The CFTC has proposed rules codifying the staff no-action relief of CFTC Letter 19-17 (thrice-renewed since, pending these rules).  I’ve written about the “long and winding road” by which we got to this momentous juncture; that story is available here

Letter 19-17 addresses the processing of margin withdrawals by the customers of futures commission merchants that are clearing members of registered derivatives clearing organizations under CFTC Rule 39.13(g)(8)(iii).  Rule 39.13(g)(8)(iii) provides that a registered DCO must require its FCM clearing members to ensure that their customers do not withdraw funds from their accounts unless the net liquidating value plus the margin deposits remaining in the customer’s account after the withdrawal would be sufficient to meet the initial margin requirement applicable to the account.  The intent of the rule is to mitigate the risk that a clearing member fails to hold customer funds sufficient to cover the required initial margin, and thus, the risk that the clearing member will effectively cover one customer’s margin shortfall using another customer’s funds.

In Letter 19-17, staff carved out from the terms of Rule 39.13(g)(8)(iii) a scenario in which a DCO may permit its clearing member to maintain “separate accounts” for the same customer, and to release excess funds from one such separate account, notwithstanding an outstanding margin call in another (subject to the clearing member’s compliance with certain conditions).  They did this in response to entreaties from the buy and sell side alike of the industry, urging consideration of the reasons why a customer might want separate treatment for its accounts.  For example, a municipal pension fund may allocate assets to investment managers under separate investment management mandates.  Those managers will, ordinarily, want assurances that the funds allocated under those separate mandates will be entirely available to them, and will not be affected by the activities of other investment managers with discretion over other allocations of the customer’s assets.  

Letter 19-17 affirms that the risk management goals of Rule 39.13(g)(8)(iii) may be addressed if the clearing FCM carrying a customer with separate accounts satisfies 16 conditions.  The proposed rulemaking codifies those conditions in a new sub-section (j) of Rule 39.13. The conditions are designed to ensure that clearing FCMs (i) carry out separate account treatment in a consistent and documented manner; (ii) monitor customer accounts on a separate and combined basis; (iii) identify and act upon instances of financial or operational distress that necessitate a cessation of separate account treatment; (iv) provide appropriate disclosures to customers regarding separate account treatment; and (v) apprise their designated self-regulatory organizations when they apply separate account treatment or an event has occurred that would necessitate cessation of separate account treatment.      

The proposal notes that where a clearing FCM is already complying with the conditions set forth in Letter 19-17, it is thereby also already complying “in significant part” with the requirements of the proposed rule.  A few notes on the “in significant part” qualifier:

  • Clearing FCMs are currently implementing separate account margining consistent with Letter 19-17 for all account origins – US futures, non-US futures and cleared swaps – without regard to whether the related clearinghouse is a registered DCO.  The proposal seeks comment on whether it needs to take “further action” in order to implement separate account requirements for customer account cleared at a clearinghouse that is not a registered DCO. 
  • Letter 19-17 includes the condition that separate accounts “must be on a one business day margin call” (not including situations of administrative error or operational constraints reasonably determined by the clearing FCM to prevent the call from being met within one day).  The proposal replicates this condition, but with additional guidance, including:
  1. a definition of “one business day margin call” to mean a call, to be settled in USD or CAD, which is issued by 11:00 a.m. (ET) on a US business day to be met by the close of Fedwire on the same day;
  2. a safe harbor for calls settled in Japanese Yen by 12 pm (ET) on the second US business day following the business day on which the call is made (subject to tolling for one US business day in consideration of a local banking holiday);
  3. an additional safe harbor for calls settled in currencies other than USD, CAD or Japanese Yen by 12 pm (ET) on the US business day following the business day on which the call is made (subject to tolling for one US business day for relevant local banking holidays); 
  4. a prohibition on clearing FCM’s agreeing “to provide customers with periods of time to meet margin calls that extend beyond” these deadlines. A footnote adds that “if a clearing FCM and a customer contract for a grace or cure period that would operate to make margin due and payable later than the deadlines described herein, including a case where the FCM would not have the discretion to liquidate the customer’s positions and/or collateral where margin is not paid by such time, such an agreement would be inconsistent with the conditions under which such clearing FCM may engage in separate account treatment.”  Notably, the proposal makes clear that these margin provisions are not intended to prohibit contractual arrangements inconsistent with their requirements for customers that are not “separately margined.”  That said, a clearing FCM that contracts with a customer not receiving separate account treatment for a grace or cure period that would operate to make margin due and payable later than these deadlines, might find examiners second-guessing such terms as inconsistent with other requirements, including CME Rule 930.K (which requires clearing members to “maintain full discretion to determine when and under what circumstances positions in any account shall be liquidated”).

The proposal notes, perhaps more cheerfully than most clearing FCMs would concede feeling about the Letter 19-17 regime, that it “has been applied successfully since July 2019.”  That said, there’s no going back, and market participants will welcome the legal certainty and clear standards that rulemaking promises to establish.   Comments will be due 60 days after publication in the Federal Register, which is likely forthcoming within the next week or so. 

The “Pre-Print Version” of the proposal is here.  Letter 19-17 is available here.  Joint Audit Committee Regulatory Alerts 19-02, 19-06 and 20-02 (all cited by the CFTC in the proposal) are available here.