Investment Advisers Act of 1940 — Section 17(f)
Chicago Mercantile Exchange
July 10, 2013
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
IM Ref. No. 20137101539
Your letters dated June 24, 2013 request our assurance that we would not recommend enforcement action to the Securities and Exchange Commission ("Commission") under Section 17(f) of the Investment Company Act of 1940 ("1940 Act") against any registered investment company (a "Fund") if the Fund or its custodian places and maintains cash and/or certain securities ("assets") in the custody of the Chicago Mercantile Exchange ("CME"), a derivatives clearing organization registered with the Commodity Futures Trading Commission ("CFTC") or a CME or a Board of Trade of the City of Chicago ("CBOT") clearing member that is a futures commission merchant ("FCM") registered with the CFTC for purposes of meeting CME's or a CME Clearing Member's (as defined below) margin requirements for certain cash-settled commodity index swap contracts ("CIS") and foreign currency swap contracts ("FXS") that are cleared by CME.
You state the following: CME Group Inc. ("CME Group"), a Delaware stock corporation, is the holding company for CME, as well as certain other exchanges, including CBOT. CME and CBOT are designated contract markets regulated by the CFTC, for the trading of futures contracts and options on futures contracts. In addition, CME Group operates its own clearing house, which is a division of CME. The CME clearing house is a derivatives clearing organization ("DCO") regulated by the CFTC. The clearing house clears, settles and guarantees the performance of all transactions for which CME Group provides clearing services, including CIS and FXS. CME, as part of its clearing services, will be interposed as a central counterparty for transactions in cleared CIS and FXS. Customers (including Funds) that wish to clear CIS and FXS through CME must maintain an appropriate account relationship with a registered FCM that is a CME or CBOT, as applicable, clearing member (a "CME Clearing Member"). The CME Clearing Member will clear the transaction and post margin directly with the CME and serves as their agent and guarantor in respect of cleared CIS and FXS. In this regard, CME Clearing Members require customers to deposit a specified amount of assets as initial margin as security for performance of their obligations.
CME's rules alone or in combination with laws and regulations applicable to CME and the clearing members for its exchanges require that any CME Clearing Member who purchases, sells, or holds CIS and FXS positions for other persons (i.e., customers including any Fund): must (1) be registered with the CFTC as an FCM; (2) effectively provide for the separate treatment of funds and securities of other persons (except positions held in proprietary accounts of the clearing member, i.e., positions of the clearing member or affiliates of the clearing member) that it holds in its custody or control for the purpose of purchasing, selling, or holding CIS and FXS positions; (3) maintain adequate capital and liquidity; and (4) maintain sufficient books and records to establish (a) that the CME Clearing Member is maintaining adequate capital and liquidity and (b) separate ownership of the funds, securities, and positions it may hold for the purpose of purchasing, selling, or holding CIS and FXS positions for other persons and those it holds for its proprietary accounts.
With respect to a CME Clearing Member's responsibilities to separately treat customer assets from its proprietary positions, pursuant to Section 724(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"),1 in February 2012 the CFTC adopted final rules implementing the segregation requirements for swap collateral, including collateral securing CIS and FXS ("Collateral Protection Rules") and conforming amendments to its Part 190 Bankruptcy Rules.2 The Collateral Protection Rules adopted a segregation model for swap collateral that is referred to as the "legal segregation with operational commingling" or "LSOC", also referred to as the "complete legal segregation model." The CFTC, after considering five segregation models, concluded that LSOC "provides the best balance between benefits and costs in order to protect market participants and the public."3
One of the goals of the Dodd-Frank Act is to promote price transparency and to minimize exposure to counterparty credit risk and systemic risk in the OTC derivatives market by subjecting as many swaps as possible, including CIS and FXS, to central clearing and also requiring such swaps to be traded on exchanges or swap execution facilities.4 Title VII of the Dodd-Frank Act imposes mandatory clearing and trade execution requirements on swap contracts that are determined by the CFTC to be "clearable" and authorizes the CFTC to adopt rules designed to implement an appropriate regulatory framework.5 In particular, you expect that many forms of CIS and FXS will be subject to mandatory clearing and will be cleared by DCOs, such as CME, subject to CFTC regulation and oversight.
Notwithstanding the regulatory timetable for implementation of the Dodd-Frank Act, CME and its market participants, for business reasons, wish to implement customer clearing of CIS and FXS through FCMs as soon as possible. Therefore, you represent that CME is subject to extensive regulation and oversight under the CEA and pursuant to the Dodd-Frank Act, the CFTC has adopted additional requirements, including, but not limited to, additional core principles related to risk management requirements and product eligibility, to which CME is subject.6 While it may be necessary to make some changes in response to any additional regulations ultimately adopted by the CFTC, you do not anticipate that any regulations subsequently adopted will materially affect CME's ability to clear CIS and FXS because, as noted above, CME is already subject to extensive regulation and oversight by the CFTC.
You believe that the requested relief would provide Funds equal access to the benefits and protections afforded to other market participants using CME to clear CIS and FXS. You assert that preventing Funds from participating in the clearing of CIS and FXS would expose Funds to greater risk, and would also prevent them from realizing the benefits of clearing recognized by Congress by the passage of the Dodd-Frank Act and by market participants.
Rule 17f-6 under the 1940 Act provides that Funds may place and maintain assets with an FCM to effect a Fund's transactions in exchange-traded futures contracts or commodity options, but it does not permit Funds to place and maintain assets with an FCM to effect CIS and FXS transactions. You represent that each CME Clearing Member who holds assets for an unaffiliated Fund customer wishing to clear CIS and FXS transactions on CME will address each of the requirements of Rule 17f-6, as discussed below.
Section 17(f) of the 1940 Act and the rules thereunder govern the safekeeping of Fund assets, and generally provide that a Fund must place and maintain its securities and similar instruments only with certain qualified custodians. As stated above, Rule 17f-6 under the 1940 Act permits a Fund to place and maintain assets with an FCM that is registered under the CEA and that is not affiliated with the Fund in amounts necessary to effect the Fund's transactions in exchange-traded futures contracts and commodity options, subject to certain conditions. Among other things, the FCM must comply with the segregation requirements of Section 4d of the CEA and the rules thereunder or, if applicable, the secured amount requirements of CFTC Rule 30.7. Rule 17f-6 was intended to provide Funds with the ability to effect commodity trades in the same manner as other market participants under conditions designed to provide custodial protections for Fund assets.7
The passage of the Dodd-Frank Act reflects Congress's policy determination that the centralized clearing of swaps, including CIS and FXS, will promote price transparency and minimize exposure to counterparty credit risk and systemic risk in the OTC derivatives market. You note that we have issued letters with respect to the custody issues for Funds raised by the central clearing of credit rate default swaps ("CDS") and interest rate swaps ("IRS").8 You represent that with the exception of the fact that CME will be clearing CIS and FXS, and not CDS or IRS, your facts and representations are substantially identical to those letters.
You represent that CME's clearing of CIS and FXS incorporates the safeguards that are provided for Fund assets under the CEA and CFTC rules. In particular, you state that the CFTC has noted that LSOC, which applies to cleared swaps (including CIS and FXS), includes additional protections for cleared swap customers than those that are available for futures customers (i.e., the segregation requirements of Section 4d(2) (currently codified as Section 4d(a)(2)) for futures traded on a domestic exchange, and Rule 30.7 for futures traded on a foreign exchange, each of which is referenced in Rule 17f-6).9 In this regard, you believe that permitting Funds to place and maintain assets in the custody of CME or a CME Clearing Member in order to clear CIS and FXS transactions is consistent with the safe custody requirements of Section 17(f) of the 1940 Act and Rule 17f-6 thereunder.
We conclude that the facts highlighted above, along with certain representations provided by CME, argue in favor of flexibly applying the custody requirements of the 1940 Act in this instance. In particular we rely on your representations that each CME Clearing Member that holds assets for an unaffiliated Fund customer wishing to clear CIS and FXS transactions on the CME will address each of the requirements of Rule 17f-6, as follows:
- The manner in which a CME Clearing Member will maintain such a Fund's assets will be governed by a written contract between the Fund and the CME Clearing Member, which provides that:10
- the CME Clearing Member will comply with the requirements relating to the separate treatment of customer funds and property of CME and LSOC specifying the substantive requirements for the treatment of cleared OTC derivatives in the cleared swap account class prior to any bankruptcy;11
- the CME Clearing Member may place and maintain the Fund's assets as appropriate to effect the Fund's cleared CIS and FXS transactions through CME and in accordance with the CEA and the CFTC's rules thereunder, and will obtain an acknowledgement, to the extent required under CFTC Rule 1.20(a), that such assets are held on behalf of the CME Clearing Member's customers in accordance with the provisions of the CEA;12
- the CME Clearing Member will promptly furnish copies of or extracts from its records or such other information pertaining to the Fund's assets as the Commission through its employees or agents may request;13
- any gains on the Fund's transactions, other than de minimis amounts, may be maintained with the CME Clearing Member only until the next business day following receipt;14 and
- the Fund has the ability to withdraw its assets from the CME Clearing Member as soon as reasonably practicable if the custodial arrangement no longer meets the requirements of Rule 17f-6, as applicable.15
In taking this position, we note that, as the Commission stated in adopting Rule 17f-6 and as you acknowledge, maintaining assets in an FCM's custody is not without risk.16 Therefore, we strongly encourage Funds to weigh carefully the risks and the benefits of maintaining assets to effect transactions in CIS and FXS with a CME Clearing Member and CME.17
Based on the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 17(f) of the 1940 Act against a Fund if the Fund or its custodian places and maintains assets in the custody of CME or a CME Clearing Member for purposes of meeting CME's or a CME Clearing Member's margin requirements for CIS and FXS that are cleared by CME.
Our position herein is temporary, and will expire December 31, 2014. Because our position is based on the facts and representations made in your letter, you should note that any different facts or circumstances might require a different conclusion. This letter represents only the Division's position on enforcement action and does not purport to express any legal conclusion on the questions presented.
Incoming Letter 1 and Incoming Letter 2 are in Acrobat format.