CCPs and Legally Separated Operationally Commingled collateral: one step forward, one step backwards

On February 29th we posted about the CFTC hearing on collateral custody and segregation of client accounts. One of the things mentioned was the acceptance of Legally Separated Operationally Commingled (LSOC). Market participants still have nightmares about Lehman Brothers (Europe) and not being able to get their collateral back because it had been re-hypothecated. LSOC deals with that problem via a hybrid approach to holding client assets. To save on operations costs, the assets are held in a clearing member’s omnibus account. But for legal purposes, the full segregation of client assets is recognized. LSOC seems like a win-win. Not so fast.

In Central Credit Counterparties (CCPs) the collateral can typically be accessed to support the CCP if a clearing member defaults. It may not be at the top of the risk waterfall, but it is in there. Remember CCPs are meant to be a mutualisation of risk, not an isolation exercise. When you remove some of the collateral, the waterfall is changed. To maintain the same risk profile, something has to replace it. And that something is initial margin.

In Finadium’s March 2011 report, “Central Credit Counterparties, Margin and the Challenge of Collateral Management” we wrote,

“…Another structure being raised by U.S. regulators is called “legally segregated/operationally commingled” (LS/OM). The effect is to keep collateral in the omnibus account unless there is a default, at which point collateral will be isolated outside of the risk waterfall. The good news is that this approach could remove the mutualisation of risk that end-clients undertake. The bad news is that the buffer that mutualisation provided must come from somewhere else – namely front-loaded costs in the form of additional guarantee funds provided by the Clearing Members, or higher initial margins provided by end-clients.

In a November 4, 2010 article in Risk Magazine, Chris Edmonds, the President of ICE Trust (the credit default CCP owned by the IntercontinentalExchange) was quoted as estimating that initial margins under “legally segregated/operationally commingled” could go up by 63%. Kim Taylor, president of the clearing division at the Chicago Mercantile Exchange (CME) is said to have concurred. To the extent that the risk waterfall is rearranged by removing end-client collateral from the equation and initial margin requirements are increased as dramatically as predicted, the additional demand for collateral will be substantial and costs will be high. Paradoxically, a 2010 Greenwich Associates survey revealed that 77% of the corporates in the poll (but only 22% of the financials) said that mitigating credit risk was the most important benefit of centralized clearing. Time will tell if they are willing to pay for that mitigation…”

Unless there is some other rabbit coming out of the hat, LSOC will result in increases in initial margin and further strain the collateral markets.

A link to a synopsis of the Finadium report is here.

A link to the Finadium post from February 29, 2012 is here.

A post from the ISDA blog “derivatiViews” on LSOM is here.

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