On February 7, 2012, the Commodity Futures Trading Commission published in the Federal Register a final rule (the LSOC rule) adopting a new margin segregation model for cleared swaps1 that the CFTC termed the “legal segregation with operational commingling” model (the LSOC model).
The LSOC model differs from the CFTC’s existing segregation model for exchange traded futures contracts, under which registered futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) may commingle customer funds and, in some circumstances, a DCO may use one customer’s property to cover losses of another in the event of an FCM default. For cleared swaps, the CFTC will allow FCMs and DCOs to operationally commingle customer funds but they must maintain legally segregated customer accounts. In addition, DCOs may not use a non-defaulting customer’s collateral to cover the losses occasioned by the default of another customer and/or an FCM (such risk being “fellow customer risk”).
In adopting the LSOC rule, the CFTC struck a balance between the wishes expressed by customers to have full legal protection of its collateral in an FCM default and the concerns expressed by dealers that implementing a model of full legal segregation would result in significant additional costs.
While the LSOC rule purports to substantially eliminate the fellow customer risk that exists under current CFTC rules for segregating exchange traded futures customer funds, the LSOC rule does not address the risks that the FCM or DCO may lose customer money by incurring investment losses or through fraud or operational error, and does not protect against DCO defaults. In addition, the CFTC did not further amend its existing regulation permitting FCMs to reinvest customer funds in limited types of investments.
Section 724(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, amended Section 4d of the Commodity Exchange Act (the CEA) to provide protection for collateral deposited by cleared swaps customers of FCMs and DCOs. New Part 22 of the CFTC rules implements Section 724’s directive that FCMs and DCOs protect margin posted by customers. Part 22 also mandates related reporting and recordkeeping requirements.
Section 724(b) of the Dodd-Frank Act amended Title 11 of the US Code (the Bankruptcy Code) to clarify that cleared swaps are “commodity contracts” and that associated collateral, when deposited by customers, will be subject to the protection of the Bankruptcy Code and the CFTC’s existing Part 190 regulations.
The LSOC model
The CFTC adopted the LSOC model in light of losses of collateral that parties to OTC derivatives contracts experienced following dealer and other major counterparty insolvencies during the 2008 financial crisis. The CFTC considered a number of other potential segregation alternatives,2] including the model currently used for exchange traded futures contracts. The CFTC concluded that the LSOC model largely mitigated fellow-customer risk3 and encouraged portability of cleared swaps and customer collateral, while also providing the best balance between benefits and costs in protecting market participants and the public.
Under the LSOC model, FCMs and DCOs must segregate, on their books and records, cleared swaps and customer collateral from their own obligations and the obligations of non-customers. FCMs and DCOs are required to treat customer collateral as belonging solely to the customer. Operationally, however, each FCM and DCO may hold, or “commingle,” all of the customer collateral deposited by all customers in one account (a “cleared swaps customer account”)4 that is separate from any account holding FCM or DCO property or property belonging to non-cleared swap customers. Additionally, FCMs must ensure that DCOs do not use the collateral of one customer to support the obligations of another customer’s swap contracts.
In addition, an FCM may not grant a lien to any person (other than a DCO) on customer collateral or on its residual interest in its customer account. However, a customer may grant a lien on its own account. The FCM is not required to keep customer collateral physically in the cleared swaps customer account. Rather, the FCM may invest collateral as permitted by Regulation 1.25 as is currently in effect for exchange traded futures contracts.5 In December 2011, the CFTC narrowed the types of investments permitted by Regulation 1.25, including eliminating foreign sovereign debt and certain in-house transactions and repurchase agreements with affiliates6 as permitted investments.7 The CFTC plans to consider further restrictions on investments permitted under Regulation 1.25 at an unspecified later time.
The LSOC rule permits a customer to deposit collateral at a bank in a third-party custody account, in lieu of posting such collateral directly to the FCM. However, the FCM must comply with the CFTC’s “Segregation Interpretation 10” as originally issued in 1984,8 meaning that the funds in such a custody account will not be eligible for preferential treatment in bankruptcy and will be available for pro rata distribution to customers as set forth in the Bankruptcy Code and the CEA.
The LSOC rule also requires FCMs to compile information about swap customer portfolios and transmit it on a daily basis to DCOs. The rule requires information “sufficient to identify…the portfolio of rights and obligations”9 that the FCM intermediates for a customer.
Comparing the LSOC model and the traditional futures model
When entering into cleared swaps, a customer must post collateral to its FCM in the amount required by such FCM. Regardless of whether such FCM receives collateral from the customer, the FCM must post collateral to the DCO in the amount required by the DCO. The amount of collateral a customer and DCO must post for particular cleared swaps will be set by forthcoming CFTC regulations. The LSOC model diverges from the current futures model, as well as the other models the CFTC considered in the proposed rule, in how it handles simultaneous defaults in posting collateral by both the customer and the FCM (a double default). The FCM may default due to its lack of available funds, which may result in an FCM bankruptcy. Since the DCO, in its capacity as a central counterparty, is required to perform the obligations of the defaulting customer on back-to-back transactions that the DCO clears with the counterparties of the now-defaulted customer, the DCO is exposed to significant losses in the event of a double default.
A cleared swaps customer also faces the single default risk of its FCM, which could be occasioned by a bankruptcy of such FCM unrelated to the failure of any customer to post required collateral. The recent MF Global bankruptcy is an example of such an event. In an ideal scenario, if an FCM is defaulting but its customers are not, the FCM’s positions with the DCO would be transferred to another FCM without any losses being incurred. This “porting” process worked less than smoothly in certain cases with respect to ordinary exchange traded futures contracts in the MF Global bankruptcy; it remains to be seen whether efficient porting of FCM positions would occur in a more complex cleared swaps environment, despite the additional customer information reporting requirements described below that are designed to promote transfer. Therefore, customers should not ignore the risks that their FCMs could fail to post the required amount of collateral to the DCO, which could result in the DCO unwinding customer positions and attempting to recover a termination payment and/or collateral from the FCM even where the customer is fully performing its obligations. Customer collateral could be recovered out of an FCM bankruptcy if there is no shortfall in customer account funds (on the date of publication, a significant shortfall exists in the MF Global bankruptcy case) in both the traditional futures model and LSOC model. However, the customer is still exposed to the risk of having its swaps executed through the bankrupt FCM being unwound early and faces the attendant risks of being obligated to make an unexpected early termination payment and/or being unable to replace its positions with other, willing FCMs.
Under the traditional futures model, the DCO is permitted to use all of the collateral held in the FCM’s omnibus customer account with the DCO to satisfy that FCM’s obligations to the DCO. That is, a DCO may apply collateral posted by non-defaulting customers toward the obligations of a defaulting FCM. However, under the LSOC model, a DCO facing a double default is prohibited from using non-defaulting customer collateral to cover an FCM’s deficiency resulting from the original customer default. In such a situation, the DCO can look only to the property of the defaulting customer and other available financial resources, which could include the FCM’s contributions to a guaranty fund at the DCO, and the contributions of non-defaulting FCMs and the DCO itself to such a guaranty fund.
Unlike the current futures model, the LSOC model requires FCMs to transmit information about customers’ portfolios to DCOs on a daily basis, which is intended to help the DCO facilitate customer position transfers to other FCMs in the event of an FCM bankruptcy. If there is a double default, the LSOC model protects non-defaulting customers’ collateral by not only prohibiting DCOs from utilizing that collateral to cover the defaulting customer’s loss but also by facilitating the “porting” of the non-defaulting customers’ cleared swaps to other FCMs. Under the current futures model portfolios are portable, but the fact that a DCO has the ability to offset a defaulting FCM’s obligations with non-defaulting customers’ collateral arguably limits the DCO’s incentive to promote porting. It is unclear how porting would work in practice where customers have both cleared swaps and exchange traded futures accounts with the same FCM.
Continuing risks associated with the LSOC model
While the LSOC model adds customer protections not in the futures model in respect of fellow customer risk, the CFTC acknowledges that the LSOC model does not reduce “investment risk,” which is the risk that an FCM fails to return customer collateral because the FCM incurred losses on its investment of customer collateral in assets permitted under applicable regulations. Additionally, the LSOC model does not reduce “operational risk,” which could arise because of a shortfall in segregated funds due to fraud, negligence, theft, force majeure or other, non-investment related events resulting in loss of customer funds.
One CFTC commissioner noted that the LSOC model would not have prevented losses incurred by customers in the MF Global bankruptcy.10 The alleged shortfalls in MF Global’s customer accounts for exchange traded futures reportedly arose due to alleged operational failures and do not appear to have been exacerbated by customer defaults. Even under the LSOC model, cleared swaps customers seemingly would have shared losses resulting from a shortfall in the operationally commingled cleared swaps account on a pro rata basis, and it is unclear whether customers would have been able to quickly transfer their cleared swaps to another FCM.
In addition, cleared swaps involve an additional layer of credit risk when compared with bilateral over-the counter derivatives. Under bilateral transactions, each party assumes only the credit risk of the other party. Under cleared swaps, each party that is not itself an FCM assumes the credit risk of both its FCM and the DCO. Under the LSOC rule, DCOs are permitted to commingle collateral received from multiple FCMs on behalf of their cleared swaps customers, although DCOs may not commingle collateral with their own funds or any FCM funds. DCOs, like FCMs, may invest collateral in accordance with Regulation 1.25. In the event of a DCO bankruptcy, customers face the risk that their cleared swaps will be terminated early, resulting in a possible early termination payment owing to the defaulting DCO, and that their cleared swaps cannot be immediately replaced with identical swaps cleared through another DCO (or, if permitted, uncleared swaps). In addition, customers face the risk that any collateral to which they should be legally entitled cannot be recovered (or cannot be recovered timely) from the DCO or the FCM, whether or not there is a shortfall in the overall amount of customer collateral at the DCO or FCM.
Bankruptcy Code amendments
Section 724(b) of the Dodd-Frank Act amended the Bankruptcy Code to clarify that cleared swaps are “commodity contracts.” Accordingly, in the event of an FCM or DCO bankruptcy case commenced under the Code, customers are entitled to certain protections, including the ability to close out cleared swaps and transfer cleared swaps and collateral. If cleared swaps are subject to liquidation, customers will receive preferential treatment of the remaining collateral. For bankruptcy purposes, customer collateral in cleared swaps accounts is treated analogously to collateral in customer futures accounts.
The LSOC rule (including the Part 190 bankruptcy provisions) becomes effective on April 9, 2012 (which is the business day that is 60 days after publication of the LSOC rule in the Federal Register on February 7, 2012). FCMs and DCOs are not required to comply with Part 22 regulations until November 8, 2012.
For more information about the LSOC rule, please contact Marc Horwitz.
Read the LSOC Final Rule.
1 The final rule was adopted on January 11, 2012 and is available in this Release. 77 Fed. Reg. 6336 (Feb. 7, 2012). While the term “swap” is defined in Section 721(a)(47) of the Dodd-Frank Act, the CFTC has not yet issued its final rule defining that term. Based on the Dodd-Frank Act definition, and subject to some narrow exceptions, it is expected that the term “swap” will encompass almost all transactions commonly known as over-the-counter derivatives.
2 The models the CFTC considered included (1) the legal segregation with recourse model; (2) the physical segregation model; and (3) the futures model . Under the legal segregation with recourse model, FCMs and DCOs would segregate customer collateral on their books but could commingle such collateral in a single account that is separate from proprietary and non-cleared customer accounts. However, DCOs could pool customer collateral to satisfy obligations to DCOs following defaults by a customer and the FCM. Under the physical segregation model, each customer’s collateral would be required to be placed in a separate individual account. Under the futures model, all customer collateral would be placed in an omnibus customer account.
3 The CFTC described “fellow-customer risk” as the risk that “a DCO would need to access the collateral of non-defaulting Cleared Swaps Customers to cure an FCM default.” See 77 Fed. Reg. at 6338. Under the traditional futures model, “a DCO is permitted to use all of the collateral in the Clearing Member’s customer account to meet a loss in that account, without regard to which customer(s) in fact supplied the collateral.” 77 Fed. Reg. at 6339.
4 The final rule defines “commingling” as holding “such items in the same account, or to combine such items in a transfer between accounts.” 17 C.F.R. § 22.1.
5 See 17 C.F.R. § 22.2(e)(1).
6 Repurchase agreements with third parties are still permitted subject to a concentration limit of 25 percent.
7 Investment of Customer Funds and Funds Held in an Account for Foreign Futures, 76 Fed. Reg. 78,776 (Dec. 19, 2011).
8 See 77 Fed. Reg. at 6343. Segregation Interpretation 10 requires that an FCM follow certain policies and procedures when a customer deposits its collateral in a third-party bank.
9 17 C.F.R. § 22.11(a)(2).
10 See 77 Fed. Reg. at 6407 (Statement of Commissioner Scott D. O’Malia).