A proposal released last week by the Canadian Securities Administrators OTC Derivatives Committee is supposed to resolve a key issue in collateral segregation: who has control of collateral in the event of a broker’s insolvency. It doesn’t quite achieve its goal however.
The question of who has possession and/or control of customer collateral is near and dear to us. We reviewed this topic in some depth in our December 2013 research report, Collateral Segregation Rules and Risk Mitigation in the US and UK. One conclusion was that UK rules (including applications of EU laws in the UK) are slightly better for investors than US rules owing to what happens in case of broker bankruptcy. In the US, it looks like dealers have possession AND control of collateral even through collateral is physically segregated – the assets still belong to the dealer. UK rules allow more ownership by customers and assets are not considered broker property in case of bankruptcy. Although the UK also allows unlimited rehypothecation, this can be negotiated down to US rules.
Canada’s securities administrators have made their intentions clear in section 14 of CSA Staff Notice 91-304, Model Provincial Rule – Derivatives: Customer Clearing and Protection of Customer Collateral and Positions:
(1) A derivatives clearing agency must not apply customer collateral to satisfy the obligations of a clearing member of the derivatives clearing agency that arise as a consequence of the clearing member’s default.
(2) Despite subsection (1), a derivatives clearing agency may apply the customer collateral of a customer in full or partial satisfaction of a clearing member’s obligations that arise as a consequence of the clearing member’s default, to the extent that those obligations are attributable to the customer’s obligations.
On the face of it then, customer collateral may not be considered broker assets that can be used to settle all claims against the broker.
The matter doesn’t end there however. We looked into this a bit further and found the following commentary from law firm Borden Ladner Gervais LLP:
“The Customer Clearing Rule does not address the treatment of customer collateral under bankruptcy legislation in Canada, although it does recognize the impact that such legislation may have on the proposed collateral arrangements…. We would suggest that in order to fully protect customer collateral, changes should be made to existing bankruptcy legislation.” (A link to their full write up is here.)
This is tricky stuff, and investors should not be surprised to read one set of rules that get contradicted by another. Canada’s case shows the right intentions from regulators but conflicting rules in national bankruptcy law.