On Jan. 11, the Commodity Futures Trading Commission (CFTC) finalized the heavily debated segregation model for cleared swaps customer collateral, referred to as the Legally Segregated Operationally Commingled Model (LSOC). In the same rule, the CFTC also re-adopted a previously repealed segregation model that was authorized for use until 2005 for futures (Interpretation No. 10). The finalized rule importantly interacts (or, arguably, counteracts) with Section 766(h) of the U.S. Bankruptcy Code, which requires that customer property be distributed “ratably to customers on the basis and to the extent of such customers’ allowed net equity claims.”
This rule was implemented partially in response to concerns raised by market participants that the new clearing mandate may inadvertently increase market risks by concentrating them among major financial institutions and one or two clearinghouses instead of reducing systemic risks as intended by the Dodd-Frank Act of 2010.
The recent bankruptcy of MF Global, one of the largest futures commission merchants (FCM), demonstrated that the futures model (i.e., the omnibus account) may not be the ideal model for the swaps market, particularly considering that the swaps market is many times larger than futures market. Recognizing competing interests of FCMs and end users, the CFTC proposed the LSOC Model and the Interpretation No. 10 even though these models may increase the cost of conducting the clearing business.
LSOC Model. The new LSOC Model requires each FCM and derivatives clearing organization (DCO) to segregate (on their books) the positions of FCM customers and the related cleared swaps customer collateral. However, both FCMs and DCOs may hold all cleared swaps customer collateral together in one commingled account. Additionally, the LSOC Model will require FCMs to transmit to the appropriate DCO (or FCM, if another FCM stands in between the margin-collecting FCM and the DCO) information sufficient to identify each customer’s cleared swaps positions and related collateral. The efficacy of this model (versus certain other models that were considered, including the model currently used for futures accounts)is best explained by describing its effect in the event of an FCM’s bankruptcy. If an FCM’s bankruptcy is caused by anything other than a customer’s losses, the LSOC Model will operate much like the current futures model used for futures accounts: customer positions and related collateral may be liquidated and sent to the trustee or transferred to another FCM. Note, however, that if there is a shortfall in customer funds (e.g., because the default was triggered by the FCM’s permitted investment losses or due to misuse of client funds), remaining customer positions and collateral may only be allocated to customers to the extent of each customer’s pro rata share due to the Bankruptcy Code.
Unlike the futures model, however, DCOs (and trustees) will have more information about each individual customer’s position and collateral under the LSOC Model because that model requires FCMs to periodically provide DCOs with data regarding individual customer positions. Under the futures model, by contrast, DCOs only have information about customer’s positions on a collective basis.
Furthermore, in November, the CFTC will require that FCMs transfer collateral to DCOs on a gross basis instead of a net basis, as is currently the practice. This also is intended to reduce customer and FCMs default risks although it will increase FCMs’ cost of conducting their business.
The LSOC Model would be most different from the existing futures model if an FCM’s bankruptcy were caused by a customer’s losses that exceed both the specific customer’s collateral and the FCM’s ability to pay (i.e., a double default). Under the existing futures model, the DCO could effectively access non-defaulting customer collateral to cover such a loss. The remaining positions and collateral would then be transferred or liquidated and returned to the trustee for pro rata distribution. Under the LSOC Model, however, DCOs will only be permitted to use the collateral attributable to specific defaulting customers to cover the double default. Importantly, Dodd-Frank amended the Bankruptcy Code to include cleared swaps within the definition of “commodity contracts” in section 761(4). While this affords cleared swaps certain protections, the Bankruptcy Code also requires that collateral associated with commodity contracts be distributed ratably in the event of an FCM bankruptcy. Therefore, notwithstanding a DCO’s inability to use non-defaulting customer funds to cover shortfalls, non-defaulting customers may share in customer losses if the DCO is required to liquidate customer positions and a shortfall remains.
Interpretation No. 10. From 1984 to 2005, the CFTC permitted FCMs to deposit futures customer property with independent, third-party custodians so long as the FCM had immediate and unfettered access to such funds. The CFTC backtracked from this policy in 2005 and prohibited futures customer collateral from being deposited with third party custodians (with limited exceptions).
In response to a commenter’s request after the passage of Dodd-Frank and the recent market events with the MF Global bankruptcy, the CFTC opted again to follow the pre-2005 policy for swaps (but not futures) by specifically permitting swaps customer funds to be deposited in certain third-party custodial accounts in lieu of posting such funds directly to an FCM. However, the rule requires FCMs to have the ability to promptly liquidate and/or access such funds. Also, in the event of an FCM’s bankruptcy other than due to a double default, the same pro rata distribution would apply to all swaps customer funds even if they are deposited with a third party.
Compliance date. FCMs and DCOs must comply with the rules regarding segregation of cleared swaps customer collateral and the provision of information regarding cleared swaps positions by Nov. 8. Mandatory clearing may commence prior to that date, but the initial phase of mandatory clearing will apply primarily to dealer-to-dealer transactions.