Dechert published a new "OnPoint" legal update, entitled, "CFTC Guidance on FCM and DCO Investments in Money Market Funds." The brief, written by Stephen Cohen, Jack Murphy, Philip Hinkle, and Neema Nassiri, says, "Divisions of the U.S. Commodity Futures Trading Commission (CFTC) on August 8, 2016 issued letters restricting futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) from investing in money market funds that have the authority to impose redemption restrictions under 2014 amendments to Rule 2a-7 under the Investment Company Act of 1940 (Amended Rule 2a-7). FCMs and DCOs will nonetheless continue to be permitted to make certain investments in other money market funds, as discussed below." (See our August 25 News, "CME Says CFTC Interpretation to Prohibit Prime Money Funds for Margin.")

It explains, "The no-action letter issued by the staff of the Division of Swap Dealer and Intermediary Oversight (DSIO) and the interpretative letter issued by the staff of the Division of Clearing and Risk (DCR) were issued in anticipation of the October 14, 2016 compliance date for Amended Rule 2a-7 -- after which a money market fund that is not a "government money market fund" (Non-Government MMF) or a government money market fund that elects to retain the authority to impose redemption restrictions (Electing Government MMF) will be required to impose redemption restrictions in the event its liquidity level falls below certain thresholds. A government money market fund is a money market fund that invests at least 99.5% of its total assets in cash, U.S. government securities and/or certain repurchase agreements."

Dechert continues, "Specifically, in light of the letters, FCM and DCO investments of customer funds in Non-Government MMFs and Electing Government MMFs will be prohibited as of October 14, 2016. However, the DSIO letter states that DSIO will not recommend an enforcement action against an FCM that: Invests customer funds in a government money market fund that is not an Electing Government MMF (Non-Electing Government MMF); Treats investments of customer funds in a Non-Electing Government MMF as not subject to any CFTC concentration limit (provided the Non-Electing Government MMF satisfies a new, heightened minimum asset requirement); or Invests amounts of its own funds held in customer accounts in a Non-Government MMF or Electing Government MMF, to the extent such amounts are in excess of the FCM's "targeted residual interest" (discussed below). This OnPoint describes key issues arising under applicable CFTC rules in light of the authority to impose redemption restrictions under Amended Rule 2a-7, and provides an overview of the guidance and relief set forth in the letters."

They explain, "CFTC regulations provide that customer collateral posted for transactions in futures, futures and commodity options, cleared swaps and uncleared swaps may only be invested by FCMs and DCOs as specifically permitted in CFTC Regulation 1.25. Money market funds are listed as permitted investments in CFTC Regulation 1.25. However, to qualify as a permitted investment under CFTC Regulation 1.25: Any investment must be "'highly liquid' such that [it has] the ability to be converted into cash within one business day without material discount in value" (Highly Liquid Requirement); and A money market fund also must be "legally obligated to redeem an interest and to make payment in satisfaction thereof by the business day following a redemption request" (Next-Day Redemption Requirement)."

The article continues, "CFTC Regulation 1.25(c) enumerates certain exceptions to the Next-Day Redemption Requirement, and generally permits FCMs to invest customer assets in money market funds that could postpone or suspend redemptions, as long as the funds could do so only in certain circumstances specified in the regulation (Enumerated Redemption Requirement Exemptions). The DSIO letter identifies conflicts with each of the Highly Liquid and Next-Day Redemption Requirements relating to Non-Government and Electing Government MMFs."

It tells us, "The DCR letter notes that each of the above requirements obligates a DCO to maintain liquid resources sufficient to make prompt payments to members with gains opposite a defaulting member. The DCR letter notes that redemption gates would not serve to minimize, and could instead substantiate, the risk of delayed access to assets belonging to the DCO, its clearing members or their customers.... `Any assets subject to a redemption gate would not be available for prompt liquidation to ensure that a DCO is able to make on-time payments to its customers; as such, the DCR letter notes that these assets do not present minimal liquidity risks for purposes of the DCO core principles. Accordingly, the DCR letter states that DCR interprets these requirements as incompatible with the prospect of the redemption gates that may be imposed by Non-Government and Electing Government MMFs."

Dechert states, "For these reasons, the DCR letter states that DCR interprets the CFTC's Part 39 regulations to prohibit DCOs from accepting or holding initial margin, or investing in Non-Government or Electing Government MMFs any assets belonging to the DCO, its clearing member FCMs or clearing members' customers. However, while the DCR letter does not address Non-Electing Government MMFs, it appears that DCOs may continue to invest in such funds."

Finally, they conclude, "The DSIO and DCR letters substantially restrict FCM and DCO investments in Non-Government MMFs and Electing Government MMFs. Importantly, under the letters, Non-Electing Government MMFs that do not choose to participate in the ability to impose redemption restrictions would remain permissible investments for customer funds. Accordingly, prior to the October 14, 2016 compliance date for Amended Rule 2a-7, money market fund sponsors may need to modify their arrangements with FCMs and DCOs so that the FCMs and DCOs invest in Non-Electing Government MMFs to the extent required under the letters."

In other news, a press release entitled, "Fitch: Prime Money Fund Liquidity Buffers Surge One Month Ahead of Reform," explains, "While prime institutional money market funds already lost $733 billion in assets, primarily to government money funds, the continued build-up of liquidity in these funds indicates fund managers expect additional outflows ahead of reform, as well as a structural shift in portfolio management post-reform."

It tells us, "As of Sept. 9, prime institutional funds' weekly liquidity averaged 75.5%, up 3.6% from Aug. 31 and 11.4% from Aug. 15. Some prime money funds' weekly liquidity is at 100%, and others will likely reach similar levels in the month running up to reform.... Prime institutional money funds continue to experience significant asset outflows, declining $176 billion during the two weeks between Aug. 26 and Sept. 9.... Meanwhile, government institutional funds' assets increased by $178 billion in the same period, reaching a total of approximately $1.3 trillion."

The update adds, "Fitch expects continued outflows from prime funds driven by investors in the one month remaining before the reform compliance deadline of Oct. 14. This, in turn, has led to a widening of the yield spread between assets such as Tier 1 90-day commercial paper held by prime funds and the 30-day net yield on government institutional money market funds. At Sept. 12, this spread had widened to 72 basis points from 55 at June 30.... The presence of these features means that investors will be monitoring weekly liquidity closely, ready to pull cash out of prime money funds on indications of stress. To avoid even coming close to the regulatory threshold of 30%, fund managers will be maintaining buffers to weekly liquidity well above this level."

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