CFTC to Segregate OTC Collateral

Terry Flanagan

The Commodity Futures Trading Commission is moving ahead with plans to radically alter the way margin collateral for cleared OTC swaps contracts is protected in the event of a default by a clearing member or one of its customers.

Under the Dodd-Frank Act, futures commission merchants (FCMs) must treat all collateral deposited by a customer to margin its cleared swaps as belonging to each customer. The FCM may not commingle such collateral with its own property or used it to margin the cleared swaps of any other customer.

Under the setup proposed by the CFTC, called legal segregation with operational commingling or LSOC, each derivatives clearing organization (DCO) and FCM must segregate the cleared swaps of each individual customer. Operationally, however, FCMs and DCOs are permitted to commingle the relevant collateral in one account. Each FCM and DCO must ensure that such account is separate from any account holding FCM or DCO property or property belonging to non-cleared wasps customers.

“Segregation should be pursued, as it provides the vital advantage of reduced systematic risk,” Zohar Hod, vice president and head of Americas at SuperDerivatives, told Markets Media. “The CFTC should be cognizant of this, since risk mitigation is a key tenet of Dodd-Frank. The U.S. need only look across The Pond for evidence of success, where Europe has already been reaping the benefits of segregated accounts.”

In the event of a simultaneous default of an FCM and one or more cleared swaps customers, the DCO may access the collateral of the FCM’s defaulting cleared swaps customers to cure the default, but not the collateral of the FCM’s non-defaulting cleared swaps customers.

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.

Market participants are split on the issue, with most buyside participants favoring the LSOC model, and most FCMs and DCOs (with the notable exception of LCH.Clearnet) favoring the futures model.

Buyside 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 collate protection and note that their counterparties enjoy considerable profit from this business model.

In contrast, most FCMs, and DCOs, say that the omnibus model has served the futures industry well for many decades and should be continued.

LCH.Clearnet, however, supports the complete legal segregation (i.e., LSOC) model put forward by the CFTC as the most appropriate model for customers clearing swaps transactions. It’s also the model that most closely parallels the protections that will be required in Europe under the European Commission’s proposed European Markets Infrastructure Regulation (EMIR).

“We are aware that some clearinghouses argue that higher costs are involved in the complete legal separation structure,” said Ian Axe, LCH’s CEO. “However, having implemented this model we can categorically refute these claims.”

The primary arguments against LSOC don’t withstand detailed analysis, and the operational costs feared by those favoring the futures model are unfounded, according to LCH.

“No clearinghouse should be able to offer client clearing for swaps without full visibility at the individual client level,” said LCH. “This requirement should therefore stand irrespective of the account structure selected by the CFTC.”

Because the client account under LSOC is operationally commingled, clearing members and DCOs can utilize the same gross omnibus account structure from an operational perspective, limiting additional infrastructure costs, noted LCH.

In other words, the operational infrastructure of LSOC is the same as the futures model; it’s only the legal segregation that’s different.

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