New DCO Standards to Impact Banks and Other Clearing Customers

By Margaret Scullin

On December 2, 2013, the Commodity Futures Trading Commission (“CFTC”) published final regulations establishing additional standards for derivatives clearing organizations (“DCOs”). The primary purpose of these rules is to harmonize the CFTC’s core principles and rules governing DCOs with international standards. Specifically, the regulations were developed for consistency with the Principles for Financial Market Infrastructures (“PFMIs”) published by the Committee on Payment and Settlement Systems and the Board of the International Organization of Securities Commissions.

The PFMIs apply to all financial market infrastructures, including DCOs (also referred to as “central counterparties” or “CCPs”), which have been determined by a national authority to be systemically important. In addition to applying these new regulations to DCOs that the Financial Stability Oversight Counsel has designated as systemically important (“SIDCOs”), the CFTC will also allow DCOs that have not been designated as systemically important to elect to become subject to the CFTC regulations implementing the PFMIs. (DCOs that opt in to these regulations are called “Subpart C DCOs”, referring to the subpart of the regulations where the relevant provisions reside.)

Why would DCOs voluntarily subject themselves to additional regulation? The answer lies in the Capital Requirements for Bank Exposures to Central Counterparties published by the Basel Committee on Banking Supervision in 2012, which govern capital charges arising from bank exposures to CCPs related to derivatives. Banks’ capital charges will be significantly reduced for exposures arising from derivatives cleared through CCPs that are prudentially supervised in a jurisdiction that has adopted regulations consistent with the PFMIs (“qualifying CCPs”). Banks will face substantially higher capital charges for exposures arising from derivatives cleared through non-qualifying CCPs. Because of the incentives for banks to clear their derivatives through qualifying CCPs, non-qualifying CCPs may be at a competitive disadvantage. By electing to become Subpart C DCOs, otherwise non-qualifying CCPs are expected to be qualifying CCPs, similar to SIDCOs.

There will be costs associated with opting in, where applicable, and achieving and maintaining compliance with the CFTC’s additional standards. The Chicago Mercantile Exchange, Inc. (“CME”) and ICE Clear Credit LLC (“ICE”) have been designated as SIDCOs and therefore are automatically subject to these new rules. LCH.Clearnet LLC and LCH.Clearnet Ltd. are CFTC-registered DCOs that have not been designated as SIDCOs and therefore will have a choice as to whether to become Subpart C DCOs. Based on comments submitted on the proposed rule by LCH.Clearnet Group Limited (“LCH”), it appears that they intend to opt in to the regulations. LCH stated that it “strongly supported” the CFTC’s proposal to allow non-SIDCOs to become qualifying CCPs by complying with stricter standards. In fact, LCH proposed that the heightened standards should automatically apply to all currently registered DCOs instead of making compliance optional for non-SIDCOs.

The new and revised standards introduced by the CFTC for consistency with the PFMIs address: governance arrangements, financial resources, system safeguards, default rules and procedures for uncovered losses or shortfalls, risk management, additional disclosure requirements, efficiency, and recovery and wind-down procedures.

The enhanced financial resources requirements are likely to have the most direct and immediate impact on users of DCOs. Under previously adopted CFTC regulations, all DCOs are required to maintain, at minimum, financial resources in excess of the amount required to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions (“Cover One”). SIDCOs and Subpart C DCOs will be required to maintain financial resources sufficient to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the two clearing members creating the largest combined financial exposure for the DCO in extreme but plausible market conditions (“Cover Two”) if the SIDCO or Subpart C DCO is either systemically important in more than one jurisdiction or involved in activities with a more complex risk profile. The CFTC has defined “activity with a more complex risk profile” to include the clearing of credit default swaps, credit default futures, or derivatives referencing either of the foregoing, as well as any other activity designated by the CFTC as having a more complex risk profile. Both of the existing SIDCOs, CME and ICE, will be subject to a Cover Two requirement. The new regulations clarify that DCOs are prohibited from including assessments as a financial resource in meeting either the Cover One or Cover Two requirement. Therefore, guaranty fund contributions must be pre-funded in order to be included in the calculation of the DCO’s available financial resources.

All SIDCOs and Subpart C DCOs are required to maintain eligible liquidity resources sufficient to enable them to perform their settlement obligations under a wide range of stress scenarios, including the default of the clearing member creating the largest liquidity requirements under extreme but plausible circumstances. Such liquidity resources must be maintained in all relevant currencies in which the SIDCO or Subpart C DCO has settlement obligations to its members. Only a short list of defined “qualifying liquidity resources” will satisfy the minimum liquidity requirements (generally, cash and certain committed funding arrangements). Several commenters raised practical concerns about the eligibility requirements, particularly the requirement to maintain resources in all settlement currencies, the requirement that sovereign obligations, such as U.S. Treasuries, be subject to prearranged funding arrangements, and the disqualification of funding arrangements including material adverse change conditions. It was argued that the restriction on eligibility of U.S. Treasuries as resources would require clearing members to deposit more cash with the DCO and that bank-affiliated clearing members could be subject to higher capital charges as a result. Despite these comments, the CFTC adopted the regulations largely as proposed with only minor modifications to the language.

Most of the new regulations will become effective on December 31, 2013; some will be effective earlier. The CFTC determined to waive the effective date requirements prescribed by statute to facilitate attainment of qualifying CCP status by year end. In order for non-SIDCOs to obtain qualifying CCP status by December 31, 2013, their election forms must be received by the CFTC by December 13, 2013. The CFTC declined to phase in the implementation of these new standards, as recommended by several commenters, but will consider individual requests for extensions of up to one year to comply with certain of the regulations.


CFTC Modifies No-Action Relief for Swaps Intended to be Cleared

By Margaret Scullin

On November 15, 2013, the CFTC Division of Swap Dealer and Intermediary Oversight (“SDIO”) issued a letter (CFTC Letter No. 13-70) providing no-action relief from certain external business conduct standards for swaps that are intended to be cleared. This letter modifies and effectively supersedes CFTC Letter No. 13-33, which was published on June 27, 2013 (the “June No-Action Letter”). According to the more recent letter, “circumstances in the market…have changed” since the June No-Action Letter was issued. Specifically, swap execution facilities (“SEFs”) have become subject to mandatory registration and the CFTC Divisions of Clearing and Risk and Market Oversight have jointly issued staff guidance on swaps straight-through-processing requirements (“STP Guidance”, discussed in a previous post).

Swap dealers and major swap participants are subject to extensive requirements under the Dodd-Frank Act and related regulations when entering into swaps with counterparties. These include the CFTC’s external business conduct standards and the requirement to execute swap trading relationship documentation, meeting prescribed standards, prior to or contemporaneously with entering into a swap transaction with a counterparty. Relief was requested due to the practical difficulties of meeting those requirements where the identity of a counterparty is unknown prior to execution (“anonymous swaps”) and because certain requirements are unnecessary and unduly burdensome in cases where swaps are of a type accepted for clearing by a derivatives clearing organization (“DCO”) and are intended to be submitted for clearing contemporaneously with execution (“Intended-To-Be-Cleared Swaps”). SDIO granted such relief in the June No-Action Letter but has now revised the scope and conditions for availing of such relief.

Differences in Scope

• The June No-Action Letter was limited to Intended-To-Be-Cleared Swaps executed off-facility. The modified relief is available, to varying degrees and subject to conditions, for Intended-To-Be-Cleared Swaps executed off-facility as well as those executed on a SEF or designated contract market (“DCM”).
• For non-anonymous swaps, the extent of relief will vary depending on whether the swap is of a type that is accepted for clearing as of the date of the no-action letter (November 15, 2013) or is subject to mandatory clearing as of the date of execution. If the swap is not of a type that is accepted for clearing as of the date of the no-action letter and is not subject to mandatory clearing as of the date of execution, then more limited relief will be available and compliance with the “core pre-execution material disclosure requirements” of the external business conduct standards will be required. This new distinction is due to concern on the part of SDIO that swaps accepted for clearing in future that are not subject to mandatory clearing may not be “sufficiently standardized” to warrant broad relief from the business conduct standards.

Differences in Conditions

The number of conditions to be eligible for relief has been reduced. Under the modified relief, the swap dealer or major swap participant must either be a clearing member of the DCO to which the Intended-To-Be-Cleared Swap will be submitted or must have entered into an agreement with a clearing member of that DCO for clearing swaps of the relevant type. (This condition is unchanged from the June No-Action Letter.) A new condition has been introduced that the swap dealer or major swap participant may not require its counterparty or its clearing futures commission merchant (“FCM”) to enter into a breakage agreement or similar agreement as a condition to executing the Intended-To-Be-Cleared Swap. This is a major departure from the June No-Action Letter, which required entry into a written fallback agreement to address the consequences of a failure to clear. Such fallback agreements were required to provide that trades failing to clear would either be void as of execution (with no amount payable to either party) or terminated upon failure to clear (with amounts payable as agreed between the parties). The latter alternative would constitute a breakage agreement and largely tracked the existing market practice of parties entering into the FIA-ISDA Cleared Derivatives Execution Agreement to govern Intended-To-Be-Cleared Swaps. The Cleared Derivatives Execution Agreement has been met with continuing opposition from the CFTC. The STP Guidance prohibited SEFs, DCMs, FCMs and swap dealers from requiring breakage agreements as a condition for access to trading on a SEF or DCM. The recent no-action letter would extend the prohibition on breakage agreements to all Intended-To-Be-Cleared Swaps, whether executed on a SEF or DCM or off-facility, as a condition of availing of the no-action relief.

Eligibility for the relief has changed in another important, and curious, way. Under the June No-Action Letter, the swap dealer or major swap participant was required to have a written agreement with its counterparty that each party would submit the Intended-To-Be-Cleared Swap to the DCO or its clearing member as quickly as technologically practicable after execution. Under the modified relief, the written agreement requirement has been replaced with an obligation on the part of the swap dealer or major swap participant to “ensure” that both parties submit the Intended-To-Be-Cleared Swap for clearing “as quickly after execution as would be technologically practicable if fully automated systems were used”. Not only does this accelerate the timing requirement (to a degree that may be unattainable by many counterparties), it also places an unreasonable burden on the swap dealer/major swap participant to ensure the occurrence of something beyond its control (submission to clearing by its counterparty). This requirement only applies to off-facility swaps but it applies regardless of whether the identity of the counterparty to the swap is known prior to execution or not. For anonymous swaps, ensuring that the counterparty submits the swap for clearing within the required timeframe would seem to be impossible. In removing the requirement for a written fallback agreement, SDIO stated its belief that no fallback, breakage or other agreement should be necessary for off-facility Intended-To-Be-Cleared Swaps, provided they are submitted for clearing within the same timeframe that would be required had the swap been executed on a SEF or DCM. The question of what would happen if such a swap fails to clear was neither raised nor answered.

Limited CFTC No-Action Relief from SEF Rules Addresses Clearing Rejections

By Margaret Scullin

The CFTC Divisions of Clearing Risk and Market Oversight recently issued a no-action letter (CFTC Letter No. 13-66) after receiving industry feedback on their Staff Guidance on Swaps Straight-Through Processing (discussed in a previous post).  That guidance required swap execution facilities (SEFs) to have rules stating that trades rejected from clearing are void ab initio (the so-called “void rule”) and also prohibited certain registered entities from requiring breakage agreements as a condition for access to a SEF. 

Market participants pointed out that trades may be rejected for clearing due to minor problems that can easily be fixed, such as operational errors resulting in the submission of mismatched trade terms.  Currently, parties to those trades would typically agree to resubmit the trade for clearing with the corrected information. 

The resubmission of such trades, if executed on SEFs, would violate the CFTC’s regulations governing SEFs and related guidance.  For example, the SEF rules stipulate permitted methods of execution and prohibit “pre-arranged trading”.  The relief is intended to permit the resubmission of trades executed on SEFs that are rejected for clearing due to operational or clerical errors resulting in mismatched terms.  However, its impact will be limited for a number of reasons.

First, the relief expires on June 30, 2014.  No explanation is given for this limited duration.  Time-limited relief from the void rule for trades rejected due to limit breaches would be understandable, in recognition that clearing certainty remains a work-in-progress.  However, this relief is not available for clearing rejection due to a limit breach.  It only applies to rejections due to mismatches in terms caused by clerical or operational errors.  There is no reason to expect that such errors will cease to occur in future.

Second, in order to avail of the relief, a dozen conditions must be met.  Of greatest practical concern are the consent requirements.  Both clearing members must agree to resubmit the trade and each must obtain the consent of its customer (if any) to do so.  This consent may not be obtained in advance (for example, in a standing instruction) but must instead be sought on a case-by-case basis after the trade has been rejected.  Notwithstanding that consent can only be obtained post-rejection, resubmission must occur within a very short timeframe.  The trade must be resubmitted “as quickly as technologically practicable after receipt by the clearing members of notice of the rejection from clearing, but in any case no later than 30 minutes from the issuance of a notice of rejection by the [derivatives clearing organization] to the clearing members”.  It is easy to imagine how the post-rejection consent requirement could cause parties to miss the resubmission window (either because the clearing member has not sought the consent within that time or the customer was unavailable to provide it).  Post-rejection consent also provides an opportunity for a party to decline resubmission if the market has moved against them or other circumstances have changed making the trade less desirable to them.  Such second-guessing would be avoided if consent could be obtained pre-trade.

Finally, the SEF must have rules stating that, if the resubmitted trade is also rejected, it is void ab initio and may not be resubmitted a second time.  Especially given the narrow universe of trades likely to be eligible for this relief in the first instance, the purpose of this limitation is unclear.     

CFTC Finalizes Customer Protection Rules, including for Cleared and Uncleared Swaps Collateral

By Margaret Scullin

The Commodity Futures Trading Commission (CFTC) approved its final set of customer protection reforms on October 30, 2013. These rules address customer funds held by futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) and apply to domestic and foreign futures customers, as well as cleared swaps customers. Other rules were approved addressing protection of uncleared swaps collateral.

Lessons Learned

Several of the reforms were developed in response to the bankruptcies of FCM’s MF Global and Peregrine Financial in 2011 and 2012, respectively. A few of the reforms had already been introduced by the National Futures Association, a self-regulatory organization that was Peregrine’s primary regulator and is overseen by the CFTC. For example, the CFTC adopted what had been dubbed the “Corzine rule” (after MF Global CEO Jon Corzine) restricting withdrawals of funds from customer segregated accounts. The rule requires written approval of senior management and notification to the regulator prior to withdrawal of more than 25% of the FCM’s proprietary funds (referred to as “residual interest”) from customer segregated accounts. The new rules also require daily segregated account reports to regulators, including identification of depositories of customer funds. Reports and notices will be required to be delivered electronically and the CFTC will be granted direct online access (in read-only format) to FCMs’ depository accounts. These changes, while reflecting technological advancements, are intended to prevent the falsification and interception of paper statements that Peregrine’s CEO employed for years to avoid detection of his misappropriation of customer funds. The rules also introduce enhanced auditing of FCMs and require new mandatory disclosures to FCM customers.

Residual Interest Controversy

The rules that generated the most comments and opposition were those related to FCMs’ residual interest in customer segregated accounts. Existing section 4d of the Commodity Exchange Act prohibits the use of one customer’s funds to margin, secure or guarantee the positions of any other person. Rules intended to implement this prohibition were met with numerous practical objections. The CFTC has emphasized that this prohibition applies at all times. This reminder was apparently needed because, at MF Global, customer segregated funds were often used intra-day to meet the firm’s liquidity needs and then returned (or intended to be returned) before the end-of-day segregation calculation was performed. In order to avoid the use of one customer’s collateral for another customer’s positions, the FCM is required to use its own property to cover any margin deficit, to the extent it has not collected from its under-margined customer(s). The CFTC had proposed a rule that would require an FCM to maintain a residual interest in the customer segregated account at least equal to any margin deficiency in the account “at all times”. Commenters objected that it would be practically impossible to meet a continuous calculation requirement and that calculation of the residual interest requirement should be made at a point in time. Commenters also noted that the section 4d prohibition is a prohibition on “use” of customer collateral and that use would not occur until settlement. The CFTC amended the language in the final rule to provide for calculation of the residual interest requirement by reference to the DCO’s daily settlement time.

Several commenters raised concerns about the timing for meeting the residual interest requirement. At what point in time must an FCM cover any shortfall in the customer segregated account? It was noted that, the sooner the FCM is required to do so, the more likely that FCM would require pre-funding of margin from its customers. Pre-funding of margin not only adds burdens to customers but also increases their exposure to their FCMs. If the FCM chooses instead to fund any shortfall from its own resources, that will likely translate into higher fees for customers. The CFTC responded to these concerns by delaying implementation of and phasing in the residual interest deadline for FCMs. Beginning one year after the rule is published in the Federal Register, the deadline will be 6pm Eastern time on the date of settlement. The phase-in period will expire on December 31, 2018, at which time the deadline will become the time of settlement, unless the phase-in period is earlier terminated or the phase-in schedule is amended. During the phase-in period, the CFTC must conduct and publish a report on the feasibility, costs and benefits of shortening the deadline to the time of settlement. Termination of the phase-in period cannot be ordered until nine months after the study has been published and at least one year’s notice must be given of termination.

The residual interest deadline described above will apply only to domestic futures accounts. The CFTC noted that the rules applicable to cleared swaps accounts (17 CFR Part 22, implementing Legal Segregation with Operational Commingling or LSOC) and related CFTC staff interpretations already require the FCM to cover any margin deficiency in a customer segregated account by the time of settlement. Interestingly, the CFTC primarily cites a regulatory update from the Joint Audit Committee (a representative committee of U.S. futures exchanges and regulatory organizations) in support of this statement. While the CFTC’s Staff Interpretation Regarding Part 22 is clear that an FCM must use its own property to cover any shortfall where its cleared swaps customer is under-margined, it does not discuss the timing of that obligation.

The rules also impose a capital charge on FCMs that are under-margined with respect to futures accounts. A capital charge for FCMs that are under-margined with respect to cleared swaps accounts is expected to be included in the swap dealer capital requirements, which have yet to be finalized.

Protection of Uncleared Swaps Collateral

The new rules regarding protection of uncleared swaps collateral supplement the existing requirement that swap dealers and major swap participants notify their uncleared swaps counterparties of their right to have their collateral segregated with a third party custodian. This requirement applies only to initial margin, although the parties may agree to also segregate variation margin.

The rules define the terms “segregate”, “initial margin” and “variation margin”. They also provide details as to the required frequency of notices of the right to segregation and to whom they must be delivered. Reports must also be delivered on a quarterly basis to counterparties that do not elect segregation, confirming that their collateral is being held in accordance with the terms of the parties’ agreement.

Swap dealers and major swap participants are not prohibited from using an affiliated custodian, but they must offer their customers the option of using a credit-worthy unaffiliated custodian as an alternative.

Segregated initial margin will be subject to the same restrictions on permitted investments as cleared swaps collateral (Regulation 1.25 will apply), despite several commenters’ objections to this proposal. While the CFTC acknowledged that these restrictions may lower investment returns, they noted that lower risk is associated with lower returns and that this rule protects counterparties’ collateral. The rule contains specific requirements for the written custody agreement. These relate to provisions regarding conditions for withdrawal of collateral, including a requirement that certain notices to the custodian be made under penalty of perjury. The CFTC did not address commenters’ concerns about these provisions. ISDA recently published a form of Account Control Agreement for the segregation of initial margin, which would need to be amended to comply with these requirements.

Commissioner O’Malia asked whether uncleared swaps counterparties have been availing of the collateral segregation being offered. The CFTC staff did not have that information available but may seek it, resources permitting. O’Malia indicated a concern that counterparties may be declining segregation, leaving their collateral unprotected. It seems that restricting investments to those specified by CFTC regulation, rather than allowing the parties to negotiate permitted investments, might discourage these custodial arrangements.


The CFTC staff expressed confidence, when asked by CFTC Chairman Gensler, that these new rules would likely prevent a repeat of the abuses that led to the MF Global and Peregrine bankruptcies. The CFTC Chairman quickly pointed out that FCMs will continue to fail for various reasons and that the purpose of the rules is to protect customer funds when they do. The lingering question that remains for the industry is whether the anticipated benefits will be outweighed by the associated costs.

The Quest for Clearing Certainty and the Uncertain Fate of the Cleared Derivatives Execution Agreement

Since the Dodd-Frank Act requires mandatory clearing of previously privately negotiated over-the-counter derivatives transactions (absent an exception), the need for “clearing certainty” has arisen. Clearing certainty means that the transaction counterparties know with certainty prior to execution that their transaction will be accepted for clearing. A technological solution will be required to achieve this. An industry working group has been considering various models (push, ping, hub, plus one), but consensus has yet to be reached and no clear frontrunner has emerged. While some market participants have already adopted different models and a couple of hubs have become operational, it is understood that an industry-wide solution with uniform messaging will be needed to facilitate open access. Until the problem of clearing certainty is solved, the Futures Industry Association (FIA) and International Swaps and Derivatives Association (ISDA) have published a Cleared Derivatives Execution Agreement for voluntary use by derivatives counterparties. The Cleared Derivatives Execution Agreement is intended to be an interim solution. It allows derivatives counterparties to agree what will happen if a derivatives transaction that is submitted for clearing is not accepted. Most importantly, parties can agree on how to allocate and calculate breakage costs in various circumstances where a transaction fails to clear and is terminated as a result.

The first version of the Cleared Derivatives Execution Agreement met with vigorous opposition from the Commodity Futures Trading Commission (CFTC). The CFTC published a rule prohibiting use of an optional annex to the agreement that would allow one or both parties’ futures commission merchants (FCMs) to become party to the agreement. The prohibition was stated to be in response to concerns that derivatives counterparties might be forced to disclose the identity of their trading counterparties to their FCMs who might, in turn, impose sub-limits on their trading with particular counterparties. FIA and ISDA responded with a revised Cleared Derivatives Execution Agreement (Version 1.1) that removed the offending annex. A further revised version was reported to be under discussion, which would provide the right to resubmit a trade that initially fails to clear.

In granting no-action relief from certain business conduct and documentation requirements applicable to swap dealers and major swap participants, the CFTC’s Division of Swap Dealer and Intermediary Oversight acknowledged the possibility that a trade intended for clearing might fail to be accepted by a derivatives clearing organization (DCO) for clearing. (See CFTC Letter No. 13-33.) That division granted relief from the swap trading relationship documentation requirement for swaps that are intended to be cleared, provided that the swap counterparties have entered into a written “fallback agreement” addressing swaps that are not accepted for clearing by an FCM or a DCO. Such a fallback agreement may provide for resubmission of swaps that fail to clear and must provide that swaps that ultimately fail to clear will be either void as of execution, with no amounts payable to either party, or terminated, with amounts payable as agreed between the parties. The latter option would permit “breakage agreements” along the lines of the FIA-ISDA Cleared Derivatives Execution Agreement. Of note, the relief only extends to swaps which are not executed on a swap execution facility (SEF) or designated contract market (DCM) but which are intended to be submitted for clearing contemporaneously with execution.

Subsequent guidance from the CFTC’s Divisions of Market Oversight and Clearing and Risk takes a contrary view on breakage agreements for intended-to-be-cleared swaps traded on a SEF or DCM. (See Staff Guidance on Swaps Straight-Through Processing, Sept. 26, 2013.) In that guidance, the divisions contend that the CFTC’s straight-through processing requirements for “near-instantaneous acceptance or rejection of each trade” provide “certainty of execution and clearing”. The divisions note the requirements for SEFs to facilitate pre-execution screening by FCMs and for FCMs to conduct such pre-execution screening. (SEFs and FCMs have been afforded an opportunity to delay compliance with these rules until November 1, 2013 pursuant to CFTC Letter No. 13-62.) The divisions state that an FCM “may not reject a trade that has passed its pre-execution filter because this would violate the requirement that trades should be accepted or rejected for clearing as soon as technologically practicable”. This statement ignores the fact that two levels of acceptance are required for each leg of a swap to be cleared (unless a swap counterparty is itself an FCM). Acceptance by both parties’ FCMs is not sufficient to ensure clearing, because the DCO will also have to accept or reject both legs of the swap, which determination will be subject to compliance with limits imposed by the DCO on its FCM members. Later in the guidance, the divisions acknowledge that a swap executed on a SEF or DCM that is intended for clearing might be rejected. This acknowledgement seems to contradict the earlier statement that the CFTC’s straight-through processing requirements provide certainty of clearing. In case of rejection, the guidance indicates the divisions’ belief that the rejected trade should be void ab initio. This is a surprising and extreme position.

Agreements that are void ab initio are held to be legally invalid from the outset. The parties are placed back in the position that they were in prior to entering the agreement and have no right to recover for any losses they might have incurred in reliance on the invalid agreement. That result seems reasonable in situations where the parties could have known at the outset that their agreement would not be enforceable. However, swap counterparties currently cannot and will not know whether their trade will be accepted or rejected until after execution. Further, acceptance or rejection by the DCO is outside the swap counterparties’ control. In support of the divisions’ view, the guidance cites concern about possible evasion of the clearing requirement. It postulates that parties could deliberately enter trades that exceed their credit limits, thereby ensuring rejection for clearing, and then enforce those trades bilaterally. However, mandatory pre-execution screening by the FCMs should prevent any such trades from being executed. It is acceptance by the DCO, dependent upon FCMs not exceeding their limits, which would pose the greater risk of rejection (assuming full compliance by SEFs and FCMs with the straight-through processing requirements). Also, if a trade that is required to be cleared is not accepted for clearing and the parties continue such trade bilaterally, those parties would be subject to enforcement action by the CFTC for violation of the clearing mandate. Engineering a clearing rejection and continuing a bilateral trade in violation of the clearing requirement is practically no different from simply disregarding the clearing mandate and not attempting to clear trades subject to it.

Breakage agreements such as the FIA-ISDA Cleared Derivatives Execution Agreement deter parties from intentionally entering into transactions that will be rejected for clearing, by providing financial consequences for doing so. Yet, the guidance goes on to state (without explanation) that DCMs, SEFs, FCMs and swap dealers (to whom the guidance is not addressed) “should not require breakage agreements as a condition for trading on a SEF or DCM”. Separate commentary has indicated that such guidance was prompted by concerns that requiring bilateral negotiation of breakage agreements would impede open access to trading platforms. While the guidance does not prohibit voluntary entry into breakage agreements, the divisions’ expectation that rejected trades should be void ab initio seems intended to, at a minimum, discourage such agreements. This guidance, while apparently intended to facilitate clearing certainty, has unfortunately introduced greater uncertainty into the clearing process. A technological solution to the problem of clearing certainty is eagerly awaited.

Variations in LSOC Implementation

In 2012, the Commodity Futures Trading Commission (CFTC) published its final rule selecting Legal Segregation with Operational Commingling or LSOC as the mechanism for protecting cleared swaps customer collateral [77 FR 6336 (Feb. 7, 2012)].  The CFTC considered five alternative models, including the existing futures model.  The futures model was deemed inadequate because it allows for the collateral of non-defaulting customers to be accessed in the event of a default by another customer (so called “fellow customer risk”).  LSOC requires that customer collateral be segregated on the books and records of the futures commission merchant (FCM) and derivatives clearing organization (DCO), but allows client collateral to be commingled in an omnibus account.  The CFTC considered full physical segregation of customer collateral, but concluded that it would cost more than LSOC without conferring additional benefit.  The effectiveness of a full physical segregation model would be undermined by section 766(h) of the US Bankruptcy Code, which requires pro rata distribution of customer property.  LSOC addresses fellow customer risk by prohibiting FCMs and DCOs from using the collateral of any customer to satisfy the obligations of any other customer.  [17 CFR 22.2(d)(1)]  This ostensibly improves upon the futures model, but it does not mean that customer collateral is protected in all instances.  Moreover, many industry veterans contend that LSOC adds cost and complexity to solve a problem (i.e., fellow customer risk) that has never arisen in practice.

LSOC does not protect customer collateral against what the CFTC calls “operational risks”, such as fraud or misappropriation, or investment risk.   Customers of MF Global or PFGBest would not have been protected had LSOC been in effect when those firms declared bankruptcy.

LSOC primarily protects initial margin, which must be delivered gross by the FCM to the DCO.  Variation margin receives less protection and the CFTC gives DCOs discretion as to whether or not to net variation margin.  Currently, the two primary clearing houses for interest rate swaps in the US, the CME Clearing House, a division of the Chicago Mercantile Exchange Inc. (CME), and LCH.Clearnet LLC (LCH), are electing to discontinue variation margin netting following an FCM default.  The CFTC has also indicated its interpretation that variation margin is not protected until completion of a settlement cycle, when it has been allocated and credited on a customer-by-customer basis [CFTC Letter No. 12-31].

Excess collateral may or may not be protected, depending upon whether the DCO elects to accept it.  “Excess” generally refers to collateral in excess of the DCO’s requirements that is transferred by an FCM to the DCO, if permitted.  However, an excess can also be generated at the DCO by a decrease in a customer’s margin requirement or an increase in the value of a customer’s collateral.  If a DCO accepts excess collateral, then the amount of customer collateral that is protected will be determined based on a daily report delivered by the FCM to the DCO.  The report identifies the value of collateral belonging to each individual customer.  Any excess collateral beyond what is reported daily to the DCO, where the DCO accepts excess, and all excess collateral, where the DCO does not accept excess, is considered “unallocated excess”.  Unallocated excess may not be used by a DCO to meet customer margin requirements and, unless and until such excess is allocated, it would not be available to a customer in porting trades to another FCM.  In case of bankruptcy, unallocated excess would be made available to the bankruptcy trustee for distribution through the bankruptcy process.

DCOs also have discretion in determining what resources will be applied in the event of default, and in what sequence.  This sequence is generally referred to as the “default waterfall”.  Below is a summary of the current default waterfalls of CME and LCH (listed in the order in which resources would be applied):

  1. Defaulting Customer/Member Margin
  2. Defaulting Member’s Guaranty Fund Contribution
  3. DCO’s Capital Contribution
  4. Non-Defaulting Members’ Guaranty Fund Contributions
  5. Assessments for Additional Guaranty Fund Contributions (unfunded)

Despite the apparent similarities, differences exist in the amount of resources available at each stage of the waterfall.

One such major difference is the amount of each DCO’s maximum capital contribution should the defaulter’s margin and guaranty fund contributions be insufficient to cover the loss.  CME will contribute up to $150 million (which amount was recently increased from $100 million).  LCH will contribute no more than $2 million.  Further, CME’s capital contribution is unconditional, whereas the LCH rulebook provides that LCH is only required to make such payment if doing so would not result in its being unable to meet all of its other liabilities [Regulation 302(3)].

Another area where the DCOs’ default waterfalls may vary is in the levels of their margin and guaranty fund contribution requirements.  One DCO may favor higher margin requirements under a “defaulter pays” principle; another may prefer lower margin and higher guaranty fund contributions, which mutualizes risk.

While LSOC imposes a single model to protect cleared swaps customer collateral, implementation is more nuanced and variation among DCOs is permitted.  Cleared swaps customers should consider these differences and their various options when choosing a DCO.