January 11, 2012
Today, the Commodity Futures Trading Commission (the “Commission”) is voting to finalize a rulemaking on protection of cleared swaps customer collateral.1 Whereas I support this rulemaking, I believe that it is important to detail its limitations, so that we do not offer market participants a misleading sense of comfort in light of the collapse of MF Global, Inc. (“MF Global”). As I will explain further, the Commission has much more work to do to increase confidence in the customer protections that our regulations offer.
This rulemaking does not address MF Global
First, this rulemaking does not address MF Global. The rulemaking is entitled, in part, Protection of Cleared Swaps Customer Contracts and Collateral. Therefore, it benefits cleared swaps customers, and not futures customers (who are bearing the brunt of MF Global). This rulemaking would not have prevented a shortfall in the customer funds of the ranchers and farmers that transact daily in the futures market. Nor would it have expedited the transfer of positions and collateral belonging to such customers in the event of a collapse similar to that of MF Global.
This rulemaking may expose swaps customers to more risk
Second, this rulemaking only addresses one of three categories of risk that an intermediary – like MF Global – can pose to its customers. The three categories of risk are
(i) “fellow-customer” risk, (ii) operational risk, and (iii) investment risk. By its own admission, this rulemaking only protects against “fellow-customer” risk. It does not protect against operational risk – namely, the risk that an intermediary improperly segregates cleared swaps customer collateral.2 Moreover, it does not protect against investment risk – namely, the risk that an intermediary experiences losses on its investment of cleared swaps customer collateral, which it cannot cover using its capital.3 To be plain, I support limiting intermediaries from investing customer collateral in risky instruments – regardless of whether such collateral margins futures or swaps contracts.4 However, I am not naïve enough to believe that such limitations – without additional Commission oversight or action – would be sufficient. I have warned against complacency in the past.5 I reiterate such warning here
Under this rulemaking, what happens if an intermediary – like MF Global – becomes insolvent as operational or investment irregularities are revealed? Basically, under the Bankruptcy Code,6 cleared swaps customers would share pro rata in any shortfall. A shortfall would complicate the porting of cleared swaps customer contracts and associated collateral, notwithstanding the enhanced recordkeeping and reporting requirements of this rulemaking.
By not protecting against operational and investment risk, this rulemaking may have the effect of exposing some swaps customers to more risk than they currently bear in the over-the-counter markets. Since December 2, 2011, we have received eight comment letters from end-users, many of which explicitly asked the Commission to not finalize this rulemaking until it explores other alternatives that may provide greater protection.7 These end-users include Fidelity Investments, the Committee on Investment of Employee Benefit Assets (“CIEBA”), and the Federal Home Loan Banks. According to many of these comment letters, swaps customers in the over-the-counter markets currently have the option to enter into tri-party custody agreements. In general, these agreements may provide superior protection to this rulemaking against not only fellow-customer risk, but also operational and investment risk.8
I understand that staff has been directed to “carefully analyze” various proposals that commenters have advanced “with the goal of developing proposed rules that provide additional protection for collateral belonging to market participants.”9 This is a laudable goal. I only hope that we achieve this goal before mandatory clearing becomes effective.10 Otherwise, we may be subjecting a substantial portion of cleared swaps customer collateral to operational risk and investment risk. To provide some context, such collateral – in the aggregate – may amount to anywhere from $500 billion to $833 billion.11 As one commenter stated, “[i]t would seem to be a perverse result that, because of rulemaking promulgated under the Dodd-Frank…Act, which was…meant to enhance the safety of the over-the-counter markets by reducing systemic and counterparty risks, market participants were to be placed [in] [sic] a worse position with regard to risk than they are currently.”12 Other commenters supported this statement.13
This rulemaking may imperfectly address fellow-customer risk
Let me now say a few words on “fellow-customer” risk. Preliminarily, what is it? According to this rulemaking, it is the risk that a derivatives clearing organization (“DCO”) will access the collateral of non-defaulting cleared swaps customers to cure the default of an intermediary.14 Under what circumstances could a DCO access such collateral? Under this rulemaking, there are two circumstances and they have to occur simultaneously. First, a swaps customer would need to default to an intermediary. Second, as a result of such default, the intermediary must be unable to meet its DCO obligations. In short, swaps customer losses must exceed the capitalization of the intermediary.15 As this rulemaking acknowledges, “fellow-customer” risk is rare.16 In comparison, according to notices received by the Commission, operational risk is far more prevalent.17
Of course, just because a risk is rare does not mean that the Commission should not protect against it. But let us take a closer look at the protection that this rulemaking is offering. First, although it is close to 230 pages, with nearly 100 pages in rule text, only a couple of the provisions of this rulemaking address “fellow-customer” risk. They are regulations 22.11 to 22.16.18 The remainder of regulation Part 22, as well as the majority of changes to regulation Part 190 (Bankruptcy), simply aligns the cleared swaps segregation regime with the existing futures segregation regime.19 As MF Global reveals, the futures segregation regime may have some vulnerabilities. In this rulemaking, the Commission is unthinkingly replicating these vulnerabilities.
Second, this rulemaking only offers protection to a portion of the cleared swaps customer collateral that an intermediary holds. In general, cleared swaps customer collateral may fall within two categories: (i) collateral needed to support contracts; and (ii) collateral in excess of that needed to support contracts (“Excess Collateral”). The Commission, in its final rulemaking on Derivatives Clearing Organization General Provisions and Core Principles, states that a DCO must require its clearing members to collect Excess Collateral.20 However, as certain commenters have astutely observed, and as this rulemaking readily admits, this rulemaking does not protect Excess Collateral deposited outside of the DCO.21 So, the Commission has required cleared swaps customers to provide collateral that it then does not protect.
Third, this rulemaking cites, as a major benefit, the possibility of enhanced portability of cleared swaps customer contracts, as well as associated collateral, after an intermediary defaults due to “fellow-customer” risk.22 The rulemaking sets forth more stringent recordkeeping and reporting requirements as a foundation for enhanced portability. As commenters have identified, these requirements have two significant weaknesses.
Preliminarily, to maximize portability, each intermediary must (i) keep complete and accurate records and (ii) comply with reporting requirements. As MF Global and earlier intermediary collapses have demonstrated, a distressed intermediary may not prioritize recordkeeping and reporting.23
Secondarily, despite requests from various commenters (including the Association of Institutional Investors and Vanguard), this rulemaking does not provide guidance on the concrete steps that a DCO should take to ensure that an intermediary is providing accurate and complete information. Instead, the rulemaking states: “… the DCO should take the steps appropriate, in the professional judgment of its staff, to verify that [intermediaries] have and are using systems and appropriate procedures to track accurately, and to provide to the DCO accurately, the positions of each customer.”24 In light of MF Global, the Commission should give this provision – and the requests of commenters – more thought.
Finally, this rulemaking is silent on one important factor that may affect the portability of cleared swaps customer contracts, as well as associated collateral – namely, whether the intermediary is both a futures commission merchant and a securities broker-dealer. I am touching on this issue in the interest of full disclosure.
A comprehensive solution is needed
Despite its limitations, I ultimately support this rulemaking. As I have stated previously, the Commission must immediately take action to renew public confidence in our customer protection regime.25 Although this rulemaking largely replicates futures segregation, this rulemaking – if it works as promised in an intermediary bankruptcy – may enhance portability for cleared swaps customers in the event of “fellow-customer” risk. Even the possibility of such enhancement is non-negligible – especially in the volatile economic environment that exists today.
However, this rulemaking also vividly illustrates some of my concerns regarding our Dodd-Frank rulemaking process. First, the Commission has a duty to regulate the swaps market. It also owes a duty to futures customers. Right now, it is unclear from this rulemaking how the Commission means to address futures customer concerns. I understand that the investigation into the MF Global collapse is ongoing. However, the Commission could examine the manner in which operational and investment risks contribute to undersegregation. Our undersegregation reports would help us with such an examination, as well as the detection of potential causal patterns for undersegregation.26
Second, instead of rushing to complete this rulemaking, I would have preferred that the Commission focus on providing a more comprehensive solution to operational, investment, and “fellow-customer” risk. Moreover, I would have preferred that the Commission more fully explore the alternatives that various commenters have advanced, which may provide greater protection for futures, as well as cleared swaps customer, collateral. Further, it would have been helpful for the Commission to have weighed, in one analysis, the benefits and costs of offering a combination of (i) this rulemaking and (ii) one or more alternatives.
Finally, the Commission needs to contemplate whether any alternative would be workable in light of the pro rata distribution provisions of the Bankruptcy Code. If not, the Commission should contemplate recommending to Congress changes to the Bankruptcy Code.
After MF Global, the Commission needs to provide market participants with real, fully developed reforms. I look forward to the Commission taking such action.
1 Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. [___] ([__________] (to be codified at 17 C.F.R. pts. 22 and 190) (referenced herein as the “rulemaking”).
2 See id. at [___] (section I(D)(2) of the preamble to this rulemaking).
4 See id. at [___] (to be codified at 17 C.F.R. §§ 22.2(e)(1) and 22.3(d)) (limiting an FCM and a DCO to investing cleared swaps customer collateral in instruments enumerated in regulation 1.25).
5 See “Opening Statement of Commissioner Scott D. O’Malia”, dated December 5, 2011, available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement120511.
6 See section 766(h) of the Bankruptcy Code, 11 U.S.C. 766(h).
7 See comment letters from (i) Managed Funds Association, dated December 2, 2011; (ii) Fidelity Investments, dated December 8, 2011; (iii) Och-Ziff Capital Management Group, dated circa December 12, 2011; (iv) State Street Corporation, dated December 14, 2011; (v) the Committee on Investment of Employee Benefit Assets, dated December 22, 2011; (vi) the European Federation for Retirement Provision (“EFRP”) and APG Algemene Pensioen Groep, N.V. (“APG”), dated December 23, 2011; (vii) the Federal Home Loan Banks, dated January 9, 2012; and (viii) BlueMountain Capital Management, LLC, Elliot Management Corporation, Moore Capital Management, LP, Paulson & Co. Inc., and Tudor Investment Corporation, dated January 9, 2012 (the “Moore et. al. letter”). In each case, the comment letters were filed in answer to the notice of proposed rulemaking on the Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 76 Fed. Reg. 33818 (Jun. 9, 2011). All comment letters to such notice are available at: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-10737a.pdf.
8 See, e.g., comment letters from (i) Fidelity Investments, dated December 8, 2011; (ii) Och-Ziff Capital Management Group, dated circa December 12, 2011; and (iii) CIEBA, dated December 22, 2011.
9 77 Fed. Reg, at [___] (section I(F) of the preamble to this rulemaking).
10 See comment letter from CIEBA, dated December 22, 2011 (stating that “…the Commission should not permit mandatory clearing of swaps to become effective until a physical segregation option, such as the individual settlement account…or another satisfactory structure, has been made available to swaps customers.” [emphasis original]).
This rulemaking does attempt to resolve one request repeated in the comment letters filed since December 2, 2011. In section I(F) of the preamble, the rulemaking makes clear that the Commission’s 2005 Amendment to Financial and Segregation Interpretation No. 10, 70 Fed. Reg. 24768 (May 11, 2005) (“Segregation Interpretation 10-1”), does not apply to cleared swaps. Therefore, Segregation Interpretation 10-1 would not prohibit an intermediary from entering into a tri-party custody agreement with a cleared swaps customer. However, this rulemaking similarly makes clear that Segregation Interpretation No. 10, which the Commission issued in 1984, would continue to apply to collateral segregated according to a tri-party custody agreement. In other words, cleared swaps customers could not avoid the pro rata distribution provisions of the Bankruptcy Code (as well as regulation Part 190). Therefore, the resolution in this rulemaking may provide commenters with cold comfort.
11 77 Fed. Reg, at [___] (section VII(B)(2) of the preamble to this rulemaking) (citing estimates provided by CME Group, Inc. and the International Swaps and Derivatives Association, Inc.).
12 Comment letter from Och-Ziff Capital Management Group, dated circa December 12, 2011.
13 See the Moore et. al. letter (stating “[g]iven the crucial role that central clearing will play in reducing systemic risk in the swaps market, we see no valid argument to suggest that customers to cleared swaps should be subject to weaker regulatory protections than those afforded counterparties to uncleared swaps.”); and comment letter from EFRP and APG, dated December 23, 2011 (stating “EFRP and APG support the CFTC’s efforts to reduce risk, enhance transparency, and promote market integrity, as the U.S. Congress intended by enacting Title VII of the Dodd-Frank…Act. It should be clear though that such reform will only improve financial stability, if it is prudent from the perspective of end users, such as pension funds. However, as currently framed the Proposed Rules subject us to increased risks.”).
14 77 Fed. Reg, at [___] (section I(B)(6) of the preamble to this rulemaking).
16 Id. at [___] (section VII(B)(2) of the preamble to this rulemaking) (stating that “double defaults are rare events.”).
17 Regulation 1.12(h) requires an intermediary that knows or should know that it is under-segregated to report to the Commission and its designated self-regulatory organization. Usually, under-segregation results from minor operational failure, and does not lead to the collapse of an intermediary. However, a pattern of operational failure would draw greater attention and inquiry.
18 77 Fed. Reg, at [___] (to be codified at 17 C.F.R. §§ 22.11 (Information to be Provided Regarding Customers and Their Cleared Swaps), 22.12 (Information to be Maintained Regarding Cleared Swaps Customer Collateral), 22.13 (Additions to Cleared Swaps Customer Collateral), 22.14 (Futures Commission Merchant Failure to Meet a Customer Margin Call in Full), 22.15 (Treatment of Cleared Swaps Collateral on an Individual Basis), 22.16 (Disclosures to Customers)).
19 See, e.g., id. at [___] (to be codified at 17 C.F.R. § 22.10 (Incorporation By Reference)).
20 See Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg. 69334, 69438 (Nov. 8, 2011) (to be codified at 17 C.F.R. § 39.13(g)(8)).
21 See 77 Fed. Reg. at [___] (section III(B) of the preamble to this rulemaking) (stating “CME notes that a portion of the Cleared Swaps Customer Collateral will be held at the FCM, not the DCO, and that this collateral will not be protected by Complete Legal Segregation in the event that an FCM becomes insolvent. This proposition is true but is of little or no relevance to the comparison of Complete Legal Segregation with the Futures Model favored by these commenters.”).
22 Id. at [___] (section I(D)(2) of the preamble to this rulemaking). To be fair, this rulemaking does make the point that enhanced recordkeeping and reporting requirements may also foster portability in the event of operational or investment risk.
23 See, e.g., comment letters from (i) the Federal Home Loan Banks, dated January 9, 2012 and (ii) CIEBA, dated December 22, 2011. See also the Moore et. al. letter.
24 77 Fed. Reg. at [___] (section IV(K) of the preamble to this rulemaking).
25 See Statement on MF Global: Next Steps, dated November 16, 2011, available at: http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement111611.
26 See supra note 17.
Last Updated: January 11, 2012