CFTC Adopts Amendments to Permissible Customer Funds Investments by FCMs and DCOs

The Commodity Futures Trading Commission recently published a final rule amending the list of permissible investments for customer funds by futures commission merchants and derivatives clearing organizations.

On December 17, 2024, the Commodity Futures Trading Commission (CFTC or Commission) published a final rule (the Final Rule) amending its regulations that govern the investment of customer funds held by futures commission merchants (FCMs) and derivatives clearing organizations (DCOs).[1] Specifically, the Final Rule updates the list of instruments under Commission Regulation 1.25 in which FCMs and DCOs may invest funds held for the benefit of customers engaging in futures, foreign futures, and cleared swaps transactions.

BACKGROUND ON CFTC REGULATION 1.25

As required by the Commodity Exchange Act (CEA), and Commission regulations promulgated thereunder, the CFTC has established strict rules governing FCMs’ and DCOs’ treatment of customer funds. These rules require, among other things, that FCMs and DCOs segregate customer funds to protect them from unauthorized use, and to facilitate their return in the event of an FCM or DCO insolvency. As set forth in the Final Rule, segregated customer funds are classified as either (1) “futures customer funds;” (2) “Cleared Swaps Customer Collateral;” or (3) “30.7 customer funds” (foreign futures and options secured amount funds) (collectively, Customer Funds).[2]

Originally, the CEA authorized FCMs and DCOs to invest Customer Funds in certain limited instruments enumerated in Section 4d(a)(2).[3] CEA § 4d(a)(2) also provided the CFTC with explicit authority to promulgate rules and conditions that limit (or expand) the scope of investments that FCMs and DCOs could make with Customer Funds. With that authority, the Commission adopted Regulation 1.25.

Similar in concept to CEA § 4d(a)(2), Regulation 1.25 contains a list of instruments in which FCMs and DCOs may invest Customer Funds (Permitted Investments).[4] The CFTC conservatively selected the allowable Permitted Investments with the objectives of minimizing the potential loss of principal and maintaining liquidity.

In addition to providing a list of Permitted Investments, the framework under Regulation 1.25 includes a liquidity standard, restrictions on instrument features, concentration limits, parameters on the time-to-maturity for Permitted Investments, and limitations on investments in instruments issued by affiliates.

BACKGROUND OF THE PETITIONS TO AMEND REGULATION 1.25

As Regulation 1.25 is a key piece of the framework governing the treatment of Customer Funds, the Commission has conducted periodic assessments and has continually updated the rule. Given that, the CFTC received two petitions that separately requested the Commission make significant changes to the list of Permitted Investments. The first was a joint petition from the Futures Industry Association (FIA) and CME Group Inc. (CME).[5] The second was a petition from Invesco Capital Management LLC (Invesco Petition).[6]

The Joint Petition requested that the Commission (1) expand the list of Permitted Investments to include the foreign sovereign debt of Canada, France, Germany, Japan, and the United Kingdom (Specified Foreign Sovereign Debt), (2) exempt FCMs and DCOs from the provisions of Regulation 1.25(d)(2) by authorizing them to enter into repurchase agreements with foreign banks and foreign securities brokers or dealers, and (3) allow FCMs and DCOs to deposit Specified Foreign Sovereign Debt in safekeeping accounts at foreign banks. The Joint Petition also requested that the Commission codify No-action Letters 21-02 and 22-21 allowing FCMs and DCOs to invest in adjustable-rate securities that correlate closely to the Secured Overnight Financing Rate (SOFR).[7]

The Invesco Petition focused its request on allowing FCMs and DCOs to invest Customer Funds in exchange-traded funds (ETFs) that invest their assets only in short-term US Treasury obligations and cash (short-term US treasury ETFs), subject to certain conditions. (The Joint Petition also requested that the Commission authorize FCMs and DCOs to invest Customer Funds in short-term US treasury ETFs.)

Using these requests as a foundation, the Commission published a proposal to amend the list of Permitted Investments on November 21, 2023 (Proposed Rule or Proposal).[8]

The Commission adopted most of the amendments as proposed, along with key changes in response to feedback from commenters.

UPDATES TO THE LIST OF PERMITTED INVESTMENTS – CFTC REGULATION 1.25(A)

Newly Permitted Investments

Foreign Sovereign Debt

The Final Rule amended Commission Regulation 1.25 to allow DCOs and FCMs to invest Customer Funds in Specified Foreign Sovereign Debt, if such FCM or DCO has balances in segregated accounts owed to either its customer or clearing member (for DCOs), denominated in that country’s currency.

The Commission emphasized that permitting the investment of Customer Funds in Specified Foreign Sovereign Debt will allow FCMs and DCOs to manage foreign exchange risk more effectively, consistent with the overall goals of Regulation 1.25.

Interests in US Treasury Exchange Traded Funds

The Commission also revised the list of Permitted Investments to allow FCMs and DCOs to invest Customer Funds in interests in short-term US treasury ETFs that seek to “replicate the performance of a published short-term U.S. Treasury security index composed of bonds, notes, and bills 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 U.S. Department of Treasury” (Qualified ETFs).

The Commission acknowledged that permitting investment in Qualified ETFs may lead to improved operational efficiencies, further diversification for Customer Funds, and healthy competition and innovation in the ETF market.

In a deviation from the Proposal, and in response to comments received, the Final Rule will allow an FCM or DCO to invest customer funds in interests in a Qualified ETF as either an authorized participant of the Qualified ETF or by entering into an agency agreement with an authorized participant, whereby the authorized participant would transact with the ETF on behalf of the FCM or DCO. For either scenario, the Commission provided guidance that the FCM or DCO must ensure that (1) all Commission segregation requirements are met throughout the process; (2) the transaction occurs on a delivery versus payment basis; (3) no fees and/or other costs associated with the transaction are charged to the customer segregated accounts; and (4) no person, including, but not limited to, the ETF or the authorized participant, has any claim over customer funds held by the FCM or DCO.

The Commission is also requiring FCMs and DCOs that are not authorized participants to be able to redeem Qualified ETF shares in cash within one business day of the redemption request. For those FCMs and DCOs conducting the redemption through an authorized participant, the FCM or DCO must ensure that its contractual agreement with the authorized participant requires the authorized participant to transfer cash to the customer segregated account of the FCM or DCO on a delivery versus payment basis, within one business day of the redemption request. For those FCMs and DCOs that are authorized persons of the Qualified ETF, they will be allowed to redeem Qualified ETF shares in kind, provided that the FCM has the operational ability to convert the instruments received pursuant to the redemption into cash within one business day of the redemption request.

Finally, the Commission did not adopt the proposed requirement that FCMs and DCOs obtain the acknowledgment letter required by Regulation 1.26[9] from an entity that has substantial control over the ETF interests purchased with customer funds and that has knowledge and authority to facilitate redemption and payment or transfer of the Customer Funds. The Commission indicated that it was comfortable eliminating the proposed requirement because Qualified ETF shares would typically be held with the FCM’s or DCO’s custodian, rather than directly with the fund or its affiliate. This change, however, will not fully relieve FCMs and DCOs of their obligation to obtain an acknowledgment letter. The Final Rule will require FCMs and DCOs to obtain the acknowledgment for certain Permitted Investments under Commission Regulation 1.20.[10]

Adjustments to the Scope of Existing Permitted Investments

• Interests in Money Market Funds (MMFs): The Final Rule narrowed the scope of MMFs that qualify as Permitted Investments to funds that are not subject to a liquidity fee. To accomplish this, the amendments revise Regulation 1.25(a)(iv), and other specified rules that reference money market funds, including by replacing the term “money market mutual fund” with the “term “government money market funds” as defined in Section 270.2a-7 of the Investment Company Act provided, however, that the funds not elect to be subject to liquidity fees in accordance with § 270.2a-7(c)(2)(i).”[11] The Commission’s underlying rationale for this adjustment was that MMFs subject to a liquidity fee are inconsistent with the liquidity requirements and the overall goals of Regulation 1.25.
• Investments in Permitted Investments with Adjustable Rates of Interest: In light of the transition away from the London Interbank Offered Rate (LIBOR) to SOFR, the Final Rule revised the existing restrictions on instrument features to permit adjustable-rate securities that reference the overnight, one-month, three-month, and six-month SOFR rate. Additionally, the Final Rule permits adjustable-rate securities that otherwise qualify as Permitted Investments to be benchmarked to the CME Term SOFR Rate published by the CME Group Benchmark Administration Limited. Notably, the Commission declined to adopt additional alternative reference rates proffered by commenters, citing that the Commission has not conducted a thorough review of any other rate but SOFR.

No-Longer Permitted Investments

• Investments in Commercial Paper and Corporate Notes or Corporate Bonds: As proposed, the Final Rule removed commercial paper, corporate notes, and corporate bonds that are guaranteed by the United States under the Temporary Liquidity Guarantee Program (TLGP) as administered by the Federal Deposit Insurance Corporation from the list of Permitted Investments. The Commission noted the expiration of the TLGP in 2012 and the general need to remove an outdated investment type.
• Investments in Certificates of Deposit Issued by Banks: As proposed, the Final Rule removed bank certificates of deposit from the list of Permitted Investments. As noted in the proposal, and restated in the Final Rule, the Commission explained that FCMs and DCOs generally have not elected to use bank certificates of deposit as an investment option for customer funds.

AMENDMENTS TO CONCENTRATION LIMITS AND CAPITAL CHARGES

Asset-based and Issuer-based Concentration Limits for Permitted Investments

The Final Rule adopted the concentration limits largely as proposed.

Regulation 1.25(b)(3) sets forth asset-based and issuer-based concentration limits for an FCM’s or DCO’s investment of Customer Funds in Permitted Investments. These limits are set at the same levels, and are required to be calculated separately, for futures customer funds, cleared swaps customer collateral, and customer funds held in accordance with Regulation 30.7.[12]

The updated concentration limits are as follows:

• Asset-based Concentration Limits (Regulation 1.25(b)(3)(i)):
  • Investments in government MMFs or Qualified ETFs with >$1 billion in assets and whose management company manages >$25 billion in assets may not exceed 50% of the total assets held in segregation by the FCM or DCO.
  • Investments in government MMFs or Qualified ETFs with <$1 billion in assets or which have a management company managing <$25 billion in assets may not exceed 10% of the total assets held in segregation by the FCM or DCO.
• Issuer-based Concentration Limits (Regulation 1.25(b)(3)(ii)):
  • Securities of any single issuer of municipal securities held by a FCM of DCO may not exceed 5% of the total assets held in segregation by the FCM or DCO.
  • Interests in any single family of government MMFs or Qualified ETFs may not exceed 25% of the total assets held in segregation by the FCM or DCO.
  • Interests in any individual government MMF or Qualified ETF may not exceed 10% of the total assets held in segregation by the FCM or DCO.

Despite a substantial number of comments on various aspects of the proposed concentration limits, the Commission adopted the limits largely as proposed with limited changes. In particular, the Commission adopted an issuer-based concentration limit for investment of Customer Funds in any individual government MMF or Qualified ETF of 10%, which was increased from the proposed 5% limit. Finally, the Final Rule clarified that Specified Foreign Sovereign Debt was excluded from concentration limits.

FCM Capital Charges on Permitted Investments

Currently, Commission Regulation 1.17(c)(5)(v)[13] requires an FCM to take specified capital charges on certain investments in computing the firm’s regulatory capital to reserve liquidity for potential losses resulting from the investment of Customer Funds. The existing rule also requires FCMs to apply the capital charges specified in Rule 15c-3-1 under the Securities Act and Appendix A to SEC Rule 15c3-1 to Permitted Investments.

According to the Final Rule, and consistent with SEC Rule 15c3-1, an FCM investing customer funds must comply with these updated capital charges:

• Qualifying Sovereign Debt of Canada: With respect to Canadian sovereign debt, there is no capital charge for debt instruments with a remaining time-to-maturity of less than three months. There is, however, a capital charge of 0.5% of the market value for debt instruments with a remaining time-to-maturity of three to six months.
• Sovereign Debt of France, Germany, Japan, and the UK: Capital charges for sovereign debt for these countries are determined under SEC rules by reference to nonconvertible debt securities with a fixed interest rate, fixed maturity date, and minimal credit risk. For those with a remaining time-to-maturity of one year or less, a capital charge of 2% of the market value of the security is applied pursuant to SEC Rule 15c3-1(c)(2)(F)(1).
• Qualified ETFs: For Qualified ETF shares that do not comprise a full creation unit the capital charge is 6%.

OTHER CORRESPONDING CHANGES

• Segregation Investment Detail Report (SIDR): The SIDR, which is required to be submitted by FCMs under Regulations 1.32(f), 22.2(g)(5) and 30.7(l)(5),[14] was updated by the Commission to reflect the revised list of Permitted Investments.
• Read-only Electronic Access to Customer Funds Accounts Maintained by FCMs: Current Commission regulations provide that an FCM may deposit Customer Funds only with specified types of depositories and custodians that agree to provide the Commission with direct, read-only electronic access to the Customer Fund accounts (Read-only Access Provisions). The Final Rule eliminated these provisions due to, among other reasons, practical and operational challenges implementing the Read-only Access Provisions.
• Revisions to the Customer Risk Disclosure Statement: Finally, the Commission adopted conforming amendments to the required Risk Disclosure Statement under Regulation 1.55(a)[15] to reflect the changes to the categories of Permitted Investments.

Compliance Dates

The compliance date for the Final Rule is 30 days after the Final Rule is published in the Federal Register.

With respect to the SIDR Report and Risk Disclosure Statement updates, the Commission set a compliance date of March 31, 2025.

(Note: As of January 9, 2025, the Final Rule has not been published in the Federal Register.)

TAKEAWAYS

Overall, the Final Rule is a positive outcome for FCMs, DCOs and their customers/clearing members. Although the Commission did not incorporate all the feedback proffered by commenters, the Final Rule granted key requests made in the Joint Petition and the Invesco Petition. Just as important, the Commission signaled its commitment to continually assessing the scope of Permitted Investments under Regulation 1.25 and its willingness to listen to industry petitions, so long as the petitions are supported by data and in line with the spirit of the regulation.

The Final Rule will provide additional flexibility for FCMs and DCOs to effectively manage risk and produce potentially higher yields for customers while continuing to safeguard their funds.