| Release No. 34-24726 July 22, 1987
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 Table of Contents
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I. Introduction
On October 28, 1986, the Securities Exchange Act of 1934 (the "Exchange Act") was amended by Public Law No. 99-571, the Government Securities Act of 1986 (the "Government Securities Act"). The Government Securities Act provides for the regulation of government securities brokers and government securities dealers. The regulatory system to be established under the Government Securities Act is a limited one in that it does not provide generally for regulation that would affect particular transactions in government securities, e.g., margin or suitability regulation. 1 Instead, the Government Securities Act requires the Secretary of the Treasury (the "Treasury") to adopt rules concerning the financial responsibility, protection of securities and funds, recordkeeping, reporting, and audit of government securities brokers and government securities dealers. The Commission is to provide for the registration of government securities brokers and government securities dealers that are not financial institutions or registered broker-dealers. Financial institutions and registered broker-dealers are required to file notice of their government securities broker or government securities dealer status with their appropriate regulatory agency.
Under the Government Securities Act, the terms government securities broker 2 and government securities dealer 3 do not include any person registered with the Commodity Futures Trading Commission ("CFTC"), any contract market designated by the CFTC, such a contract markets affiliated clearing organization, 4 or any floor trader on such a contract market (hereinafter collectively referred to as "CFTC-regulated persons") solely because such person effects transactions in government securities that the commission, after consultation with the CFTC, has determined to be incidental to such persons futures-related business.
After consulting with the CFTC, 5 the Commission on February 25, 1987, proposed two rules, Rule 3a43-1 and 3a44-1, defining activities it preliminarily believed were incidental to the futures-related business of certain CFTC-regulated persons. (See Securities Exchange Act Rel. No. 24135 (February 25, 1987) 52 FR 6340 (March 3, 1987) ("Proposing Release")).
Twenty-five comment letters were received from 25 commenters on the proposed rules. 6 In addition, three letters were received from the CFTC and its staff. 7 As discussed more fully below, numerous comments criticized Rules 3a43-1 and 3a44-1 as too restrictive in their attempt to define those activities that are "incidental transactions." In response to commenters concerns, the Commission has narrowed the preliminary requirements of the rules and has broadened the types of transactions in government securities and accounts for which such transactions are permitted. Consistent with the Commissions responsibility under the Exchange Act, the rules contain conditions and provide safeguards that the Commission believes are necessary to further the goals of investor protection as intended by the Government Securities Act. As required in Sections 3(a)(43) and 3(a)(44), the Commission has continued to consult with the CFTC concerning these rules. In its June 30 letter, the staff of the CFTC indicated that it believed the rules to be generally responsive to CFTC and commenters concerns.
II. Rule 3a43-1: Customer-related Transactions
A. Preliminary Conditions
Rule 3a43-1 concerns customer-related transactions that, but for the Commissions determination, might cause a futures commission merchant regulated by the CFTC to be considered a government securities broker or government securities dealer. Futures commission merchants take orders for execution on futures exchanges and carry customer accounts. In connection with this business, they may act as agent for futures customers in effecting transactions in government securities or engage as principal in certain combination transactions that involve both futures and government securities.
The legislative history of these exceptions suggests that, in determining whether such customer activity is futures-related, the Commission should assure that the government securities activities of such customers are protected by the regulatory scheme administered by the CFTC. 8 The proposed rule, therefore, contained a requirement that the funds and securities involved in the government securities transactions proposed to be determined to be incidental to the futures-related business be held in a customer segregation account subject to the CFTCs rules at 17 C.F.R. §§ 1.20-1.30.
Several commenters stated that the condition would unfairly restrict investments on behalf of proprietary accounts (e.g. affiliates and other insiders) in government securities and argued that such accounts should be entitled to the same treatment as segregated customer accounts. Other commenters noted that futures commission merchants should be permitted to execute government securities transactions with funds deposited to margin or guarantee foreign futures and options contracts. 9 In addition, commenters including the staff of the Division of Trading and Markets of the CFTC noted that CFTC regulations applicable to segregation of funds associated with "dealer options" are codified at 17 C.F.R. §32.6 rather than in the referenced sections. 10 Finally, the CFTC staff advised that the definition of customer should be revised to include a reference to foreign futures and options on futures customers. The staff further advised that it would be inappropriate to require segregation of funds and securities associated with effecting delivery pursuant to a futures contract. CFTC staff explained that commodities exchange rules permit delivery through a delivery account as well as the segregation account.
The rule has been modified to address the concerns raised by commenters. Accordingly, the definition of customer has been expanded to include proprietary accounts, foreign futures and options on futures customers, and options on physicals customers by defining the term to mean any person for whom the futures commission merchant effects or intends to effect transactions in futures, options on futures, or any other instruments subject to CFTC jurisdiction. 11 The definitions of futures and options on futures contracts have been expanded to include contracts traded on or subject to the rules of any board of trade located outside the United States, its territories, and possessions. 12
The rule as adopted contains a definition of regulated account that is defined as a customer segregation account subject to CFTC regulations 13 except where CFTC regulations do not permit segregation or require maintenance of a separate regulated account. The rule provides that where CFTC rules require maintenance of a separate regulated account, the term means such an account. The CFTC staff has indicated that it will recommend CFTC consideration of a requirement for such an account for customer funds and securities related to trading of foreign instruments. The regulations applicable to such an account would require segregation of the funds in such an account from proprietary funds, and would not permit commingling such funds with customer funds related to domestically traded instruments. The rule also provides that where CFTC regulations do not permit segregation, 14 the term means any other account subject to CFTC recordkeeping regulations. Proprietary accounts are not permitted to be kept in customer segregation accounts. Nevertheless, these accounts are subject to the general recordkeeping regulations of the CFTC. Finally, the rule excepts from the preliminary condition that requires funds and securities associated with such transactions to be maintained in a regulated account transactions to effect delivery of securities pursuant to a futures contract.
Solicitation
As proposed, Rule 3a43-1 contained a second condition that required that the transactions in government securities be unsolicited. The purpose of that condition was to ensure that the transactions proposed to be excepted were truly incidental to a futures commission merchants business. Commenters believed that such a prohibition would not permit legitimate recommendations of combination transactions to customers and was likely to have anticompetitive effects. They believed that futures commission merchants should be able to solicit transactions that were otherwise incidental to the futures business. In view of these concerns, the Commission has determined not to impose as a preliminary condition to the availability of the exception a prohibition against solicitation. Accordingly, the rule as adopted permits specified transactions by a futures commission merchant to be solicited. 15
Advertising
Proposed Rule 3a43-1 also contained a condition prohibiting a futures commission merchant from advertising that it is in the business of effecting transactions in government securities. That condition was designed to assure further that the enumerated transactions are incidental and to avoid the use of the exceptions to circumvent securities self-regulatory organization authority to regulate government securities advertising. Commenters including the CFTC argued that the prohibition placed futures commission merchants at a competitive disadvantage to futures commission merchants that are also registered as broker-dealers. They believed that futures commission merchants that are not registered broker-dealers would be required to stop advertising the services they offer their customers or incur the additional expense of registering as broker dealers, whereas registered broker-dealer futures commission merchants would only be required to file notice with the Commission of their government securities activities.
The Commission is sympathetic to these concerns and has modified the condition to permit limited advertising. Limiting a futures commission merchants advertisement of a general government securities business is appropriate in order to assure that the futures commission merchants government securities transactions are truly incidental to its futures-related business. However, advertising of government securities transactions in connection with futures-related trading would be permitted under the revised rule. This revision is intended to allow futures commission merchants to inform their customers of the types of government securities services they provide in connection with futures trading and investment of excess customer funds. For instance, it would allow futures commission merchants to advertise that they may purchase government securities on behalf of customer so as to permit customers to receive interest on customer segregated funds, that they can execute certain hedging and arbitrage strategies in government securities and futures contracts, and that they effect exchange of futures for physicals transactions involving futures on government securities. However, it would not allow futures commission merchants to advertise their willingness to execute trades in government securities alone.
B. Excepted Transactions
Agency Transactions
The first section of the rule excepts agency transactions relating to delivery pursuant to a futures contract or for risk reduction or arbitrage of existing or contemporaneously created futures positions. One commenter suggested that the Commission clarify what the commenter perceived as a definitional ambiguity with regard to permitted "agency" investments by futures commission merchants. The commenter noted that "the government securities market is virtually exclusively a dealer market. Thus, if a futures commission merchant is instructed by its customer to purchase a U.S. Treasury Bill or other government security, the futures commission merchant will purchase the security in its name as principal. The futures commission merchant will then resell the security to its customer."
As the Treasury Department noted in its discussion of its exemption for agency transactions by financial institutions, it may be appropriate to consider a futures commission merchant acting as principal with a counterparty in the government securities market to be acting as agent vis--vis its customer. In the context of this rule, the Commission recognizes as indicia of an agency transaction the key factors identified by the Treasury Department. Specifically, the Treasury Department stated:
Two major characteristics of an agency transaction are that the transacting broker purchases or sells a security on the order of the customer, not from or to its own inventory, and that the customer is charged an explicit transaction-based fee or commission. It should be noted that the counter-party of the transacting broker need not and indeed usually does not know that the transaction is a brokerage rather than a dealer transaction except perhaps by the size of the order. 16
Thus, where a futures commission merchant acts as agent for a customer, and as part of this relationship purchases a security in the futures commission merchants own name on behalf of its customer, it will be acting as agent for purposes of this rule.
Delivery Transactions The first excepted transaction is an agency transaction in government securities to effect delivery pursuant to a futures contract. Currently, three commodities exchanges actively trade contracts on government securities. 17 Futures commission merchants regularly make and take delivery of the securities underlying these contracts at expiration as agent for customers. In addition, futures commission merchants may purchase a government security as agent for a customer for the purpose of making delivery. These activities are integral to the operation of the futures markets. As noted above, the Division of Trading and Markets of the CFTC supported this exception and urged that the preliminary condition requiring segregation not be applicable to this type of transaction. Accordingly, the Commission has made that change and has otherwise adopted this part of the rule as proposed.
Risk Reduction and Arbitrage. The second type of agency transactions excepted by the rule are those for risk reduction or arbitrage of existing or contemporaneously created futures or options on futures positions. In the Proposing Release the Commission proposed to except transactions in government securities for bona fide hedging or arbitrage of futures or options on futures positions. Although the Commission did not define the terms bona fide hedging and arbitrage, the Commission stated that it believed.
these terms comprehend the purchase or sale of government securities to reduce the risk of a futures position or to take advantage of pricing disparities between the government securities and futures contracts for government securities. The Commission acknowledges that bona fide hedging and arbitrage transactions may involve government securities of a different type, maturity, or coupon than the government security that is the subject of the futures contract and that there may be residual basis risk in a hedging or arbitrage position. 18
The Commission solicited comment on whether a definition was needed.
Two commentaters believed that these terms should be expanded to include risk management strategies other than transactions merely intended to reduce the risk of futures or options on futures positions as suggested in the Proposing Release. 19 One commenter suggested that the Commission avoid a definition that would limit the activities of futures commission merchants or refrain from adopting a definition altogether in view of the CFTCs current review of its definition. Another commenter proposed an exception for agency transactions for risk reduction or arbitrage of futures or options on futures positions. One commenter recommended that the Commission clarify that, for purposes of the exception, these activities should relate to existing futures and options on futures positions and not to situations where the futures or options on futures are purchased to hedge an existing government securities position.
Consistent with these comments, the commission has not adopted a definition of bona fide hedging and arbitrage transactions. The rule as adopted provides an exception for transactions in government securities for the purpose of risk reduction 20 or arbitrage of existing or contemporaneously created futures or options on futures positions. 21 The rule would not permit taking of cash positions in anticipation of reducing the risk of futures or options on futures positions to be established in the future. The purposes of these limitations are to assure that transactions in government securities effected by a futures commission merchant on behalf of a customer in reliance upon this exception are directly related to a customers hedge or arbitrage of a futures or options on futures position and that such agency transactions are truly incidental to the futures commission merchants futures-related business.
Margin and Excess Customer Funds
The second section of the rule provides exceptions for investment of margin and excess customer funds. As proposed, Rule 3a43-1 excepted agency transactions for the purchase of government securities by a futures commission merchant for deposit as initial margin. As discussed in the Proposing Release, the Division of Trading and Markets of the CFTC submitted a comment letter suggesting that the scope of this exception was too narrow because it did not provide for the investment of other types of margin and excess customer funds on deposit for futures or options on futures trading (collectively "excess customer funds"). Accordingly, the Commission specifically requested comment on the need for such an exception. In particular, the Commission solicited comment on whether to use objective standards that could be formulated either in terms of the number of transactions, dollar amount of compensation received for effecting agency transactions in government securities, or percentage of firm revenues that are derived from effecting agency transactions in government securities, or in terms of the securities, issuers, maturities, or arrangements that are customarily utilized for these purposes.
Commenters including the CFTC uniformly objected to the limitation of the proposed exception to initial margin as too narrow. These comments were part of a general theme that deemed the rules as too restrictive in listing "incidental transactions". Commenters generally recommended that the Commission abandon the "list" approach and generally grant CFTC-regulated persons greater latitude in their government securities transactions. 22 The CFTC and others observed that transactions in securities for segregated customer accounts are already highly regulated by the CFTC and futures self-regulatory organizations and believed this regulation provides sufficient protection to the customer. The CFTC and other commenters noted that excess customer funds are invested as an accommodation to customers who desire to have their funds invested and to receive interest on those investments. 23 Several commenters including the CFTC believed that granting an exception for transactions only for initial margin would place sole futures commission merchants at a competitive disadvantage to futures commission merchants that are also registered broker-dealers. One commenter suggested that customer funds would be channeled possibly to less desirable investments such as commercial paper, certificates of deposit, and bankers acceptances. The CFTC and other commenters also observed that these services often are provided at cost.
Most commenters argued that the use of objective criteria such as those proposed was unnecessary, and hence they failed to supply any empirical data on the relevance of the criteria suggested by the Commission. Commenters generally agreed, however, that if a standard had to be imposed, they would recommend one based on a percentage of revenues. 24 Some commenters argued against a standard based on a dollar limit or on the number of agency transactions in the belief that such limitation could place futures commission merchants with a large customer base at a competitive disadvantage.
Several commenters observed that futures commission merchants purchase primarily Treasury bills for their customers for the investment of excess customer funds. One commenter suggested a standard that provided for investment of excess customer funds for a period of up to 91 days; another recommended a similar provision permitting investments in repurchase agreements and transactions in Treasury bills or other Treasury securities maturing within a short term from the date of the investment. Others suggested that a standard based on the short-term nature of the investment was an unreliable measure of whether a transaction was incidental.
Some commenters argued that no restrictions should be placed on the investment of excess customer funds if it was done at cost as an accommodation to that customer. These commenters suggested that firms generally did not seek to recover more than their costs in effecting government securities transactions for their customers.
The Commission continues to believe that an unlimited exception for the investment of excess customer funds may permit futures commission merchants to engage in a substantial government securities business that cannot fairly be categorized as merely "incidental" to its futures business. 25 In response to the comment letters, however, the Commission has added subparagraph (2) which provides futures commission merchants with greater flexibility to meet the various needs of their customers. Subparagraph (2) provides for agency transactions for the investment of margin and excess customer funds 26 in government securities under conditions designed to ensure that such trading is an accommodation to the futures commission merchants customers without permitting these accounts effectively to be converted into accounts primarily for the purpose of effecting government securities transactions. 27 Under this section, futures commission merchants may effect agency transactions in government securities provided that these transactions satisfy any one of the three alternatives discussed below.
The first alternative permits futures commission merchants to engage in unlimited agency transactions involving Treasury securities with a maturity of less than 93 days at the time of the transaction. 28 This condition permits purchases and sales of short-term Treasury securities such as Treasury bills. As noted above, several commenters indicated that futures commission merchants customarily invest excess customer funds in Treasury bills. This provision will permit a futures commission merchant to invest as agent excess customer funds temporarily in short-term Treasury securities pending consummation of futures and options transactions without registering as a government securities broker. As noted above, a futures commission merchant will be permitted to solicit these transactions and to advertise these services as available in connection with futures or options on futures accounts.
The second alternative is that the transactions generate no monetary profit for the futures commission merchant in excess of the cost of executing such transactions. This responds to comments of futures commission merchants that these transactions are truly accommodations to customers done at no profit. It permits a futures commission merchant to invest customer funds as agent as an accommodation to its customers provided that the fee charged the customer does not include a commission higher than the cost of executing the transaction. 29 Accordingly, the futures commission merchant may pass on to the customer the incremental cost of providing the service to the customer.
The third alternative under the rule is intended to provide futures commission merchants with a safe harbor for government securities transactions relating to excess customer funds based on a percentage of revenues and is primarily designed to permit futures commission merchants to accommodate the various needs of their customers. Because of its breadth, the alternative is available only for unsolicited transactions. 30 The alternative requires that gross income from executing government securities transactions under this alternative (including transactional fees passed through to the customer) cannot exceed 2% of the futures commission merchants total commission revenues. 31 Commenters generally agreed that if the Commission adopted a general limitation on government securities transactions then an appropriate standard would be one based on a percentage of revenues. 32 The Commission believes a standard of 2% of total commission revenues from unspecified incidental agency transactions for customers will enable futures commission merchants to continue to serve their futures customers related government securities needs but will prevent futures commission merchants from employing this exception to operate a substantial government securities business without registration.
The Commission expects that the futures commission merchant will retain in its records information to document compliance with the alternatives provided by this section. The courts and the Commission have consistently held that the person claiming an exemption under provisions of the federal securities laws has the burden of proving the exemption is available to it. 33 Accordingly, any CFTC-regulated person who relies on the rule has the burden of establishing that it has satisfied the conditions of the rule.
Exchange of Futures for Physicals Transactions
The third section of the rule provides an exception for exchange of futures for physicals transactions. This exception also is subject to the two preliminary requirements concerning segregation and advertising. 34 This section, containing the only exception for transactions as principal with customers in the Rule 3a43-1, has been adopted essentially as proposed. An exchange of futures for physicals transaction is a type of combination cash and futures transaction that is exempt from the Commodity Exchange Acts requirements for competitive execution on a futures exchange floor. CFTC rules, by reference to contract market rules, permit such off-exchange transactions. 35 Generally, these transactions involve one party who simultaneously buys a government security and sells a (or gives up a long) futures contract while the other party to the transaction simultaneously sells a government security and buys a (or receives a long) futures contract, at a price difference mutually agreed upon. Among other uses, these transactions permit the establishment, transfer, or close-out of hedged or arbitrage positions. 36 Because the futures commission merchant is often the counter-party to such a transaction, this type of transaction may be done as principal with a customer and as agent for a customer.
Exemptive Authority
One commenter proposed that the Commission provide that CFTC-regulated entities could apply to the Commission for determination that additional government securities activities are incidental futures-related business. Accordingly, the rule contains a fourth section that authorizes the Commission to exempt as incidental to futures-related business certain transactions of an individual or group of futures commission merchants. The Commission intends to continue to consult with the CFTC in determining what activities are incidental to a futures-related business for purposes of exemptions under the rules.
III. Principal Transactions
A. Preliminary Conditions
Rule 3a44-1 concerns principal activities that, but for the Commissions determination, might cause a person regulated by the CFTC to be considered a government securities dealer. Because Congress intended that the Commission except CFTC-regulated persons only where their government activities are closely related to their futures activities, the rule applies only to persons who do not hold themselves out or advertise as government securities dealers. 37 This rule does not apply to transactions with customers other than CFTC-regulated persons except for making or taking delivery of a government security pursuant to futures contract. The Commission is adopting Rule 3a44-1 essentially as proposed. As discussed below, however, the rule has been modified in some respects in response to issues raised by commenters.
B. Excepted Transactions
Delivery Transactions
The first excepted activity, consistent with proposed Rule 3a43-1(b)(1)(i), is the sale or purchase of government securities for delivery pursuant to a futures contract. As noted above, physical delivery pursuant to a futures contract is integral to the trading of government securities futures contracts, and hence clearly is incidental to the functioning of the futures market.
Exchange of Futures for Physicals Transactions
The second excepted activity is exchange of futures for physicals transactions between CFTC-regulated persons. This exception permits floor brokers, floor traders, and futures commission merchants to engage in such transactions with one another. 38 In response to suggestions of commenters, the rule has been amended to clarify that exchange of futures for physicals transactions as principal may be done with government securities brokers or dealers that have registered or provided notice pursuant to Section 15C(a) of the Exchange Act. Thus, for example, the rule permits a futures commission merchant to solicit as principal a trade directly with a CFTC-regulated person or a government securities broker or government securities dealer that has registered with the Commission or filed notice pursuant to Section 15C(a) of the Exchange Act in order to permit a combination cash and futures position taken in a customer initiated principal transaction to be offset with a professional transaction.
Transactions in Segregated Funds
The third excepted activity is transactions, including transactions involving repurchase agreements and reverse repurchase agreements, by futures commission merchants for investment of customer segregation funds or by a clearing organization for investment of funds it holds. These transactions are excepted if they are done with a bank 39 or with a government securities broker or government securities dealer that has registered or filed notice with its appropriate regulatory agency. The exception specifically permits transactions with banks as well as with those who will be subject to the Government Securities Act regulations because current CFTC interpretations on the investment of customer funds require some of such investments to be with banks, 40 and the Treasury Department has exempted certain banks from the requirement to file notice as a government securities dealer. 41
Commenters asserted that the paragraph should be expanded to include futures commission merchants as acceptable counterparties. The Commission has declined to include futures commission merchants within the scope of this exception. As a practical matter, the efficient investment of customer segregated funds requires the services of a person whose business it is to buy and sell government securities rather than a person whose sales and purchases are based on its own cash management and futures trading strategies. Where a futures commission merchant stands ready regularly to engage in government securities transactions for the investment of customer segregated funds of other futures commission merchants, it is engaged in a government securities business and accordingly should be registered as a government securities broker or government securities dealer.
Risk Reduction and Arbitrage Transactions
The fourth exception has been revised to refer to risk reduction and arbitrage transactions consistent with and for the reasons set forth above with respect to Rule 3a43-1(b)(1)(iii). Commenters also believed that futures commission merchants should be included as counterparties under the rule because risk reduction and arbitrage transactions would be incidental to both parties futures business. The rule has been modified accordingly and allows these transactions to be with a CFTC-regulated person as well as a government securities broker or government securities dealer who has registered or filed notice with its appropriate regulatory agency.
Certain Repurchase Transactions
The rule contains a fifth exception that provides for repurchase and reverse repurchase agreement transactions between a futures commission merchant acting in a proprietary capacity and another CFTC-regulated person acting in a proprietary capacity with contemporaneous offsetting transactions by the futures commission merchant with certain other regulated entities. This exception was added at the suggestion of a commenter. It permits a futures commission merchant to act as principal in matched book repurchase transactions for investment of excess funds of floor broker and floor trader customers through repurchase and reverse repurchase transactions with regulated government securities dealers, banks, or other CFTC-regulated persons on the other side. 42 The requirement that the futures commission merchant be acting in a proprietary capacity assures that segregated customer funds and clearing funds cannot be used in these transactions except by CFTC-regulated entity customers as to whom those funds are proprietary.
Cash Management
Commenters suggested that the rule be amended to make clear that a futures commission merchants investment of its own capital in government securities for cash management and other trading purposes should be permitted. These commenters observed that this activity was cited by Congress as the type of activity that should be excepted from government securities regulation. These commenters requested the rule be clarified to permit explicitly this type of activity. Others suggested that the adopting release make it clear that the limitations in the rule are inapplicable to those who are not "regularly engaged in the business."
The legislative history to the Government Securities Act suggests that whether a firms activities bring it within the definition of a government securities dealer is to be largely determined based on traditional interpretations of the definitions of dealer. The definition of dealer excludes any person who buys and sells securities for his own account but not as part of a regular business. 43 As the legislative history suggests, commodities professionals, as an incidental part of their futures business, may buy and sell government securities for cash management purposes. These transactions generally would not bring such professionals within the definition of government securities dealer because they would not be considered to be "engaged in the business". Accordingly, the Commission does not believe any explicit exemption is necessary for incidental cash management investment activities.
Exemptions
At the suggestions of one commenter, the rule contains a new section that provides the Commission with general authority to exempt other transactions by CFTC-regulated persons that it finds to be incidental to their futures-related business either upon its own motion or upon request. This section parallels the exemptive authority in Rule 3a43-1.
IV. Commodity Pool Operators and Commodity Pools
Although commodity pool operators are excepted from the definition of government securities dealer under Rule 3a44-1, the Commission did not propose to except commodity pool operators from the definition of government securities brokers because the Commission understands that commodity pool operators are not separately compensated for effecting transactions for the commodity pools they operate. Therefore, the Commission believes generally that their activities would not come within the traditional interpretation of the term broker. 44 In addition, commodity pool operators, generally, do not directly hold funds and securities or effect transactions with persons who are not government securities brokers or government securities dealers.
One commenter observed, however, that it was unclear whether commodity pool operators "generate income from commissions on government securities transactions effected on behalf of the pools they manage." The commenter believed, that "to the extent that government securities transactions engaged in by commodity pool operators would bring them within the definition of broker, a similar exclusion from the definition of government securities broker is appropriate."
Receipt of transaction-related compensation is one of the key factors that distinguishes a broker from an investment adviser. Absent data suggesting that this form of compensation is customary in the futures industry, the Commission believes that this would be a key factor in distinguishing commodity pool operators who are also government securities brokers from those whose activities are incidental to their futures-related business. Accordingly, the Commission has not adopted the commenters suggestion.
One commenter also suggested that the Commission staff exercise its no-action or interpretive authority to make it clear that commodity pools themselves that actively trade government securities are not required to register as government securities dealers. That commenter suggested that all government securities transactions are executed through regulated government securities broker-dealers or financial institutions. The Commission believes that a separate exception for commodity pools is unnecessary because the activities described above generally do not fall within the traditional interpretation of the definition of dealer. 45
V. Competition Findings, Effective Date, and Statutory Basis
Section 23(a)(2) of the Exchange Act requires the Commission, in adopting rules under that Act, to consider the anticompetitive effect of such rules, if any, and to balance this effect against the regulatory benefits gained in terms of furthering the purposes of the Exchange Act. The Commission has considered proposed Rules 3a43-1 and 3a44-1 and believes that adopting the rules will not impose any burden on competition not necessary or appropriate in furtherance of the Exchange Act. Indeed the Commission believes that by defining a variety of government securities transactions as incidental to a futures-related business, the rules relieve potentially burden-some registration and regulatory requirements for certain CFTC-regulated persons. At the same time, the rules provide for a fair playing field by assuring that CFTC-regulated persons who are competing directly with government securities and government securities dealers must register.
Section 553(d) of the Administrative Procedure Act, 5 U.S.C. 553(d) provides that the "required publication or service of a substantive rule shall be made not less than 30 days before its effective date except... a substantive rule which grants or recognizes an exemption or relieves a restriction... or... as otherwise provided by the agency for good cause found and published with the rule." Because Rules 3a43-1 and 3a44-1 except certain CFTC regulated-persons from the definitions of government securities brokers and government securities dealers, they have the effect of removing restrictions in that they relieve such persons from the requirements of registration and regulation under the Exchange Act that would otherwise be imposed by the operation of the Government Securities Act.
The Government Securities Act directs that by July 25, 1987, the Commission shall provide final regulations as are initially required to implement the Government Securities Act. Futures commission merchants that are government securities brokers or dealers are currently operating under a temporary exemption from registration and other requirements that expires October 31, 1987. The Commission believes good cause exists for the rules to become effective July 25, 1987, so that futures commission merchants and other CFTC-regulated persons can determine whether they must register by October 31, 1987. Accordingly, Rules 3a43-1 and 3a44-1 will become effective as final rules on July 25, 1987.
VI. Regulatory Flexibility Act Considerations
The Commission has prepared an Initial Regulatory Flexibility Analysis ("IRFA") and a Final Regulatory Flexibility Analysis ("Analysis") in accordance with 5 U.S.C. 603 and 604 respectively regarding proposed Rules 3a43-1 and 3a44-1. No comments were received on the Commission IRFA although several commenters raised issues involving considerations addressed by the Regulatory Flexibility Act.
The intent of and the possible costs and benefits of each rule proposal is also discussed in the Analysis. The Analysis notes that the objective of the rules is to implement the provisions of the Government Securities Act. The rules except from the definition of government securities broker and government securities dealer certain persons subject to CFTC oversight by defining as incidental to their futures-related business certain activities in government securities. Therefore, the rules reduce cost burdens on small futures commission merchants and other small CFTC-regulated entities. A copy of the Final Regulatory Flexibility Analysis may be obtained by contacting Lynne G. Masters, Esq., Division of Market Regulation, Securities and Exchange Commission, Washington, D.C. 20549, (202) 272-2848.
VII. Statutory Authority
Pursuant to the Securities Exchange Act of 1934 and particularly Sections 3 and 23 thereof, 15 U.S.C. 78c and 78w, the Commission adopts §§ 240.3a43-1 and 3a44-1 of Title 17 of the Code of Federal Regulations, in the manner set forth below.
VIII. List of Subjects in 17 C.F.R. Part and 240
Reporting and recordkeeping requirements, securities, government securities, futures commission merchant, customer funds.
IX. Text of Amendments
In accordance with the foregoing, 17 C.F.R. §240 is amended as follows:
PART 240--GENERAL RULES AND REGULATIONS SECURITIES EXCHANGE ACT OF 1934
1. The authority citation for Part 240 is amended by adding the following citations:
Authority: Sec. 23; 48 Stat. 901, as amended; 15 U.S.C. 78w;
* * *
Sections 240.3a43-1 and 240.3a44-1 also issued under Sec. 3; 15 U.S.C. 78c;
2. By adding §240.3a43-1 and §240.3a44-1 as follows:
§240.3a43-1. Customer-related government securities activities incidental to the futures-related business of a futures commission merchant registered with the Commodity Futures Trading Commission.
(a) A futures commission merchant registered with the Commodity Futures Trading Commission ("CFTC") is not a government securities broker or government securities dealer solely because such futures commission merchant effects transactions in government securities that are defined in paragraph (b) as incidental to such persons futures-related business.
(b) Provided that the futures commission merchant (i) maintains in a regulated account all funds and securities associated with such government securities transactions (except funds and securities associated with transactions under paragraph (b)(1)(i) below) and (ii) does not advertise that it is in the business of effecting transactions in government securities otherwise than in connection with futures or options on futures trading or the investment of margin or excess funds related to such trading or the trading of any other instrument subject to CFTC jurisdiction, the following transactions in government securities are incidental to the futures-related business of such a futures commission merchant:
(1) Transactions as agent for a customer--
(i) to effect delivery pursuant to a futures contract; or
(ii) for risk reduction or arbitrage of existing or contemporaneously created positions in futures or options on futures;
(2) Transactions as agent for a customer for investment of margin and excess funds related to futures or options on futures trading or the trading of other instruments subject to CFTC jurisdiction, provided further that,
(i) such transactions involve Treasury securities with a maturity of less than 93 days at the time of the transaction,
(ii) such transactions generate no monetary profit for the futures commission merchant in excess of the costs of executing such transactions, or
(iii) such transactions are unsolicited, and commissions and other income generated on transactions pursuant to this subparagraph (iii) (including transactional fees paid by the futures commission merchant and charged to its customer) do not exceed 2% of such futures commission merchants total commission revenues;
(3) Exchange of futures for physicals transactions as agent for or as principal with a customer; and
(4) Any transaction or transactions that the Commission exempts, either unconditionally or on specified terms and conditions, as incidental to the futures-related business of a specified futures commission merchant, a specified category of futures commission merchants, or futures commission merchants generally.
(c) Definitions.
(1) "Customer" means any person for whom the futures commission merchant effects or intends to effect transactions in futures, options on futures, or any other instruments subject to CFTC jurisdiction.
(2) "Regulated account" means a customer segregation account subject to the regulations of the CFTC; provided, however, that, where such regulations do not permit to be maintained in such an account or require to be maintained in a separate regulated account funds or securities in proprietary accounts or funds or securities used as margin for or excess funds related to futures contracts, options on futures or any other instruments subject to CFTC jurisdiction that trade outside the United States, its territories, or possessions, the term "regulated account" means such separate regulated account or any other account subject to recordkeeping regulations of the CFTC.
(3) "Unsolicited transaction" means a transaction that is not effected in a discretionary account or recommended to a customer by the futures commission merchant, an associated person of a futures commission merchant, a business affiliate that is controlled by, controlling, or under common control with the futures commission merchant, or an introducing broker that is guaranteed by the futures commission merchant.
(4) "Futures" and "futures contracts" mean contracts of sale of a commodity for future delivery traded on or subject to the rules of a contract market designated by the CFTC or traded on or subject to the rules of any board of trade located outside the United States, its territories, or possessions.
(5) "Options on futures" means puts or calls on a futures contract traded on or subject to the rules of a contract market designated by the CFTC or traded or subject to the rules of any board of trade located outside the United States, its territories, or possessions.
§240.3a44-1. Proprietary government securities transactions incidental to the futures-related business of a CFTC-regulated person.
(a) A person registered with the Commodity Futures Trading Commission ("CFTC"), a contract market designated by the CFTC, such a contract markets affiliated clearing organization, or any floor trader on such a contract market (hereinafter referred to collectively as a "CFTC-regulated person") is not a government securities dealer solely because such person effects transactions for its own account in government securities that are defined in paragraph (b) as incidental to such persons futures-related business.
(b) Provided that a CFTC-regulated person does not advertise or otherwise hold itself out as a government securities dealer except as permitted under rule 3a43-1 (§240.3a43-1) the following transactions in government securities for its own account are incidental to the futures-related business of such a CFTC-regulated person:
(1) Transactions to effect delivery of a government security pursuant to a futures contract;
(2) Exchange of futures for physicals transactions with (i) a government securities broker or government securities dealer that has registered with the Commission or filed notice pursuant to Section 15C(a) of the Act or (ii) a CFTC-regulated person;
(3) Transactions (including repurchase agreements and reverse repurchase agreements) involving segregated customer funds and securities or funds and securities held by a clearing organization with (i) a government securities broker or government securities dealer that has registered with the Commission or filed notice pursuant to Section 15C(a) of the Act or (ii) a bank;
(4) Transactions for risk reduction or arbitrage of existing or contemporaneously created positions in futures or options on futures with (i) a government securities broker or government securities dealer that has registered with the Commission or filed notice pursuant to Section 15C(a) of the Act or (ii) a CFTC-regulated person;
(5) Repurchase and reverse repurchase agreement transactions between a futures commission merchant acting in a proprietary capacity and another CFTC-regulated person acting in a proprietary capacity and contemporaneous offsetting transactions between such a futures commission merchant and (i) a government securities broker or government securities dealer that has registered with the Commission or filed notice pursuant to Section 15C(a) of the Act, (ii) a bank, or (iii) a CFTC-regulated person acting in a proprietary capacity; and
(6) Any transaction or transactions that the Commission exempts, either unconditionally or on specified terms and conditions, as incidental to the futures related business of a specified CFTC-regulated person, a specified category of CFTC-regulated persons, or CFTC-regulated persons generally.
(c) Definitions.
(1) "Segregated customer funds" means funds subject to CFTC segregation requirements.
(2) "Futures" and "futures contracts" means contracts of sale of a commodity for future delivery traded on or subject to the rules of a contract market designated by the CFTC or traded on or subject to the rules of any board of trade located outside the United States, its territories, or possessions.
(3) "Options on futures" means puts or calls on a futures contract traded on or subject to the rules of a contract market designated by the CFTC or traded on or subject to the rules of any board of trade located outside the United States, its territories, or possessions.
By the Commission.
1Section 15C(b)(1) of the Government Securities Act explicitly requires the Secretary of the Treasury to adopt regulations related to the transfer and control of securities in repurchase transactions.
2New section 3(a)(43) of the Exchange Act defines a government securities broker as:
any person regularly engaged in the business of effecting transactions in government securities for the account of others, but does not include--
(A) any corporation the securities of which are government securities under subparagraph (B) or (C) of paragraph (42) of this subsection; or
(B) any person registered with the Commodity Futures Trading Commission, any contract market designated by the Commodity Futures Trading Commission, such contract markets affiliated clearing organization, or any floor trader on such contract market, solely because such person effects transactions in government securities that the Commission, after consultation with the Commodity Futures Trading Commission, has determined by rule or order to be incidental to such persons futures-related business.
3New section 3(a)(44) of the Exchange Act defines a government securities dealer as:
any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise, but does not include--
(A) any person insofar as he buys or sells such securities for his own account, either individually or in some fiduciary capacity, but not as a part of a regular business;
(B) any corporation the securities of which are government securities under subparagraph (B) or (C) of paragraph (42) of this subsection;
(C) any bank, unless the bank is engaged in the business of buying and selling government securities for its own account other than in a fiduciary capacity, through a broker or otherwise; or
(D) any person registered with the Commodity Futures Trading Commission, any contract market designated by the Commodity Futures Trading Commission, such contract markets affiliated clearing organization, or any floor trader on such contract market, solely because such person effects transactions in government securities that the Commission, after consultation with the Commodity Futures Trading Commission, has determined by rule or order to be incidental to such persons futures-related business.
4The CFTC Division of Trading and Markets has advised the Commissions staff that many commodities clearing corporations are not legally controlling, controlled by, or under common control with designated contract markets ("exchanges"). Nevertheless, in this context, the Commission interprets the term "affiliated clearing organization" to include those clearing organizations that have a contractual or customary arrangement to clear futures contracts traded on a particular futures exchange.
5The CFTC Division of Trading and Markets reviewed and submitted preliminary comments on each of the proposed exceptions. Letter from Kevin M. Foley, Chief Counsel, Division of Trading and Markets, CFTC, to Richard G. Ketchum, Director, Division of Market Regulation, SEC, dated February 18, 1987.
6The letters of comment and Commission staff summary thereof are available for public inspection and copying at the Commissions Public Reference Room. See File No. S7-5-87.
7Letter from Jean A. Webb, Secretary, CFTC, to Jonathan G. Katz, Secretary, SEC, dated April 3, 1987; see infra text following notes 15 and 22; letter from Andrea M. Corcoran, Director, Division of Trading and Markets, CFTC, to Richard G. Ketchum, Director, Division of Market Regulation, SEC, dated May 20, 1987; see infra text and accompanying note 10; letter from Andrea M. Corcoran, Director, Division of Trading and Markets, CFTC, to Richard G. Ketchum, dated June 30, 1987 (recommending technical changes to the rules).
8Report of the Senate Committee on Banking, Housing and Urban Affairs to accompany S. 1416, S. Rep. No. 426, 99th Cong. 2d. Sess. 19 (1986) hereinafter cited as Senate Report.
9CFTC rules do not currently permit such funds to be placed in a customer segregation account. In addition, the definitions of futures and options on futures contracts in the proposed rules referred to contracts traded on a contract market designated by the CFTC, i.e., a U.S. futures exchange.
10The CFTC uses the term "dealer options" to distinguish a class of options on physicals authorized to be traded off-exchange from those traded on or subject to the rules of a contract market.
11In particular, options on physicals are included in the phrase "other instruments subject to CFTC jurisdiction."
12Subject to certain limited exceptions, the domestic offer and sale of foreign options on futures and foreign options on physicals are currently prohibited.
13This change addresses the dealer options problem raised by the commenters by deleting the reference to specific CFTC segregation requirements.
14The Commission has not adopted the suggestion of some commenters that segregation not be required if it is not required by the CFTC. Where CFTC rules permit segregation, segregation is required unless there is a separate regulated account.
15As discussed below, the prohibition on solicitation has been retained for certain transactions relating to the investment of customer margin and excess funds. See infra text at n. 30.
1652 FR 19646 (May 26, 1987).
17The Chicago Board of Trade ("CBT") trades Treasury bond futures and options on those futures, Treasury note futures and options on those futures, and GNMA futures; the Chicago Mercantile Exchange ("Merc") trades Treasury bill futures and options on those futures; the Mid-America Commodity Exchange also trades Treasury bill futures and Treasury bond futures, but the size of the contracts is one-half the size of the contracts traded on the CBT and the Merc respectively.
18Proposing Release at n. 13.
19The Commission has declined to adopt this recommendation because such an essentially unbounded provision would undermine the purpose of the exception and would be inconsistent with its interpretation of those terms as stated in the Proposing Release.
20The Commission notes that it will interpret the term "risk reduction transactions" independently from the CFTC definition of "bona fide hedging."
21Under this standard, positions resulting from market orders entered simultaneously would be considered contemporaneously created even if market conditions resulted in the cash market order being executed prior to the related futures or option on futures order.
22Several commenters argued that all government securities transactions routinely affected by CFTC-regulated persons whose primary business is in the futures industry are incidental to such futures business. Two commenters argued that additional regulation of futures commission merchants and other CFTC-regulated persons is warranted only when their primary business ceases to be futures-related or when their government securities activities deviate from the normal and legitimate business practices in the futures industry. The Commission, they suggested, should make that determination after consultation with the CFTC on a case-by-case basis.
23Commenters indicated that these types of transactions are traditionally done on an agency basis, although one commenter who focused on this provision specifically suggested that futures commission merchants be permitted to engage in sales from inventory for initial margin purposes.
24One comment letter suggested establishing a standard of incidental transactions based on revenue derived from any government securities activities that amounted to a percentage of total revenue. Another recommended that the Commission adopt a safe harbor provision to each rule providing that in addition to the types of transactions specified in the rules, a CFTC-regulated person could engage in a limited amount of government securities transactions as long as the revenues derived from the additional transactions compose only a small part (ten percent) of the CFTC-regulated persons total revenue. Other commenters suggested that the limitations on advertising and solicitation would eliminate the potential for abuse that might occur with the investment of excess customer funds.
25The suggestions by some commenters that no firm would accept the pervasive regulation under the Commodity Exchange Act in order to avoid registration as a government securities broker misses the point. The Commissions concern is that an existing futures commission merchant would engage in a substantial government securities business over and above its existing futures business.
26This provision applies to margin and excess funds on any investment subject to CFTC jurisdiction, such as options on physicals as well as futures and options on futures.
27Because this rule is intended to permit agency transactions, no provision has been made for a futures commission merchant to sell government securities to its customers from its own inventory or to engage in repurchase transactions directly with its customers; see supra n. 16.
28Once a year Treasury issues a security that has a maturity of 92 days.
29The Commission believes that cost recovery for brokerage execution services should be measured by the incremental costs directly attributable to providing that service.
30As defined in the rule, "unsolicited transaction" means a transaction that is not recommended to a customer or effected in a discretionary account by the futures commission merchant, an associated person of the futures commission merchant, a business affiliate that is controlled by, controlling, or under common control with the futures commission merchant, or an introducing broker that is guaranteed by the futures commission merchant. As discussed in the Proposing Release, futures commission merchants could generally acquaint customers of their willingness to invest excess customer funds in government securities without any resulting transactions being deemed solicited. Proposing Release at note 9.
31Income received in connection with transactions in Treasury securities under subparagraph (b)(2)(i) or in connection with transactions that generate no monetary profit under subparagraph (b)(2)(ii) of the rule would be excluded from the 2% ceiling.
32Suggestions for an appropriate standard without the unlimited exception for revenues from short-term securities or futures commission merchant costs ranged from .05% to 10%. The only quantitative information, however, was submitted by Mocatta which indicated that revenues from agency transactions in government securities accounted for less than .05% of its total revenues. See Letter from Gary Alan DeWaal, General Counsel, Mocatta Futures Corporation, to Jonathan G. Katz, Secretary, SEC, dated March 27, 1987.
33See e.g., SEC v. Netelkos, 592 F. Supp. 906 (S.D.N.Y. 1984).
34See supra text at notes 8 through 15.
3517 C.F.R. §1.38. Chicago Mercantile Exchange Rule 538, Chicago Board of Trade Rule 444.01(c).
36A futures commission merchant that engages in a series of transactions with a customer that are structured to result in a purchase or sale of a government security without the establishment, transfer, or close-out of a related futures position would not be eligible for this exception from the definitions of government securities broker and government securities dealer.
37A futures commission merchant that runs a matched repurchase agreement book in accordance with the provisions of subparagraph (b)(5) would not be deemed holding itself out as a government securities dealer for purposes of the rule.
38A futures commission merchants transactions with customers as agent or principal are also excepted under rule 3a43-1(b)(2).
39The term "bank" is defined in section 3(a)(6) of the Exchange Act.
40See e.g., Financial and Segregation Interpretation No. 2--Use of Customers Funds for the Purchase of Obligations Under Repurchase Agreements, 7112 CCH Commodity Futures Law Reports (1975).
4117 C.F.R. §401.4, 52 FR 1986 (May 26, 1987).
42The requirement that transactions with banks and government securities brokers and government securities dealers be contemporaneously offsetting transactions contemplates repurchase transactions on the same day in securities of the same type, coupon, and maturity as are the subject of the transaction with the CFTC-regulated entity. The repurchase obligation in such transactions would be for the same or shorter period as the transaction with the CFTC-regulated person.
43See, e.g. letter from Robert L. D. Colby, Chief Counsel, Division of Market Regulation, SEC, to Elizabeth J. Tolmach, Esq., Caplan & Drysdale, dated April 2, 1987 (publicly available April 2, 1987); letter from Susan J. Walters, Branch Chief, Division of Market Regulation, SEC to Martin E. Lybecker, Esq., Drinker Biddle & Reath, dated June 26, 1986 (publicly available July 26, 1986).
44See L. Loss, Securities Regulation, Vol. II, at 1299 (2d. ed. 1961).
45See supra letters cited note 43.
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