Eurex is currently the only clearinghouse to offer full segregation. In a Q&A, Eurex Clearing’s Jennifer Vuong explains how full segregation works and the advantages and disadvantages of this model compard to omnibus models.
Q: Eurex Clearing is currently the only CCP to offer individual collateral segregation. Can you briefly explain this model and how it works within Eurex Clearing?
A: Full segregation, or also called individual segregation refers to the model where the client positions and collateral is segregated at individual account levels and held separately from the clearing member who handles those assets and clearing activities on behalf of the client to ensure the highest level of customer asset protection and portability of positions.
Individual collateral segregation is different from omnibus segregation models, which generally segregates the margin of clearing members from the non-clearing members (NCMs) or client and pools the client positions in a single ‘omnibus’ account. The margining of this single omnibus account differs slightly in different models where, for instance, in the futures market model used in the US called legally separated operationally comingled (LSOC), the positions held in the omnibus account are margined on a gross basis (as opposed to net). The graph below provides a good summary of the key differences.
To explain the individual segregation model, it is best to review the Eurex Clearing Individual Clearing Model (ICM) structure, because Eurex Clearing is currently the only central counterparty (CCP) to offer this level of collateral segregation and portability. The individual segregation model at Eurex Clearing operates on three main functions: title transfer, close-out netting and pledges.
Firstly, NCMs transfer their title of assets used for collateral to their clearing member and the clearing member will then transfer title to Eurex Clearing. Eurex Clearing will then become the legal owner of the collateral and the NCM remains the beneficial owner so any income will go back to the beneficial owner.
In this model, Eurex Clearing also provides for segregation of books and records so all of the positions of the segregated NCMs will be recorded individually in their own accounts. The margin for these accounts will be held in a sub account in the client’s name at Clearstream Bank in Frankfurt. In the event of a default of a clearing member, Eurex Clearing is then able to pick up that sub account and transfer to a new clearing member or return the collateral as per the client request in a timely manner. In the Eurex Clearing individual segregation offering, there is no cash equivalent of collateral returned to the buy side but rather a ledger transfer reference change to the new clearing member.
In the event of the insolvency of a clearing member, use of close-out netting and pledging procedures achieves timely portability of a NCMs’ positions and margin. This process will take place between Eurex Clearing and the clearing members and between Eurex Clearing and the NCM. It is important to note that final payment resulting from this close-out netting process will take place without the involvement of the defaulted clearing member.
Q: What are the advantages and disadvantages of individual segregation model compared to omnibus models?
A: Firstly one of the benefits of the full segregation model is that it is expected to be compliant with the European Markets Infrastructure Regulation (EMIR) requirement for CCPs to provide individual segregation as well as other options for collateral segregation to support protection of customer assets. Also, Basel III fully recognises collateral segregation in OTC clearing by applying lower risk weightings where collateral is held “bankruptcy remote”. Eurex Clearing is considered “bankruptcy remote” and the risk weightings under Eurex Clearing’s ICM will be significantly reduced. It is important to remember collateral segregation only protects NCMs against their clearing member default and not any other brokers that they may be using in between.
It has been said that individual client segregation carries a higher cost. Cost not from a CCP perspective because Eurex Clearing is not charging for the service, nor do we have any additional costs related to the opening of subaccounts at Clearing Banking Frankfurt. However, we can envisage that this is an additional service that a clearing member would be providing to their clients and therefore charging for.
Another disadvantage is the loss of cross margining capabilities in that a client forfeits the possibility of cross netting positions cleared within Eurex Clearing with any of its other positions or portfolios held externally with other clearinghouses.
Q: Why have you decided to go with full segregation model first? Why have other CCPs focused on the omnibus model first as opposed to going to the full segregation straight away?
A: Both full and omnibus segregation is required within EMIR so from our perspective, have simply just gone initially to offer full segregation and portability now, but we are also building towards omnibus segregation as well. Other CCPs obviously started with omnibus segregation solutions and they are working towards an individual segregation model.
For us it was important to have a full segregation model available for individual NCMs to be able to identify individual NCMs before segregating clients that are not NCMs of Eurex Clearing. The ICM model was launched in August 2011.
Q: Which jurisdictions do you currently support with your full segregation model and what are the general plans for future expansion?
A: Currently there are a set number of combinations, which are available, so for UK clients, they can use individual segregation if they have a UK, German or French clearing member., So, it is a mix and match and we are working on expanding that list further. Every single jurisdiction in which we offer individual segregation is legally sound and we are starting the legal analysis for Luxembourg, Ireland, and Sweden.
In addition to jurisdictional expansion, the full segregation model will be extended to the buy-side clients under a new status called ‘registered customer (RC).’ The difference between the NCM status and RC status is that the RC does not have trading rights on the exchange so they would only be using their clearing broker to enter trade. The RC structure allows the buy side to segregate collateral and positions on a per-fund basis and allows complete portability and protection in the event of a clearing member default by way of the interim participant facility (covered later in this article).
The full segregation service therefore is available to NCMs and registered customers and of course, clearing members.
Q: How are you approaching the US market and do you plan to establish segregation services to support the model required in that market (i.e. LSOC)?
A: We take into account the regional specificities of the markets where we operate such as in the US where we are working on different projects, such as the Derivatives Clearing Organisation (DCO) application, to become a recognised CCP in the US, which will allow us to use some of our existing solutions to service the US.
Q: Can you explain how your segregation process works in the event of a clearing member defaulting in detail?
A: Generally from a default perspective the lines of defense of the CCP are the same To support the default process, we have built in an interim participant facility, which lasts up to five days and allows an NCM or Registered Customer to act temporarily as a clearing member to have more time to find a replacement-clearing member and conduct the transfer of positions and collateral via close-out and re-opening processes in the event of a clearing member default. This gives the NCM the ability to continue trading after a clearing member defaults if they choose, and is an instant benefit to any participant during this 5-day period. In the five-day period those with the interim participant status will be required to act as a clearing member hence will have to pay into the contribution fund, pay all margin requirements and will be able to add to positions
Q: What has been the response from buy-side users to the individual segregation model?
A: Post-MF Global, the buy side wants a greater level of asset protection and are thus in favour of a model that can provide this. There are obviously operational costs and collateral requirements involved in the individual segregation model compared to omnibus model, but the customer still wants that extra layer of segregation to have additional comfort in the safety of assets in the event of clearing member default.
