Markets Urge Caution on Regulations

Terry Flanagan

Rush to judgment based on events like MF Global would be counterproductive.

Market participants are sounding a note of caution on potential unintended consequences of regulations intended to protect customer collateral posted for OTC transactions.

“As such changes could create new costs and burdens for market participants, it will be important for regulators to demonstrate how their rule changes will be effective in protecting segregated funds from bad actors,”  Luke Zubrod, director at Chatham Financial, told Markets Media. “At this juncture, though all market participants are eager to ensure posted collateral is safe going forward, we think it’s too early to prescribe a treatment for MF Global because the root cause analysis is yet to be finalized.”

The Commodity Futures Trading Commission has adopted what’s known as the Complete Legal Segregation Model (CLSM), under which both the FCM and the DCO are required to segregate the cleared swaps collateral relating to each customer.

Under the CFTC’s rules, clearinghouses will have to collect margin on a gross basis. This means that as of this upcoming November, FCMs will no longer be able to offset one customer’s collateral against another and then send only the net to the clearinghouse.

Although the CFTC is not definitively framing CLSM as a response to MF Global and anticipates additional changes to address MF Global related lessons at a future date, there are some concerns about the CLSM approach.

CLSM will be more expensive for end users than omnibus accounts and end users want to be confident that the additional expense is warranted, Zubrod said.

Though some end users may well prefer the higher levels of protection afforded by CLSM, other end users are uncertain about just how much more expensive the CLSM model will be.

“In the absence of clear data on cost, they would prefer to retain discretion as to which segregation model would apply to their funds,” said Zubrod. “This would allow them to weigh the benefits of higher levels of segregation against the costs, once known. “

This is not to say that rule changes may be altogether unhelpful.  Regulatory changes could, for example, make it more difficult to break rules in the future, or regulatory changes could make it easier to detect rules that have been broken.

Although policymakers are understandably eager to identify lessons learned from MF Global and enact solutions that address those problems, it’s essential that those solutions are tightly mapped to the problems they are intended to address, said Zubrod

“If policymakers rush to judgment on solutions, they risk making risk management more expensive without fundamentally addressing the root causes,” he said.

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