Daily Rules, Proposed Rules, and Notices of the Federal Government
All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to
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This Advanced Notice of Proposed Rulemaking (“ANPR”) is intended to obtain comment from interested parties concerning the appropriate model for protecting the margin collateral posted by customers clearing swaps transactions. As discussed in more detail below, the statutory language in Dodd-Frank concerning the protection of swaps customer margin is substantially similar, though not identical, to analogous provisions in Section 4d(a) of the Commodity Exchange Act (“CEA”)
Section 4d(f)(2) of the CEA,
The provisions applicable to the margin posted by exchange-traded futures customers are similar, but not identical. Section 4d(a)(2) provides that “property received [by a futures commission merchant] to margin, guarantee or secure the [exchange-traded] contracts of any customer of such [futures commission merchant] * * * shall not be commingled with the funds of such commission merchant or be used to guarantee the trades or contracts * * * of any person other than the one for whom the same are held.”
Commission Regulation (“Reg. § ”) 1.22
Thus, if a futures customer suffers sufficient losses that the customer's debit balance exceeds the FCM's available capital, and such customer (the “defaulting customer”) fails to promptly pay such loss, the FCM may, as a practical matter, be unable to “top up” the loss, and the FCM may be unable to make a required payment to a DCO with respect to that FCM's customer account. Such an FCM would then be a defaulter to the DCO (a “Defaulting FCM”). In case of such an FCM default in the futures customer account, the DCO is permitted to use the collateral of all customers of the Defaulting FCM to meet the net customer obligation of the Defaulting FCM to the DCO (including the use of any customer gains to meet customer losses), without regard to which customers gained or lost, or which customers defaulted or made full payment.
In such a case, customers of the Defaulting FCM other than the defaulting customer may lose collateral they have posted with the Defaulting FCM, and/or gains on their positions. The risk these other customers face shall be referred to as “fellow-customer risk.”
In considering how to implement Section 4d(f) of the Dodd-Frank Act, the Commission and its staff have heard countervailing concerns from various stakeholders. Some customers have noted that, in the context of uncleared swaps that they currently engage in—and may be obligated to clear under Dodd-Frank
FCMs and DCOs, on the other hand, point out that models of protecting swaps customer collateral that are different from the current model for protecting futures customer collateral would bring significant added costs, which they aver would ultimately be borne by the customers. Moreover, the use of fellow-customer collateral is included in existing DCO models for dealing with member defaults. The Commission has proposed to require DCOs to maintain default resources sufficient to
[e]nable the derivatives clearing organization to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the derivatives clearing organization in extreme but plausible market conditions.
Typically, DCOs use a variety of resources in addressing defaults arising from a member's customer account.
If the collateral of non-defaulting swaps customers is not available as a default resource, DCOs will need to change their models for sizing their default waterfalls, and/or the size of the components of those default waterfalls. One means to do this would be to increase the collateral required to margin each customer's positions. One DCO estimated that it might need to increase collateral from a 99% confidence level to a 99.99% confidence level, which would cause an increase in required collateral of approximately 60%.
An alternative approach to reacting to changes in the model for sizing default waterfalls would be to increase clearing members' default fund contributions. FCMs note that if they are required to commit added capital to clearing, they would pass such costs on to customers. Certain models for protecting collateral posted by customers clearing swaps could also cause significant added administrative costs, in requiring more transactions per customer every day, which costs would also be passed on to customers.
The Commission is seeking to achieve two basic goals: Protection of customers and their collateral, and minimization of costs imposed on customers and on the industry as a whole. It is considering four models of achieving these goals with respect to cleared swaps. These are listed in order below, from most protective of customer collateral to least protective of customer collateral.
Each of these various models would potentially impose different levels of costs upon the various parties—
The Commission seeks comment on each of the following four potential models, as well as any additional models that may be proposed by commenters:
i. The FCM may post the total required customer margin on an omnibus basis, without regard to the customer to whom any particular item of collateral (
ii. If the FCM loans to a customer any portion of the property necessary to margin that customer's positions, that collateral is treated at the DCO as belonging to the customer, and at the FCM as a debt from the customer to the FCM.
iii. The DCO may require an FCM to post its own capital as collateral for its guarantee of its customers.
a. The DCO may use the remaining
b. Before using the remaining
The Commission seeks comment on all of the following questions from all members of the public, but will direct specific questions to three particular groups of stakeholders:
(1) Cleared Swaps Customers, including asset management firms and others who may act on their behalf.
(2) FCMs who currently intermediate swaps on behalf of customers, or who intend to do so in the future, or trade organizations with FCM members.
a. What are the benefits of
b. What costs would you expect to incur for each of the models relative to the baseline model? Please provide a detailed basis for that estimate.
c. How should the Commission balance such costs and benefits?
For Each Model (Other Than the Baseline Model)
i. What compliance activities (including gathering of information) would you need to perform as a result of that model that you do not perform now (
ii. What is a reasonable estimate of the initial and annualized ongoing cost of
iii. How can such costs be estimated industry-wide? Please provide a detailed basis for that estimate?
b. Risk environment:
i. How do you see the industry adapting to the risk changes attendant to the model?
ii. What types of costs would you expect your institution to incur if the industry adapts to that model in the most efficient manner feasible? How are these costs different from the costs you would incur under the baseline model?
iii. What is a reasonable estimate of the initial and annualized ongoing incremental cost incurred by your institution? Are these costs the same for each FCM clearing member, or a function of activity level? Please provide a detailed basis for that estimate.
iv. How can such costs be estimated industry-wide? Please provide a detailed basis for that estimate?
c. What benefits does the model present relative to the baseline model, and relative to other models?
a. Compliance (internal):
i. What compliance activities (including gathering of information) would you need to perform as a result of that model that you do not perform now (
ii. What is a reasonable estimate of the initial and annualized ongoing cost of such incremental activities (relative to the baseline model) for your DCO? Please provide a detailed basis for that estimate.
b. Compliance (members):
i. What compliance activities (including gathering of information) would you expect each of your members to perform as a result of that model that they do not perform now (
ii. What is a reasonable estimate of the initial and annualized ongoing cost of such incremental activities (relative to the baseline model) for each such member? Do these costs vary with the member's level of activity? How? Please provide a detailed basis for your estimates.
iii. What is a reasonable estimate of the initial and ongoing costs of such activities across your membership? May there be some members who do not incur these costs? Please provide a detailed basis for these estimates.
c. Changes to default management structure:
i. What changes to your default management structure (relative to the baseline model) would the model require?
ii. Costs to the DCO
1. What types of costs would these changes impose on the DCO if the industry adapts to that model in the most efficient manner feasible? How are these costs different from the costs the DCO would incur under the baseline model?
2. What is a reasonable estimate of the initial and annualized ongoing incremental cost to the DCO? Please provide a detailed basis for that estimate.
iii. Costs to members
1. What types of costs would these changes to the DCO's default management impose on members if the industry adapts to that model in the most efficient manner feasible? How are these costs different from the costs the members would incur under the baseline model?
2. What is a reasonable estimate of the initial and annualized ongoing incremental cost to each member? Are these costs the same for each member, or are they a function of activity level? Please provide a detailed basis for that estimate.
3. What is a reasonable estimate of the initial and ongoing costs of such activities across your membership? May there be some members who do not incur these costs? Please provide a detailed basis for these estimates.
iv. To what extent do the costs identified above represent increased costs to the system as a whole (
b. What benefits does the model present relative to the baseline model, and relative to other models?
For all commenters:
A point frequently raised is that individual customer protection should be made available on an optional basis. There are questions as to how such a model could be implemented, and how the costs imposed by a customer obtaining individual protection could be attributed to—and charged to—that customer. For example, in the “Full Physical Segregation” and “Legal Segregation with Commingling” models discussed above, a significant portion of the marginal costs may arise from the fact that the collateral posted by the opting-out customer would not be available in the event of a default caused by other customers of the same FCM. How could a payment by the opting-out customer be used to address the changes to the DCO's default management structure that would be attributable to that opting out? Considered from another perspective, how much cost would be avoided from an optional as contrasted to a mandatory implementation of each of the models above? Also, what would be the effect on customers of an FCM in bankruptcy if different DCOs of which the FCM was a member adopted different voluntary models? If a marketplace in which varying models were in use was otherwise desirable, what changes to the Regulation Part 190 rules regarding bankruptcy account classes could or should be made to accommodate such variety?
Another point frequently raised is that customers should risk-manage their FCMs, and provide market discipline by doing business with FCMs that pose less risk. DCOs already monitor the eligibility of their members, supervising the member's risk relative to collateral and capital, and considering members' risk management.
a. To what extent would each model lead to moral hazard concerns? How, if at all, could such concerns be addressed?
b. Are the capital requirements currently imposed by the Commission on FCMs and by DCOs on their clearing members sufficient? If not, what steps should DCOs or the Commission take to address this insufficiency?
c. Do the rules and procedures of DCOs currently provide adequate tools and incentives for DCOs to supervise their clearing members so as to mitigate the risk of default? If not, what steps should DCOs or the Commission take to address this inadequacy?
In analyzing costs, the Commission needs to consider the additional cost incurred by customers risk-managing their FCMs on an initial and ongoing
d. What information would each customer need, on an initial and an ongoing basis, to effectively manage the risk posed by fellow-customers at an FCM?
e. What information should be provided to each customer regarding the FCM's risk management policies, and how those policies are, in fact, implemented with respect to other customers, on both an initial and ongoing basis?
f. What information should be provided to each customer regarding fellow-customer risk, on both an initial and ongoing basis?
g. What is or would be the cost, per customer, on an annualized basis, of conducting this risk management?
h. What is or would be the cost to the industry as a whole, on an annualized basis, of customer-conducted FCM risk management?
1. Did Congress evince an intent as to whether the Commission should adopt any one or more of these models?
How do commenters view Interpretation 85-3, and how should it inform the rulemaking on segregation of collateral for cleared swaps customers? (A copy of this interpretation is attached as an appendix to this Request for Comment.)
Use of Segregated Funds by Clearing Organizations Upon Defaults By Member Firms
The rights of a clearing organization to make use of margin funds deposited by a clearing member firm that has defaulted on an obligation to the clearing organization are defined by the rules and by-laws of the clearing organization subject to limitations imposed by the Commodity Exchange Act (“Act”) and the rules and regulations promulgated thereunder, 17 CFR 1,
Section 4d(2) of the Act, 7 U.S.C. 6d, defines the manner in which futures commission merchants (“FCMs”), clearing organizations, and other depositories of funds deposited by commodity customers to margin or settle futures transactions, or accruing to customers as the result of such trades, must deal with such funds. Section 4d(2) requires that FCMs “treat and deal with” funds deposited by a customer to margin or settle trades or contracts or accruing as the result of such trades or contracts “as belonging to such customer,” separately account for such funds, and refrain from using such funds “to margin or guarantee the trades or contracts, or to secure or extend the credit, of any customer or person other than the one for whom the same are held.” Section 4d(2) specifically authorizes FCMs to commingle such funds, for purposes of convenience, in the same account or accounts with any bank, trust company or clearing organization of a contract market. This provision also authorizes withdrawals from such funds of “such share thereof as in the normal course of business shall be necessary” to margin, guarantee, secure, transfer, adjust, or settle trades or contracts, “including the payment of commissions, brokerage, interest, taxes, storage and other charges, lawfully accruing in connection with such contracts and trades.”
The final sentence of Section 4d(2) defines the obligations of clearing organizations, depositories and all other recipients of customer margin funds and property in the following terms:
It shall be unlawful for any person, including but not limited to any clearing agency of a contract market and any depository, that has received any money, securities, or property for deposit in a separate account as provided in paragraph (2) of this section, to hold, dispose of or use any such money, securities, or property as belonging to the depositing futures commission merchant or any person other than the customers of such futures commission merchant.
This provision prohibits clearing organizations and all other depositories of customer funds from using such funds to discharge proprietary obligations of the depositing FCM or for any purpose other than to margin, guarantee, secure, transfer, adjust, or settle trades or contracts of the depositing firm's customers, including the payment of commissions and other charges “lawfully accruing in connection with” such contracts and trades.
In our view, Section 4d(2)'s provisions with respect to clearing organizations' treatment of customer funds must be construed in light of the fact that clearing organizations' direct customers are, generally, clearing firms, not the ultimate “customers” who entered into the futures contracts and options positions accepted for clearance by the clearing organization. Margin deposits posted with clearing organizations by their member firms normally consist, at least in part, of funds belonging to clearing firm customers, whose margin deposits were posted with the clearing firm and subsequently drawn upon by the clearing firm to satisfy its margin obligations to the clearing organization. The clearing organization normally has no direct dealings with such customers and has knowledge neither of their specific identities nor of the extent of their respective ownership interests in margin funds posted by its clearing firms. Consequently, to the extent that Section 4d(2) of the Act requires that clearing organizations use margin deposits on behalf of the “customers of such [depositing] futures commission merchant,” we are of the view that it requires only that the clearing organization use such funds as the property of the clearing firm's customers collectively, but does not require the clearing organization to treat such funds as the property of the particular customers who deposited them or to whose positions they have accrued.
This view accords with the legislative history of Section 4d(2) of the Act. The Act did not specifically govern the treatment of commodity customer funds by clearing organizations and other depositories of customer margin funds until the enactment of Section 4d(2)'s final paragraph, quoted above, in 1968. The legislative history of this provision reflects Congress's intention to ensure that customer funds would not be used to discharge the general obligations of the FCM or otherwise diverted from their lawful purposes. According to the Senate Report, for example, the amendment was proposed “to prohibit expressly customers' funds from being used to offset liabilities of the futures commission merchants or otherwise being misappropriated.” S. Rep. No. 947, 90th Cong. 2d Sess. 7 (1968).
The Commodity Exchange Authority's Administrator described the 1968 amendment as one which would afford additional protection against a situation presented in the De Angelis salad oil case “in which one of the banks actually took over funds of customers of one of the brokerage firms to offset liabilities of the firm.”
Our conclusion that Section 4d(2) generally allows clearing organizations to treat customer funds as the property of the depositing firm's customers, collectively, without regard to the respective interests of particular customers, also finds support in the legislative history of the Bankruptcy Reform Act of 1978. In recommending new provisions to govern bankruptcy liquidations of commodity firms, the Commission described the clearing house system then (and now) operant in the futures market as one in which “a clearing house deals only with its clearing members” and thus “does not know the specific customer on whose behalf a particular contract was entered into by one of its clearing members.”
The Commission's regulations are also consistent with the view that the clearing organization's direct obligations under Section 4d(2) include an obligation to treat customer funds as the property of the depositing FCM's customers but do not include a duty to separately account for or to employ such funds as the property of particular customers. Regulation 1.20(b), 17 CFR 1.20(b) (1984), for example, requires that a clearing organization separately account for and segregate all customers' funds received from a member of the clearing organization to purchase, margin, guarantee, secure or settle the trades, contracts or commodity options of the clearing member's customers and all money accruing to such customers as the result of such trades, contracts, or commodity options “as belonging to such commodity or option customers,” and specifies that a clearing organization shall not hold, use or dispose of such customer funds “except as belonging to such commodity or option customers.” 17 CFR 1.20(b) (1984).
Regulation 1.22, 17 CFR 1.22 (1984), which precludes FCMs from using or permitting the use of “the customer funds of one commodity and/or option customer to purchase, margin, or settle the trades, contracts, or commodity options of, or to secure or extend the credit of, any person other than such customer or option customer,” refers only to FCMs and, hence, does not govern clearing organizations or other depositories of customer funds.
Our conclusion that Section 4d(2) does not preclude a clearing organization from using all margin funds deposited by a clearing member firm to satisfy obligations arising from the account for which such funds were deposited reflects the essential function of margin deposits in the futures markets' clearing system. Clearing organizations generally stand as guarantors of the net futures and options obligations of the member firms and require margin deposits as security for the performance of obligations which, in the event of a member's default, the clearing organization must discharge. Margin deposits at the clearing level thus facilitate the clearing organization's performance of its guarantee obligations, serving to confine losses stemming from a clearing firm default to the defaulting firm and preventing their spread to the market as a whole.
In sum, we conclude that clearing organization rules and by-laws awarding clearing organizations the right to apply all customer margin funds within their custody to satisfy nonproprietary obligations of defaulting clearing firms are not inconsistent with Section 4d(2) of the Act or the Commission's regulations. Clearing organizations' rights with regard to the use of customer margin deposits of their member firms are not, however, wholly unlimited. A clearing organization may not use the margin deposits of one clearing member firm to satisfy obligations of another clearing firm or of any other person. In addition, as noted above, the final paragraph of Section 4d(2) of the Act was enacted to present use of customer funds to satisfy the FCM's own obligations. Consequently, customer margin funds deposited by a member FCM may not be used to margin, guarantee or settle the futures or options transactions or to satisfy any other proprietary obligation of the depositing firm. Such funds must be used to margin, guarantee, secure, or settle trades or contracts of the depositing FCM's customers or for charges “lawfully accruing in connection with” such contracts and not for any other purpose.
I support the advance notice of proposed rulemaking concerning protection of collateral of customers entering into cleared swaps. There has been much public input into these matters, but I think it is appropriate to have a formal ANPR soliciting input on a number of options and questions on how best to protect customers' collateral in the event of another customer's default. This is particularly important as we move forward to implement Congress's mandate that for the first time standardized swaps