Regulatory: CFTC adopts rules further protecting FCM customer property

Despite rules, fellow-customer risk still remains

On Jan. 11, the Commodity Futures Trading Commission (CFTC) finalized the heavily debated segregation model for cleared swaps customer collateral, referred to as the Legally Segregated Operationally Commingled Model (LSOC). In the same rule, the CFTC also re-adopted a previously repealed segregation model that was authorized for use until 2005 for futures (Interpretation No. 10). The finalized rule importantly interacts (or, arguably, counteracts) with Section 766(h) of the U.S. Bankruptcy Code, which requires that customer property be distributed “ratably to customers on the basis and to the extent of such customers’ allowed net equity claims.”

This rule was implemented partially in response to concerns raised by market participants that the new clearing mandate may inadvertently increase market risks by concentrating them among major financial institutions and one or two clearinghouses instead of reducing systemic risks as intended by the Dodd-Frank Act of 2010.

The efficacy of this model (versus certain other models that were considered, including the model currently used for futures accounts)is best explained by describing its effect in the event of an FCM’s bankruptcy. If an FCM’s bankruptcy is caused by anything other than a customer’s losses, the LSOC Model will operate much like the current futures model used for futures accounts: customer positions and related collateral may be liquidated and sent to the trustee or transferred to another FCM. Note, however, that if there is a shortfall in customer funds (e.g., because the default was triggered by the FCM’s permitted investment losses or due to misuse of client funds), remaining customer positions and collateral may only be allocated to customers to the extent of each customer’s pro rata share due to the Bankruptcy Code.

Unlike the futures model, however, DCOs (and trustees) will have more information about each individual customer’s position and collateral under the LSOC Model because that model requires FCMs to periodically provide DCOs with data regarding individual customer positions. Under the futures model, by contrast, DCOs only have information about customer’s positions on a collective basis.

Importantly, Dodd-Frank amended the Bankruptcy Code to include cleared swaps within the definition of “commodity contracts” in section 761(4). While this affords cleared swaps certain protections, the Bankruptcy Code also requires that collateral associated with commodity contracts be distributed ratably in the event of an FCM bankruptcy. Therefore, notwithstanding a DCO’s inability to use non-defaulting customer funds to cover shortfalls, non-defaulting customers may share in customer losses if the DCO is required to liquidate customer positions and a shortfall remains.

Interpretation No. 10. From 1984 to 2005, the CFTC permitted FCMs to deposit futures customer property with independent, third-party custodians so long as the FCM had immediate and unfettered access to such funds. The CFTC backtracked from this policy in 2005 and prohibited futures customer collateral from being deposited with third party custodians (with limited exceptions).

Contributing Author

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Peter Malyshev

Peter Y. Malyshev, counsel, practices corporate law in the firm’s Washington, D.C. and New York offices and focuses his practice on regulatory, compliance...

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Contributing Author

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Jonathan Ammons

Jonathan T. Ammons is an associate at Latham & Watkins where he practices corporate law in the firm’s Washington, D.C. office. His practice focuses...

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