DerivSource's Julia Schieffer talks to industry participants to better understand how the LSOC model works and how it should evolve going forward. Comments from DerivSource video.
The legal segregation with operational commingling (LSOC) model is designed to provide better protection of customer funds and to mitigate fellow customer risk to which customer collateral is exposed in the futures clearing system. The Commodity Futures Trading Commission (CFTC) approved new rules to establish the use of LSOC models by Futures Commission Merchants (FCMs) and Derivatives Clearing Organizations (DCOs) with respect to cleared swaps customer contracts and associated collateral. The new collateral segregation rules are due to take effect in November 2012, however many market participants are still uncertain as to how this segregation model works in practice.
LSOC is an approach to margin similar to the way in which collateral has traditionally been held in Over-the-Counter (OTC) derivatives business. Operationally, collateral provided by OTC trades may be commingled though the legal rights of those providing credit support are protected by the terms of the documentation.
Once the Dodd-Frank Act was passed, concerns were raised by market participants with the CFTC that they were in effect less protected in margin arrangements for cleared swaps than for non-cleared OTC swaps in which they had third party custodial agreements. LSOC creates operational challenges where a third party custodian is involved, though provides additional protection, albeit at an additional cost to cleared swap customers beyond those of the current futures DCO model. In the futures DCO model any FCM customer's swap collateral is available to the DCO upon a default of both the FCM and one of the FCM’s customers. The FCMs and DCOs may commingle customer collateral. The CFTC has not yet extended LSOC to the futures market.
One of the main components of the Dodd-Frank Act was an emphasis on clearing, bringing many of the protections from the futures clearing model to other derivatives markets including the swap market, said Mark Young, partner and leader of the Derivatives Regulatory and Litigation Practice Group at Skadden, Arps, Slate, Meagher & Flom LLP. He added, "the DCO you often hear becomes the buyer to every seller and the seller to every buyer."
The CFTC have heard from several market participants not in favor of the idea of moving swap clearing to the futures clearing model. Those not in favor of adopting the futures model for swaps clearing had concerns around the issue of 'fellow customer risk' that exists under the futures model. In a default situation the DCO would access the collateral of non-defaulting customers in order to alleviate the default.
A double default situation occurs when both the customer and the FCM defaults or when the customer defaults to the FCM and the FCM defaults to the DCO said Young. "In the instance of a double default, the DCO could apply the collateral of non- defaulting customers held in the DCO accounts to cure the FCM's default."
Many industry participants are concerned that if the futures clearing model is applied to swaps cleared swaps customers would be exposed to 'fellow customer risk' if their fellow customers default on their swap positions. "Market participants complain that it would be better not to require swaps clearing at all," said Young.
On 11th January 2012 the CFTC adopted LSOC rules to address 'fellow customer risk' for swaps. Like futures clearing, swaps clearing would involve one account at the FCM level and one at the DCO level each of which contains commingled customer collateral. "Unlike the futures model the DCO could identify any customers that are in default. The difference between swaps clearing and futures clearing is the kind of traceability from the DCO to the customer," said Young.
The CFTC acknowledge that the final LSOC rules directly address only 'fellow customer risk' and not 'investment risk' - the risk that an FCM faces a shortfall because of its investment of customer collateral. Nor do the final rules address 'operational risk' in the sense that, for example, an FCM improperly segregates customer collateral and suffers a loss due to staff negligence or theft.
The CFTC further acknowledge that the final rules would not have prevented the MF Global problem nor do the rules address mutualized risk in bankruptcy. All customer collateral held at an FCM is considered customer property subject to rateable distribution to the extent of each customer's allowed net equity claims, should the FCM go into bankruptcy. "These three issues [investment risk, operational risk and rateable distribution risk] are not addressed by LSOC and remain to be considered in the future to see if additional protections could be made available," said Young.
From the buy-side perspective Joanne Medero, managing director at BlackRock said, "LSOC is a good balance between cost and operational complexity, yet still providing the protection against 'fellow customer' risk that exists in the futures world not the cleared world."
"People need to have a clear understanding of the risks that remain and the default terminology used such as 'unscrambling the eggs,' said Amy McCormick, executive director, Market Risk Management in the CME Clearing Division of CME Group. Separating the defaulting party's collateral from a commingled account may not be easy in the moment of default.
"Overall it does provide additional protection particularly to those gaining on the day of default. You have to take into account the costs and complexities of not having the operationally commingled model. The compromise is the 'unscrambling the eggs' problem but the flip side is it's a little more cost effective," said McCormick.
Young agreed with McCormick regarding cost effectiveness. Young added: " the history of clearing in the futures space is a great success with very few defaults over the years. Protection of collateral in the default situation is the exception rather than the rule."
Implementing LSOC creates a number of operational challenges including the method of collecting margin, the form of reporting to clearing houses, handling of excesses and the failure of the FCM caused by a client default.
For some products at the CME, McCormick said: "there is no book keeping at the DCO, at the customer level FCMs may have to provide more information to the central counterparty (CCP) clearing. With LSOC customer information will have to be reported to the CCP on a daily basis."
Implementation for the buy-side is relatively simple said Medero, "we keep and manage these records already on behalf of our clients and we don't expect our interface with the FCM to change dramatically."
With LSOC on the swaps side there will be more interfacing with customers, though the legal implications of this remain to be seen said Young.
As a result of LSOC, more customers, whether intermediaries like the buy-side or big customers of FCMs will ask more questions of their clearing members to make sure that information is getting through to the DCO they way they expect it to, said Medero.
Medero continues: "there is a strong desire from market participants to enhance LSOC to a full segregation solution for swaps, though this is difficult in the US due to the existing bankruptcy regime. There are a number of stakeholders in any change, DCO, the customer, clearing banks and the FCM."
Young said: "I don't think at this stage after the MF Global situation people should shy away from doing the right thing just because it involves changing the bankruptcy code or regulations."
When asked whether the US futures market should be subjected to legal segregation with operational commingling approved for the OTC market on January 11 2012, McCormick of the CME said "we feel strongly that we should not extend LSOC to the futures markets, better to wait to do the implementation for swaps, learn from the experience and determine whether it would be a good idea for the futures markets."
Young, McCormick and Medero were all in agreement that the industry must await the conclusions to be drawn from applying LSOC to swaps before subjecting the futures markets to the same model. "LSOC is an important piece of the puzzle not the end game, there is a lot more work to be done in better protecting customer collateral," said Young.
LSOC offers an appropriate compromise said Medero, "it is just one part of a big change as we move from a cleared environment with more swaps being traded on facilities."
All agree that LSOC is a good step in the right direction. The CFTC will continue to consider the approach to margin in both the cleared swaps and futures models as the market builds experience with LSOC and more details come to light regarding what happened with MF Global. The implication for other jurisdictions remains to be seen and is something the market will have to contend with as the regulation evolves.