Background
At the heart of the statutory and regulatory framework governing transactions in derivatives in the United States is a customer asset protection regime that requires futures commission merchants (FCM) and derivatives clearing organizations (DCO) to hold customer funds in segregation. The Commodity Exchange Act (CEA), and the regulations of the Commodity Futures Trading Commission (CFTC) promulgated thereunder, create what courts have termed a "special statutory trust" over funds deposited by customers to secure futures, foreign futures and cleared swaps held by FCMs and cleared by DCOs (customer funds). This means that the rights and duties of FCMs and DCOs with respect to segregated assets are determined by statute and regulation, rather than by general principles of trust law.
The difference is evident from the terms of that statute and those regulations. At variance with traditional trust principles, Section 4d(a)(2) of the CEA authorizes FCMs to invest futures customer funds in US Treasuries, US agency securities, and US municipal securities; and CFTC Regulation 1.29 allows FCMs to keep for themselves the interest or other return from investments of customer funds. Congress created the statutory trust to protect customers from misuse of their funds by their FCMs, and from claims by creditors of the FCM in the event of its insolvency; while at the same time, they gave the FCMs a way to generate yield from low-risk investments of customer property.
In 1968, the CFTC's predecessor agency adopted Regulation 1.25 to implement the CEA's limited authorization to engage in permitted investments. Between 1968 and 2005, the CFTC expanded the list of permitted investments to include certificates of deposit, commercial paper, corporate notes, foreign sovereign debt and interests in money market funds, as well as repo and reverse repo transactions in any security approved as a permitted investment. The CFTC also imposed conditions on permitted investments, including a restriction on the dollar-weighted average of the time-to-maturity of the securities held in permitted investment portfolios, asset-based and issuer-based concentration limits, and prohibitions on certain investments containing embedded derivatives. More generally, it amended Regulation 1.25 to require that all permitted investments be consistent with the objectives of preserving principal and maintaining liquidity.
In 2011, for the first time, the CFTC removed a permitted investment from Regulation 1.25 by eliminating foreign sovereign debt from the list. Timed such that it was widely viewed at the time to be a reaction to the bankruptcy of MF Global, in fact, the CFTC acted primarily due to its concerns with the financial stability of certain sovereign issuers and because the data (at the time) suggested that foreign sovereign debt was not used with sufficient frequency by FCMs and DCOs to justify the risk.
The 2011 amendments to Regulation 1.25 included an invitation to market participants to petition for exemptions from the prohibition on investing customer funds in foreign sovereign debt. In 2018, in response to a request from Chicago Mercantile Exchange (CME), the CFTC issued an exemptive order permitting DCOs (but not FCMs) to invest customer funds, subject to conditions, in the foreign sovereign debt of France and Germany. Then in 2023, the CME joined the Futures Industry Association (FIA) in a petition to the CFTC to amend Regulation 1.25 to include the foreign sovereign debt of Canada, France, Germany, Japan and the United Kingdom (Specified Foreign Sovereign Debt), subject to the condition that any investment is limited to balances owed by FCMs and DCOs to customers and FCM clearing members denominated in the related currency. The CME/FIA petition also sought amendment of Regulation 1.25 to permit repo/reverse repo transactions involving Specified Foreign Sovereign Debt with foreign banks and foreign securities brokers or dealers, to deposit Specified Foreign Sovereign Debt in safekeeping accounts at foreign banks, and to permit 1.25 investment in certain exchange-traded funds (ETFs) that invest primarily in short-term US Treasury securities (US Treasury ETFs).
Final Rule
Last week, the CFTC approved a final rule substantially granting the CME/FIA petition (Final Rule). As adopted, the revisions to Regulation 1.25 (and related regulations) are as follows:
- Add Specified Foreign Sovereign Debt to the list of permitted investments, to the extent the FCM has balances in segregated accounts owed to its customers denominated in that country's currency and the DCO has balances in segregated accounts owed to its FCM clearing members denominated in that country's currency. Permitted investments in Specified Foreign Sovereign Debt are subject to the following conditions:
- The dollar-weighted average of the remaining time-to-maturity of the portfolio, computed on a country-by-country basis, may not exceed 60 calendar days.
- Investments in permitted foreign sovereign debt with a remaining maturity greater than 180 calendar days is prohibited.
- If the two-year credit default spread, computed as the average of the bid and ask prices between willing buyers and sellers, of an issuing sovereign of permitted foreign sovereign debt is greater than 45 basis points, new investments in that sovereign's debt are prohibited and repo transactions referencing that sovereign's debt must be unwound as soon as practicable under the circumstances.
- Permit investment in government money market funds (that do not rely on the ability to impose discretionary liquidity fees consistent with regulations under the Investment Company Act).
- Permit investment in ETFs that seek to replicate the performance of a published short-term US Treasury security index composed of instruments with a remaining maturity of 12 months or less, issued by or unconditionally guaranteed as to the timely payment of principal and interest by the US Treasury. Permitted investments in ETFs are subject to the following conditions:
- Investments in eligible government money market funds and US Treasury ETFs with $1 billion or more in assets and whose management company manages $25 billion or more in assets may not exceed 50 percent of the total assets held in segregation by the FCM or DCO.
- Investments in government money market funds or US Treasury ETFs with less than $1 billion in assets or which have a management company managing less than $25 billion in assets may not exceed 10 percent of the total assets held in segregation by the FCM or DCO.
- Interests in any single family of government money market funds or US Treasury ETFs may not exceed 25 percent of the total assets held in segregation by the FCM or DCO.
- Interests in any individual government money market fund or US Treasury ETF may not exceed 10 percent of the total assets held in segregation by the FCM or DCO.
- Remove commercial paper, corporate notes and corporate bonds from the list of permitted investments.
- Replace the London Interbank Offered Rate with the secured overnight financing rate (SOFR) published by the Federal Reserve Bank of New York or a CME Term SOFR Rate published by the CME Group Benchmark Administration, a benchmark for permitted investments that contain an adjustable rate of interest.
- Amend certain counterparty and depository requirements set forth in CFTC Rule 1.25 and revise the concentration limits for permitted investments.
- Specify regulatory capital charges that would apply to the new categories of permitted investments.
- Clarify that DCOs are financially responsible for any losses resulting from investment of cleared swap customer funds in permitted investments (as they and FCMs are for any such investments of segregated, secured or cleared swap customer funds, under CFTC Rule 1.29).
- Eliminate the requirement that each depository holding customer funds must provide the CFTC with read-only electronic access to such accounts for the FCM to treat the funds held in the accounts as customer-segregated fund accounts.
Permitted Investments in US Treasury ETFs
As proposed, an FCM or DCO would have been required to execute permitted investments in US Treasury ETFs solely in its capacity as an authorized participant pursuant to an authorized participant agreement, as defined under Investment Company Act regulations. In response to industry comments, the Final Rule offers a broader menu of transactional alternatives in these instruments, as well as more prescriptive guidelines for those alternatives:
- FCM and DCO purchases and redemptions must be on a delivery versus payment basis, at a price based on the net asset value computed in accordance with the Investment Company Act and regulations thereunder.
- An FCM or DCO that is an authorized participant of an eligible ETF may redeem interests in the fund in kind, provided that the FCM or DCO is able to convert the securities received pursuant to the in-kind redemption into cash within one business day of the redemption request.
- An FCM or DCO that transacts with the fund through an authorized participant acting as an agent for the FCM or DCO must have a contractual agreement obligating the authorized participant to pay the FCM's or DCO's redemption of interests in the fund in cash within one business day of the redemption request.
- An FCM or DCO may acquire or sell interests in an eligible ETF on a registered national securities exchange.
In addition, the final rule jettisons the proposed condition on permitted investments in US Treasury ETFs that the interests be acceptable as margin by a DCO.
Compliance Date
The compliance date for the Final Rule is 30 days after publication in the Federal Register. The amendments to SIDR Reports have a compliance date of March 31, 2025.
The CFTC press release announcing the adoption of the Final Rule is available here. The Final Rule is available here.
