Attempts To Make Swaps Market Safer May Backfire

by: QFinance

By Ian Fraser

First of all, a word of warning. Today I am writing about a particularly jargon laden corner of the financial markets.

The Washington-based regulator, the Commodities Futures Trading Commission, is making better-than-expected progress towards its goal of re-regulating the swaps market and implementing the objectives outlined in the Dodd-Frank Act.

On January 11 the CFTC made one notable breakthrough when it adopted a rule using the so-called “legal segregation, operational commingling” model for protecting customers’ collateral.

According to an update from the US law firm Davis Polk & Wardwell the “legal segregation, operational commingling” model is designed to ensure customers of swaps dealers and brokerages are not exposed to what’s called “fellow customer risk.” Under LSOC, if a customer of a "futures commission merchant” (which basically means a brokerage) defaults on a cleared swap margin obligation, and the brokerage is unable to meet the customer’s obligation, then the derivatives clearing organization (basically a clearinghouse) is forbidden to plunder the assets of the merchant’s non-defaulting customers.

Writing on the Harvard Law Blog, Davis Polk partner Annette Nazareth stressed that this represented a major breakthrough. Nazareth, a former commissioner at the US Securities and Exchange Commission, wrote:

In adopting final rules on the treatment of cleared swap customer collateral, the CFTC has taken a major step in defining the architecture of market-wide swap clearing, a key pillar of the Dodd-Frank Act’s derivatives reform. After receiving intense arguments for divergent types of collateral protection, the CFTC adopted the “legal segregation, operational commingling” model …

Nazareth believes the LSOC model will provide investors with further protection, albeit at an additional cost, to what can be achieved via the existing clearinghouse model.

Under the 'DCO' (=clearinghouse) model, customers’ swap collateral can be raided by the clearinghouse in the event of a default of both the brokerage and one of its futures customers. Sounds familiar to customers of MF Global? Nazareth added that: “The CFTC has not extended the LSOC model to futures at this time, but will consider doing so.”

Derivatives-clearing organizations and brokerages have being given until November 8 to comply with LSOC model’s provisions. This is the date on which they will also have to comply with a number of other recently-finalized derivatives clearing organization rules.

The CTFC also recently finalized a rule -- “business conduct rule” -- establishing business conduct standards for swap dealers and major swap participants in their dealings with counterparties. According to Davis Polk, the business-conduct rule "prohibits swap dealers and major swap participants from engaging in fraud, deception or manipulation and requires communication with counterparties to be fair and balanced and based on good faith and fair dealing."

These are noble goals but for some reason the phrasing made immediately reminded me of the US visa application form, which asks:

Do you seek to engage in terrorist activities while in the United States or have you ever engaged in terrorist activities?

On February 23 the CFTC approved a further measure clarifying the timing of the reporting of block trades -- large, over-the-counter swap deals with sensitive price and size information, which are negotiated off an exchange's trading facility and posted later. The commission, seemingly sensitive to lobbying from the likes of Goldman Sachs, said it would allow the public reporting of such block trades to be delayed.

But Republican commissioners on the CFTC have called the poor quality data used in the proposed new rule as "troubling", warning that it could undermine the regulator's efforts to boost the transparency of the swaps market. There still seems plenty of scope for haggling over things like the thresholds for exemptions, especially since these are to be reviewed annually.

Warren Buffett, chairman of Berkshire Hathaway (NYSE:BRK.B), seems underwhelmed by the revised regulatory regime for derivatives trading. Writing in his annual letter to shareholders published on February 25, Buffett wrote:-

There is little new to report on our derivatives positions, which we have described in detail in past reports.

One important industry change, however, must be noted: Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.