Interpretation to Chapter 9 - Capital Charge for Rule 106.D. Lessees and Trading Permit Holders

In 1996, the Audit Department met with several clearing members that actively qualify lessees to discuss the merits of the lessee capital charge. In general, these clearing members support the lessee capital charge. At the request of several clearing members, the Audit Department further modified the lessee capital charge as follows:

1. Eliminated the capital charge for a lessee or trading permit holder who trades exclusively for the proprietary account of the qualifying clearing member. The proprietary capital charge already appropriately assesses the risks associated with the proprietary trading activity.

2. Expanded the acceptable collateral from third party guarantors to include all performance bond collateral acceptable under Rule 930.C. Previously, that collateral was limited to cash and U.S. treasury obligations.

We also prepared a Question and Answer Guide to answer many questions not directly addressed within the Interpretation. Attached are the changes to the Interpretation and the Question and Answer Guide.

If you have any questions, please call the Audit Department at (312) 930-3238 or e-mail us at audits@cme.com

Rule 106 D. Lessee and Trading Permit Holder Capital Charge - Rule Change

Interpretations & Special Notices Relating to Chapter 9

CAPITAL CHARGE FOR A RULE 106.D.
TRANSFEREE (LESSEE) AND TRADING PERMIT HOLDER

A capital charge in the following amounts will be assessed to a clearing member's adjusted net capital: i) $50,000 for each CME, IMM, and IOM Rule 106.D. transferee (lessee) for whom the clearing member has indemnified the transferor (lessor); ii) $25,000 capital charge for each GEM 106.D. lessee for whom the clearing member has indemnified the lessor; and iii) $25,000 for each trading permit holder.

A clearing member may not avoid this charge by lending funds or guaranteeing a loan to the lessee or trading permit holder to enable the lessee or trading permit holder to meet the $50,000 or $25,000 requirement unless such loan is secured by readily marketable collateral in accordance with CFTC Regulation 1.17.

[The capital charge for each lessee or trading permit holder trading the proprietary account of the clearing member may be reduced by the performance bond requirements of positions controlled by the lessee or trading permit holder reflected in the proprietary capital charge in accordance with CFTC Regulation 1.17(c)(5)(x).]

The capital charge may be reduced by equity in excess of maintenance performance bond requirements in the respective lessee's or trading permit holder's account with the clearing member.

The capital charge will not apply with respect to a lessee or trading permit holder if any of the following are satisfied [either A. or B. below is satisfied]:

A. The lessee or trading permit holder has been unconditional guaranteed by an equity member qualified by the same clearing member. The clearing member must obtain a properly executed guarantee agreement from the equity member. An equity member may only guarantee one lessee or trading permit holder for each membership owned. A GEM equity member may only guarantee a GEM lessee.

B. The lessee or trading permit holder has been guaranteed by a third party depositing at least $50,000 (for a CME, IMM, or IOM lessee) or $25,000 (for a GEM lessee or any trading permit holder) with the clearing member in [cash and/or U.S. treasury securities] performance bond deposits acceptable under Rule 930.C. [with the clearing member.] The clearing member must obtain a properly executed guarantee agreement from the third party for each lessee or trading permit holder so guaranteed and may not use the deposit for any other purpose.

C. The lessee or trading permit holder trades exclusively for the proprietary account of the qualifying clearing member.

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CME Rule 106.D. Lessee and Trading Permit Holder Capital Charges
Question/Answer Guide

For simplicity, the following questions and answers only refer to lessees and imply a required capital charge of $50,000 to a clearing member�s adjusted net capital for each lessee for whom the clearing member has not indemnified the lessor. The principles of the questions and answers apply equally to GEM lessees and trading permit holders who are subject to a $25,000 capital charge.

1. What is the purpose of the lessee capital charge?

The lessee capital charge addresses the risks associated with a clearing member that qualifies lessees. A lessee maintains the ability to execute orders at his own discretion without the qualifying clearing member�s direct supervision/approval. The clearing member can reduce the $50,000 capital charge with equity in excess of maintenance performance bond requirements in the lessee�s account with the clearing member. The clearing member can also avoid the capital charge by obtaining an appropriate guarantee from an equity member or third party guarantor who deposits $50,000 in collateral with the clearing member. The capital charge does not apply to a lessee trading exclusively for the proprietary account of the qualifying clearing member.

2. Can an assigned membership be used to guarantee a lessee?

Answer: No. An assigned membership must be immediately available to the Exchange in the event a clearing member cannot meet its obligations to the Exchange. The Exchange may direct the sale of an assigned membership and use the proceeds to satisfy the Exchange of any outstanding obligations of the clearing member.

3. If a lessee only does floor brokerage and does not trade for his own account, does the lessee capital charge apply?

Answer: Yes. While the lessee is only executing orders and not trading for himself, he is still on the trading floor with the ability to trade for himself and/or improperly execute orders.

4. If a lessee trades from "upstairs" in the clearing member�s office, does the lessee capital charge apply?

Answer: Yes. Similar to question 2, the lessee trading from "upstairs" still maintains the ability to trade for himself on the trading floor.

5. If a lessee only executes orders on behalf of the proprietary account of a clearing member, would the lessee capital charge apply?

Answer: No. The proprietary capital charge required by +CFTC regulations already assesses the risks associated with proprietary trading activity. To be exempt from the lessee capital charge, the lessee must exclusively trade for the proprietary account (including error accounts) of the qualifying clearing member and may not have a personal trading account with the clearing member.

In certain situations, a clearing member may lease a membership for a floor manager to allow the floor manager to execute orders in an emergency situation (e.g., to P&S trades made in error). The floor manager does not trade for himself nor does he fill orders. If all orders executed by the floor manager are for the proprietary account (e.g., error account) of the qualifying clearing member, the leased membership would not be subject to the capital charge. The clearing member must demonstrate compliance with this condition to the Audit Department to avoid the capital charge.

In other situations, a clearing member may lease a membership for an employee to allow the employee to solicit customers on the trading floor. If a clearing member does not allow the lessee to trade under any circumstance, the leased membership would not be subject to the charge. The clearing member must demonstrate compliance with this condition to the Audit Department to avoid the capital charge.

6. Why must the seat owner and lessee be qualified by the same clearing member in order for the seat owner to guarantee the lessee?

Answer: The seat owner and lessee must be qualified by the same clearing member to ensure sufficient controls are in place to monitor the trading activities of both the seat owner (guarantor) and lessee (guarantee). In addition, if the seat owner and lessee were qualified by different clearing members and the lessee suffered a loss, the lessee�s qualifying clearing would have a lower priority claim to the membership than the seat owner�s qualifying clearing member pursuant to Rule 110 (Claims Against Member, Application of Proceeds).

7. Where must funds deposited by lessees to meet the $50,000 requirement be held?

Answer: Funds deposited by the lessee must be held in the lessee�s segregated account. Such funds would be used in determining the account�s net liquidating value and available to meet performance bond requirements. A lessee may not deposit funds in a non-regulated account to meet the lessee capital charge.

8. Can the lessee�s CFTC Regulation 30.7 secured funds be used to meet the $50,000 requirement?

Answer: If the lessee maintains a CFTC Regulation 30.7 secured account to trade foreign futures and options, equity in excess of initial performance bond requirements in the secured account may be used to meet the $50,000 requirement provided the excess equity is not used to secure any debit/deficits.

9. When a third party guarantees a lessee, why must the collateral be deposited into a non-regulated account and only used for the purposes of meeting the lessee capital charge requirement?

Answer: CFTC Regulation 1.20 requires a clearing member to deposit funds received from a customer to margin, guarantee, or secure that customer�s trading activity on U.S. exchanges into a segregated account. CFTC Regulation 1.20 prohibits a clearing member to deposit funds received from a third party to guarantee the customer�s trading activity into a segregated account. Such funds must be held in a non-regulated account in the name of the third party guarantor. Likewise, the funds may not be deposited into a CFTC Regulation 30.7 secured account.

10. May an equity member provide a guarantee based upon a membership at another futures exchange, such as a full Chicago Board of Trade (CBOT) membership?

Answer: Yes. A full CBOT membership or a CBOT Associate membership may be used to guarantee a lessee provided the requirements of the capital charge Interpretation are met. Depending upon the value of memberships at other futures exchanges, they may be acceptable for a 106.D. guarantee. Consult the Audit Department for further guidance as to a particular memberships� acceptability.

11. May a lessee, who also owns a membership, use the membership that he owns to guarantee another lessee?

Answer: Yes, provided the clearing member qualifying the guaranteed lessee indemnifies the seat owner and an unconditional guarantee has been properly executed. The guaranteed lessee and seat owner do not have to be qualified by the same clearing member.

12. May a lessee, who also owns a membership, use the membership that he owns to guarantee himself?

Answer: Yes. However, no guarantee agreement is required as the seat owner would be guaranteeing himself. The seat owner may also guarantee another lessee provided the clearing member qualifying the individual leasing the seat owner�s membership indemnifies the seat owner and an unconditional guarantee has been properly executed. The guaranteed lessee and the seat owner must be qualified by the same clearing member.

13. How does a lessee capital charge apply when a lessee is part of a trading group which has non-lessee participants?

Answer: For lessees included in a trading group, the total balance (equity and performance bond requirements) in the trading group account are compared to the total lessee requirement (e.g., if three lessees are part of the trading group, the total lessee requirement is $150,000) to determine the lessee capital charge. Since the entire trading group�s equity is at risk, the total account is considered in the computation of the capital charge. For example, a trading group consists of 5 lessees and 5 members has account equity of $300,000, and performance bond requirements of $75,000. The lessee requirement is $250,000 (5 lessees multiplied by $50,000) which can be reduced by $225,000 (account equity of $300,000 less performance bond requirements of $75,000) resulting in a $25,000 lessee capital charge.

14. How is the lessee capital charge computed for cross-margin accounts?

Answer: In determining excess equity, the clearing member must include the lessee�s cross-margin account and non-cross-margin commodity account (e.g., all segregated accounts). Excess equity is based on the SPAN performance bond requirement, not the SEC Rule 15c3-1(c)(2)(x) haircut. Excess equity in the lessee�s non-cross-margin security account cannot be used to meet the $50,000 requirement until a transfer of available funds to a segregated account occurs.

15. How many fractions must a GEM equity member own to guarantee a GEM lessee?

Answer: A GEM equity member must own the equivalent of a full GEM membership to guarantee a GEM lessee.

16. Is the $25,000 requirement reduced when a GEM lessee leases only the required fractions to trade certain GEM products?

Answer: No. The lessee requirement is $25,000 for all GEM lessees regardless of the number of fractions leased. However, the $25,000 requirement does not apply when a member owns at least two-fifths of a GEM membership (e.g., sufficient fractions to trade certain GEM products) and leases the additional fractions to trade other GEM products.

17. If an individual transfers his membership under Rule 106.C. (Family Transfer), may the membership still be used to guarantee a Rule 106.D. lessee?

Answer: As background to the question, a Rule 106.C. transfer is a family transfer. The clearing member qualifying the 106.C. transferee cannot indemnify the transferor -- the owner of the membership. A 106.C. transferee cannot directly guarantee a 106.D. lessee. The owner of the membership must guarantee the lessee or grant permission to the 106.C. transferee to guarantee the lessee through a power of attorney. [Note: Such power of attorney is limited and only allows the membership to be used by the 106.C. transferee to guarantee a 106.D. lessee. Such power of attorney must be maintained by the qualifying clearing member of the 106.C. transferee.]

A membership subject to a 106.C. transfer may be used to guarantee a Rule 106.D. lessee as follows:

(1) The 106.C. transferor, 106.C. transferee, and the 106.D. lessee are qualified by the same clearing member. In this case, the 106.C. transferor either owns and/or leases another membership in order to be qualified by a clearing member. The 106.C. transferor guarantees the 106.D. lessee by executing an unconditional guarantee; or

(2) The 106.C. transferee and the 106.D. lessee are qualified by the same clearing member, but the 106.C. transferor is not. The 106.C. transferee may guarantee the 106.D. lessee using the transferred membership by (a) executing an unconditional guarantee, and (b) obtaining a power of attorney from the 106.C. transferor to use the membership for a 106.D. guarantee.

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