Central Clearing: Customer Protections
By Ivana Ruffini, Financial Markets Group at the Chicago Federal Reserve
Since 1936, the segregation of customer assets from intermediaries’ house funds has been a key mechanism for customer protections in intermediated derivatives markets in the U.S. Following the 2008 crisis, regulators began implementation of the central clearing mandate for standardized swaps and the new customer margin segregation framework for centrally cleared swaps (legally segregated operationally commingled - LSOC).
Central clearing concentrates risk in central counterparties (CCPs) and financial intermediaries, such as clearing members (CMs) and futures commission merchants (FCMs). In the U.S., exposure to FCM risk is somewhat mitigated by the regulation of market intermediaries and the implementation of two customer protection frameworks - the traditional futures segregation (for futures) and LSOC (for cleared swaps). Both rely on rules that govern segregation of customer assets held by intermediaries and CCPs.
U.S. futures segregation model shields customer segregated funds at depository institutions (DIs) from the “banker’s right of setoff.” Customer segregated funds are meant to repay customer claims and cannot be applied against debts owed to DIs by an insolvent intermediary or a CCP. In the case of FCM insolvency customers are repaid in full if:
- The aggregate amount in customer segregated accounts equals or exceeds what customers are owed.
- There is an aggregate excess in customer segregated accounts - the surplus margin that does not belong to customers is returned to the estate of the FCM.
However, if there is an aggregate shortage in customer segregated accounts, customers’ claims would be prorated with all of them incurring the same percentage loss. It is important to highlight that an aggregate shortage (under-segregation) in these types of accounts is a violation of CFTC rules, but could occur due to fraudulent activity or operational problems.
LSOC precludes CCPs from using the initial margin assets of non-defaulting customers to offset losses of defaulting customers of a failed FCM. An FCM is required to transmit account-level margin and position information to the CCP which is validated daily. If there is a default, LSOC protects customer segregated accounts as reported by FCMs. Also, any excess customer margin would either be transferred together with the customer positions to another FCM or returned to the swaps clearing customer.
However, LSOC is limited by Section 766(h) of U.S. Bankruptcy Code, which provides that non-defaulters in an account class that has incurred a loss will share in any shortfall, pro-rata thus exposing customers to potential losses should their FCM fail, and under-segregation occurs because of inaccurate FCM records.
CCPs do not protect customers of a defaulting FCM, and protections offered under the U.S. futures customer segregation and LSOC are limited because under the U.S. Bankruptcy Code even individually segregated customer funds are treated as if they were held commingled in a single account.
Ivana Ruffini is a Senior Policy Specialist in the Financial Markets Group at the Chicago Federal Reserve.
The views expressed herein are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.