The Commodity Futures Trading Commission (the “CFTC”) is proposing rules to implement new statutory provisions enacted by the Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), as well as soliciting comments in connection with the implementation of other provisions of the Dodd-Frank Act. In addition, the CFTC is requesting comment on proposed rule amendments regarding the investment of customer segregated funds and funds held in an account subject to CFTC Rule 30.7 (i.e., foreign futures or foreign options customer secured amount funds). We have prepared a brief summary of the more significant rulemaking proceedings below.
Proposed Rule for Determining Eligibility of Swaps for Clearing
To implement the mandatory clearing provisions of the Dodd-Frank Act, a basic cornerstone of the new regulatory framework for swap transactions, the CFTC is proposing to adopt a rule implementing procedures (i) for determining the eligibility of a derivatives clearing organization (“DCO”) to clear swaps that it plans to accept for clearing; (ii) for DCOs submitting swaps to the CFTC for review to determine whether the swaps are required to be cleared; (iii) for CFTC-initiated reviews of swaps that have not been accepted for clearing by any DCO to determine whether the swaps should be required to be cleared; and (iv) for staying the clearing requirement pending completion of the CFTC’s review regarding whether the swaps should be subject to the clearing requirement. 75 Fed. Reg. 67277 (November 2, 2010). Comments are due by January 3, 2011.
Under the proposed rule, a DCO would be required to submit a formal written request to the CFTC demonstrating its ability to maintain compliance with core principles, maintain sufficient resources and manage the risks associated with clearing a particular type of swap. The proposed rule also would require DCOs to submit for CFTC review the swaps that they plan to clear and provide certain types of information about those swaps, including participation eligibility standards, pricing sources, models, and procedures, risk management procedures, and measures of market liquidity and trading activity. The CFTC would have ninety days to review the submission and make a determination. As part of that process, the CFTC would provide a thirty day public comment period.
The proposed rule also would establish a five-factor test for determining if a particular type of swap should be subject to the mandatory clearing requirement. The five factors would be (i) the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; (ii) the availability of a rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the swap on terms that are consistent with the material terms and trading conventions on which the swap is then traded; (iii) the effect on the mitigation of systemic risk, taking into account the size of the market for such swap and the resources of the DCO available to clear the swap; (iv) the effect on competition, including appropriate fees and charges applied to clearing; and (v) the existence of reasonable legal certainty in the event of the insolvency of the DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.
Request for Comment on Disruptive Trading Practices
The CFTC has issued an advance notice of proposed rulemaking to implement Section 747 of the Dodd-Frank Act relating to so-called “disruptive trading practices.” 75 Fed. Reg. 67301 (November 2, 2010). Comments are due by January 3, 2011. That provision authorizes the CFTC to prohibit certain specified trading practices as follows: any activity which (i) violates bids or offers; (ii) demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period; or (ii) constitutes “spoofing” (bidding or offering with the intent to cancel the bid or offer before execution), as well as any other trading practice that is “disruptive of fair and equitable trading.”
The CFTC is requesting comment on all aspects of Section 747 of the Dodd-Frank Act, as well as on a list of specific questions, including what rules should be applied to algorithmic trading systems. The CFTC also announced that it will hold a staff roundtable on December 2, 2010 to discuss these issues.
Prohibition of Market Manipulation
The CFTC is proposing rules to implement its enhanced authority to prohibit fraud and manipulation pursuant to Section 6(c) of the Commodity Exchange Act, as amended by Section 753 of the Dodd-Frank Act. 75 Fed. Reg. 67657 (November 3, 2010). Comments are due by January 3, 2011.
Among other things, the CFTC is proposing to add (i) a rule patterned after Securities and Exchange Commission (“SEC”) Rule 10b-5, subject to modifications to reflect the CFTC’s distinct mission and responsibilities (e.g., no SEC-type prohibition on insider trading) and (ii) a rule that would restate the expanded prohibition on manipulation and attempted manipulation, which now reaches “every effort to influence the price of a swap, commodity or commodity futures contract that is intended to interfere with the legitimate forces of supply and demand in the marketplace.” Id. at 67660.
Proposed Rules Relating to Investment of Customer Funds
The CFTC is proposing to amend its rules regarding the investment of customer segregated funds (i.e., Rule 1.25) and foreign futures or foreign options customer secured amount funds (i.e., Rule 30.7). The proposed rule amendments would include certain changes in the list of permitted investments of customer segregated funds in Rule 1.25, a modification of the liquidity requirement, the removal of ratings requirements pursuant to the Dodd-Frank Act, new concentration limits, including asset-based, issuer-based and counterparty concentration restrictions, revisions to the current list of exceptions to the next day redemption requirement for money market mutual funds (each, a “MMMF”), and conforming investments of Rule 30.7 funds to the list of permissible investments in Rule 1.25. 75 Fed. Reg. 67642 (November 3, 2010). Comments are due by December 3, 2010.
Among other things, the Commission is proposing to eliminate from the list of permitted investments: (i) government sponsored enterprise securities that are not backed by the full faith and credit of the U.S., (ii) commercial paper and corporate debt obligations (except if fully guaranteed as to principal and interest by the U.S. under the Temporary Liquidity Guarantee Program), (iii) foreign sovereign debt and (iv) so-called “in-house transactions.” The latter category refers to transactions entered into by a dual broker-dealer/futures commission merchant (“FCM”) that are economically equivalent to a repurchase or reverse repurchase agreement whereby the FCM exchanges customer funds for permitted investments held in its capacity as a broker-dealer or customer securities for cash or permitted investments held in its capacity as a broker-dealer. See Rule 1.25(a)(3)(i)-(iii). The CFTC is requesting comment on the impact of this proposal on the business practices of FCMs and DCOs. The CFTC similarly is proposing to prohibit repurchase and reverse repurchase agreements between an FCM or DCO and any counterparty that is an affiliate of the FCM or DCO, respectively. For this purpose, an “affiliate” includes parent companies, including all entities through the ultimate holding company, subsidiaries to the lowest level, and companies under common ownership of such parent company or affiliates.
The CFTC is also proposing that investments in MMMFs be capped at 10% of total assets in segregation and 2% of total assets in segregation in any single family of MMMFs, as well as caps on other permitted investments, all of which are referred to as “asset-based concentration limits.” Finally, the CFTC is proposing a counterparty concentration limit of 5% of total assets in segregation for securities subject to reverse repurchase agreements.