Swaps Clearing and Collateral

Segregated Funds

One of the cornerstones upon which leverage trading stands is the manner in which collateral posted against positions can be used. In the futures world, funds posted as margin are segregated from the clearing firm or parent institutions assets. Segregated funds are similar to the capital or reserves a bank must put aside to meet their obligations. 2008 taught us quite a few lessons about the double-edge sword of fractionalized lending at banks. 2011 would teach us about the same risk at clearinghouses.

The Story of M.F. Global

M.F. Global was an enormous financial services firm which was formed by EDF Man, one of the finer futures’ clearinghouses and its hedge fund subsidiary Man International. Man was ahead of the curve in forming hedge funds and fund of funds for high net worth individuals and institutions. As the nineties became the naughts, Man Financial (now renamed MF Global) decided to grow an American Investment bank of sorts. All seemed to go well for a time. The firm was highly respected, their globalized trading operation gained a good reputation and cultivated a great staff. Enter: Jon Corzine. He’d done well for himself at Goldman Sachs. Thereafter he ran for Governor of New Jersey and won. Sadly, the Governor got into a traffic accident without his seatbelt and suffered substantially in the accident. He emerged several years later at M.F. Global as CEO and Chairman. Old sayings generally become old because they’re true. At least in this case, Jon Corzine hadn’t lost the itch to trade. And trade he did. But it was one rather large trade to which Mr. Corzine became particularly wedded that would cause his downfall. M.F. Global business lines included executing and clearing trades for roughly 36,000 clients. Their clients ran the gamut from institutional corporate clients hedging their businesses, floor traders on futures exchanges where MF Global owned seats to small retail accounts. As E.D.F. Man they cleared many traders on the New York Mercantile Exchange, where I was a member. As a clearing firm providing services to floor traders, the clearinghouses hold member’s good faith deposits. These good faith deposits are in addition to initial margin posted on open contracts. All of these deposits: Exchange good faith deposits, Margin funds (initial margin), variation margin (profit & loss) and the positions they finance belong to the client.

Shock & Awe

Mr. Corzine’s trade went against him. At some point in October 2011 the trade went so badly against him, he began using segregated funds to post collateral on the firm’s badly underwater trade. I wasn’t trading on the exchange floor at the time. But I recall the night in late October 2011 I received phone calls from friends who would be unable to get onto the trading floor and trade in the morning. Their exchange good faith deposits were gone. Poof. In an instant they were barred from entering the exchanges on which they were members and central to their businesses. I sat in silence as I read emails from other friends and students who would no longer have a job and ruminated on how things went wrong. Weren’t there brakes to prevent funds from being released from these segregated accounts? These were my friends. They’d spent many years building up their businesses. For now they would have to trade from their homes or friends offices – able to only close out positions unless they had other risk capital somewhere. I went into the bathroom, and threw up.

Aftermath

Regardless of who polluted the segregation process, the situation caused many people to think about the security of the newly formed Central Counterparty (CCP) system created for Swaps in the wake of the credit crisis. M.F. Global’s clients were very lucky. The appointed Trustee, James Giddens from Hughes Hubbard & Reed was able to return 100% of client funds. 75% came back to client rather quickly, the balance came back as Mr. Gidden’s located the firms to whom Mr. Corzine had posted collateral. That Mr. Corzine had the temerity to state this proved the funds were never really missing is beyond the pale of logic. Mr. Giddens was successful because the firm had records of the firms to whom they’d posted collateral against their trades. The very fact that the funds were posted as collateral is the crime.

Managing Segregated Funds in Swaps Clearinghouses

Dodd-Frank’s mandate for central clearing of swap contracts is intended to make the market safer for all participants. The CME, LCH & SwapsClear the three largest CCPs support Legally Segregated/Operationally Comingled (LSOC) protocols.

Legally Segregated/Operationally Comingled (LSOC)

Roughly 60% of all Interest rate swaps are cleared at a Swaps Clearinghouse. Swaps clearinghouses provide tremendous risk mitigation and systemic risk. There are competing interests which must be balanced.

The risk such as the one described above with M.F. Global, more generally that you are at risk to your clearing agent losing money on their other activities.
“Investment risk” to a much lesser extent due to the Clearinghouse investing in an interest bearing vehicle resulting from their obligation to pay interest on margin deposits.
- LSOC mitigates this risk by strictly limiting the securities in which a CCP can invest.
“Fellow customer” risk, or the risk that another client of your clearinghouse defaults and, unless legally segregated, might dip into your collateral in order to cure the default.
The risk of being able to move your portfolio to another CCP in the event of a default.

These need to be weighed against the issues facing your Clearing Agent (clearing member of the CCP) or the Central Counterparty (CCP or clearinghouse) itself.

Preserving the operational efficiency of each FCM in the absence of default
Ensuring the solvency and operational continuity of a CCP in the event of a related FCM or customer’s default.

LSOC strikes a balance between these two by providing the client the protection of segregation while allowing the clearinghouse (CCP) to operate normally. Here are some links which speak to LSOC in greater detail.