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When Legal Segregation Isn’t Enough: The Protection Of Customer Contracts And Collateral

January 6, 2012

Photo by Nicholas B. Some rights reserved.

On January 11th the CFTC will consider whether to adopt three new rules, whether to propose for comment  its version of the Volcker rule, and whether to delegate to the National Futures Association the authority to register swap dealers and major swap participants.

One of the three final rules being considered addresses the protection of cleared swaps customer contracts and collateral, a concern made real by the collapse of MF Global and the disappearance of up to $1.2 billion in customer funds.

In the proposed rule, the CFTC concludes that the complete legal segregation (“CLS”) model provides the best mechanism for protecting customer money when weighed against the costs associated with the other possibilities. (Four other models were also discussed: physical segregation; legal segregation; the futures model; and the optional approach.)

Under the CLS model, a futures commission merchant (“FCM”) would keep records and documentation to account for each customer’s money, but would actually hold the customer money in an omnibus account. If the FCM defaulted or became insolvent, the derivatives clearing organization (“DCO”) would have recourse only to the defaulting customer’s accounts. Non-defaulting customers would be protected, and since the requisite books and records existed, non-defaulting customers would be able to move their accounts to alternative FCMs quickly and easily.

The demise of MF Global put paid to those conclusions.

Initially, most commenters supported the CLS model. But last month the CFTC received seven supplemental comments and communications from the industry. Many of these comments noted the hypothetical shortcomings of the CLS model which MF Global’s collapse made real.

First, as both pre- and post-MF Global commenters discussed, current bilateral swaps contracts allow for the physical segregation of customer collateral. As more than one commenter noted, the proposed CLS model actually creates risk for current bi-lateral swap users by exposing them to commingled accounts. It is an ironic reform that creates risk where none previously existed.

Second, MF Global’s collapse exposed the myth of CLS portability. The feasibility of transferring (or porting) an account from one FCM to another is only as good as the FCM’s recordkeeping. As many of MF Global’s customers have found, you can’t move your money if the FCM can’t trace your money.

Third, MF Global’s insolvency has exposed the necessity of addressing how swaps (and futures) are treated in bankruptcy.

And finally, at least two commenters believe that the physical segregation of customer collateral is so important that not just swaps customers should be afforded its protections. These commenters called upon the CFTC to make physical segregation available to futures and options customers as well.

We’ll see how the CFTC responds next week.

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