U.S. Commodity Futures Trading Commission Proposes to Modify and Codify Margin Adequacy Relief

On February 20, 2024, the U.S. Commodity Futures Trading Commission (CFTC) approved on a 5–0 vote a proposal (the Proposal)¹ that would allow clearing and nonclearing futures commission merchants (FCMs) to treat separate accounts of the same beneficial owner as accounts of different legal entities for purposes of the CFTC’s margin adequacy regulations. The Proposal would codify relief provided by the CFTC staff in 2019 (and extended multiple times) that currently facilitates separate margining of accounts of the same customer at the same FCM.

Sidley's Take

Among other things, the Proposal would provide multistrategy fund managers and other investors that allocate trading capital to multiple trading advisors with long-term comfort that their FCMs will continue to be allowed to determine margin adequacy on an account-by-account, rather than customer-by-customer, basis. Absent such relief, management of initial margin across multiple accounts would be substantially more difficult and require a level of coordination between trading advisors that is not consistent with current practices.

The Proposal represents the culmination of years of engagement with the CFTC staff by various industry groups, including the Managed Funds Association, the Futures Industry Association, and the Asset Management Group of the Securities Industry and Financial Markets Association.

The Use of Separate Accounts

There are several commercial reasons the same customer, whether it is an investment fund, sovereign wealth fund, insurance company, or corporate end-user, might seek to maintain multiple accounts at the same FCM. For example, an investment fund or sovereign wealth fund that allocates capital to multiple investment advisors may allocate a preset amount of capital and establish separate accounts for each advisor and grant each advisor power of attorney over only a single account to ensure that each advisor is able to manage on the capital allocated to it, and pursue its strategy independently of other advisors.

The same approach may be taken by an investment fund that operates separate strategies and wishes to keep each strategy separate to maintain clear strategy-by-strategy track records or to allow portfolio management teams to receive incentive compensation solely tied to the performance of their own strategies. Corporate entities may wish to establish separate accounts to house different types of hedging (e.g., physical commodity hedging in one account and interest rate and foreign exchange hedging in another account). Separate accounts may also be used to create separate pools of collateral over which a customer may grant secondary security interests² to its lenders. Separate accounts may also facilitate the trading and settlement activities of branches that are part of the same banking organization but that operate in different countries and across different time zones.

Importantly, the use of separate accounts typically allows excess margin to be withdrawn from one account, even if another account of the same beneficial owner is currently in margin deficit. 

The JAC Advisories

Prior to 2019, FCMs often allowed customers to establish multiple accounts with the same beneficial ownership and agreed to treat the accounts as accounts of different beneficial owners for margin and other purposes. FCMs also would include “nonrecourse” or “limited recourse” provisions in their customer agreements, pursuant to which they agreed to limit their ability to look across accounts for purposes of determining margin adequacy and covering trading losses.

On May 14, 2019, this practice was called into question when the Joint Audit Committee (JAC)³ issued two advisories: Advisory #19-02⁴ and Advisory #19-03.⁵

Combining Accounts for Margin Purposes

CFTC regulations require derivatives clearing organizations (DCOs) to collect margin from FCMs with respect to their customer accounts on a gross basis — i.e., without netting excess customer margin against customer margin deficits. This requirement limits “fellow-customer risk” because it makes it less likely that a default by one customer will cause the default of the FCM, with any resulting shortfall in customer funds shared pro rata across other customers of the FCM (i.e., “fellow-customer risk”).

One of the rules designed to facilitate this approach is CFTC Regulation 39.13(g)(8)(iii), which requires DCOs to require their clearing members to “ensure that their customers do not withdraw funds from their accounts with such clearing members unless the net liquidating value plus the margin deposits remaining in a customer’s account after such withdrawal are sufficient to meet the customer initial margin requirements with respect to all products and swap portfolios held in such customer’s account which are cleared by the [DCO].”⁶

In line with this requirement, JAC Advisory #19-02 reminded FCMs that “[a]ll 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.” The advisory further stated 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 [… and] an account’s available funds from one regulatory account classification cannot be used for disbursement from another regulatory account classification.” 

Guarantees Against Loss

CFTC Regulation 1.56(b) prohibits FCMs from representing that they will guarantee customers against loss, limit the losses of customers, or not call for, or attempt to collect, initial or maintenance margin. JAC Advisory #19-03 reminded FCMs of their obligations under Regulation 1.56(b) and indicated that it was JAC’s view that limited recourse and nonrecourse clauses in FCM customer agreements are not consistent with those obligations because CFTC regulations “require an FCM to have at all times the absolute right to look to funds in all accounts of the beneficial owner, including accounts that are under different control, as well as the right to call the beneficial owner for funds.” 

JAC provided an example to illustrate this point: “… in the case of a separate account of a beneficial owner managed by an asset manager, the FCM must have at all times the absolute right to look to funds in all accounts of the beneficial owner even accounts that are under different control, as well as the right to call the underlying beneficial owner for funds even if beyond the amount the beneficial owner has allocated to the asset manager(s).”

CFTC Letter 19-17

The issuance of JAC Advisories #19-02 and #19-03, although viewed by JAC and its members as reminders to FCMs of their existing obligations under CFTC regulations, caused a great deal of concern among market participants and industry groups because they called into question practices that had become common. A number of market participants and industry groups actively engaged with the CFTC staff to seek relief and avoid the inevitable disruption that would have been caused by widespread and sudden changes in market practice.

On July 10, 2019, the CFTC’s Division of Swap Dealer and Intermediary Oversight (the predecessor of today’s Market Participants Division) and Division of Clearing and Risk jointly issued Letter No. 19-17: Advisory and Time-Limited No-Action Relief with Respect to the Treatment of Separate Accounts by Futures Commission Merchants.  

Letter No. 19-17 again emphasized the requirements of CFTC Regulation 1.56(b) and expressed the view that “the FCM must retain the ability to ultimately look to funds in other accounts of the beneficial owner, including accounts that may be under different control, as well as the right to call the beneficial owner for additional funds.” Nevertheless, the CFTC staff provided time-limited relief from CFTC Regulation 39.13(g)(8)(iii), allowing DCOs to permit their FCM members to treat the separate accounts of the same beneficial owner as accounts of separate entities for the purpose of determining the adequacy of margin in each account. To rely on the relief provided by Letter No. 19-17, FCMs were required to have and to comply with internal controls that satisfy a number of highly detailed and prescriptive requirements.

Letter No. 19-17 was originally scheduled to expire on June 30, 2021, but the relief was extended multiple times and is now scheduled to expire on June 30, 2024.

The Proposals

On April 14, 2023, the CFTC published a notice of proposed rulemaking⁷ that would have codified many aspects of Letter No. 19-17. In light of comments the CFTC received on that proposal, it has now determined to withdraw the original proposal and replace it with the Proposal.

The CFTC is now proposing regulations that would allow FCMs, under certain circumstances and subject to certain conditions, to treat the separate accounts of a single customer as accounts of separate entities for margin purposes.

Proposed Regulation 1.44

The Proposal would allow a clearing or nonclearing FCM, during the “ordinary course of business,” to treat separate accounts of the same beneficial owner as accounts of different beneficial owners for purposes of determining the adequacy (and proper segregation) of margin in each such account. An FCM electing this separate account treatment would be required to comply with proposed CFTC Regulation 1.44 and to maintain written internal controls and procedures designed to ensure such compliance. 

Proposed Regulation 1.44 would require the following:

• The FCM would be required to include the customer for which separate account treatment has been elected on a list of such customers maintained in the FCM’s books and records. This list would be required to include the identity of each separate account customer and identify each separate account of such customer, and it would be required to be kept current over time.
• The FCM would be required to notify the CFTC and its designated self-regulatory organization (DSRO) within one business day of the FCM’s adding a customer to its list of separate account customers for the first time.

“Ordinary Course of Business”

The Proposal would allow separate account treatment by an FCM only during the “ordinary course of business.” The Proposal lists events the occurrence of which would be inconsistent with the ordinary course of business: one list of events that would affect the ongoing separate account treatment of a particular customer, and one list of events that would affect the FCM’s ability to continue to offer separate account treatment.

Customer-Specific Events

The following events would be deemed inconsistent with the “ordinary course of business” with respect to the separate accounts of a particular separate account customer. The occurrence of any of these events would require the FCM to cease permitting disbursements on a separate account basis with respect to all accounts of the affected customer:

• if the separate account customer, including any separate account of the customer, fails to deposit initial margin or maintain maintenance margin or make payment of variation margin or option premium on a one-business-day margin call basis, as described below
• the occurrence and declaration by the FCM of an event of default, as defined in the governing agreement between the FCM and the customer
• a “good faith determination” by the FCM’s chief compliance officer (CCO), one of its senior risk managers, or other senior manager, following the FCM’s internal escalation procedures, that the customer is in financial distress or there is significant and bona fide risk that the customer will be unable promptly to perform its financial obligations to the FCM, whether due to operational reasons or otherwise
• the insolvency or bankruptcy of the customer or a parent company.
• the receipt by the FCM of a notification that a board of trade, DCO, self-regulatory organization (SRO), the CFTC, or another regulator with jurisdiction over the customer has initiated an action with respect to the customer based on an allegation that the customer is in financial distress
• if the FCM is directed, pursuant to applicable rules, regulations, or laws, by a board of trade, DCO, SRO, the CFTC, or another regulator with jurisdiction over the customer to cease permitting disbursements on a separate account basis with respect to the customer

FCM-Specific Events

The following events would be deemed to be inconsistent with the “ordinary course of business” with respect to the separate accounts of all separate account customers of the FCM. The occurrence of any of these events would require the FCM to cease permitting disbursements on a separate account basis with respect to all of its customers:

• The FCM is notified by a board of trade, DCO, SRO, the CFTC, or another regulator with jurisdiction over the FCM that the board of trade, DCO, SRO, the CFTC, or other regulator with jurisdiction over the FCM believes the FCM is in financial or other distress.
• The FCM is under financial or other distress, as determined in good faith by its CCO, senior risk managers, or other senior management.
• The FCM or a parent company is insolvent or bankrupt.

The FCM would be required to notify the CFTC and its DSRO of the occurrence of any of these events by no later than the next business day. 

One-Day Margin Calls

To be treated as a separate account under CFTC Regulation 1.44, an account would be required to be on a one-business-day margin call — that is, the separate account customer generally would be required to meet a margin call from its FCM by no later than the close of the Fedwire Funds Service on the business day on which the margin call is issued. 

Exceptions to the one-business-day requirement would be made for margin calls denominated in currencies other than U.S. dollars or Canadian dollars, as follows:⁸

• Australian dollar (AUD), Chinese renminbi (CNY), Hong Kong dollar (HKD), Hungarian forint (HUF), Israeli new shekel (ILS), Japanese yen (JPY), New Zealand dollar (NZD), Singapore dollar (SGD), South African rand (ZAR), Turkish lira (TRY): Margin must be received by the FCM no later than the end of the second business day after the margin call is issued.
• All other fiat currencies: Margin must be received by the FCM no later than the end of the business day after the margin call is issued.

The foregoing margin deadlines would not be permitted to be extended by agreement between the customer and the FCM.

Overall, the Proposal, if approved, would have a significant impact on futures and cleared swaps account structures and margin procedures, providing long-term comfort to investors that utilize multiple trading advisors that margin adequacy can be determined on an account-by-account basis.

Comments on the Proposal must be submitted on or before April 22, 2024.