Enclosed are two letters that explain the current regulatory position; one from the FIA to the CFTC/SEC, and the other from the CFTC to the Joint Audit Committee. In summary, funds held in recognized customer regulated accounts (e.g. segregated or customer 30.7 funds), securities held in safekeeping, and normal operating balances may be held at an affiliate or a subordinated lender. Deposits in excess of normal operating balances, certificates of deposit, or other securities issued by the affiliate or subordinated lender are nonallowable for regulatory capital.

A standard definition for normal operating balances does not exist. However, the CME uses as a guideline one-twelfth of the firm�s annual operating expenses plus 200 percent of the average amount required for payment of variation and performance bond calls. Determination of these amounts must be substantiated with quantitative data.

If you have any questions, please contact the Audit Department at (312) 930-3230.

Audit Information Bulletin 9401

From: Audit Department

Date: March 14, 1994

Re: Regulatory Update on Various Investment Vehicles

As profit margin pressure maintains its grip on our industry, we understand a clearing firm's need to find investment vehicles allowable for regulatory capital earning something higher than T-Bill rates. Over the past few years, the allowability of certain investments has been questioned. These debates are often fueled by some kind of interpretive notice issued by various regulatory authorities. From a regulatory perspective, the Exchange strongly prefers that this type of policy setting be done via formal rule making channels. We are also concerned with the communication problems associated with this type of informal policy setting. These concerns have been strongly voiced to the CFTC and SEC.

The purpose of this bulletin is to summarize the current regulatory/enforcement position on the following investment vehicles and to provide you with any documentation we have.

Funds Held at Affiliates and Subordinated Lenders. Attached are two letters: One from the FIA to the CFTC/SEC , and one from the CFTC to the Joint Audit Committee detailing the current position. In summary, all funds held in accounts for the benefit of customers, all securities in safekeeping, and normal operating balances may be held by an affiliate or a subordinated lender. (A standard definition for normal operating balances does not exist. Please contact your lead regulator for guidance on the reasonableness of your normal operating balances.) Deposits in excess of normal operating balances and CDs or other securities issued by the affiliate or subordinated lender are nonallowable.

Offshore Deposits (Cayman Islands, Nassau, etc.): These house investments are typically done overnight with a branch of a major U.S. or foreign bank. The Joint Audit Committee has negotiated, albeit unsuccessfully, with the SEC, CFTC, and banks in structuring some framework that would allow such deposits as regulatory capital. Consideration was given to accepting these deposits if the primary bank provided a "comfort" letter stating they stood behind their branch deposits. The SEC's position, and CFTC's as of late, is that these deposits are nonallowable unless the main bank unconditionally guarantees the branch deposits. However, the CFTC is still reviewing the matter; for those of you investing in these vehicles, or considering such investments, we suggest you contact your respective CFTC Branch Chief for guidance.

Reverse Repurchase Transactions with Segregated Funds. The CFTC released Interpretation No. 2-1 on December 15, 1993 (attached). The Exchange was able to provide some input for the redraft. The new interpretation is less restrictive than its predecessor and includes certain amendments and clarifications that are more consistent with the industry practice of transferring government securities.

If you have any comments on these or any other issues we would appreciate hearing from you. We also encourage you to take advantage of the research and advisory services we provide to our clearing members on any existing or contemplated investment activity.

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Letter sent from the FIA to the CFTC/SEC dated May 15, 1992

Mr. Michael A. Macchiaroli
Assistant Director
Compliance and Financial Responsibility
Securities and Exchange Commission
450 5th Street, N.W.
Washington, DC 20549

Ms. Andrea M. Corcoran
Director
Division of Trading and Markets
Commodity Futures Trading Commission
2033 K Street, N.W.
Washington, DC 20581

Dear Mr. Macchiaroli and Ms. Corcoran:

On March 11, 1992, representatives of the Futures Industry Association ("FIA") met with Mr. Macchiaroli to discuss the following interpretation:

Compensating Balance Deposited With Others

"Compensating balances or other assets (e.g. Cash, CDs, time deposits, commercial paper, etc.) deposited with or held by subordinated lenders, or lenders under a NYSE rule 328 fixed asset agreement, should be treated as assets not readily convertible to cash.

These balances should be treated as non-allowable assets up to the value of the liability to the related party."

During the meeting, the FIA raised concerns about the scope of the interpretation. In our view, it assumes that all of a firm's deposits held by a bank, which has loaned funds on a subordinated basis to the firm, may be subject to offset by the bank regardless of the existence of any legal right to offset. The interpretation ignores the fact that the bank is required to sign a legally enforceable subordinated loan agreement which on its face prohibits offsets; that the loan agreements are written in accordance with CFTC and SEC rules; and that the loans are approved by the various exchanges.

As a result of our meeting with Mr. Macchiaroli, however, we now understand the interpretation is not intended to limit a firm from using the services of its subordinated lender for its normal banking needs, including the use of operating, safekeeping, segregated, secured and reserve bank accounts. However, it is our understanding that the CFTC and SEC are not yet confident that the presence of a subordinated loan agreement restricts banks from offsetting firm assets against the subordinated loan. The FIA believes that the two agencies' concerns are unfounded. However, if there are instances where this has occurred, the agencies should look toward strengthening the rules regarding these types of loans rather than treating the balances as non-allowable assets.

In this regard, the FIA is still very concerned about the SEC's and CFTC's position regarding the treatment of other investments held by firms which are offered by banks as part of their normal banking operations. Specifically, the FIA is concerned that the agencies may disallow the following transactions: CDs, Commercial Paper (issued by the lending bank's holding company), Time Deposits, Money Market Accounts and Eurodollars. The only rationale for the decision to disallow appears to be based on the fact that the bank where the funds are deposited has lent a firm money on a subordinated basis. Such an interpretation would have major implications for FIA member firms because of current requirements that firms maintain their capital in the form of cash or readily marketable securities. Because of the far-reaching consequences to firms this limitation would cause, we would like to continue our dialogue with you on the treatment of these transactions.

In the meantime, to ensure that the interpretation is clarified in the areas that the parties have reached agreement, we ask that the SEC and CFTC stipulate that the following be treated as allowable assets:

1. All cash deposited with a subordinated lender including: operating accounts, funds in recognized segregated accounts under CFTC Regulation 1.20, secured amounts under CFTC Regulation 30.7 and reserve accounts under SEC 15-C3-3.

2. All readily marketable securities held in segregated, secured or reserve accounts (i.e., customer-owned securities, firm investment of segregated funds) or general safekeeping accounts (i.e., noncustomer-owned securities, firm-owned securities).

Clarification of the treatment of the above assets is vital to the successful operation of all FCMs. FCMs must be able to anticipate their daily capital requirements based on market fluctuations and be able quickly to move assets to various locations (i.e., clearing organizations and carrying brokers). In order to ensure their ability to transfer assets immediately, FCMs must keep a substantial amount of their assets with banking institutions. As a result, an FCM may appear to hold excess assets with a particular depository, when in fact these assets are held to ensure the FCM's ability to meet its financial obligations immediately.

We appreciate the opportunity to meet and discuss these important issues. We would be happy to further discuss these issues or any others relating to this interpretation at your convenience.

Sincerely, 

Hal T. Hansen
Chairman

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Letter sent from the CFTC to the Joint Audit Committee dated June 25, 1996

Mr. Arthur McCoy
Chairman, Joint Audit Committee
New York Mercantile Exchange
Four World Trade Center
New York, NY 10048 

Dear Mr. McCoy:

This letter addresses the Joint Audit Committee's ("JAC" or "Committee") recent inquiries regarding the net capital treatment of deposits maintained by a futures commission merchant with bank affiliates and subordinated debt holders.

The Division appreciates the JAC's interest in this issue and will keep the Committee apprised of developments in this area. Although no formal advice has been issued to date, the Division believes that the following balances in accounts, which are maintained at affiliates or financial institutions that have made subordinated loans to an FCM, may be counted as regulatory capital: segregated commodity customers' funds held pursuant to Section 4d(2) of the Commodity Exchange Act, deposits held in a reserve bank account under rule 15c3-3 of the Securities Exchange Act of 1934, securities held in a safekeeping account, and normal operating balances. The Division is working with Securities and Exchange Commission staff to formally issue advice on these three items which will confirm that they may be treated as good regulatory capital.

There is also the issue of time deposits and securities, e.g., certificates of deposit, maintained at or issued by bank affiliates or subordinated debt holders. The Division is willing to further consider these items. However, at the present time, the Division's position is that such items are not deemed to qualify for regulatory capital purposes. The Division believes it is incumbent upon the JAC membership to bring any firms which rely on such assets for a material portion of their capital to the Division's attention. This information would assist the Division in further considering this issue.

Finally, the JAC has indicated that it intends to take action on its own on various regulatory issues. As noted above, the Division appreciates the Committee's interest in resolving regulatory issues and would be pleased to receive the Committee's thoughts on any matter of concern or interest. However, so far as the Committee's developing regulatory interpretations is concerned, the Division expects each designated self-regulatory organization to carry out its program in accordance with the Commodity Exchange Act ("Act"), rules promulgated thereunder, existing interpretations and exchange or SRO rules that have been properly submitted under the Act and, where necessary, approved by the Commission. Also, as you know, as a general matter the Division relies upon interpretations of the Securities and Exchange Commission with respect to treatment of net capital items. Therefore, SEC interpretations in the net capital area must be followed by DSRO staffs in executing their compliance programs, unless the Division has issued specific advice to the contrary based upon special circumstances.

If you have any questions or wish to meet, please call me.

Sincerely, 

Paul H. Bjarnason, Jr.
Chief Accountant

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