CFTC hearing on custody of collateral and segregation of client accounts

The CFTC held a hearing today on several issues including segregation of client accounts and alternative methods of custody for customer collateral. While the “elephant in the room” (their words, not mine) of MF Global was not allowed to be discussed, it appeared to be a large backdrop for the hearing. The first panel focused on the legal separated operationally commingled (LSOC) model of customer account segregation and the second covered segregation of customer collateral for futures and cleared swaps.

We found this hearing important because of possible ramifications for other products like securities lending and repo currently or possibly being centrally cleared. Where goes futures and cleared swaps in the US, other cleared products are very likely to follow. Some notes from the morning are below.

– Futures Commission Merchants do not have enough capital to meet the obligations of cleared swaps, particularly for increases in guarantee funds and margins. Add to that the requirements of LSOC and the number of FCMs in the US will shrink substantially. This will concentrate risk in the hands of future FCMs.
– The CFTC says that the notional value of the US futures market is $40 trillion but the size of the potentially cleared OTC derivatives market is $800 trillion. Clearing is profitable and if clearing firms need to raise more money to protect clients and the worldwide economy then they should be able to raise the money.
– CME: LSOC for swaps is going in. They have a duty to understand the LSOC risks but are not yet sure that will get support in case of a new FCM bankruptcy. There are structural differences between futures and swaps markets. Buy-side responds well to LSOC – not responsible if someone else causes a default. But, how does this risk sharing or not work all the way around?
– Large end-users want to be “guaranteed clearing participants,” making the end-user not a client of the FCM but really integrated with the CCP. The idea here is ring fencing against an FCM default.
– Eurex has an individual client asset protection model. Meets the needs of the clearing member that is kept at Eurex Clearing in a totally segregated account. Eurex wants to introduce this into US as well.
– EU regulation considering full segregation as the default, not an option that has to be chased down. This is what happens now in OTC derivatives and should be preserved when OTC swaps get cleared.
– Basel rules need to be worked through on capital liens for FCMs.
– A panelist brought up the disintermediation of the FCM, which has echoes of old conversations by stock exchanges about who is their client, the broker or perhaps one day the end user – can end-users each have their own CCP account?

Today’s hearings was the first of a two day event. The press release for the panels as well as links to transcripts are at the CFTC’s website here.

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