01.12.2012
By Terry Flanagan

Markets Weigh Collateral Protection

CFTC’s Complete Legal Segregation Model deficient, participants say.

Derivatives market participants are up in arms over the procedures established by the Commodity Futures Trading Commission for protecting the collateral of cleared swaps customers in the event of a default of a clearing member or one of its customers.

A group of asset managers—BlueMountain Capital Management, Elliott Management, Moore Capital Management, Paulson & Co., and Tudor Investment Corp.—which collectively manage in excess of $65 billion, said that the model adopted by CFTC, known as the Complete Legal Segregation Model (CLSM), was deficient in a number of respects.

They said in a comment letter that the MF Global situation raises “significant questions as to whether the CLSM model adequately protects customer assets.”

The asset managers instead proposed a Physical Segregation Model as a means of protecting collateral. By establishing separate customer account, the ability of an FCM to improperly access or otherwise fail to segregate customer collateral, whether by mere oversight of overt act, would be greatly diminished.

Additionally, customers must be given real-time “view-only” access to their accounts via depository website, which would provide an additional layer of oversight that isn’t possible with customer omnibus accounts.

Futures customers should be given the same protections as swaps customers, the asset managers said. Prior to MF Global, the U.S. futures model for customer asset segregation had worked well for many years, and various FCM and DCO segregation processes are deeply ingrained in the futures markets, they noted. However, in the aftermath of MF Global, regulatory changes are needed.

Some DCOs, such as CME Group, contend that the CLSM model will raise operating costs. “The purported remedial benefits of CLSM will either be unmasked immediately, which will be a black eye for the Commission, or be brought to light if there is another failure that leaves customers facing a shortfall in funds. Either result is horrible for
CFTC-regulated markets and the participants we serve,” CME said in a statement.

CME recommends instead that the CFTC permit DCOs to use the omnibus model employed in the futures industry, whereby property is treated separately from the property of the FCM, but futures customers are treated as a group, rather than individually.

However, CME also favors permitting cleared swaps customers that desire or require full physical segregation of their contracts and associated collateral to opt out of the commingled customer account of their FCM.

CME Clearing has engaged in initial customer discussions concerning the structure of an opt-out model. One possible approach would be the use of multiparty agreements among the DCO, a settlement bank designated as custodian, the customer and the customer’s sponsoring FCM clearing member.

A separate account at the settlement bank would be established for each opt-pit customer pursuant to the rules of the DCO and the multiparty agreement. Operationally, the account would be managed in the same way at the clearing level as a commingled FCM customer account, except that it would be designate din the name of the customer or the DCO, and not the FCM.

While the requirements to support such accounts would still inject additional risk and operational costs into the system, such costs would be substantially lower than that for a full physical segregation model, and the optional nature of the program would permit many of the costs to be allocated only to those parties choosing to participate, according to CME.

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