion
    C. Permissible Locations of Segregated Funds
    1. Alternatives
    2. Discussion
    D. Qualifications of Depositories
    1. Alternatives
    2. Discussion
    E. Segregation and Net Capital Treatment
    1. Alternatives
    2. Discussion
    F. Bankruptcy Treatment
    1. Alternatives
    2. Discussion
IV. A Specific Approach
V. Request for Comment


SUPPLEMENTARY INFORMATION:

I. Background

A. Current Regulatory Requirements

1. Commodity Regulation
    The maintenance and location of customer funds is prescribed by
Section 4d of the Act which requires that each FCM:

    Treat and deal with all money, securities, and property received
by such [FCM] to margin, guarantee, or secure the trades or
contracts of any customer of such [FCM], or accruing to such
customer as the result of such trades or contracts, as belonging to
such customer. Such money, securities, and property shall be
separately accounted for and shall not be commingled with the funds
of such [FCM] or be used to margin or guarantee the trades or
contracts, or to secure or extend the credit, of any customer or
person other than the one from whom the same are held.

    It further provides that:

    It shall be unlawful for any person, including but not limited
to any clearing agency of a contract market and any depository, that
has received any money, securities, or property for deposit in a
separate account as provided in paragraph (2) of this section, to
hold, dispose of, or use any such money, securities, or property as
belonging to the depositing [FCM] or any person other than the
customers of such [FCM].

    The Commission's segregation requirements are set forth in
Regulations 1.20-1.30, 1.32 and 1.36, 17 CFR 1.20-1.30, 1.32 and 1.36.
They provide, among other things, that a customer's funds: must be
accounted for separately by the FCM; may not be commingled with the
FCM's own funds or those of any other person; must be available
immediately upon demand; and must be used only to margin or to secure
contracts traded on or subject to the rules of a designated contract
market. Neither Section 4d of the Act nor these regulations address the
holding of customer funds offshore or in foreign currencies.
    Interpretation No. 12 permits the deposit of U.S. customer funds
offshore, subject to conditions intended to ensure consistency with the
segregation requirements of the Act and ``generally to prevent the
dilution of customer funds held in segregation in the United States.''
Accordingly, Interpretation No. 12 limits the circumstances under which
funds may be held offshore; requires specified qualifications for
foreign depositories; requires a certain

[[Page 67842]]

amount of funds to be held in dollars in the U.S.; and requires that
customers whose funds are deposited offshore subordinate their claims
against segregated funds to those of customers whose funds are
deposited in the U.S. or in other currencies.
    More specifically, Interpretation No. 12 permits customer funds,
including funds of U.S. customers, to be held offshore subject to the
following conditions:
    1. With respect to U.S.-domiciled customers, only funds held for
trading contracts that are priced and settled in a foreign currency may
be held in foreign depositories;
    2. FCMs must segregate sufficient funds in dollars in the U.S. to
meet all dollar-denominated obligations to customers;
    3. Customer funds may be held only in the country of origin of the
applicable currency or in a country with which the Commission has an
information sharing arrangement;
    4. Foreign depositories must meet Commission Regulation 30.7(c)
criteria; <SUP>5</SUP> and
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    \5\ These criteria are detailed in Part III C infra.
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    5. FCMs must obtain from customers a subordination agreement
whereby the customer authorizes the deposit of its funds in a foreign
depository and subordinates its claim thereto to the claims of
customers whose accounts are denominated in U.S. dollars.<SUP>6</SUP>
The subordination agreement would be activated in the event the FCM is
placed in bankruptcy or receivership and there are insufficient
customer funds available for distribution to satisfy all customer
claims.
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    \6\ Commission staff has interpreted this requirement to apply
with respect to funds denominated in foreign currencies, wherever
held. See, fn. 11 infra and accompanying text.
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2. Bankruptcy Regulation
    Subchapter IV of Chapter 7 of the Bankruptcy Code (11 U.S.C.)
accords customers of an insolvent commodity broker priority in the
distribution of customer property:

    The trustee shall distribute customer property ratably to
customers on the basis and to the extent of such customers' allowed
net equity claims, and in priority to all other claims, except
claims * * * attributable to the administration of customer
property.

    In 1983, the Commission adopted Part 190 of its regulations to
implement the Bankruptcy Reform Act of 1978.<SUP>7</SUP> Part 190
recognizes different account classes to permit ``the implementation of
the principle of pro rata distribution so that the differing
segregation requirements with respect to different classes of accounts
benefit customer claimants based on the class of account for which they
were imposed.'' <SUP>8</SUP> The account classes are: futures accounts,
foreign futures accounts, leverage accounts, commodity options
accounts, and delivery accounts.<SUP>9</SUP> Futures and options
accounts that trade foreign currency contracts, contain foreign
currencies, or are located offshore are not recognized as a separate
account class. The subordination agreement required by Interpretation
No. 12, in effect, results in these accounts being treated as belonging
to separate account classes in the event of an FCM's bankruptcy.
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    \7\ 48 FR 8716 (1983).
    \8\ See Part 190 proposal, 46 Fed. Reg. 57535 (1981) (the
``Proposing Release'').
    \9\ Commodity options accounts do not constitute a separate
class to the extent they relate to transactions subject to
regulation under the Act and the Commission's regulations, because
FCMs are permitted to commingle funds required to be segregated.
Section 4d(2) of the Act, 7 U.S.C. 6d(2); Commission's Regulations
190.01 and 1.3(hh).
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3. Banking Regulation
    Prior to 1988, the Board of Governors of the Federal Reserve had a
policy discouraging banks in the U.S. from accepting deposits of
foreign currencies. Shortly after the Commission issued Interpretation
No. 12, in order to address the needs of contracts settled in foreign
currencies, the Board changed its policy and began to allow banks
located in the U.S. to accept foreign currency deposits.
    Regulation Q (12 CFR Sec. 217) generally prohibits U.S. banks from
paying interest on demand deposits. <SUP>10</SUP> Regulation Q does not
prohibit foreign branches of U.S. banks from paying interest on demand
deposits, provided that the U.S. bank does not expressly guarantee
repayment of the deposits in the U.S.
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    \10\  The Commission requirement that customer funds be
available upon demand results in these funds being categorized by
banks as demand deposits. A bill to repeal the prohibition on the
payment of interest on demand deposits was introduced by Rep.
Metcalf on July 31, 1997, and is currently pending. See H.R. 2323,
105th Cong., 1st Sess. (1997).
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B. Developments Since the Issuance of Interpretation No. 12

    At the time Interpretation No. 12 was issued, the Commission stated
its intention to ``monitor experience under this interpretation * * *
to alter or supplement the conditions for keeping segregated funds
offshore as such experience renders advisable.'' Various developments
since 1988 make it appropriate to revisit this area. First, as noted
above, when Interpretation No. 12 was issued, U.S. banks generally did
not hold foreign currencies in the U.S. Therefore, Interpretation No.
12 does not explicitly address risks related to customer funds
denominated in foreign currencies and held in the U.S.<SUP>11</SUP>
Second, since 1988, U.S. contract markets have listed many futures and
option contracts that are priced and settled in foreign currencies. The
use of foreign currencies in connection with trading these contracts,
particularly the use of currencies of countries that are major
financial centers, has become commonplace. Third, trading volume in the
competing offshore and over-the-counter markets has increased
dramatically since 1988, raising competitiveness concerns in the
industry. Fourth, industry sources have expressed the view to
Commission staff that the subordination requirement of Interpretation
No. 12 is cumbersome, unnecessarily penalizes customers who deposit
foreign currencies with FCMs, and is an impediment to access to the
U.S. futures markets for non-U.S. customers who may be reluctant to
subordinate their claims.<SUP>12</SUP>
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    \11\ However, Commission staff has interpreted the subordination
requirement of Interpretation No. 12 to be applicable to customer
funds denominated in foreign currencies, wherever held.
    \12\ Interpretation No. 12 ``has the effect of making overseas
customers less willing to use U.S. futures markets because it
imposes a subordination requirement on foreign currency deposits
that is obsolete in today's global economy * * *.'' (Letter dated
November 4, 1997, to the Commission from the Chicago Mercantile
Exchange). A number of brokerage firms interviewed by Commission
staff in connection with reviewing the requirements of
Interpretation No. 12 expressed the same view.
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    Finally, several FCMs and a clearing organization have requested
permission to maintain in offshore accounts customer funds denominated
in foreign currencies. The FCMs represented that holding funds offshore
would better serve the needs of their foreign-domiciled clientele. The
clearing organization contended that it could draw interest on customer
funds held offshore, which would permit it to be more competitive.
Interpretation No. 12 allows customer funds to be held offshore only if
``such funds are used to margin, guarantee, or secure positions in a
contract traded on a domestic contract market that is priced and
settled in a foreign currency'' and only with the express consent and
subordination of the customer. Moreover, Interpretation No. 12 clearly
states the Commission's belief that ``some constraints are necessary to
prevent the transfer of funds overseas for reasons unrelated to trading
in the relevant contracts.'' Accordingly, a clearing organization could
not move and maintain customer funds offshore except as permitted by
Interpretation No. 12 or unless it

[[Page 67843]]

obtained relief from the requirements thereof.<SUP>13</SUP>
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    \13\ Indeed, on a case by case basis, the Division of Trading
and Markets has permitted customer funds to be maintained by
clearing organizations in London and Mexico City.
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II. Policy Considerations

A. Goals

    The protection of customer funds is a cornerstone of the Act and
the Commission's regulations. Typically, U.S. market participants
deposit dollars or dollar-denominated assets with their FCM. These
assets are held in segregation in the U.S. Increasingly, however, there
appears to be a need or desire to hold customer funds overseas or in
non-U.S. dollar denominations.
    Historically, the Commission has proceeded with caution in allowing
customer funds to be held offshore or denominated in foreign currencies
and intends to continue to do so. Nevertheless, at this juncture, the
Commission wishes to take a comprehensive look at the needs and
practices of the industry in evaluating possible revisions of its
requirements. Three distinct questions must be considered: (1) Whether
and under what circumstances customers may choose to have segregated
funds deposited offshore or denominated in foreign currencies; (2)
whether and under what circumstances FCMs may choose to hold segregated
funds offshore or in foreign currencies; and (3) whether and under what
circumstances clearing organizations may choose to hold segregated
funds offshore or in foreign currencies.
    In each case, the extent of the need or desire for holding customer
funds offshore or in foreign currencies must be assessed against the
related risks. Risk limiting measures must be considered, and the
question of who should bear the risks that cannot be eliminated must be
explored. One of the premises of Interpretation No. 12 is that
customers whose accounts are denominated in U.S. dollars must be
insulated from the risks resulting from an FCM holding funds offshore
or in foreign currencies. The continuing viability of this premise has
been questioned by some industry participants.
    The Commission encourages commenters to describe their current
practices and to provide a detailed analysis of the reasons for their
desire or need to keep segregated funds offshore. Commenters should
discuss related risks and how these risks should be addressed for the
protection of customers. Commenters should also explain how revisions
to the current requirements could affect their business.

B. Risks

    Holding segregated funds offshore or in foreign currencies creates
three types of risk:

--currency risk;
--depository risk; and
--sovereign risk.
    Currency risk arises when an obligation is denominated in one
currency and the asset held to meet that obligation is in another
currency. Fluctuations in exchange rates can cause the amount of the
obligation to change at a different rate than the value of the asset,
thereby resulting in insufficient funds in segregation to meet the
obligation.
    Depository risk is the danger that a depository holding customer
funds may be unable or unwilling to release those funds on demand. This
risk, of course, exists with domestic depositories but contains
additional elements overseas, particularly insofar as the Commission's
knowledge of, or authority over, foreign depositories may be less.
    Sovereign risk is the chance that a foreign government might take
action preventing a depository or an FCM from releasing customer funds
despite the requirements of Section 4d of the Act.

III. Potential Approaches

    This part of the concept release sets forth a number of possible
methods to address the risks described above and the issues that have
arisen since Interpretation No. 12 was issued. Some of the listed
methods are existing requirements; others are measures suggested by
industry members or devised by Commission staff. The listing of
potential approaches in this concept release is designed only to elicit
public comment. It is not intended as an endorsement or to indicate a
willingness on the part of the Commission to adopt these approaches or
to abandon existing provisions.
    The Commission requests commenters to indicate their preferred
alternatives from among those listed or to suggest other methods. The
alternatives are organized into six categories. These categories
represent potential avenues for dealing with the risks described above.
They are:
--the permissible denominations of FCMs' obligations to their
customers;
--the permissible denominations of assets held in segregation;
--the permissible locations of segregated funds;
--the qualifications of non-U.S. depositories;
--the segregation and net capital treatment of customer funds held
offshore or in foreign currencies; and
--the bankruptcy treatment of these funds.

    The first five categories above primarily involve steps that could
reduce risks. The last category involves steps that could be taken to
allocate losses equitably in the event that shortfalls in segregated
funds nevertheless occur. The list of potential choices in each area of
intervention generally proceeds from most restrictive to least
restrictive. Each option may address more than one type of risk, and
choices within one section are not necessarily mutually exclusive.
Moreover, a choice under one area may affect a choice in another. For
example, choices under section C, relating to countries where
segregated funds may be held, must be made in conjunction with related
requirements under section E, regarding the segregation treatment of
customer funds. Each section is followed with a brief discussion of the
potential impact of listed choices. A variety of overall approaches can
be constructed by selecting different combinations.
    Because the Commission generally favors an approach that emphasizes
prophylactic measures, most listed choices are intended to reduce
relevant risks. However, the Commission recognizes that all risks
cannot be prevented. Accordingly, possible procedures also are included
to alleviate the consequences of residual risks, i.e., any risks that
cannot be effectively eliminated.

A. Permissible Denominations of Obligations

1. Alternatives
    An FCM's obligation to a customer may be denominated in a currency
other than U.S. dollars:
    a. In connection with contracts priced and settled in that
currency.
    b. (i) In connection with contracts priced and settled in that
currency; or (ii) if the customer is domiciled overseas.
    c. If the currency is acceptable for margin purposes on a U.S.
contract market.
    d. With the customer's written authorization.
    e. Other, please specify.
2. Discussion
    As noted above, because currencies fluctuate at different rates,
where obligations are denominated in one currency and assets held to
meet these obligations are denominated in another,

[[Page 67844]]

an imbalance may result between assets and obligations resulting in
insufficient funds in segregation to meet the obligations. Accordingly,
the denomination of both assets and obligations to customers must be
considered.
    Discussions with participants in the industry indicate that, under
current practices, the agreement signed by a customer opening an
account with an FCM usually specifies either that obligations to the
customer are in U.S. dollars, unless otherwise agreed, or that the
customer will be paid in the currency it deposits or in which any
earnings are accrued. The discussions also indicate, however, that
these principles are not uniformly applied and indeed that some FCMs
may not have a clear agreement with their customers regarding the
currencies in which customers are to be paid. This should be clarified
as it may ultimately dictate whether gains and losses resulting from
currency fluctuations will accrue to, or be borne by, the FCM or its
customers. The choices made for this section must be considered in
close conjunction with those made for the next section relating to
permissible denomination of assets.

B. Permissible Denominations of Assets

1. Alternatives
    Assets held in segregation may be denominated in a foreign currency
only:
    a. In connection with contracts priced and settled in that
currency.
    b. (i) In connection with contracts priced and settled in that
currency; or (ii) if the customer is domiciled overseas.
    c. If the currency is acceptable for margin purposes on a U.S.
contract market.
    d. With the customer's written authorization.
    e. Other, please specify.
2. Discussion
    Current Interpretation No. 12 permits the deposit offshore of funds
``used to margin, guarantee, or secure positions in a contract traded
on a domestic contract market that is priced and settled in a foreign
currency or accrue to such a customer as a result of positions in such
contracts.'' Provided that FCMs recompute the asset/obligation balance
on a daily basis, any choice above would effectively address currency
risk. Absent a requirement to rebalance asset/obligations daily, only
choice (a) could result in a ``natural'' balance. The other choices
would not ensure the continuous balance of assets and
obligations.<SUP>14</SUP> Commenters should indicate whether
alternatives (b), (c), and (d) should be limited further to specific
currencies.
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    \14\ However, potential imbalances would be mitigated by other
measures such as a requirement that FCMs take a haircut in their net
capital computation for any unhedged foreign currencies. See Part
III E infra.
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C. Permissible Locations of Segregated Funds

    1. Alternatives
    Segregated funds may be held at an approved depository in any of
the following geographic locations (commenters should choose the
appropriate combination):
    a. The U.S.
    b. The country of origin of the currency in which the related
contract is priced and settled.
    c. A country with which the Commission has an information sharing
arrangement.<SUP>15</SUP>
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    \15\ The Act enables the Commission to enter into various types
of cooperative arrangements with foreign futures authorities. See,
e.g., Sections 8(a)(1) and 12(f)(2) of the Act.
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    d. For a limited period of time, the country in which the customer
is domiciled, and only for operational ease in receiving and disbursing
funds from and to customers living in foreign countries and trading on
U.S. contract markets.
    e. Without time limitation, the country of domicile of the
customer.
    f. The G7 countries (plus Switzerland).<SUP>16</SUP>
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    \16\ The G7 is a group of industrialized countries. It includes:
the U.S., Canada, France, Germany, Italy, Japan and the United
Kingdom. For purposes of determining major money centers,
Switzerland is often added to the list.
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    g. Some or all of the twenty-four countries that the Securities and
Exchange Commission (``SEC'') considers as major money
centers.<SUP>17</SUP>
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    \17\ SEC no action letter from Michael Macchiaroli to Douglas
Preston of the Securities Industry Association [1992 Transfer
Binder], SEC Rep. (CCH) para. 76,245 (August 21, 1992). Subject to
certain conditions, the Market Regulation Division would not
recommend any enforcement action against broker dealers who hold
money market instruments in a ``major money market'' if they do not
take a one hundred percent haircut on these instruments in
calculating net capital under Rule 15c3-1 of the Securities Exchange
Act of 1934. The letter lists twenty-four countries that are
considered as major money markets. These countries are: Australia;
Austria; Belgium; Canada; Denmark; Finland; France; Germany; Greece;
Hong Kong; Ireland; Italy; Japan; Luxembourg; the Netherlands; New
Zealand; Norway; Portugal; Singapore; Spain; Sweden; Switzerland;
the United States; the United Kingdom.
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    h. Other, please specify.
2. Discussion
    Choice (a), requiring funds to be held in the U.S., is more
restrictive than the current Interpretation No. 12 approach. This
choice is more viable now than it was at the time Interpretation No. 12
was issued because, as noted above, in the interim, the Federal Reserve
changed its policy concerning foreign currency deposits in the U.S.
Nevertheless, the Commission recognizes that it could impose additional
costs on the industry. The requirement that segregated funds be held in
the country of origin of the currency (choice (b)) is a current
Interpretation No. 12 requirement. Under choice (b), an increase in the
number of currencies in which contracts traded in U.S. contract markets
settle would automatically trigger additional countries as permissible
segregated funds locations.<SUP>18</SUP> This choice may result in
countries being added and taken off the list of permissible locations
based on contract designations at any given time.
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    \18\ When Interpretation No. 12 was issued, no contracts priced
and settled in a foreign currency were traded on U.S. contract
markets. However, two applications were pending before the
Commission for designation of such contracts. Currently, many
contracts that margin and settle in foreign currencies are traded on
U.S. contract markets.
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    Choice (c) also reflects current Interpretation No. 12. In 1988,
the Commission had an information sharing arrangement with the
Australian National Companies and Securities Commission and with the
United Kingdom Securities and Investments Board. The Commission
currently has information sharing or cooperation arrangements with
regulators of over fifteen foreign jurisdictions. While the existence
of a framework of cooperation with the Commission is a positive factor,
other factors, such as economic and political soundness of the country,
also are important. Choices (f) and (g) would limit possible depository
countries to countries generally considered to be secure and to have
sophisticated regulatory regimes. Alternative (e) would permit FCMs to
hold customer funds offshore for operational convenience in any country
where an FCM's customer is domiciled.

D. Qualifications of Depositories

1. Alternatives
    To qualify to hold segregated funds, a depository must provide the
depositing FCM the segregation acknowledgment required by Commission
Regulation 1.20 and:
    a. Must be located in the U.S.
    b. If located offshore, must have a branch or correspondent in the
U.S. which guarantees repayment in the U.S. in the event the foreign
depository fails to fulfill its obligation for any reason.

[[Page 67845]]

    c. If located offshore, must have a branch or correspondent in the
U.S. which guarantees repayment in the U.S. in the event the foreign
depository fails to fulfill its obligation for any reason other than
sovereign action.
    d. If located offshore, must be an FCM or a designated bank or
trust company as defined in Advisory 87-5.<SUP>19</SUP>
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    \19\ Pursuant to CFTC Advisory 87-5 (1987-1990 CCH Transfer
Binder para. 23,997), FCMs are required to disclose on their Form 1-
FR the identity of offshore depositories. Any bank or trust company
located outside the U.S. whose commercial paper or long term debt is
rated in one of the two highest rating categories by Standard &
Poors Corporation or Moody's Investors Service, Inc. is deemed
automatically recognized. FCMs must submit an application for
recognition of other non-U.S. located banks and trust companies not
meeting this standard. Such banks or trust companies are deemed
recognized unless the Division gives the FCM notice to the contrary
within 60 days following receipt of the application. No such
application has been received.
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    e. Some combination of the elements of alternatives (a) through d.
    f. Other, please specify.
2. Discussion
    Alternative (d), which relies on the commercial paper or long term
debt rating of foreign depositories, is the current Interpretation No.
12 requirement. Alternative (b) would effectively address location risk
(both sovereign and depository risks) by requiring a repayment
guarantee in the U.S. whatever the cause of the shortfall. However, as
noted above, it appears that banks would not be allowed to pay interest
if an unconditional guarantee were given. Accordingly, choice (b) would
be unsatisfactory where customer funds are held offshore for the
purpose of yielding interest. Alternative (c) would address only
depository risk.

E. Segregation and Net Capital Treatment

1. Alternatives
    a. Customer funds must be segregated only in accounts payable in
the U.S. No account located or payable outside the U.S. is considered
an acceptable segregated deposit.
    b. A percentage of excess segregated funds on deposit in non-U.S.
locations (e.g., ten to twenty-five percent) may be recognized as good
segregated assets.
    c. Only funds received from foreign-domiciled customers may be held
offshore. However, they will not be considered to be properly
segregated.
    Segregated funds may be held offshore and/or in foreign currencies:
    d. Provided that sufficient funds are held in each currency to meet
all obligations in that currency, as computed daily.
    e. Provided that sufficient U.S. dollars are segregated in a U.S.
depository to meet all U.S. dollar obligations. To the extent other
currencies are segregated in foreign depositories, excess U.S. dollars
(e.g., 10%) must be held in the U.S. as a cushion.
    f. Provided that alternative sources of funding such as dedicated
lines of credit, in a form acceptable to the Commission, are available
to cover shortfalls or delays in payment.
    g. Some combination of the elements of alternatives (c) through
(e).
    h. Other, please specify.
2. Discussion
    Under alternative (a), funds deposited by customers for trading on
U.S. contract markets would be held in the U.S. only. This is founded
on the proposition that futures and options positions are carried in
the U.S., and therefore, the need for these funds, for variation
settlements and for standing margin is in the U.S. Having these funds
in the U.S. ensures that the funds will be available and subject to
U.S. law in the event of insolvency and that they will be distributed
according to the Bankruptcy Code and the regulations thereunder.
    Alternative (b) would recognize a percentage of excess segregated
funds held offshore as properly segregated. All other segregated funds
would be required to be held in the U.S. Alternative (c) would set no
limit on the amount of foreign-domiciled customer funds held in
offshore locations; however, these funds would not be recognized as
good segregated funds. Under alternative (d) customer funds could be
properly segregated offshore, subject to daily balancing of assets and
obligations in each currency. This would address currency risk, but not
location risk. Under alternative (e), all dollar obligations would be
matched by U.S. dollars held in segregation in the U.S. An FCM could
hold foreign currencies in segregation. As a protection against
currency rate fluctuations, however, the FCM would be required to hold
additional U.S. dollars in the U.S. Alternatives (a) through (e) all
are intended to prevent the occurrence of shortfalls. Alternative (f)
provides a method to cover shortfalls should they occur. As noted,
these alternatives are not necessarily mutually exclusive.

F. Bankruptcy Treatment \20\

1. Alternatives
    a. Customers whose funds are held offshore or in foreign currencies
must subordinate their claims against these funds to those of customers
whose funds are segregated in the U.S. and in U.S. dollars in the same
manner as under current Interpretation No. 12.
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    \20\ As noted above, the special provisions of the Bankruptcy
Code applicable to the bankruptcy of commodity brokers generally
require that in the event of the bankruptcy or insolvency of an FCM
all segregated funds be distributed on a pro rata basis to customers
of the same class.
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    b. Customers whose funds are held offshore or in foreign currencies
must subordinate their claims against these funds to those of customers
whose funds are segregated in the U.S. and in U.S. dollars in the same
manner as in Appendix B to the Commission's Bankruptcy
regulations.<SUP>21</SUP>
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    \21\ 17 C.F.R. 190 Appendix B. Appendix B, which governs the
distribution of property where a bankrupt FCM holds cross-margin
funds, while intended to assure that non-cross-margining customers
of such an FCM will not be adversely affected by a shortfall in the
pool of cross-margining funds, modified the applicable
distributional rules such that the required subordination is more
limited.
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    c. Customers whose funds are held offshore or in foreign currencies
must subordinate their claims against these funds to claims of
customers whose funds are segregated in the U.S. and in U.S. dollars in
the event there are shortfalls as a result of sovereign action.
<SUP>22</SUP>
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    \22\ Some industry members believe that the risk that a foreign
government would freeze deposits within its borders is ``remote,
especially when dealing with the major global currencies.'' They
recommend that the Commission exempt deposits of the major
currencies, wherever held, from all aspects of Interpretation No.
12. See letter dated October 16, 1997, to Chairperson Born from the
Chicago Board of Trade.
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    d. In the event of bankruptcy of an FCM or foreign depository,
segregated funds in each currency will constitute a separate pool, and
each customer will recover to the extent that there are funds in the
pool against which the customer holds a claim.
    e. In the event of bankruptcy of an FCM or foreign depository, all
segregated funds will constitute a single pool and will be distributed
pro rata without regard to the location or denomination of these funds.
    f. Other, please specify.
2. Discussion
    The majority of measures considered earlier in this release were
intended to minimize risks. This section deals with apportioning losses
should they occur. Alternative (a) is the requirement of current
Interpretation No. 12. As noted

[[Page 67846]]

above, to ensure that in the event of an FCM bankruptcy customers whose
funds are held in the U.S. and in U.S. dollars will not share pro rata
in possible shortfalls in customer funds held offshore, Interpretation
No. 12 requires that customers who deposit funds denominated in a
foreign currency subordinate their claims to those of customers with
U.S. dollar claims. Alternative (b) would use the same device in a
manner that would be less adverse to customers with funds denominated
in foreign currencies. Under alternative (c), the subordination would
be activated only in the event shortfalls resulted from sovereign
action. Other losses would be shared pro rata.
    Alternative (d) would pay each customer a pro rata share of the
currency pool(s) against which it had a claim. In certain
circumstances, this alternative could be inequitable to customers with
foreign-denominated claims. For example, the bankruptcy of a depository
could result in shortfalls in foreign currencies of the type held by
the depository. Under this alternative, the shortfalls would be shared
only by customers with claims against those currencies. However, some
of these customers may not have had funds in that depository or any
responsibility for its selection.
    As noted above, the Bankruptcy Code and regulations require pro
rata sharing among customers in each account class. Accordingly, this
alternative would require the Commission to amend its bankruptcy
regulations to define each currency pool as a separate account class.
By sharing all available customer funds among all customers without
regard to the segregation locations, alternative (e) furthers the view
that shortfalls should be shared among all customers without regard to
the denomination or location of customer funds.

IV. A Specific Approach

    To illustrate the interrelationship of choices under the various
headings and to assist the Commission further in reaching a resolution
of the issues, staff has prepared a specific formulation combining
choices from each category.<SUP>23</SUP> The Commission is not
endorsing this approach at this time, but the Commission believes that
receiving comments on it would provide a valuable supplement to the
other comments. This approach would address the concern that current
regulatory standards may impede access to the U.S. futures market by
eliminating the subordination agreement currently required by
Interpretation No. 12. To facilitate the receipt of funds from offshore
customers, this approach, however, would permit FCMs to maintain
operating accounts in non-U.S. depositories. Under this approach:
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    \23\ This approach combines, with some modifications, choices
(A)(1)(c), (B)(1)(c), (C)(1)(a), (D)(1)(a), (E)(1)(a), and
(F)(1)(a).

--Funds used by an FCM to meet its obligations to customers who trade
on U.S. contract markets must be segregated in accounts payable in the
U.S. That is, no account located or payable outside of the U.S. would
be considered an acceptable segregated depository. In addition:
--As an operational convenience, an FCM would be permitted to receive
commodity margin funds into non-U.S. accounts from customers located
outside the U.S. However, funds in these accounts would not be
recognized as segregated assets. This means that customer funds in
accounts located outside of the U.S. would not have to be transferred
to the U.S. An FCM would be considered in compliance with the
segregation rules as long as there were sufficient funds segregated in
the U.S. to cover its obligations to all of its customers, including
the non-U.S. customers whose funds had not yet been transferred to the
U.S.
--A deposit of any customers' funds into an account outside of the U.S.
would result in an increase in the FCM's segregated liability to its
customers. The FCM's excess segregated funds would be used to cover the
credit to the customer's account. This coverage must be made
immediately upon receipt of the funds in the non-U.S. account.
--An FCM would be permitted to recognize as segregated assets foreign
currencies credited to the FCM in segregated foreign currency accounts
with banks located in the U.S. as long as the account balances were
payable in the U.S. The non-U.S. currencies which would be recognized
as segregated assets would be limited to those foreign currencies which
would have been identified as acceptable for margin purposes by the
contract markets on which the FCM's customers trade.
--An FCM must take appropriate action to maintain a balance between the
currencies it had in segregated accounts and its obligations to
customers denominated in the same foreign currency. To achieve this, an
FCM must perform a daily calculation of the balance between its foreign
currency deposits and its obligations to its customers in those
currencies, including U.S. dollars. This calculation must be performed
as part of the daily segregation calculation. Imbalances must be
corrected by the day following the ``as of'' date of the calculation.
An appropriate capital charge must be taken on any imbalances, pursuant
to the Commission's net capital rule, regardless of any rebalancing
achieved the following day.

    This approach would not compel an FCM to transfer any funds into
the U.S., provided the FCM had sufficient excess segregated assets in
the U.S. FCMs could maintain accounts in non-U.S. locations and use
such accounts to take in deposits from foreign-domiciled customers and
to make disbursements. However, the funds contained in these accounts
would not count towards meeting the FCM's segregated liability.
Although funds in these accounts would not qualify as good segregated
funds, they could qualify for net capital purposes, provided the
accounts met the requirements of the net capital rule, which are less
stringent than those of the segregation rule.

V. Request for Comment

    The Commission requests comment on the need for and effectiveness
of the various alternatives and, in particular, on the ``specific
approach.'' In formulating their choices, commenters should consider
the following factors: (a) FCMs increasingly have a customer base
offshore; (b) U.S. banks are currently prohibited by the Board of
Governors of the Federal Reserve from paying interest on demand
deposits while unguaranteed offshore deposits may yield interest; (c)
some U.S. depositories are reluctant to hold a substantial amount of
foreign currencies; (d) as the volume of contracts that are priced and
settled in foreign currencies increases, the need to deposit customer
funds denominated in foreign currencies also increases; (e) the
enforceability of the subordination agreement has not been tested and
is not clear in the event of a bankruptcy adjudicated by a non-U.S.
court; and (f) other steps outside the Commission's purview could help
reduce the risks related to customer funds held offshore or in foreign
currencies, such as steps to facilitate the movement of foreign
currencies through the Fedwire.
    The Commission encourages commenters to provide information on
their current business practices and how they could be affected by the
methods listed in this release and any additional

[[Page 67847]]

methods they propose. The Commission also requests comment on the
practicality of the various methods.
    Finally, the Commission requests comment on whether it is
appropriate to allow exchanges and/or clearing organizations to hold
customer funds offshore without the customers' express authorization
and without a direct operational necessity. If so, commenters should
indicate what conditions and limitations should be imposed. The
Commission welcomes any cost-benefit analysis commenters care to
provide in support of their choices.
    The Commission requests that commenters, in making their choice
among the proposed alternatives or in indicating other alternatives,
clearly indicate whether the provision should apply at the FCM level
and/or at the clearing level. The Commission will give serious
consideration to the comments in determining an appropriate manner in
which to revise the requirements set forth in Interpretation No. 12.
The Commission wishes: (a) To facilitate access to the United States
markets for the growing international customer base using them; (b) to
reduce the regulatory burden, where practicable, on FCMs and clearing
organizations that accept customer deposits in foreign denominations
and use foreign depositories; and (c) to maintain the safety of
customer funds.

    Issued in Washington, DC on December 23, 1997, by the
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-33955 Filed 12-29-97; 8:45 am]
BILLING CODE 6351-01-P
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