A Commodity Futures Trading Commission
(CFTC) interpretive letter on cleared collateral segregation is
likely to spur resistance within the financial industry without
significantly reducing systemic risk, US lawyers have
November 1 letter headed 'Staff Interpretation Regarding
Part 22’ seeks to clarify
rules published by the CFTC on February 7. Those rules
implement Dodd-Frank provisions that require the legal
segregation, but allow operational commingling, of cleared
swaps customers’ margin collateral - referred to
as the LSOC model.
compliance date was November 8, and the CFTC was asked to
clarify a number of issues in advance of this date. This
included guidance on the definition of cleared swaps customer
collateral, said David Pentlow, partner at Herrick Feinstein in
But observers criticise
the rules and letter for seeking to fulfill a Dodd-Frank
regulatory master plan without offering credible protection to
cleared swaps customers.
The November 1 letter
allows commingling of the collateral of more than one customer
for operational purposes while, theoretically at least,
mandating a requirement to keep customers' collateral
The letter, which takes
a Q&A format, prohibits futures commission merchants from
posting the cleared swaps collateral of one customer to meet a
margin call for another customer's cleared swaps. It also bans
the use of one customer's excess to secure or guarantee the
cleared swaps of another customer.
In theory, such
safeguards would prevent situations where an unforeseen
disaster or trading error, of the kind experienced by MF
Global, would cause one innocent customer's collateral to get
sucked into the maelstrom of a second customer's trading
Whether or not the
safeguards are effective, they are likely to spur negative
reactions from futures commission merchants and cleared swaps
customers alike, observers said.
"I see the CFTC trying
to stay true to its mandate, not trying to loosen things or
liberalise anything," said Pentlow.
"People will disagree
as to whether this is appropriate. The industry is going to
complain that the interpretation limits flexibility, which may
be true – flexibility that might, if things go well,
improve the profitability or functioning of certain markets,"
The CFTC rules clearly don’t
anticipate a situation where cleared swaps customers have
willingly opted to allow their excess margins to breathe
fungibility into the market.
There are concerns about how effective the
protections are that legally separate different
customers’ collateral. Apart from market
participants’ negative reaction, there is a very
real question as to whether the CFTC's rules allow the right
degree of flexibility, and will ultimately protect
Jonathan Schwartz, a former Securities and
Exchange Commission and Federal Trade Commission lawyer who now
represents clients in CFTC enforcement matters, expressed
doubts about the utility of existing CFTC rules.
As a practical matter, an operational
staff member at a futures commission merchant faced with a
sudden collapse of collateral, and pressure to immediately stop
the leak, may take advantage of access to other customers'
money, he said.
"If the other customers' collateral is
locked away and buried underground, that's very nice, but in
reality that collateral has a role to play in the financial
health of the company," Schwartz noted.
The CFTC is not above being influenced in
the wrong ways by some of the major players in the industry it
regulates, he added.
"I would like to know what 'operational'
means in this context, because it suggests to me that in the
broker-dealer situation, the MF Globals of this world can write
a check on my collateral," he commented.
Those looking to the November 1 letter for
clarification are likely to come away disappointed.
For example, the
CFTC’s answer to question 4 states that futures
commission merchants are permitted to keep firm money,
securities, and other property in cleared swap customer
accounts at the derivatives clearing organizations. This
appears to create a situation where the merchants may legally
make withdrawals from the same accounts where customers have
been depositing their collateral.
'MF Global client
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CFTC’s new cleared swaps rules are potentially