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The Long And Winding Road Of JAC Regulatory Alert 14-03 – Commodities/Derivatives/Stock Exchanges

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Once, many years ago, the Joint Audit Committee released a
Regulatory Alert (RA 14-03) addressed to futures commission
merchants that are clearing members of derivatives clearing
organizations registered with the CFTC, which included the
following passage:

“Additionally, all accounts of the same beneficial owner
within the same regulatory account classification (i.e., customer
segregated, customer secured, cleared swaps customer, or
noncustomer) should be combined for margin purposes. FCMs should be
reminded that when determining an account’s margin funds
available for disbursement, all accounts of the same beneficial
owner, even if under different control, within the same regulatory
account classification must be combined” (emphasis in
the original).

FCMs and institutional money managers received this deliverance
with some consternation. Could it possibly be that if Money Manager
A and Money Manager B each separately contracts with Municipal
Pension Fund X and then both A and B establish futures clearing
arrangements with FCM 1, FCM 1 would be required to combine the
accounts of A and B for margin purposes – notwithstanding
that A and B are not affiliated, are implementing different
investment mandates from X, and would have no visibility into each
other’s portfolios at FCM 1?

Over the course of the next five years, FCMs addressed this
question, in various configurations and contexts, to the JAC.
Finally, having tired of dialogue, the JAC released a Regulatory
Alert (RA 19-02), reiterating RA 14-03’s separate
account margining mandate (with the same emphasis on the
“must”!) and ordering FCM clearing members to comply. On
the same day, JAC released an interpretation of CFTC Rule 1.56 (RA 19-03) which purported to find any
“limited recourse” arrangement entered into by an FCM
inconsistent with the provision of that rule prohibiting FCMs from
guaranteeing customers against loss. This was addressed to the FCM
practice (which surfaced in the course of the preceding five
years’ discussions), widespread at the time, of acceding to
investment manager demands to limit FCM recourse against their
clients to the assets made available to the manager under the
related investment mandate.

In response, FCMs took their case to the Staff of the CFTC. In
CFTC Letter 19-17, Solomon-like, Staff split
the JAC-baby: they endorsed the JAC’s interpretation of Rule
1.56; but they opened a path to separate margining of separately
managed accounts of the same customer, notwithstanding the
unequivocal, twice-emphasized JAC prohibition of the practice. This
path was time-limited (expiring in June 2021), by way of no-action
relief, and in contemplation of time for Staff to recommend, and
for the CFTC to “determine whether to conduct, and if so, to
in fact conduct, a rulemaking to implement appropriate relief on a
permanent basis.”

Letter 19-17 may have seemed a final settlement; but fresh
antagonisms soon stirred between the JAC and the FCM clearing
members, particularly over the deadline by which the FCMs would be
expected to be in full compliance with the requirement to remediate
documentation not in compliance with the new interpretation of Rule
1.56 and with the (16) new compliance conditions around separate
account margining. Once again, Staff was prevailed upon to impose
peace upon the fractious parties; the result was CFTC
Letter 20-28
, which gave the industry until March 31, 2021 to
remediate and come into compliance. Letter 20-28 also deferred the
expiration of Letter 19-17’s no-action relief from June 30,
2021 to December 31, 2021. In CFTC
Letter 21-29
, Staff extended that deadline again, to September
2022, citing, once more the CFTC’s need for more time “to
consider whether, and if so, how, to codify that relief.”

And now Staff has extended the deadline, once more. Under CFTC
Letter 22-11
, the new deadline is the earlier of September 30,
2022 or the effective date of any final CFTC action relating to
separate account margining.

Meanwhile, FCM clearing members continue to feel the heat from
the members of the JAC responsible for conducting financial and
operational audits of compliance with CFTC and exchange regulations
governing their clearing activities. Most recently, reportedly,
examiners are taking the position that FCM clearing members are
prohibited from agreeing to a contractual grace or cure period
overlying a customer’s failure to pay (that is not qualified by
reference to administrative or operational reasons for the failure)
– a position that might be sustained as another interpretive
extension of Rule 1.56, or might be footed in exchange rules like
CMR 930.K (which requires clearing members to “maintain full
discretion to determine when and under what circumstances positions
in any account shall be liquidated”). At any rate, space
cleared since 2014 by industry discussion and dispute over separate
accounts and limited recourse, and the whiplash many FCMs have
experienced between the not-always-convergent views of the JAC and
its members on the one side, and CFTC Staff on the other, show that
the space remains unsettled. The need for proposed rulemaking, a
full airing of public comments, and final rules clearly setting
forth the regulators’ expectations concerning the constraints
around customer futures and cleared swap documentation and the
operational and compliance constraints around separate account
margining remains as pressing as ever.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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