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Final Rule: Customer Margin Rules Relating to Security FuturesCOMMODITY FUTURES TRADING COMMISSION17 CFR Part 41RIN 3038-AB71SECURITIES AND EXCHANGE COMMISSION17 CFR Part 242[Release No. 34-46292; File No. S7-16-01]RIN 3235-AI22Customer Margin Rules Relating to Security FuturesAGENCIES: Commodity Futures Trading Commission and Securities and Exchange Commission. ACTION: Joint final rules. SUMMARY: The Commodity Futures Trading Commission ("CFTC") and the Securities and Exchange Commission ("SEC") (collectively, "Commissions") are adopting rules to establish margin requirements for security futures. The final rules preserve the financial integrity of markets trading security futures, prevent systemic risk, and require that the margin requirements for security futures be consistent with the margin requirements for comparable exchange-traded option contracts. EFFECTIVE DATE: September 13, 2002 FOR FURTHER INFORMATION CONTACT: CFTC: Phyllis P. Dietz, Special Counsel; or Michael A. Piracci, Attorney, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW, Washington, DC 20581. Telephone: (202) 418-5000. E-mail: (PDietz@cftc.gov); or (MPiracci@cftc.gov). SEC: Onnig Dombalagian, Attorney Fellow, at (202) 942-0737; Theodore R. Lazo, Senior Special Counsel, at (202) 942-0745; Hong-anh Tran, Special Counsel, at (202) 942-0088; and Lisa Jones, Attorney, at (202) 942-0063, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-1001. SUPPLEMENTARY INFORMATION: The CFTC is adopting Rules 41.42 through 41.49, 17 CFR 41.42 through 41.49, and the SEC is adopting Rules 400 through 406, 17 CFR 242.400 through 242.406, (the "Final Rules") under authority delegated by the Federal Reserve Board pursuant to the Securities Exchange Act of 1934 ("Exchange Act"). C. Overview of the Comment Letters D. Overview of the Final Rules II. DISCUSSION OF THE FINAL RULES A. Who is Covered by the Final Rules 2. Financial Relations between a Security Futures Intermediary and a Foreign Person 3. Margin Requirements Imposed by Clearing Agencies or Derivatives Clearing Organizations a. Financial Relations with an Exempted Person C. Interpretation of, and Exemptions from, the Final Rules E. Application of Regulation T to Security Futures F. Account Administration Rules 1. Separation and Consolidation of Accounts 3. Contribution to a Joint Venture G. Customer Margin Levels for Security Futures 1. Definition of Current Market Value 2. Margin Levels for Unhedged Positions 5. Procedures for Certain Margin Level Adjustments H. Satisfaction of Required Margin 1. Type, Form and Use of Collateral a. Acceptable Collateral Deposits b. Use of Money Market Mutual Funds 3. Satisfaction of Required Margin for Positions Other than Security Futures I. When Margin May Be Withdrawn 1. Withdrawal of Margin by the Customer 2. Withdrawal of Margin by the Security Futures Intermediary J. Consequences of Failure to Collect Required Margin K. CFTC Procedures for Notification of Proposed Rule Changes Related to Margin IV. COSTS AND BENEFITS OF THE FINAL RULES a. Compliance with Regulation T a. Benefits to Security Futures Intermediaries V. CONSIDERATION OF BURDEN ON COMPETITION, PROMOTION OF EFFICIENCY, AND CAPITAL FORMATION VI. REGULATORY FLEXIBILITY ACT TEXT OF RULESI. BACKGROUNDA. Statutory ProvisionsThe Commodity Futures Modernization Act of 2000 ("CFMA"),1 which became law on December 21, 2000, lifted the ban on single stock and narrow-based stock index futures ("security futures"). In addition, the CFMA established a framework for the joint regulation of security futures by the CFTC and the SEC. As part of the statutory scheme for the regulation of security futures, the CFMA provided for the issuance of rules governing customer margin for transactions in security futures. Specifically, the CFMA added a new subsection (2) to Section 7(c) of the Exchange Act,2 which directs the Board of Governors of the Federal Reserve System ("Federal Reserve Board") to prescribe rules establishing initial and maintenance customer margin requirements imposed by brokers, dealers, and members of national securities exchanges for security futures products. In addition, Section 7(c)(2)(B) provides that the Federal Reserve Board may delegate this rulemaking authority jointly to the Commissions. On March 6, 2001, the Federal Reserve Board delegated its authority under Section 7(c)(2)(B) to the Commissions.3 Pursuant to that authority, the SEC and the CFTC have adopted customer margin requirements for security futures.4 Section 7(c)(2) provides that the customer margin requirements for security futures must satisfy four requirements. First, they must preserve the financial integrity of markets trading security futures products. Second, they must prevent systemic risk. Third, they must (a) be consistent with the margin requirements for comparable option contracts traded on any exchange registered pursuant to Section 6(a) of the Exchange Act; and (b) provide for initial and maintenance margin levels that are not lower than the lowest level of margin, exclusive of premium, required for comparable exchange-traded options. Fourth, they must be and remain consistent with the margin requirements established by the Federal Reserve Board under Regulation T.5 B. Proposed RulesOn September 26, 2001, the CFTC and the SEC issued for public comment proposed rules (the "Proposed Rules") relating to customer margin requirements for security futures.6 In response to a joint request from the Futures Industry Association ("FIA") and the Securities Industry Association ("SIA") for an extension of the public comment period, the Commissions granted a 30-day extension until December 5, 2001.7 C. Overview of the Comment LettersThe Commissions received a total of 19 comment letters from securities and futures industry associations,8 exchanges,9 a clearing organization,10 financial services firms,11 systems vendors,12 a member of the academic community,13 and two members of the public.14 In general, the comment letters focused on three major issues raised by the Proposed Rules: the applicability of Regulation T and the desirability of an account-specific margin regime; the appropriateness of the proposed 20% margin level; and the permissibility of portfolio margining. The majority of commenters expressed the view that Regulation T should not be applied to futures accounts. They stated their concern that application of Regulation T to security futures carried in futures accounts would impose heavy costs on carrying firms in the form of reprogramming of systems and training of staff. Some believed that it would discourage futures commission merchants ("FCMs") from trading security futures. One commenter, however, supported the application of Regulation T to security futures, regardless of the type of account in which they are carried. Several commenters identified specific provisions of Regulation T that would have to be addressed in order to accommodate carrying security futures in a securities account, e.g., rules for variation margin payments. Ten of the commenters specifically endorsed the concept that the margin rules should build on the existing regulatory infrastructure and that, to the extent possible, the rules applicable to security futures should be determined by the type of account in which the security futures are carried. Under this "account-specific" approach, for example, rules relating to acceptable collateral, collateral haircuts, timing for collection of margin, and calculations of current market value would be determined in accordance with the rules otherwise applicable to a securities account or futures account, respectively. Several commenters observed that this would be consistent with the Commissions' proposed customer funds rules15 and would be the most prudent and cost effective approach. Most commenters found the proposed 20% minimum margin level to be acceptable, although some thought the minimum should instead be 25%. The SIA/FIA Letter noted that "members of the Associations are divided" as to whether the minimum level of initial and maintenance margin should be 20% or 25%. Another commenter expressed the view that the 20% level could be either too high or too low depending on the circumstances, and that for certain positions 50% initial margin would be appropriate. Eleven commenters supported the implementation of full portfolio margining for security futures, as soon as possible. Two other commenters emphasized the need for experience with a proposed pilot program.16 One commenter supported portfolio margining only for sophisticated customers, with another commenter joining in the view that portfolio margining might not be appropriate for all customers. After carefully considering the public comments, the Commissions have adopted Final Rules that reflect modifications to the Proposed Rules in response to the views and concerns expressed by the commenters. The Commissions believe that the Final Rules fulfill the statutory requirements and that the changes made to the Proposed Rules will more effectively promote market efficiency and liquidity. D. Overview of the Final RulesThe Commissions have carefully considered the commenters' views, and have modified the Proposed Rules in various respects. The Final Rules, among other things:
II. DISCUSSION OF THE FINAL RULESA. Who is Covered by the Final RulesThe Commissions are adopting the Final Rules under the authority delegated to them by the Federal Reserve Board under Section 7(c)(2) of the Exchange Act, which applies to brokers, dealers, and members of national securities exchanges extending credit to or for customers, or collecting margin from customers, in connection with security futures. In the Proposed Rules, the Commissions used the term "creditor," as defined in Regulation T, to delineate those persons who would be subject to the margin rules.17 Because FCMs that effect transactions in security future products are broker-dealers,18 they were included in the definition of "creditor" under the Proposed Rules. To avoid characterizing the collection of margin for a security futures contract as involving an extension of credit, the Final Rules use the term "security futures intermediary" instead of the term "creditor." 19 The term "security futures intermediary" is intended to include the same persons as are included in the Regulation T definition of "creditor," but solely with respect to their financial relations involving security futures. SEC Rule 401(a)(29) defines security futures intermediary by reference to the term creditor. For the sole purpose of clarifying the scope of the Final Rules for market participants that are not subject to Regulation T, the definition of security futures intermediary in CFTC Rule 41.43(a)(29) specifies that the term includes FCMs and enumerated affiliated persons.20 The Commissions believe that the term security futures intermediary is defined identically for all substantive purposes, and emphasize that the difference in the language used in the two rules to define a security futures intermediary is not intended to mean that the scope of the two rules is different. In addition, the term "customer" is defined under the Final Rules as any person or persons acting jointly on whose behalf a security futures intermediary effects a security futures transaction or carries a security futures position, or who would be considered a customer of the security futures intermediary according to the ordinary usage of the trade.21 The definition of customer further includes (i) any partner in a security futures intermediary that is organized as a partnership who would be considered a customer of the security futures intermediary absent the partnership relationship, and (ii) any joint venture in which a security futures intermediary participates and which would be considered a customer of the security futures intermediary if the security futures intermediary were not a participant.22 This definition is derived from the Regulation T definition of customer.23 B. Exclusions from CoverageThe Final Rules include specific exclusions for certain categories of financial relations, substantially as proposed. The exclusions are described below. 1. Financial Relations between a Customer and a Security Futures Intermediary under a Portfolio Margining SystemThe Proposed Rules provided an exclusion for margin calculated by a portfolio margining system that has been approved by the SEC and, as applicable, the CFTC.24 The Commissions are adopting this exclusion substantially as proposed.25 The Final Rules add a provision requiring that the portfolio margining system meet the criteria set forth in Section 7(c)(2)(B) of the Exchange Act.26 This addition is intended to clarify that the portfolio margining system must be consistent with a risk-based system used for comparable exchange-traded options. This requirement does not preclude the use of an existing portfolio margining system that interfaces with an FCM's bookkeeping system, so long as the portfolio margining system is modified to produce results that comply with the Final Rules.27 Portfolio margining establishes margin levels by assessing the market risk of a "portfolio" of positions in securities or commodities. Under a portfolio margining system, the amount of required margin is determined by analyzing the risk of each component position in a customer account (e.g., a class of option with the same expiration date) and by recognizing any risk offsets in an overall portfolio of positions (e.g., across options and futures on the same underlying instrument). So that adequate margin is deposited to cover extraordinary market events, one or more additional adjustments may be applied in calculating a customer's required margin. A portfolio margining system may also be used in conjunction with a risk-based margining system, which assesses margin based on the historical performance of individual instruments, rather than as a fixed percentage of current market value. Depending upon the risks attributable to one or more positions, the amount of required margin in a portfolio margining system may be greater than or less than the margin levels currently required for securities positions in a fixed-percentage, strategy-based margining system. The Commissions received 14 comment letters that addressed the issue of portfolio margining, all of which supported the concept of portfolio margining for security futures. 28 Ten of the commenters strongly supported the implementation of full portfolio margining for security futures as soon as possible.29 Five commenters observed that portfolio margining recognizes the market risk associated with a specific position more accurately than a fixed-percentage margin scheme.30 One commenter criticized the Proposed Rules for limiting customers to an "archaic strategy-based system."31 One commenter stated its opinion that portfolio margining should be allowed immediately for security futures, and that the higher margin levels collected under a strategy-based approach would make it difficult for U.S. markets to attract liquidity in security futures.32 This commenter raised concerns that strategy-based margining would disadvantage U.S. markets and would encourage investors to seek foreign markets.33 Another commenter supported portfolio margining for security futures, securities, and securities options to promote global competitiveness.34 It observed that portfolio margining has become the international standard for major futures markets and without it, the U.S. markets will be at a disadvantage.35 One commenter expressed the view that portfolio margining should not be approved for security futures before it is approved for options, and stated that it was critical that any portfolio margining system applicable to security futures apply to all related products, including options and the underlying securities.36 Another commenter supported implementation of a portfolio margining framework under which the margin requirements for portfolios comprised of securities and security futures would be determined through a risk-based analysis.37 Two other commenters, while strongly supporting the concept of portfolio margining, expressed the opinion that portfolio margining was not necessarily appropriate for all investors, and that it might be appropriate to limit the use of portfolio margining for security futures to sophisticated investors.38 The SEC and the CFTC have approved the use of portfolio margining systems for certain purposes. The CFTC has approved portfolio margining using the SPAN system for all currently traded futures contracts, at both the clearing level and the customer level.39 The SEC has approved portfolio margining using The Options Clearing Corporation's ("The OCC") Theoretical Intermarket Margin System ("TIMS") for margin collected by The OCC for the options positions of its clearing members.40 The SEC and CFTC also have approved self-regulatory organization ("SRO") rules that permit the use of SPAN and TIMS in connection with certain cross-margining arrangements involving futures and securities.41 In addition, as noted previously, on March 22, 2002, the SEC published notice of a proposed rule change filed by the CBOE to implement a portfolio margining system on a pilot basis for certain customers.42 Section 7(c)(2)(B)(iii) of the Exchange Act43 provides that the margin requirements for security futures must be consistent with the margin requirements for comparable exchange-traded options, and that the initial and maintenance margin levels for security futures may not be lower than the lowest level of margin, exclusive of premium, required for any comparable exchange-traded option. After considerable deliberation about the application of this standard to security futures margin, the Commissions have determined that risk-based portfolio margining for security futures will not be permitted until a similar methodology is introduced for comparable exchange-traded options. Three commenters expressed opinions regarding the future selection and use of SPAN or TIMS as a portfolio margining system.44 The Commissions will consider issues related to the use of any particular portfolio margining system at such time as the Commissions consider the actual implementation of portfolio margining for security futures. The Commissions strongly encourage the efforts of market participants to develop a portfolio margining proposal for security futures, and are committed to working with these participants to resolve any outstanding issues as quickly as feasible. Such a portfolio margining system would be in keeping with current practices in the futures industry and would be responsive to the Federal Reserve Board's desire to encourage the development of more risk-sensitive, portfolio-based approaches to margining security futures products.45 2. Financial Relations between a Security Futures Intermediary and a Foreign PersonThe Proposed Rules provided an exclusion from the margin requirements for financial relations between a foreign branch of a creditor and a foreign person involving foreign security futures.46 This exclusion was intended to be consistent with the way Regulation T treats financial relations between a foreign branch of a creditor and a foreign person involving foreign securities.47 The Commissions are adopting this exclusion with two modifications.48 First, in response to concerns raised by a commenter,49 the scope of the exclusion is being expanded so that it applies to the U.S. offices as well as foreign branch offices of a security futures intermediary. This commenter expressed the view that the exclusion, as proposed, would create a competitive disadvantage for U.S. firms whose existing foreign futures customers would likely migrate to foreign offices or competing foreign firms to obtain the margin levels available on the foreign exchange. After considering the commenter's view, the Commissions have concluded that expanding the exclusion is appropriate and, in light of the potential competitive issues, is not inconsistent with Regulation T. The second modification clarifies the scope of this exclusion. Because the Proposed Rules did not define the term "foreign security future," the Final Rules provide that the exclusion applies to financial relations between a security futures intermediary and a foreign person involving "security futures traded on or subject to the rules of a foreign board of trade." Thus, the exclusion applies regardless of whether the underlying security is issued in the United States or a foreign country.50 3. Margin Requirements Imposed by Clearing Agencies or Derivatives Clearing OrganizationsThe Proposed Rules provided an exclusion from the margin requirements for margin collected by registered clearing agencies from their members.51 The Commissions received no comments relating to this provision. The text of the proposed exclusion has been revised to specify that the Final Rules exclude clearing agencies registered under Section 17A of the Exchange Act and derivatives clearing organizations registered under Section 5b of the CEA.52 These textual changes do not affect the meaning of the provision and, therefore, the Commissions have effectively adopted the provision as proposed. Section 7(c)(2) of the Exchange Act directs the Federal Reserve Board to prescribe rules regarding customer margin for security futures products, but it does not confer authority over margin requirements for clearing agencies and derivatives clearing organizations. Accordingly, the Federal Reserve Board stated in its delegation letter that "[t]he authority delegated by the Board is limited to customer margin requirements imposed by brokers, dealers, and members of national securities exchanges. It does not cover margin requirements imposed by clearing agencies on their members." The margin rules of clearing agencies registered with the SEC are approved by the SEC pursuant to Section 19(b)(2) of the Exchange Act.53 The CFTC has authority to ensure compliance with core principles for derivatives clearing organizations registered with the CFTC under Sections 5b and 5c of the CEA.54 This exclusion clarifies that margin requirements that clearing agencies registered with the SEC or derivatives clearing organizations registered with the CFTC impose on their members are not subject to the Final Rules. 4. Financial Relations between Security Futures Intermediaries and Broker-Dealers, and Certain Members of National Securities Exchangesa. Financial Relations with an Exempted PersonThe Proposed Rules provided an exclusion from the margin requirements for credit arrangements between a creditor and a borrower that is a member of a national securities exchange or is a registered broker-dealer (including an FCM registered as a broker-dealer under Section 15(b)(11) of the Exchange Act) if the creditor made a good faith determination that the borrower was an "exempted borrower" under Regulation T.55 The Regulation T criteria for an "exempted borrower" establish standards for the exception from federal margin regulation for exchange members and registered brokers and dealers, a substantial portion of whose business consists of transactions with persons other than brokers or dealers.56 In addition, the Proposed Rules provided that a person that ceased to qualify for the exempted borrower exclusion would be required to notify the creditor of this fact before establishing any new security futures positions.57 Any security futures positions subsequently established by that person would be subject to the Commissions' customer margin requirements. One commenter addressed the exclusion, asserting that an FCM or floor broker whose only securities business consists of trading security futures would not likely qualify as an exempted borrower under Regulation T.58 The commenter asked the Commissions to clarify that the scope of the exclusion includes FCMs or floor brokers that do not have a substantial securities or security futures business, as long as they have a substantial customer futures business. After considering the commenter's view, the Commissions have adopted the exclusion with several modifications to clarify the application of the exclusion.59 As a preliminary matter, the Commissions are replacing the term "exempted borrower" with the new term, "exempted person," to avoid characterizing the collection of margin for a security futures contract as involving an extension of credit. Consequently, the Commissions are also adding to the Final Rules a definition of "exempted person." The Commissions believe that the definition of exempted person is consistent with the definition of exempted borrower in Regulation T. More specifically, the Final Rules define an exempted person as a member of a national securities exchange, a registered broker or dealer, or a registered futures commission merchant, a substantial portion of whose business consists of transactions in securities, commodity futures, or commodity options with persons other than brokers, dealers, futures commission merchants, floor brokers, or floor traders, including a person who:
Although the commenter recommended that floor brokers as well as FCMs be permitted to qualify as exempted borrowers, the Commissions have not included floor brokers in the definition of exempted person. This is because the exemption cannot readily be applied to floor brokers given that they do not carry the type of customer accounts contemplated by the Regulation T exempted borrower provision. The Commissions note that, although floor brokers are not included in the definition of exempted person, they may still qualify for an exclusion from the security futures margin requirements if they meet the criteria for a market maker under the Final Rules, as discussed below.61 The Final Rules also set forth an express definition of "persons affiliated with" a futures commission merchant, floor broker, or floor trader,62 which parallels the definition in the Exchange Act of "person associated with a broker or dealer."63 The purpose of this definition is to establish consistency with the Regulation T definition of exempted borrower, which excludes transactions with "persons associated with a broker or dealer," as that term is defined in Section 3(a)(18) of the Exchange Act.64 The phrase "persons affiliated with" has been used in the definition with respect to transactions with FCMs, floor brokers and floor traders, and the phrase "persons associated with" has been used with respect to transactions with brokers and dealers. This is not intended to create a substantive difference in the provisions applicable to the securities and futures industries. Rather, it is intended to avoid confusion insofar as the CFTC's definition of "affiliated person" (which includes corporate affiliates)65 more closely matches the Exchange Act definition of "persons associated with a broker or dealer," than does the CFTC definition of "associated person," which is a registration category.66 The Final Rules clarify that a person may qualify as an exempted person based on transactions in commodity futures and commodity options, as well as securities. For purposes of the "1000 active accounts" threshold, an FCM or broker or dealer that clears a bona fide customer omnibus account for another FCM or broker or dealer may treat that account as a single customer account. For purposes of the $10 million and 10% thresholds, the gross revenues from transactions for bona fide customer omnibus accounts may be included in the computation. An omnibus account will not be considered a bona fide customer account if it is used to clear transactions for market professionals that would otherwise be excluded from the exempted person computation. A fully disclosed customer account will be considered a single customer account of the clearing firm, as well as the introducing firm. The exempted person provision further states that a member of a national securities exchange or a registered broker, dealer, or futures commission merchant that has been in existence for less than one year may meet the definition of exempted person based on a six-month period.67 This incorporates the standard set forth in Regulation T.68 In response to one commenter's suggestion,69 the Commissions are also defining the term "good faith," consistent with the definition of that term in Regulation T,70 for the purposes of determining what steps a security futures intermediary must take to assure itself that a person is an exempted person.71 The Final Rules further provide that a person who ceases to qualify as an exempted person must notify the security futures intermediary of that fact, and become subject to the provisions of the Final Rules, but only before entering into any new security futures transaction or related transaction that would require additional margin to be deposited.72 This would permit a person to enter into new offsetting transactions that reduce the required margin in an account without triggering higher margin requirements. b. Margin Arrangements with a Borrower Otherwise Excluded Pursuant to Section 7(c)(3) of the Exchange ActThe Proposed Rules included an exclusion for credit extended, maintained, or arranged by a creditor to or for a registered broker-dealer, or member of a national securities exchange (including an FCM registered as a broker-dealer under Section 15(b)(11) of the Exchange Act) that is otherwise excluded under Section 7(c)(3) of the Exchange Act.73 The Commissions have decided not to adopt this exclusion. Under Section 7(c)(3)(B) of the Exchange Act,74 the financing of the market making or underwriting activities of a member of a national securities exchange or a registered broker-dealer is excluded from the scope of federal margin regulation. The Federal Reserve Board has expressed the view that floor traders on open-outcry futures exchanges act as market makers and therefore would be excluded from the margin requirements for security futures pursuant to Section 7(c)(3)(B).75 The proposed exclusion was intended to codify this view. One commenter addressed this exclusion and maintained that the exclusion was confusing because the Commissions did not provide any guidance as to the factors under which a broker-dealer would qualify for the exclusion.76 The commenter asked the Commissions to clarify the circumstances under which a floor trader on an open outcry exchange qualifies for the market maker exclusion. The Commissions have not adopted the proposed exclusion. As noted above, the Federal Reserve Board has taken the position that floor traders on open-outcry futures exchanges qualify for the statutory market maker exception. However, any further interpretation of Section 7(c)(3) of the Exchange Act is within the purview of the Federal Reserve Board. As a result, the Commissions would not be able to provide specific guidance as requested by the commenter as to the circumstances under which Section 7(c)(3) applies to floor traders on an open-outcry futures exchange. The Commissions emphasize that any person excluded from federal margin regulation under Section 7(c)(3) of the Exchange Act is not subject to the rules adopted by the Commissions today. The Commissions encourage market participants to seek interpretive guidance from the Federal Reserve Board regarding the circumstances in which the exception under Section 7(c)(3) of the Exchange Act applies. c. Financial Relations between a Security Futures Intermediary and a Member of a National Securities Exchange or Association in Connection with Market Making ActivitiesThe Commissions proposed to exclude from the scope of the margin requirements credit extended, maintained, or arranged to or for members of a national securities exchange or a national securities association in connection with market making activities.77 As proposed, the exclusion had two conditions. First, the borrower could not directly or indirectly accept or solicit customer orders or provide advice to any customer in connection with the trading of security futures. Second, the borrower had to be registered with the exchange or association as a security futures dealer, pursuant to regulatory authority rules that require the borrower: (a) to be registered as a floor trader or floor broker with the CFTC, or as a dealer with the SEC; (b) to comply with applicable SEC or CFTC net capital requirements; (c) to maintain records sufficient to demonstrate compliance with the exclusion and the rules of the exchange or association; (d) to hold itself out as willing to buy and sell security futures for its own account on a regular or continuous basis; and (e) to be subject to disciplinary action if it failed to comply with the Commissions' margin rules or the rules of the exchange or association.78 The Commissions are adopting this exclusion with modifications in light of commenters' views.79 The Commissions received four comments on the exclusion.80 These comments generally supported the proposed exclusion, but suggested that the Commissions clarify certain aspects of the conditions. One commenter expressed the view that a person is a market maker in security futures if it provides liquidity on a regular basis, even if it is not under an affirmative obligation to do so.81 Based on that view, the commenter suggested two alternatives to the Commissions' proposal to determine whether a trader is a liquidity provider. First, the commenter recommended that the Commissions consider a person to be a liquidity provider solely because that person is registered with either the SEC or the CFTC as a trading professional (e.g., as a broker-dealer or FCM) and is a member of an exchange. In the alternative, the commenter recommended that the Commissions consider a trader to be a liquidity provider if that person can demonstrate through its business activity that it is a professional liquidity provider, regardless of its regulatory status or membership in an exchange.82 This commenter further stated that the net capital requirements for persons acting as market makers in security futures should be uniform in order to prevent security futures market makers subject to CFTC financial responsibility rules from obtaining an unfair competitive advantage over security futures market makers (or security options market makers) subject to SEC financial responsibility rules.83 Another commenter asked the Commissions to modify the condition to the exclusion for exchange members that requires that the member "hold itself out as being willing to buy and sell security futures for its own account on a regular or continuous basis."84 The commenter maintained that market makers on a screen-based trading system either should have an enforceable obligation to provide liquidity or should meet an objective standard for supplying liquidity.85 Specifically, the commenter suggested that the condition be narrowed further with respect to members of screen-based trading systems so that it would apply only to members of such systems that: (1) have a continuous, affirmative obligation to quote a two-sided market; or (2) effect more than two-thirds of their security futures trades on that exchange with persons other than registered market makers on that exchange.86 A third commenter asked the Commissions to eliminate the condition to the exclusion for exchange members that requires that the member not "directly or indirectly accept or solicit orders from any customer or provide advice to any customer in connection with the trading of security futures."87 The commenter maintained that a broker-dealer acting as a market maker should not be precluded from also carrying out a customer securities business. The fourth commenter asked the Commissions to confirm that registered floor brokers and floor traders would qualify for the exclusion even if they are not subject to a net capital requirement under CFTC rules. 88 In support of this request, the commenter stated that market makers in options are exempt from the SEC's net capital rule.89 After considering the commenters' views, the Commissions have adopted the exclusion with certain modifications. First, the Commissions are clarifying that the provision relating to accepting or soliciting customer orders was not intended to bar a member from engaging in such activities. That provision was intended to limit the exclusion from the margin requirements to circumstances where the member was trading for its own account, not for the account of others. Accordingly, the rule has been modified to make clear that the exclusion is available to a member only with respect to trading activity for its own account.90 Thus, the member may conduct a customer business and still qualify for the exclusion from the Commissions' margin requirements for security futures with regard to its market making activity. The Commissions have also decided that it is unnecessary to restate the applicability of existing net capital requirements under CFTC and SEC rules, or to impose additional net capital requirements, as a condition of the exclusion for persons acting as market makers. Firms will continue to be subject to applicable CFTC or SEC net capital requirements. Further, even if a member is not subject to net capital requirements, the member's carrying firm will be subject to the treatment provided in existing SEC or CFTC net capital rules, whichever are applicable, with respect to the member's security futures transactions. As noted above, the Commissions received several comments regarding the circumstances under which an exchange member should be considered a market maker for purposes of the margin rules, other than in circumstances that fall within the exception in Section 7(c)(3) of the Exchange Act. These comments largely refer to the requirement that the exchange member "hold itself out as being willing to buy and sell security futures for its own account on a regular or continuous basis" in order to qualify for the exclusion. The Commissions do not believe that registration with the SEC or CFTC is, by itself, sufficient to show that a market participant is holding itself out as willing to buy and sell security futures. However, the Commissions believe that there are a number of different ways that an exchange member could satisfy this condition. For example, an exchange's or association's rules could require the member to effect a certain percentage of its security futures trades on that exchange or association with persons other than registered market makers on that exchange or association.91 Alternatively, such rules could require that a large majority of such exchange member's revenue is derived from business activities or occupations from trading listed financial-based derivatives (i.e., security futures, stock index futures, stock and index options, foreign currency futures and options, and interest rate futures and options) on any exchange in the capacity of a member. As another alternative, the exchange member could be subject to rules that impose on it an affirmative obligation to quote on a regular or continuous basis in security futures. C. Interpretations of, and Exemptions from, the Final RulesThe Commissions are adopting two provisions in the Final Rules to clarify the Commissions' authority to respond to issues that arise in connection with the implementation of the Final Rules. First, the Commissions are adding a provision regarding the interpretation of the security futures margin rules. The Final Rules provide that the Commissions shall jointly interpret the margin rules, consistent with the criteria set forth in clauses (i) through (iv) of Section 7(c)(2)(B) of the Exchange Act and Regulation T.92 Second, the Final Rules add a provision providing that each Commission may issue an exemption from any provision of the Final Rules.93 CFTC Rule 41.42(d) provides that the CFTC may grant an exemption with respect to any provision of CFTC Rules 41.42 through 41.49, provided that the CFTC finds that the exemption is consistent with the public interest and the protection of customers. Similarly, SEC Rule 400(d) provides that the SEC may grant an exemption with respect to any provision of SEC Rules 400 through 406, provided that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors. Because financial relations involving security futures are subject to the Final Rules as adopted by both the CFTC and the SEC, any person seeking an exemption under these rules must request and obtain the same exemption from both the CFTC and SEC. The Commissions intend to work together on exemption requests to establish uniform policies for security futures trading. D. DefinitionsThe definition section of the Proposed Rules has been expanded to include all applicable defined terms. Under the Proposed Rules, many of these definitions and provisions would have been incorporated through the application of Regulation T. The terms "contract multiplier," "daily settlement price," and "Regulation T" are defined in the Final Rules as proposed.94 The Proposed Rules defined the terms "examining authority," "initial margin," and "maintenance margin."95 These terms are not, however, included in the Final Rules because modifications made to the Proposed Rules make them unnecessary. The Final Rules also define the term "self-regulatory authority,"96 instead of the term "regulatory authority" as proposed,97 and its definition has been revised to include a reference to registration under the CEA. In addition, the Final Rules define the term "current market value" with respect to a security other than a security future consistently with the Regulation T definition.98 Some of the defined terms incorporate by reference definitions from the CEA, the Exchange Act, or CFTC or SEC rules.99 Terms that are not otherwise defined in the definition section of the Final Rules will have the meaning set forth in the margin rules applicable to the account.100 Terms that are neither defined in the definition section nor in the margin rules applicable to the account will have the meaning set forth in the Exchange Act and the CEA.101 If the definitions of a term in the Exchange Act and the CEA are inconsistent as applied in particular circumstances, such term shall have the meaning set forth in rules, regulations, or interpretations jointly promulgated by the SEC and the CFTC. E. Application of Regulation T to Security FuturesSection 7(c)(2)(B)(iv) of the Exchange Act requires that the margin requirements for security futures (other than levels of margin), including the type, form, and use of collateral, must be consistent with the requirements of Regulation T.102 To carry out that statutory mandate, the Commissions proposed that Regulation T would apply to all transactions in security futures, to the extent consistent with the Proposed Rules. Thus, under the Proposed Rules, Regulation T would have applied both to securities accounts (which are already subject to Regulation T) and to futures accounts (which are not otherwise subject to Regulation T) that carry security futures.103 This approach also would have applied existing and future Federal Reserve Board interpretations of Regulation T to the margin requirements for security futures and kept the margin requirements consistent with Regulation T without the need for amendments to the Final Rules. The Commissions, however, also recognized that there could be more than one approach to prescribing rules that are "consistent" with Regulation T. Accordingly, the Commissions specifically requested commenters' views on alternative approaches to establishing consistency with Regulation T. In particular, the Commissions solicited comment on the approach of issuing comprehensive "stand-alone" margin rules that would parallel Regulation T requirements for securities to the extent that such requirements are relevant to security futures. Under that approach, the stand-alone rules would apply to security futures and any related securities or futures contracts that are used to offset positions in such security futures. However, the stand-alone rules would not apply to any other securities or futures transactions. The Commissions received a total of 12 comment letters on the application of Regulation T to security futures transactions.104 One commenter supported the Commissions' proposed approach regarding Regulation T.105 Nine commenters opposed general application of Regulation T to security futures carried in futures accounts,106 and two other commenters specifically opposed applying the Regulation T account structure to FCMs.107 The commenter that supported application of Regulation T to all security futures transactions believed that the alternative approach of stand-alone rules would not satisfy the statutory requirement that the margin requirements for security futures (other than levels of margin) be "consistent" with those imposed on securities.108 The commenter expressed the view that the term "consistent" should mean that there is no appreciable difference between rules applicable to exchange-traded options and rules applicable to security futures. In addition, the commenter noted that if the Commissions adopt stand-alone margin rules there is a risk that over time such rules will vary materially from Regulation T because of the difficulty of promptly incorporating the Federal Reserve Board's future interpretations of Regulation T into stand-alone rules. Commenters opposing the general application of Regulation T to security futures did not believe that the CFMA required such application. One commenter contended that application of Regulation T to futures accounts "is impractical and unnecessary" and "not required," and that the CFMA's "consistent" standard did not necessarily require rules "identical" or "equivalent" to the rules applicable to exchange-traded options.109 Rather, this commenter argued, Regulation T permits commodity futures to be recorded in an account other than a margin account (a "good faith" account) and, as a result, permitting security futures to be carried in a futures account (not a margin account) is "consistent" with Regulation T.110 Another commenter observed that while "consistency requires reasonable comparability. . .[, i]f Congress had meant `consistent' to mean `identical,' however, it would have used that word" or would have clearly directed that Regulation T be applied to security futures.111 Similarly, another commenter pointed out that "the CFMA did not mandate the application of Reg[ulation] T to security futures maintained in a futures account" and that the "imposition of Reg[ulation] T with respect to security futures is inconsistent with Congress's goal of facilitating trading in security futures."112 Commenters that disagreed with the Commissions' proposed approach generally urged the Commissions to adopt "stand-alone" margin rules for security futures.113 All of these commenters maintained that the programming changes necessary to enable FCMs to comply with Regulation T would be overly costly.114 Generally, those commenters believed that it would be operationally difficult or impossible to carry security futures in a standard futures account without costly and time-consuming reprogramming. 115 Commenters were concerned that this would place FCMs at a considerable disadvantage in comparison to broker-dealers and would discourage them from trading security futures. One commenter pointed out that a broker-dealer "would need to do little, relative to an FCM, to bring itself into compliance with the Proposed Rules."116 Another commenter expressed concern that FCMs would have to undertake a substantial development project requiring "the restructuring of FCMs' accounts and related systems changes."117 The commenter estimated that this would result in the expenditure of "several thousands of personnel hours,"118 while another commenter believed that costs would "run well into six figures."119 Eight commenters recommended the adoption of an account-specific margin regime for purposes of account administration.120 The adoption of an account-specific margin regime was effectively endorsed by two other commenters that advocated retention of specific existing practices121 and one other that believed the imposition of Regulation T on FCMs would be highly burdensome.122 One commenter argued against the adoption of an account-specific margin regime, stating that FCMs will have to revise a number of their operating procedures and there is no compelling reason to make an exception for margin procedures.123 After considering the commenters' suggestions, the Commissions have determined that it is not necessary to apply Regulation T in its entirety to security futures transactions to satisfy the requirements under Section 7(c)(2) of the Exchange Act.124 Given the relative infrequency of the Federal Reserve Board adopting amendments to Regulation T and issuing formal regulatory guidance, the Commissions do not believe that it will be unduly burdensome or impractical to amend these rules to maintain consistency with Regulation T. Accordingly, the Commissions have adopted stand-alone margin rules that include certain requirements of Regulation T. The Commissions believe that the inclusion of these requirements in the Final Rules satisfies the statutory requirement that margin requirements for security futures be and remain consistent with Regulation T. The Commissions believe that many of the rules governing margin for positions carried in securities accounts are similar enough to the rules governing margin for positions carried in futures accounts that the differences do not, by themselves, create an incentive for customers either to trade security futures instead of options, or to hold security futures in a futures account rather than a securities account. Accordingly, the Commissions are adopting an "account-specific" approach for those aspects of account administration that need not be conformed to satisfy the requirement that the margin rules for security futures be consistent with Regulation T. Thus, the Final Rules provide that security futures held in a securities account are subject to the Final Rules, Regulation T, and to the margin requirements of the self-regulatory authorities of which the security futures intermediary is a member.125 Security futures held in a futures account, on the other hand, will be subject to the Final Rules and the margin requirements of the self-regulatory authorities of which the security futures intermediary is a member.126 Notwithstanding the Commissions' determination not to apply Regulation T in its entirety to security futures, the Final Rules include certain uniform provisions that govern account administration, type, form, and use of collateral, calculation of equity, withdrawals from accounts, and treatment of undermargined accounts. The Commissions believe that the inclusion of these provisions in the Final Rules satisfies the statutory requirement that the margin rules for security futures be consistent with Regulation T. F. Account Administration Rules1. Separation and Consolidation of AccountsRegulation T establishes specific types of accounts for recording different types of customer transactions (e.g., a margin account, a cash account, a good faith account).127 Regulation T generally provides that a customer can have only one margin account.128 While a margin account may be divided into separate parts for bookkeeping purposes, as authorized by the customer, all parts must be considered as one unit in determining whether or not any transaction is permissible under Regulation T.129 The determination as to whether an account satisfies the requirements of Regulation T, moreover, may not take into consideration items in any other account; bookkeeping entries must be made whenever cash or securities in one account are used for purposes of meeting requirements in another account.130 Consistent with Regulation T, the Final Rules provide that the margin requirements for one account may not be met by considering items in another account, except where excess margin is transferred using appropriate bookkeeping entries.131 To facilitate the enforcement of this general prohibition, this provision also requires that if withdrawals of cash, securities, or other assets deposited as margin are permitted under the Final Rules, a security futures intermediary must make and keep accurate bookkeeping entries when those assets are used to meet requirements in another account.132 This provision parallels Section 220.3(b)(1) of Regulation T, and is intended to be consistent with existing futures account practices under Section 4d of the CEA, 133 CFTC Rules 1.20 and 1.22, and applicable futures exchange rules. Currently, futures exchange rules or practices similarly recognize accounts of different types for different customer transactions (e.g., customer segregated, customer secured, nonsegregated). Customers may maintain multiple accounts of the same regulatory classification or account type, although futures exchange rules provide that identically owned accounts within the same regulatory classification or account type should be combined for margin purposes.134 Moreover, an FCM may not apply free funds in an account under identical ownership but of a different regulatory classification or account type to an account's margin deficiency.135 As is the case under Regulation T, however, the Final Rules require the FCM to actually document through bookkeeping entries the transfer of funds from one account to satisfy the margin deficiency in another account. The Commissions do not believe that this provision will create any substantial operational burdens for FCMs carrying security futures in futures accounts. The Final Rules provide that all futures accounts of the same regulatory type or classification that carry security futures shall be considered a single account for purposes of the Regulation.136 The Final Rules also permit a securities futures intermediary to further consolidate all futures accounts of the same regulatory classification or account type, regardless of whether they carry security futures, for purposes of determining whether the required margin for all of a customer's futures positions (including security futures) is satisfied.137 2. Accounts of PartnersThe Final Rules provide that if a partner of a security futures intermediary (organized as a partnership) has an account with the security futures intermediary in which security futures or related positions are held, the security futures intermediary must disregard the partner's financial relations with the firm (as shown in the partner's capital and ordinary drawing accounts) in calculating the margin or equity of any such account.138 This provision parallels Section 220.4(b)(5) of Regulation T,139 and is consistent with current futures exchange practices. The provision is intended to reinforce the principle of "separation of accounts" with respect to partners in a security futures intermediary organized as a partnership, when a partner maintains a trading account with the firm. 3. Contribution to a Joint VentureUnder the Final Rules, if an account in which security futures or related positions are held is the account of a joint venture in which the security futures intermediary participates, any interest of the security futures intermediary in the joint account in excess of the interest which the security futures intermediary would have on the basis of its right to share in the profits must be margined in accordance with the Final Rules.140 This provision parallels Section 220.4(b)(6) of Regulation T,141 which is intended to prevent firms from indirectly extending credit to customers in circumstances where the customer does not deposit equity in the account corresponding to its share of the profits in the account (e.g., if the customer is entitled to 90% of the profits in an account, but only deposits 40% of the equity at the outset, the broker-dealer is effectively extending credit to the customer in the amount of 50% of the equity in the account). 4. Extensions of CreditThe Final Rules prohibit any extension of credit with respect to security futures, if the extension of credit is designed to evade or circumvent the security futures margin requirements.142 Among other things, this provision is intended to prevent security futures intermediaries from extending unsecured credit to customers, or extending credit secured by securities or other assets in excess of the value such assets would have under the Final Rules,143 to satisfy or maintain the required margin for security futures carried in the customer's account.144 For example, a security futures intermediary may not lend a customer $100 in cash secured by less than $200 in margin equity securities to meet a margin call for a security future. This provision does not, however, preclude a security futures intermediary from advancing funds to a customer to meet variation settlement calls on behalf of an undermargined customer account, in the ordinary course of business, provided that the security futures intermediary issues a margin call for the funds advanced. The Final Rules permit a security futures intermediary to arrange for an extension of credit to or for a customer by a person, provided that the extension of credit would not constitute a violation of Regulations T, U, or X by such person.145 In this connection, the Commissions believe that credit extended for the purpose of satisfying or maintaining the required margin for a security future is "purpose credit" for purposes of the Federal Reserve Board's credit regulations. For example, a security futures intermediary may not arrange for a Regulation T creditor to extend credit to a customer against securities or other assets in a nonpurpose or nonsecurities credit account to enable the customer to meet a margin requirement with respect to a security future. Likewise, a security futures intermediary may not arrange for a bank or other Regulation U lender to extend credit secured directly or indirectly by margin stock in excess of the maximum loan value of the collateral (i.e., 50% of current market value) securing the credit for the purpose of purchasing or carrying a security future. Similarly, a security futures intermediary may not arrange for a Regulation X borrower to obtain an extension of credit within or from outside the United States for the purpose of effecting or carrying a security futures transaction unless the credit conforms to the Federal Reserve Board's margin regulations, as provided in Regulation X. G. Customer Margin Levels for Security FuturesThe Commissions proposed to require both the seller and the buyer of a security future to provide and maintain, on a daily basis, cash or other acceptable assets equal to a percentage of the "current market value" of the security future. The Commissions are adopting those requirements substantially as proposed. 1. Definition of Current Market ValueThe Commissions proposed to define the term "current market value" of a security future as the product of the daily settlement price of the security future (as shown by any regularly published reporting or quotation service) and either the applicable number of shares per contract (when the underlying instrument is a single stock), or the applicable contract multiplier (when the underlying instrument is a narrow-based security index).146 The Commissions also proposed to define the term "current market value" with respect to a narrow-based security index future to mean the product of the daily settlement price of such security future, as shown by any regularly published reporting or quotation service, and the applicable contract multiplier.147 The Commissions received one comment on these definitions, which suggested that the pricing convention for determining current market value need not be the same for security futures held in a security account and for security futures held in a futures account.148 The Commissions, however, believe that a uniform definition of current market value is necessary to ensure that identical contracts are not subject to different margin requirements based on the type of account in which they are carried. As noted above, Section 7(c)(2)(B)(3)(I) of the Exchange Act149 requires that the margin requirements for security futures be consistent with the margin requirements for comparable exchange-traded options. The Commissions believe that using the daily settlement price150 at the end of each trading day to calculate margin requirements for security futures on that day is consistent with the use of the closing price of the option and the underlying security for determining maintenance margin for equity options.151 In addition, the Commissions continue to believe that using the daily settlement price of a security future on the day of a transaction to calculate the initial margin (rather than the daily settlement price on the day preceding the transaction) is consistent with using the underlying stock's closing price on the preceding business day. The daily settlement price of a security future on the preceding business day, for example, may not exist if such security future were not available for trading on the preceding business day. Accordingly, the Commissions are adopting the definition of "current market value" as proposed. 2. Margin Levels for Unhedged PositionsThe Commissions proposed that the minimum initial and maintenance margin levels required of customers for each security future carried in a long or short position be 20% of the current market value of such security future.152 This proposed level was based on the requirement under Section 7(c)(2) of the Exchange Act that the initial and maintenance margin levels for a security future not be lower than the lowest level of margin, exclusive of premium, required for any comparable option contracts traded on any exchange registered pursuant to Section 6(a) of the Exchange Act.153 Twelve commenters commented on this aspect of the Proposed Rules.154 Six commenters found 20% to be an acceptable level.155 Two commenters advocated a 25% margin level,156 and one commenter, joined by a second, stated that its members could not reach a consensus as between 20% and 25%.157 One commenter expressed the view 20% could be either too high or low, and suggested that for certain positions, 50% initial margin would be appropriate.158 One commenter considered the 20% level to be consistent with the margin requirements for exchange-traded options, but "more than adequate" in terms of preserving the financial integrity of the market and preventing systemic risk.159 Another commenter stated that it "does not oppose" the 20% level, but favors portfolio margining.160 One commenter said that its members were split between recommending 20% and 25%.161 Those supporting the 20% level believed that it was consistent with the levels applicable to exchange-traded options and consistent with the intent of the CFMA. This margin level in combination with a T+1 settlement period and the fact that the Proposed Rules permit higher margin levels, made some members conclude that 20% is a prudent minimum level.162 Other members thought that 20% is too low, failing to take into account the varying volatility/share price profiles of equity securities and the credit risk implications of those differences. Those members favored a 25% minimum, finding this to be "consistent" with margin levels for options.163 They further noted that a comparable option position consists of a long (short) call/short (long) put option pair struck at the forward price of the underlying security.164 Finally, one commenter urged the Commissions to adopt a 25% margin level, citing historical data and stating that this level is consistent with the minimum margin level applied under SRO rules to long equity positions.165 It argued that the 20% level would create an advantage for security futures as compared to listed option put/call pairs, noting margin levels in excess of 30% for combinations based on relatively high volatility stocks, and margin levels in excess of 20% for combinations based on relatively low volatility stocks.166 After considering the commenters' views, the Commissions have adopted the margin levels as proposed. The Commissions believe that a security future is comparable to a short, at-the-money option, as discussed in the release accompanying the Proposed Rules ("Proposing Release").167 Currently, the margin requirement for a short, at-the-money option, where the underlying instrument is either an equity security (such as a stock or an instrument immediately convertible into a stock) or an index, is 100% of the option proceeds plus 20% of the value of the underlying security or index.168 Unlike an options contract, however, a futures contract involves obligations of both parties to perform in the future: the buyer (long) to purchase the asset underlying the future, and the seller (short) to deliver the asset. As a result, both the buyer and the seller of a futures contract must post and maintain margin on a daily basis to assure contract performance and the integrity of the marketplace. In addition, all market participants pay or receive daily variation settlement as a result of all open futures positions being marked to current market value. Accordingly, the margin levels apply equally for both buyers and sellers of security futures. The Commissions have considered the comments, and have determined that a minimum margin level of 20% satisfies the comparability standard of Section 7(c)(2) of the Exchange Act.169 In addition, the Commissions note that the Final Rules permit self-regulatory authorities and security futures intermediaries to establish higher margin levels or to take appropriate action to preserve their own financial integrity.170 As a result, the Commissions are adopting the minimum initial and maintenance margin levels for unhedged positions, as proposed. 3. Margin OffsetsThe Proposed Rules included a provision to allow national securities exchanges and national securities associations to adopt rules that reduce the margin levels below 20% of current market value for customers with certain positions in securities or futures that offset the risk of their positions in security futures.171 The Proposed Rules provided further that the resulting margin levels could not be lower than the lowest customer margin levels required for comparable offset positions involving exchange-traded options.172 In addition, the Commissions published a table that included offsets for security futures that the Commissions had preliminarily identified as consistent with those permitted for comparable offset positions involving options and that would qualify for reduced margin levels.173 The Commissions received three comments with respect to the proposed offsets.174 One of the commenters stated that offsets involving security futures and options should be recognized only if the risk from the security future is completely offset by the option.175 Another commenter expressed concern that the offsets would produce margin levels that did not accurately reflect the risk of the positions and suggested that the Commissions adopt general provisions regarding margin levels for offsetting positions instead of providing specific examples. 176 Finally, one commenter suggested modifying the existing strategy-based rules to put security futures on a par with cash equities in connection with offsetting strategies involving listed options and to reduce the margin requirements for certain calendar and basket spreads involving security futures.177 This commenter also suggested that the Commissions address the treatment of spreads involving non-fungible security futures.178 After considering the commenters' views, the Commissions have adopted, substantially as proposed, rules that permit self-regulatory authorities to establish margin levels for offset positions involving security futures that are lower than the required margin levels for unhedged positions.179 Under the Final Rules, a self-regulatory authority may set the required initial or maintenance margin level for an offsetting position involving security futures and related positions at a level lower than the level that would be required if the positions were margined separately. Such rules must meet the criteria set forth in Section 7(c)(2)(B) of the Exchange Act180 and must be effective in accordance with Section 19(b)(2) of the Exchange Act181 and, as applicable, Section 5c(c) of the CEA.182 The Commissions have retained, with certain revisions, the table of offsets that they deem to be consistent with offsets recognized for comparable exchange-traded options. In particular, the revised table of offsets reflects an adjustment in the level of margin required for certain calendar and basket spreads involving security futures to more accurately reflect the risk of such positions relative to comparable spreads involving exchange-traded options. An offset position for spreads involving non-fungible security futures also has been added to the table. When it approved strategy-based offsets for options, the SEC found that it was appropriate for the SROs to recognize the hedged nature of certain combined options strategies and prescribe margin requirements that better reflect the risk of those strategies.183 The SEC also found that the SROs' proposals relating to strategy-based offsets involving options contracts were carefully crafted as they were based on the SROs' experiences in monitoring the credit exposures of options strategies. In particular, the SEC noted that the SROs regularly examine the coverage of options margin as it relates to price movements in the underlying securities and index components. Moreover, the SROs' proposals were thoroughly reviewed by the NYSE Rule 431 Review Committee, which is comprised of securities industry participants who have extensive experience in margin and credit matters. As a result of these factors, the SEC was confident that the SROs' proposed margin requirements were consistent with investor protection and properly reflected the risks of the underlying options positions. The table of offsets reflects a reduction in the minimum initial and maintenance margin requirement for calendar spreads184 and basket spreads,185 in response to the comment that the risk posed by certain spreads involving security futures is lower than the risk posed by comparable spreads involving exchange-traded options. 186 In light of the observation that security futures are not subject to early exercise and therefore do not exhibit the same price volatility as options, the minimum initial and maintenance margin requirement recognized for calendar spreads and basket spreads has been reduced to 5% of the current market value of the long or short position.187 The Commissions deliberated as to whether risk-based margin computations using SPAN could be applied to these strategies, so long as the offsetting positions were the only positions included in the margin computation. The Commissions have decided not to permit risk-based margin computations for these offsets at this time. The table of offsets, likewise, reflects a reduction in the required margin recognized for spreads involving a long or short security future and a short or long position in the same security underlying the security future, given that these spreads are economically analogous to calendar spreads.188 The Commissions intend to review the margin levels for the offsets discussed above after six months of security futures trading to determine whether the margin levels have resulted in regulatory arbitrage with comparable positions involving exchange-traded options, and may jointly undertake appropriate action. Based on the same commenter's suggestion, the Commissions believe that an additional offset should be recognized for spreads involving identical, non-fungible security futures.189 Because there is a possibility that certain security futures may not be fungible across markets, a customer may simultaneously hold a long security future and a short security future on the same underlying security even when those security futures have identical contract terms. As a result, the customer will be economically neutral but will be required to hold both positions to expiration and meet daily variation settlement calls with respect to each contract. The commenter expressed the view that a minimum margin level of 1% would be appropriate.190 The Commissions recognize that the rules of a clearing agency or derivatives clearing organization may effectively net the two contracts at final settlement. However, due to potential differences in daily settlement prices across markets or other market-specific events, the Commissions have determined that such offset positions will be subject to a minimum margin requirement of 3%. The Commissions believe that the offsets identified in the following table are consistent with the strategy-based offsets permitted for comparable offset positions involving exchange-traded options. The Commissions expect that self-regulatory authorities seeking to permit trading in security futures will submit to the Commissions proposed rules that impose levels of required margin for offsetting positions involving security futures in accordance with the minimum margin requirements identified in the following table of offsets.
Table Notes1 Baskets of securities or security futures contracts must replicate the securities that comprise the index, and in the same proportion. 2 Generally, for the purposes of these rules, unless otherwise specified, stock index warrants shall be treated as if they were index options. 3 "Aggregate exercise price," with respect to an option or warrant based on an underlying security, means the exercise price of an option or warrant contract multiplied by the numbers of units of the underlying security covered by the option contract or warrant. "Aggregate exercise price" with respect to an index option means the exercise price multiplied by the index multiplier. See, e.g., Amex Rules 900 and 900C; CBOE Rule 12.3; and NASD Rule 2522. 4 "Out-of-the-money" amounts must be determined as follows: (1) for stock call options and warrants, any excess of the aggregate exercise price of the option or warrant over the current market value of the equivalent number of shares of the underlying security; (2) for stock put options or warrants, any excess of the current market value of the equivalent number of shares of the underlying security over the aggregate exercise price of the option or warrant; (3) for stock index call options and warrants, any excess of the aggregate exercise price of the option or warrant over the product of the current index value and the applicable index multiplier; and (4) for stock index put options and warrants, any excess of the product of the current index value and the applicable index multiplier over the aggregate exercise price of the option or warrant. See, e.g., NYSE Rule 431 (Exchange Act Release No. 42011 (October 14, 1999), 64 FR 57172 (October 22, 1999) (order approving SR-NYSE-99-03)); Amex Rule 462 (Exchange Act Release No. 43582 (November 17, 2000), 65 FR 71151 (November 29, 2000) (order approving SR-Amex-99-27)); CBOE Rule 12.3 (Exchange Act Release No. 41658 (July 27, 1999), 64 FR 42736 (August 5, 1999) (order approving SR-CBOE-97-67)); or NASD Rule 2520 (Exchange Act Release No. 43581 (November 17, 2000), 65 FR 70854 (November 28, 2000) (order approving SR-NASD-00-15)). 5 "In the-money" amounts must be determined as follows: (1) for stock call options and warrants, any excess of the current market value of the equivalent number of shares of the underlying security over the aggregate exercise price of the option or warrant; (2) for stock put options or warrants, any excess of the aggregate exercise price of the option or warrant over the current market value of the equivalent number of shares of the underlying security; (3) for stock index call options and warrants, any excess of the product of the current index value and the applicable index multiplier over the aggregate exercise price of the option or warrant; and (4) for stock index put options and warrants, any excess of the aggregate exercise price of the option or warrant over the product of the current index value and the applicable index multiplier. 6 Two security futures will be considered "identical" for this purpose if they are issued by the same clearing agency or cleared and guaranteed by the same derivatives clearing organization, have identical contract specifications, and would offset each other at the clearing level. The Commissions note that positions in a securities account may not be cross-margined with positions in a futures account except in accordance with the rules of a self-regulatory authority that have become effective under Section 19(b)(2) of the Exchange Act and, as applicable, Section 5c(c) of the CEA. At present, the Commissions have not approved the use of a cross-margining methodology for customer securities and futures accounts. Accordingly, security futures or other positions carried in a futures account may not currently be offset against security futures or other positions carried in a securities account to reduce a customer's total margin requirement. 4. Higher Margin LevelsThe Proposed Rules expressly provided that self-regulatory authorities could impose on their members initial and maintenance margin levels that are higher than the minimum levels otherwise specified in the rules.191 The Proposed Rules also provided that self-regulatory authorities could permit their members to use a method for computing required margin that could result in margin levels that are higher than the minimum levels specified in the rules.192 The Commissions have decided that it is not necessary to adopt these provisions of the Proposed Rules because other provisions of the Final Rules make clear the ability of a self-regulatory authority to establish higher margin levels. The Final Rules establish minimum levels and do not set any limitations as to maximum levels. Moreover, the Final Rules expressly do not preclude a self-regulatory authority or a security futures intermediary from imposing additional margin requirements, including higher initial and maintenance margin levels, consistent with the Final Rules.193 As noted previously, a portfolio margining system such as SPAN may be used to compute required margin based on the parameters established in accordance with the Final Rules. Each security futures intermediary remains responsible for collecting margin in compliance with the Final Rules. 5. Procedures for Certain Margin Level AdjustmentsThe Commissions proposed to allow national securities exchanges registered under Section 6(g) of the Exchange Act194 and national securities associations registered under Section 15A(k) of the Exchange Act195 to raise or lower margin levels in accordance with Section 19(b)(7) of the Exchange Act,196 as long as the resulting levels satisfy the minimum level requirements.197 The Commissions received no comments on this aspect of the proposal, and are adopting it as proposed.198 H. Satisfaction of Required MarginSection 7(c)(2)(B)(iv) of the Exchange Act199 requires that the type, form and use of collateral for security futures products be and remain consistent with the requirements of Regulation T. To fulfill this statutory requirement, the Commissions proposed to permit security futures intermediaries to accept as margin for security futures any of the types of collateral permitted under Regulation T to satisfy a margin deficiency in a margin account.200 The Commissions also proposed to allow self-regulatory authorities to establish their own margin collateral requirements as long as those requirements were consistent with the requirements of Regulation T.201 The Final Rules continue to limit the type, form, and use of collateral deposits that security futures intermediaries may accept to satisfy the required margin for security futures to those permitted under Regulation T.202 The Commissions are, however, permitting security futures intermediaries to include the net value of certain additional items -- specifically, long options203 and open trade equity204 -- in computing the equity in an account. Moreover, for purposes of determining whether the required margin in an account is satisfied, the final rules permit security futures intermediaries to compute equity in accordance with applicable self-regulatory authority rules, subject to certain adjustments to ensure consistency with Regulation T.205 1. Type, Form and Use of Collaterala. Acceptable Collateral DepositsThe Commissions proposed to permit security futures intermediaries to accept as margin for security futures a deposit of any combination of cash, margin securities as defined in Regulation T,206 exempted securities as defined in Section 3(a)(12) of the Exchange Act,207 and other collateral permitted under Regulation T to satisfy a margin deficiency in the margin account.208 The Commissions received four comments on this issue.209 One commenter supported the Commissions' proposal with respect to permissible collateral.210 The other three commenters suggested that the Commissions should permit security futures intermediaries to accept other forms of collateral in addition to those permitted by Regulation T.211 Two of these commenters suggested that the type of collateral permitted should be determined based on the type of account. Under an account-specific approach, for security futures held in futures accounts, the types of permissible collateral would be determined by SRO rules; and for security futures held in securities accounts, the types of permissible collateral would be governed by Regulation T.212 The other commenter maintained that, unless the Commissions recognize other instruments that are commonly accepted as collateral within a futures account (e.g., letters of credit), the margin requirements would disadvantage the futures community and would make it unlikely that customers would carry security futures products in a futures account.213 The Commissions have considered the commenters' views, and have adopted the provisions regarding acceptable collateral deposits substantially as proposed. In particular, the Commissions do not believe that it would be consistent with the requirements regarding type, form, and use of collateral under Regulation T to permit customers to satisfy the required margin for security futures in a futures account using letters of credit or other types of collateral not currently permitted under Regulation T. Any types of collateral the Federal Reserve Board may subsequently permit in a Regulation T margin account, however, may also be used to satisfy the required margin for security futures under the Final Rules.214 b. Use of Money Market Mutual FundsThe definition of "margin security" under Regulation T includes, among other securities, money market mutual funds. A number of futures exchanges currently accept money market mutual fund shares as performance bond deposits for futures and options on futures, subject to certain conditions imposed under CFTC Rule 1.25.215 Regulation T also permits creditors to extend good faith loan value to shares in money market mutual funds and other mutual funds carried in a securities account, although the limitations on extensions of credit in connection with new issues of securities under Section 11(d)(1) of the Exchange Act have limited the practicability of their use.216 The Final Rules permit the use of money market mutual fund shares217 to satisfy the required margin for security futures and related positions carried in a securities account or futures account, subject to certain conditions.218 These conditions are intended to facilitate a security futures intermediary's hypothecation or liquidation of money market mutual fund shares deposited as margin for security futures, as necessary to meet a customer's clearing obligations. Specifically, a security futures intermediary may accept money market mutual fund shares as margin if the following conditions are met (e.g., under the rules of a self-regulatory authority or pursuant to a three-way agreement among the security futures intermediary, the customer, and the money market mutual fund or its transfer agent): (1) The customer waives any right to redeem the fund shares without the consent of the security futures intermediary and instructs the fund or its transfer agent accordingly; (2) The security futures intermediary (or clearing agency or derivatives clearing organization with which the security is deposited as margin) obtains the right to redeem the shares in cash, promptly upon request; and (3) The fund agrees to satisfy any conditions necessary or appropriate to ensure that the shares may be redeemed in cash, promptly upon request. 2. Computation of EquityThe Proposed Rules would have required security futures intermediaries to compute the equity in an account in accordance with Regulation T for purposes of determining whether the required margin for security futures is satisfied.219 The Commissions received one comment on this issue.220 The commenter expressed the opinion that the rules governing collateral haircuts in securities and futures accounts need not be identical, as long as the relevant standards do not create a material incentive for customers to carry security futures positions in a futures account rather than a securities account.221 The Commissions have considered this commenter's views and have determined not to require security futures intermediaries to compute equity in accordance with Regulation T. The Final Rules provide that, for purposes of determining whether the required margin for security futures carried in an account is satisfied, the equity in an account shall be computed in accordance with the margin rules applicable to the account.222 However, so that that collateral and other components of equity are valued consistently in securities and futures accounts, the Final Rules require security futures intermediaries to make certain adjustments to equity when determining whether the required margin for security futures carried in an account is satisfied.223 Each of these components of equity is discussed in turn below. a. Security FuturesThe Proposed Rules provided that security futures would not be "margin securities" for purposes of the margin requirements and therefore would not have loan value for margin purposes.224 One commenter addressed this provision and supported the view that security futures should not have loan value for margin purposes.225 The Commissions have considered the commenter's views and have adopted Final Rules that provide that security futures will have no value for purposes of determining whether the required margin in a securities or futures account is satisfied.226 This is consistent with the treatment of other futures contracts carried in futures accounts. To avoid confusion as to whether extensions of credit in connection with security futures are considered "purpose credit" for purposes of the Federal Reserve Board's credit regulations,227 however, the Commissions have revised the Final Rules to eliminate the statement that security futures are not margin securities. b. Option ValueThe Proposed Rules did not address the question of whether the net value of options in a securities or futures account could be applied to satisfy the required margin for security futures.228 The rules of the futures exchanges generally permit FCMs to include the value of listed options on contracts for future delivery in computing the equity in a futures account. The rules of the national securities exchanges and the NASD, however, generally deny value to options carried for a customer for the purpose of computing the equity in the customer's account.229 One commenter expressed concern that the exclusion of net option value from the calculation of equity in a futures account would create significant operational difficulties for security futures intermediaries that carry security futures in futures accounts.230 Two other commenters noted, however, that recognition of option value for purposes of determining whether the required margin for security futures is satisfied in a futures account would create a significant regulatory disparity with exchange-traded options carried in securities accounts.231 The Commissions, having considered the commenters' concerns, are adopting Final Rules that provide that a net long or short position in a listed put or call option carried in a futures account shall be valued in accordance with the margin rules applicable to the account for purposes of determining whether the required margin for a security future in the account is satisfied.232 For these purposes, the term "listed option" is defined to mean any put or call option that is (i) issued by a clearing agency that is registered under Section 17A of the Exchange Act233 or cleared and guaranteed by a derivatives clearing organization that is registered under Section 5b of the CEA;234 and (ii) traded on or subject to the rules of a self-regulatory authority.235 The SEC is willing to entertain proposed rule changes by the national securities exchanges and the NASD to grant value to listed options in a securities account under appropriate circumstances. In addition, the Commissions intend to review their determination to grant value to long options carried in futures accounts after six months of security futures trading to determine whether it has created a material disparity between the margin requirements for security futures and the margin requirements for comparable exchange-traded options, and may jointly undertake appropriate action. c. Open Trade EquityThe Proposed Rules did not address in detail how "open trade equity" (i.e., the daily marked-to-market gain or loss in value of futures or other exchange-traded contracts) would be included in the equity in an account for purposes of determining whether the required margin for security futures is satisfied. However, eight commenters raised the issue and requested clarification from the Commissions.236 Those commenters generally requested that the Commissions clarify that broker-dealers and FCMs could treat open trade equity on security futures positions as cash for purposes of margin and collateral. One of those commenters maintained that disallowing the use of open trade equity to satisfy margin on trades and position in other markets could dampen customers' interest in security futures.237 Another of the commenters suggested that FCMs would have to make costly systems changes if they were not allowed to recognize open trade equity for security futures as they are permitted to do for other futures positions.238 In light of commenters' views on this issue, the Final Rules clarify that "open trade equity" may be applied to satisfy the required margin for security futures and related positions. Specifically, the Final Rules define a new term, "variation settlement," to mean any credit or debit to a customer account, made on a daily or intraday basis, for the purpose of marking to market a security future or any other contract that is: (i) issued by a clearing agency that is registered under Section 17A of th |