CFTC Net Capital Rule - Should a More Risk-Based Approach Be Adopted?
21 Pages Posted: 6 Nov 2010
Date Written: 1996
The leverage available from futures contracts and the price volatility of the commodities underlying such contracts may cause large losses and quickly threaten the financial viability of a futures commission merchant. The insolvency of a futures commission merchant in turn raises a concern that customer funds may be endangered. That concern is heightened by the fact that there is no federal insurance available to protect the customers of a futures commission merchant.
In lieu of such protection, the futures industry uses margin requirements to limit the accumulation of trading losses. The Commodity Futures Trading Commission ("CFTC") also imposes certain regulatory requirements that are designed to protect customer funds held by futures commission merchants. One part of the CFTC's regulatory structure is a requirement that futures commission merchants maintain a minimum amount of net capital in order to remain in business. The CFTC's net capital rule is, however, only indirectly related to the market risks encountered by futures commission merchants. The CFTC's net capital rule is also flawed in several respects, and may actually reduce customer protection in some circumstances.
The large losses experienced by firms dealing in over-the-counter derivatives has further focused attention on the need for a more risk-based net capital rule when a firm is exposed to large market risks by leveraged instruments. This Article will examine the CFTC's present net capital rule, discuss its deficiencies, and propose an alternative risk-based methodology.
Keywords: Commodity Futures Trading Commission (CFTC), futures industry, Net Capital Rule, prices, futures commission merchants, customer, protection, over-the-counter, derivatives
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