Buy Side Seeks Wider Margin Choice

Terry Flanagan

Use of third-party custodians for cleared swaps is urged.

The buy side is weighing in on the protection of collateral for cleared swaps as the Commodity Futures Trading Commission prepares to issue a final rule.

The CFTC has proposed that each FCM and derivatives clearing organization be required to segregate the cleared swaps of each individual customer and relevant collateral, while permitting FCMs and DCOs to operationally commingle all relevant collateral in one account, known as the legally-separate and operationally-commingled (LSOC) model.

The LSOC model is a departure from the segregation requirement currently applicable to futures, under which a DCO recognizes the cleared swaps that an FCM intermediates on a collectivize, or omnibus basis. Under the futures model, in the event of a default, the DCO would be permitted to access the collateral of non-defaulting clear swaps customer before applying its own capital.

Buy side participants note that they’re currently able to negotiate for individual collateral protection at independent swaps dealers, and are therefore exposed to neither fellow-customer risk nor investment risk. They are accustomed to the costs associated with individual collateral protection and note that their counterparties enjoy considerable profit from this business model.

The recent challenges in recovering funds from customer accounts following the bankruptcy of MF Global have added to buys side participant concerns, according to State Street Corp.

To address these concerns, the CFTC should adopt rules that provide buy side participants clearing through FCMs with the option of using a tri-party custody arrangement for holding initial margin, State Street said in a comment letter.

Under an optional tri-party custody regime, a customer would post margin to a custodian in an amount at least equal to the margin required to be posted by an FCM to the clearinghouse.

Unlike the LSOC model, third-party custody does not rely on the FCM or clearinghouse’s recordkeeping to monitor the location of customer funds, which the experience of MF Global has shown may be inadequate.

Allowing optional third-party custody of cleared swaps margin would promote consistency across U.S. and global markets for both cleared and uncleared swaps, according to State Street. The Dodd-Frank Act mandates that swap dealers and major swap participants provide customers the option to have initial margin for uncleared swaps segregated with an independent third-party custodian, “evidencing Congress’ understanding of the importance of such arrangements,” said State Street.

European Market Infrastructure Regulation (EMIR) stipulates that clearinghouses must have procedures for protection of collateral in the event of a default by a clearing member. EMIR is less prescriptive in this regard than Dodd-Frank, as it essentially leaves it up to the clearinghouses to devise their own methods for handling a default.

“Whereas the [U.S. Commodity and Futures Trading Commission] is currently in favor of the LSOC [legally separate but operationally commingled] as the de facto segregation model, EMIR provides greater flexibility in the models that CCPs can offer,” Matthias Graulich, executive director at Eurex Clearing, told Markets Media.

Eurex Clearing’s individual clearing model provides full legal and operational segregation of all positions and assets for clients of clearing members at the clearinghouse level. The service is the first building block of segregation solutions offered by the clearinghouse, and Eurex Clearing is the first CCP globally to offer full legal and operational segregation across all cleared markets, the company said.

“The level of protection in the individual clearing model is higher than either omnibus or LSOC, because in the event of a clearing member default the clearinghouse has the power to transfer customer positions and collateral to an alternative clearing member, without involving the defaulting clearing member or its administrator,” Graulich said.

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