It is confounding that futures customers currently receive a lower level of protection than cleared swaps customers under US law. This legal phenomenon has occurred because the law in the US derivatives markets developed in a piecemeal fashion over several decades.

The Commodity Exchange Act (“CEA”) was designed to include protections for the collateral (known as margin) that futures customers post with their Futures Commission Merchants (“FCM”).[1] Section 4d (a) contains a ‘segregation requirement’, which places the margin of a futures customer into a trust account. This prohibits an FCM from “using” a customer’s margin for its own purposes or “guaranteeing” the contracts of another customer.

The original intention of the law was to allow the customers of an insolvent FCM to recover their margin deposits in priority to the FCM’s other general creditors; however, this has not occurred in practice. The CEA has not been able to fulfill its intended purpose because the Code of Federal Regulations (“CFR” or “CFTC Regulations”) introduced a loophole that allows FCMs to commingle the funds of futures customers into an omnibus account “for convenience”.[2] Thus, the current model for segregating margin deposited by futures customers is known as the “Futures Model”.

The ability to commingle customer funds has provided Central Counterparties (CCP) with two major advantages. Firstly, the CFR only requires CCPs to identify an omnibus account as ‘collectively’ belonging to the futures customers.[3] Therefore, CCPs have deliberately ignored the identity of individual futures customers in order to avoid the cost of having to maintain updated records on individual customer margin deposits.

Secondly, the practice of commingling and ignoring the identity of futures customers has permitted CCPs to use the margin of the non-defaulting customers of an insolvent FCM to cover the obligations of the defaulting customers. This is known as ‘fellow customer risk’.

This type of risk can manifest in a ‘double default’ situation, which occurs where one or more customers default on their obligations to their FCM, and the resulting losses are so large that it causes the FCM to default on its obligations to the CCP. In these situations, CCPs have been able to ‘use’ the margin of the non-defaulting customers as a part of their default waterfall[4] when there is a shortfall in the customer omnibus account.

CCPs have been able to access these protected funds because they have ‘super-priority’ creditor status under the clearing arrangement that was signed by all the clearing members. This gives CCPs the right to access the entire commingled customer margin pool in order to cover the losses of the defaulting customers, without any regard for the customers that are negatively affected. As a CCP is unable to ‘identify’ which customer’s margin it is ‘using’, the non-defaulting customers will subsidize the losses of the defaulting customers if there is a large shortfall in the omnibus account.

This loophole occurred because there is a discrepancy between the CEA and the Bankruptcy Code. Upon the insolvency of an FCM, the Bankruptcy Code requires the trustee to “liquidate” any margin deposits that cannot be “identified” with a particular customer and distribute the proceeds in the form of money on a pro rata basis.[5] In practice, this means that the non-defaulting futures customers will mutually share in any shortfall that results in the commingled omnibus account after the CCP has withdrawn the amount it was owed by the defaulting futures customers.

While futures customers are made expressly aware of their exposure to fellow customer risk when they enter into a brokerage agreement with their futures brokers, it is unfair that these customers are not receiving the level of protection that was intended under the law.

In light of this weaker level of protection, and in response to the 2008 global financial crisis, Congress passed the Dodd-Frank Act (“DFA”) to provide cleared swaps customers with protection from fellow-customer risk. Section 724 (a)(2)(A)[6] of the DFA was introduced to mirror section 4d (a) of the CEA; however, the CFTC noticed that this provision had the same limitations as its predecessor.

Therefore, the CFTC was swift to amend its Regulations[7] and adopt the “Legal Segregation and Operationally Commingled” (“LSOC”) Model of segregation for the protection of cleared swaps customer margin deposits. The CFR specifically require CCPs to record and identify individual swaps customer margin deposits on a daily basis.

Since the Bankruptcy Code requires the CCP to transfer or return any ‘identifiable’ margin to the non-defaulting customers of an insolvent FCM, CCPs are not allowed to access the margin of the non-defaulting cleared swaps customers in a double default situation. Consequently, these customers receive a higher level of protection than futures customers.

In order to remedy this discrepancy, it is argued that there are several advantages to adopting the LSOC Model in the futures industry. Firstly, CCPs would be prohibited from using the margin of non-defaulting customers and would have fewer resources under the default waterfall to cover a clearing member default if the LSOC Model were adopted. Therefore, CCPs would have an added incentive to closely monitor the clearing members, as fellow customer risk would be shifted from customers to the CCP. This would minimize the build-up of exposures in a clearing system.

Secondly, the Futures Model creates uncertainty for customers upon the insolvency of their FCM, as they will not know the amount of their losses resulting from fellow customer risk. This decreases confidence in the futures markets and can exacerbate volatility during periods of market stress. The LSOC Model would reduce this uncertainty by facilitating the porting of margin, which should allow customers to transfer their open futures and cleared swaps positions to a solvent FCM without having to close-out all their open contractual positions.

Thirdly, the Basel III Accord imposes fewer capital requirements on banks that post customer margin in a manner that is bankruptcy remote from the CCP; therefore, costs would be lower for banks if the LSOC Model were adopted in the futures market.

Furthermore, since the LSOC Model only protects customers from fellow customer risk, it is necessary for the US to introduce insurance that protects futures customers and cleared swaps customers from an FCM insolvency that results from other operational risks (e.g. fraud, terrorism, and human error). This would provide US derivatives customers with the same protections afforded to customers in the US securities markets and derivatives customers in other jurisdictions (e.g. Canada).

The recommended changes are easy to implement: Firstly, the CFTC would need to publish a press release to confirm that the LSOC Model will replace Futures Model in the futures industry. The CFTC would need to amend its Regulations to clarify that FCMs must provide a daily report of individual futures customer margin deposits to the CCP. This would enable the CCP to identify individual customer margin deposits in the account to facilitate porting and ensure that customer margin is returned to the non-defaulting customers upon the insolvency of their FCM.

Secondly, Congress would need to pass legislation that creates a Futures Investor and Customer Protection Corporation to provide insurance to futures and cleared swaps customers. Overall, these simple changes should bolster confidence in the US derivative markets and provide them with a competitive edge over markets with weaker customer protections.

ENDNOTES

[1] The comments in this post only apply to FCMs that act as clearing members in a clearing system.

[2] 17 C.F.R. 1.20 (e)(1).

[3] 17 C.F.R. § 1.20 (g).

[4] The default waterfall is the list of emergency resources that a CCP has to cure a default by a clearing member.

[5] Section 766 (e), Bankruptcy Code.

[6] § 724 (a) of the DFA amended the CEA and added a new § 4d (f). It has been codified as 7 U.S.C. § 6d and 17 C.F.R. § 22.

[7] 17 C.F.R. § 22.11 (c)(1) and (2).

The preceding post comes to us from Christian Chamorro-Courtland, Assistant Professor at Zayed University. The post is based on his article, which is entitled “Collateral Damage: The Legal and Regulatory Protections for Customer Margin in the U.S. Derivatives Markets” and available here.