On March 1, 2011, the SEC staff issued a no-action letter to ICE Trust U.S. LLC providing that the Division of Investment Management would not recommend enforcement action under Section 17(f) of the 1940 Act against a fund if the fund or its custodian maintains certain assets in the custody of ICE Trust or its members for purposes of meeting ICE Trust’s margin requirements for credit default swap (“CDS”) contracts that are cleared by ICE Trust.
ICE Trust acts as a central clearing party for CDSs by accepting the rights and obligations under eligible CDS transactions entered into by its members. Upon its acceptance of a CDS transaction, ICE Trust becomes the seller of credit protection with respect to the CDS purchaser and the purchaser of credit protection with respect to the CDS seller.
Section 17(f) and the rules thereunder generally require funds to maintain their assets only with certain qualified custodians, including banks, in order to ensure they are properly safeguarded against misappropriation and other risks. The staff has previously indicated that a fund’s initial margin payments on futures contracts are fund assets subject to the requirements of Section 17(f). While ICE Trust falls within the definition of a bank under Section 2(a)(5) of the 1940 Act, it would be holding a fund’s margin payments at least partially for the benefit of its clearing operations and not purely for custodial purposes.
Rule 17f-6 permits a fund, subject to certain requirements, to deposit its initial margin in connection with exchange-traded futures contracts and commodity options with a futures commission merchant (“FCM”), rather than a qualified custodian. The staff notes that Rule 17f-6 does not address CDS transactions, but ICE Trust’s clearing structure is similar to the arrangements of FCMs and derivatives clearing organizations that maintain custody of fund assets in compliance with the rule.
The staff noted ICE Trust’s argument that the custody principles underlying Section 17(f) are supported by ICE Trust’s requirements when its members deal with non-members, including funds. These requirements include members segregating assets held on behalf of non-members, maintaining adequate capital and liquidity, and maintaining adequate books and records. The staff also noted the SEC’s prior statement that facilitating the establishment of central counterparties for CDS transactions can help reduce counterparty risk and mitigate potential systemic impact.
The no-action relief is subject to several representations made by ICE Trust and its members, including complying with certain recordkeeping and reporting requirements. Each ICE Trust member must be in compliance with the ICE Trust rules and all laws and regulations with respect to CDS transactions. Each member must provide disclosure that insolvency laws may affect a fund’s ability to recover assets in any insolvency proceeding of a member. Each member must also promptly transfer assets to the omnibus margin account, provide an annual self-assessment, and provide the SEC with information upon request.
The no-action relief granted by the staff is temporary and expires on July 16, 2011, which is the date the subtitle of the Dodd-Frank Act regarding regulation of security-based swap markets becomes effective. The staff has granted similar no-action relief to LCH. Clearnet Limited and the Chicago Mercantile Exchange relating to the custody of assets for the purposes of meeting each entity’s margin requirements for interest rate swaps. Like the relief granted to ICE Trust, the relief granted by these no-action letters is temporary, also expiring on July 16, 2011.