The Commodity Futures Trading Commission adopted final rules implementing section 724 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which prescribes the manner in which cleared swaps and related collateral must be treated prior to and after bankruptcy. The final rule sets forth a model entitled “Complete Legal Segregation.” The purpose of the rules is to protect swaps customers from so-called “fellow customer” risk, i.e., the risk of loss resulting from the default of one or more customers. Similar to the rules governing funds segregated on behalf of customers trading on US futures exchanges, the rules permit futures commission merchants (FCMs) and derivatives clearing organizations (DCOs) to hold cleared swaps customer collateral in commingled customer omnibus accounts. However, the rules further require FCMs that are members of a DCO to provide the DCO at least once each day with information regarding: (1) the identity of the underlying customers whose positions are held in the omnibus account, (2) the portfolio of positions held by each customer, and (3) the margin associated with those positions. In the event a default by one or more of the clearing member FCM’s cleared swaps customers results in the default of the clearing member to the DCO, the DCO would not have recourse to the collateral posted by non-defaulting cleared swaps customers to meet the FCM’s obligations to the DCO. The rules contemplate that the positions and related margin of non-defaulting customers would either be transferred to another clearing member FCM or liquidated and returned to the Trustee in bankruptcy for distribution in accordance with the commodity broker liquidation provisions of the Bankruptcy Code (Chapter 7, Subchapter IV).
At the meeting, CFTC staff emphasized that the scope of the rules is limited. They are designed to protect non-defaulting customers from “fellow customer” risk. They will not protect customers from “operational risk” (e.g., loss arising from negligence or malfeasance on the part of the FCM) or “investment risk”.
The final rules also amend the CFTC’s bankruptcy, Part 190 rules in order to implement changes required by the Dodd-Frank Act.
At the meeting, the staff also advised that the preamble to the rules set out in the Federal Register confirms that Financial and Segregation Interpretation No. 10-1, which since 2005 has prohibited third-party custodial accounts for almost all futures customers, does not apply to cleared swaps customers. Consequently, FCMs may agree to establish third-party custodial accounts for cleared swaps customers, provided all parties comply with the requirements of Financial and Segregation Interpretation No. 10, which was adopted in 1984.
The final rules will become effective 60 days after publication in the Federal Register. A copy of the fact sheet regarding the final rules is available here.