The hedge fund industry favors the Complete Legal Segregation Model in the CFTC’s proposed rules on protecting cleared swap customer contracts and collateral. In a letter to the CFTC, the Managed Funds Association asserted that the Complete Legal Segregation Model provides strong customer protections, eliminates the fellow customer risk with regard to cleared swaps, enhances the portability of customers’ positions, and would help contain financial contagion and thereby achieve a macro goal of the Dodd-Frank Act.
In addition to the Complete Legal Segregation Model, the CFTC proposal also discusses three other possible models to implement new section 724(d)(f) of the Commodity Exchange Act: (1) Full Physical Segregation, where each customer’s collateral is held in an individual account; (2) Legal Segregation with Recourse, which is similar to the Complete Legal Segregation Model, though non-defaulting customer collateral is available at the end of the derivatives clearing organization default waterfall to cure a futures commission merchant (FCM) default caused by a defaulting customer; and (3) the Futures Model, where all customer collateral is held in an omnibus account and can be used to cure any collateral deficiency resulting from an FCM default caused by a defaulting customer after the collateral of the defaulting customer and the capital of the FCM are exhausted.
As proposed by the CFTC, the Complete Legal Segregation Model requires an FCM to keep books and records that identify each customer’s cleared swaps and the related collateral, and the FCM must maintain that collateral in an account separate from any assets of the FCM or the relevant derivatives clearing organization. As a result, said the MFA, the Complete Legal Segregation Model provides strong customer protections because in the event of a customer default, the derivatives clearing organization cannot access the collateral belonging to non-defaulting customers to satisfy any losses associated with the defaulting customer and customers may identify and access collateral and port cleared swap trades if an FCM fails or appears to be failing.
In the view of the MFA, the Complete Legal Segregation Model provides superior customer collateral protection when compared to the Legal Segregation with Recourse Model and the Futures Model which , unlike the Complete Legal Segregation Model, would both fail to protect FCM customers against fellow customer risk and hamper portability. The Complete Legal Segregation Model also is operationally easier to implement than the Full Physical Segregation Model
The Complete Legal Segregation Model eliminates fellow customer risk with regard to cleared swaps, which is the risk that a derivatives clearing organization will use assets of an FCM’s non-defaulting customers to satisfy losses of that FCM’s defaulting customer in the event that those losses exceed the margin assets of the defaulting customer and the FCM. Choosing a segregation model that eliminates fellow customer risk is important, said the MFA, because without such protection swap market participants will not realize an important benefit of central clearing, which is the reduction of credit risk to parties when entering into swaps.
More importantly, an FCM’s customers do not have the necessary information to determine and mitigate any fellow customer risk to which they are exposed. Customers do not know the identity of their fellow customers or the nature of the trading activity or positions of those fellow customers. Without this information, which is properly kept confidential, no customer can assess the creditworthiness of its fellow customers. Thus, adopting the Complete Legal Segregation Model would protect customers by eliminating the need for them to accept a risk that they cannot properly assess.
According to the MFA, the Complete Legal Segregation Model will also enhance the portability of customers’ positions to a greater extent than the Legal Segregation with Recourse Model or the Futures Model. Position portability of cleared swap positions is of great importance in swap markets, emphasized the MFA, since it allows FCM customers the ability to move cleared swaps without incurring incremental transaction costs or encountering the various operational, accounting, tax and legal issues that would arise if the customer had to terminate and recreate those positions with another FCM.
In addition, enhanced portability is consistent with a central theme of the Dodd-Frank Act to strengthen the U.S. financial system. Portability minimizes the period between the default of an FCM and the reestablishment by customers of their cleared swap positions with another FCM, noted the hedge fund group, allowing customers to limit their exposure to market fluctuations. The prompt transfer of customer positions also facilitates the orderly resolution of a failing FCM and minimizes any disruption or dislocation in the swap markets. In addition, the ability to quickly transfer customer positions likely will limit the contagion effects that can occur when an interconnected FCM becomes insolvent.
Portability helps to contain financial contagion by quickly defusing the number of customers, cleared swaps and collateral maintained with a failing FCM. Customers who port quickly do not incur losses should their swaps be out-of-the-money at the time the customer ports its cleared swap positions. Moreover, once a customer has ported swaps and related collateral to a new FCM, explained the MFA, it is no longer exposed to further risks associated with the failing FCM, including operational issues such as the ability to receive the proceeds of a terminated swap in an expedient manner. Finally, porting allows the estate of a failed FCM to quickly liquidate, thus, lowering the related costs.