The evolving landscape for the segregation of assets is complicated. Lynn Strongin Dodds explores the advantages and disadvantages of the various segregation models and explains what buy-side firms should take into account as they prepare for central clearing.
The broad-brush picture of OTC regulation is easy to fathom against the backdrop of the financial crisis. However, digging deeper into the details, especially when it comes to the segregation of assets can challenge even the savviest technocrat. The US and Europe differ in their requirements but buy-side firms in both regions are looking for the safest option.
The US has the simpler version – legal segregation with operational commingling (LSOC) – which enables dealers to mix customer funds operationally, as long as they maintain legally segregated customer accounts. Traditionally, Future Commission Merchants (FCMs) held excess capital with which to meet initial margin and customer funds were physically separated from house funds. Under Dodd Frank, which started to be implemented late last year, the Commodity Futures Trading Commission (CFTC) is requiring FCMs to calculate and report their ability to cover gross margin deficiencies for a particular client using only that client’s or their pool of funds.
The three main central counterparty clearinghouses – CME Group, ICE Credit and LCH.Clearnet’s SwapClear – have wasted no time in rolling out their variations on a theme. They started with the basic “no excess” or “unallocated excess” LSOC and are now moving on to the “client-specific excess” model. This differs from the basic archetype in that client funds are commingled positions and collateral is segregated at the CCP level, with any excess value allocated among the omnibus clients accordingly. Holding excess margin at the clearinghouse layer requires clearing members to send them daily reports on the value of collateral attributable to each client.
The picture in Europe is much more complicated under the European Market Infrastructure Regulation (EMIR), which is due to take effect in the first quarter of next year. The rules state that every clearing member and anyone offering indirect clearing services must offer its clients at least a choice between omnibus client segregation and individual client segregation. The list should not be endless and the costs as well as levels of protection should be disclosed. In addition, if a client opts for an individually segregated account then “any margin posted in excess of the client’s requirement shall also be posted to the CCP and distinguished from the margins of other clients or clearing members and shall not be exposed to losses connected to positions recorded in another account.”
“It all depends on how you interpret the rules and there are so many different possible interpretations,” says John Southgate, head of derivative and collateral products for EMEA at Northern Trust. “In the US, the omnibus or LSOC model is prevalent but in Europe, EMIR doesn’t mandate full segregation but clients feel it is the only way forward in order to have active portability and their assets returned. What we are seeing is that clearinghouses are using segregation models as a competitive differentiator. However, it has made things more complex for clients and what the buy side really needs is consistency.”
To date, there are around 14 models vying for position. For example, CME Clearing Europe, which began offering client clearing for interest rates in March, offers three models – a physically segregated, an unsegregated omnibus account and the standard LSOC as well as the hybrid -with-excess-posted-to-CCP model planned. Swapclear, LCH.Clearnet’s clearing platform for interest-rate swaps currently caters to those who want either individual or omnibus segregation but expects to introduce two further segregation models in the second half of 2013.
Eurex, on the other hand, has the compliment of full segregation, net-margined omnibus segregation, and a futures-style elementary clearing model, with a fourth US-style LSOC prototype slated for later this year. The Deutsche Börse-owned derivatives market operator also recently added a net omnibus clearing model particularly for UK clearing members who need to comply with the Financial Conduct Authority’s (FCA) client asset protection rules. The new service separates the aggregate exposures of all the clients served by a single clearing member.
“What we are trying to do is offer a one-stop-shop for clients to clear different asset classes ranging from futures, bonds, repo, securities lending and OTC,” says Jens Quiram, head of clearing relations at Eurex Clearing, which has offered a client segregation model for listed derivatives since 2011. “We are seeing interest in full segregation models because it enables immediate portability to a new clearing member/broker in case a default of the current clearing member. Also, it helps ensure liquidity stays in the market.”
David Field, specialist in clearing and collateral management at consultancy Rule Financial, adds, “Full segregation as opposed to individual segregation is not mandated under EMIR, but buy-side clients do not want their assets pooled with others. They would like CCPs to hold individual names at the central securities depositaries (CSDs) although this entails a huge operational burden especially if several hundreds or thousands of accounts are involved. However, we are seeing CCPs being very proactive.”
It also has a growing fan base in the US. “The buy side would prefer full segregation but at the moment the FCMs are against it and the American market is moving towards LSOC which is what Dodd Frank has endorsed,” says David Little, director strategy and business development at Calypso. “This is because it would put severe strain on the FCMs in that the account structure is much more complex. However, I do believe that in the future the largest and most influential institutions will drive adoption of full segregation.”
There are of course the downsides which some believe may make institutional investors think twice. For example, it has not been tested in a default situation plus the legal rights over assets – and rules governing their safe return – could be subject to the quirks of local bankruptcy codes, and therefore not available in every jurisdiction. In addition, both clients and clearing members are at risk of losing netting benefits between offsetting positions and last but certainly not least, it is an expensive proposition especially for asset managers with multiple sub-accounts that each need to be segregated individually,
“The buy side will end up paying for it,” says Michael Steinbeck-Reeves of consultancy Catalyst. “If a CCP can demonstrate a satisfactory and sound level of segregation of assets, I am not sure clients would push for full segregation because it is a more expensive solution.”
By contrast, LSOC is easier to administer, preserves netting and has a high enough protective buffer. The excess model offers additional layers in that client collateral is held at a CCP rather than the clearing member. Some asset managers though would like to see the bar being raised even higher. This, for example, could entail not only the guarantee to recoup the value of assets lodged as collateral but also the instruments themselves, Others have voiced their concern that other clearing members will not be willing to take on ported positions amid the stressed conditions created by the default of a major clearing member, making it more important that the specific, posted collateral is returned.
Overall, the unsegregated omnibus solution is the simplest, most cost effective and least operational burdensome option. Under net omnibus models, FCMs can net off margin calls against other clients, lowering their cost of funding. The flipside is that assets are commingled, mutualising risk and exposing them to losses in the event of one defaulting.
If navigating through the current segregation landscape is not confusing enough, securities services firms are also putting other options on the table such as quad party which adds a custodian or CSD to the tried and tested tri-party mix of client, clearing member and CCP. Under this structure a custodian will typically act as collateral agent between the client and clearinghouse. In the expanded form, client assets are still held at the custodian, but it is the legal status of the assets that changes. They are made available to either the clearing member if the client defaults or to the CCP if the client and clearing member fails.
The benefit is that it eliminates settlement risk and end clients are given greater choice and flexibility while the clearing firms that underwrite their risk as well as the CCP are entitled to use the collateral should the need arise. It is more complicated though in terms of legal relationships.
“We are definitely seeing greater interest in quad party structures where a client’s collateral is segregated form other client’s funds and exposures,” says Mark Higgins, head of business development EMEA at BNY Mellon. “This is particularly the case with the bigger buy-side firms who have larger pools of collateral they want to move around using our infrastructure.”
