Three industry bodies have written to the US Commodity Futures Trading Commission to request a delay in the implementation of swaps clearing rules, due to come into force today (June 10).
The Investment Company Institute, the Investment Adviser Association and the Asset management Group of SIFMA, wrote to Ananda Radhakrishnan, director of the CFTC’s Division of Clearing and Risk, to express concern with respect to the “incomplete implementation of the protections provided to customer excess margin held by futures commission merchants and derivatives clearing organisations under the “legal segregation with operational commingling” or “LSOC” model adopted by the Commodity Futures Trading Commission,” and to request a delay until September 9, 2013.
The associations state in the letter, “This request does not reflect a lack of will or commitment regarding clearing but, rather, one of inadequate time for the DCO and FCM industry to implement the necessary technological infrastructure to provide this critical protection to their customers.”
They further note that only CME has launched a model providing for the “LSOC plus excess” functionality. “We understand that no FCMs have yet adhered. Some FCMs have told our members that they are waiting until each DCO has implemented its model so that they can adhere to all of the DCO models at once and on a consistent basis,” the letter states.
The bodies’ concerns with the incomplete protection of excess margin are “particularly acute”, they explain because the prohibition on FCMs using one customer’s margin to secure another customer’s positions will have the practical effect of requiring customers to either always have excess margin available to pre-fund new positions (which may be the less costly option) or borrow such margin from their FCMs. “Use of the pre-funding option will likely result in significant amounts of customer excess margin being maintained in the system. Many of our members have been planning to instruct their FCMs to hold such excess at the DCO so that it can be treated as “allocated excess,” removed from potential FCM fraud, and available for porting,” the letter argues. “Absent implementation of LSOC plus excess, excess margin remaining in the possession of the FCMs may be subject to heightened fraud risk, and such excess margin in the possession of DCOs must be treated as “unallocated excess,” required, in the event of the FCM’s insolvency, to be returned to the FCM’s trustee for distribution and unavailable for porting.”
The associations’ concerns are not eliminated by the ability of customers to request the return of excess margin at any time, they continue, noting that although this option may be helpful with respect to the small amounts of excess that may be naturally generated by increases in the value of margin or in decreases in the need for initial margin, there are other sources of margin that cannot be returned to customers.
Under Rule 22.13(c), excess margin is defined broadly to include any collateral above “the amount required by the [DCO].” Three of the most obvious sources of excess margin for which customers cannot request the return include: (1) excess margin arising from an FCM’s credit requirements; (2) excess margin arising from the extra 10% of initial margin to support “speculative” trades; and (3) excess margin transferred by a customer to pre-fund new trading.
These sources of excess margin must be held by the FCM unless the DCO “provides a mechanism by which the [FCM] is able to, and maintains rules pursuant to which the [FCM] is required to, identify each business day, for each [customer], the amount of collateral posted in excess of the amount required by the [DCO].”
“Because Category 2 entities were promised that this mechanism would be in place before the June 10 clearing mandate, we are now requesting that the CFTC delay the clearing deadline to allow adequate time for DCOs and FCMs to make the technological changes necessary to ensure the protection operational,” the letter states.
“The move to mandatory clearing under the “LSOC without excess” model raises particular concerns for our members given that the manner in which they currently trade derivatives over the counter subjects their margin to neither fraud risk nor fellow-customer risk,” it continues. “Fraud risk is eliminated through netting arrangements, which provide that regardless of how a dealer may treat a customer’s variation margin, its value is netted against the customer’s payment obligations. Both variation margin and initial margin are further protected when held in third-party, segregated custodial accounts.
“We also see significant benefits in the added discipline and controls to be provided under the “LSOC plus excess” model in the FCMs’ daily reporting to their DCOs under Rule 22.13(c)(2) regarding the identity of their customers and the amount of each customer’s excess margin. We believe that such reporting, coupled with the transfer of excess margin from the FCM to the DCO, should substantially mitigate the risks to customers and to the CFTC, particularly in light of the MF Global and Peregrine insolvencies in which insufficient records made it an almost insurmountable challenge to confirm the amount and location of customer margin.”
“We remain gravely concerned about requiring a substantial portion of the market to clear before these important protections for customer collateral are completely in place,” the letter concludes. “Without the requested extension, we fear that once most of the buy-side participants are subject to the clearing mandate, there will be less incentive for FCMs and DCOs to progress diligently with implementing the models that will provide full protection to excess margin. We believe it is imperative that the full protections of LSOC be provided to all customer collateral, including excess margin.