By Douglas Ashburn
John Lothian News
Commodity Futures Trading Commission (CFTC) Regulation 1.25 - Investment of Customer Funds, has been at the top of the news these past couple of weeks. In the wake of the MF Global bankruptcy scandal, the focus has been on the treatment of customer funds at the failed futures commission merchant/broker-dealer, and its soured investments in European sovereign debt. In the midst of the investigation of MF Global and the search for $1.2 billion in missing customer segregated funds, the CFTC approved its final set of rule changes to Reg. 1.25 related to the Dodd-Frank Act.
While many press stories have gotten it “mostly right” in terms of Reg. 1.25 and MF Global, there is much misinformation floating about. Following is a short primer on Reg. 1.25 - its history, a summary of the new changes, how the rules relate to MF Global, and the future impact of Reg. 1.25 on the FCM community.
History of Regulation 1.25
Before 2000, FCMs and clearing houses were quite limited in where customer excess funds could be invested. Basically, the choices were U.S. Government securities, municipal bonds, or cash. Beginning in December 2000, the CFTC moved to expand the choices of permitted investments. By 2005, the list included obligations of government sponsored entities (“GSE debt”), bank certificates of deposit (CDs), commercial paper, corporate notes, general obligations of a sovereign nation, (“sovereign debt”), and interests in money market mutual funds (MMMFs). Additionally, the 2005 modification permitted FCMs to invest in short-term repurchase agreements, time-to-maturity transactions, and, in the case of firms such as MF Global, who are also registered broker-dealers, certain in-house (“affiliate”) transactions.
The main stipulation was that such investments must, in most cases, possess the highest credit rating from one of the nationally-recognized statistical ratings organizations (NRSROs) such as Fitch, Moody’s or Standard & Poor’s). Additionally, the investments must be “readily marketable” and capable of being promptly liquidated.
In 2007, the commission began conducting a review of Regulation 1.25 and the effects of the changes. The review included meetings and requests for comment from market participants, independent and internal research. As the commission was concluding its review in 2008, a severe financial crisis significantly altered the regulatory landscape. Subsequent to the market turmoil, NRSROs took a lot of heat for their role in the subprime mortgage meltdown. As a result, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 included in its mandates a requirement that regulators create a framework that removes a reliance on credit ratings, in favor of other criteria such as asset concentration limits. The CFTC combined the results of its review with the mandates of Dodd-Frank and submitted a list of proposed changes to Reg. 1.25 at its October 26, 2010 open meeting. The proposals are summarized in a table HERE.