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 In the same rule, the CFTC also re-adopted a previously repealed segregation model that was authorized for use until 2005 for futures (Interpretation No. 10).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.
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.
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).