CME Group submitted amendments to its proposed rule changes previously provided to the Commodity Futures Trading Commission authorizing a new category of clearing membership, termed a “Direct Funding Participant.”
Under CME Group’s proposal, a DFP could clear all of its own CME Group trades directly with the CME clearinghouse but would not be obligated to contribute to CME Group’s guaranty fund or otherwise be responsible in case of a default by another clearing member. Instead, all of a DFP’s obligations (except for obligations arising from disciplinary actions against a DFP) to CME Group would be guaranteed by at least one other CME Group clearing member – termed a “DFP Guarantor” – that was registered with the CFTC as a futures commission merchant.
DFPs would respond to all collateral calls by paying the CME clearinghouse directly, but their performance bond requirements would typically be 104 percent of ordinary amounts.
To serve as a DFP Guarantor, an FCM clearing member would be subject to the higher of various minimum financial requirements, including potentially maintaining regulatory capital equal to the applicable CFTC requirements for positions carried in customer and non-customer accounts plus 4 percent of the total risk margin requirement for each DFP’s open positions that the DFP Guarantor guarantees. Additionally, a DFP Guarantor’s guaranty fund deposit would be increased to account for the activity of each DFP it guarantees, and a DFP Guarantor would have to serve as the exchange’s liquidating agent if a DFP defaulted.
According to CME Group, the intent of the DFP model is to enable a customer of an FCM to escape the risk of a pro rata loss allocation it might otherwise incur in the event of a customer-led or other default where there was a shortfall in any of the types of customer accounts at the FCM (segregated funds, foreign futures funds and cleared swaps) – avoiding so-called “fellow customer risk.” Moreover, even if there were no shortfall, a DFP would avoid potential delays in recovering its collateral as opposed to if it maintained an account at a failed FCM.
CME Group claimed that the DFP model would benefit US bank‑owned FCMs, as they could avoid having cash posted with them that might increase their leverage capital requirements. DFP Guarantors are authorized to provide back-office services and regulatory reporting for DFPs.
CME Group amended its earlier proposal submitted to the CFTC during July 2016, to permit a DFP Guarantor to have a second lien over collateral of a DFP it guarantees; to require DFP Guarantors to employ pre-trade risk controls for DFPs they guarantee consistent with CFTC requirements (click here to access CFTC Rule 1.73); to clarify a DFP’s financial reporting obligations (e.g., a DFP would not have to produce financial statements to the clearinghouse); and to address certain concerns previously expressed by the Futures Industry Association regarding CME Group’s DFP proposal. Among other things, FIA expressed a concern regarding the obligation of a DFP Guarantor to serve as the exchange’s liquidation agent in the event of a DFP default. However, CME Group said its view is “the DFP Guarantor is in the best position to know how to manage its designated DFP through a default as the DFP Guarantor guarantees the DFP’s financial obligation to the clearinghouse and risk manages the DFP’s portfolio.”
In response to another FIA concern, CME Group obtained a legal memorandum that concluded DFPs should not be considered customers of DFP guarantor FCMs and would not be subject to fellow customer risk at such FCMs.
Other commentators suggested that DFPs alone should fully incur any increased capital requirements prompted by their positions, by imposing on them a minimum margin of 108 percent of ordinary requirements. CME Group rejected this recommendation, positing, “whether the DFP program does in fact create heightened capital requirements on the DFP Guarantor as compared to the capital requirements set out for FCM clearing members with respect to customers under Commission Regulations.”
CME Group anticipates its amended rules authorizing DFP Memberships will be effective the earlier of June 19 or upon CFTC approval.
(Click here for background on CME Group’s earlier proposal in the article “CME Group Proposes New Clearing Member Category to Help Customers Avoid Pro Rata Distribution Risk in Case of FCM Insolvency” in the July 24, 2016 edition of Bridging the Week. Click here for a very helpful Q&A on its DFP clearing membership proposal prepared by CME Group.)
My View: Once CME Group’s DFP proposal is implemented, CME Group will become the third clearinghouse in the United States and Europe to offer direct clearing membership programs. The others are at Eurex and ICE Clear Europe. (Click here for insight into Eurex’s direct clearing model in the article “Before There Was CME Group’s Direct Funding Participant Clearing Membership Proposal There Was Eurex’s ISA Direct” in the August 7, 2016 edition of Bridging the Week, and here for background on ICE Clear Europe’s direct clearing model in the article, “…And Don’t Forget ICE Clear Europe’s Individual Segregation Through Sponsored Principal Account Offering” in the August 21, 2016 edition of Bridging the Week.) Although each model is different – mostly due to the application of different customer funds requirements and insolvency regimes in Europe and the United States, each attempts to exclude customers through direct clearinghouse membership from various risks associated with the insolvency of FCMs. However, whether FCMs will be willing to provide necessary guarantees will be seen. Ultimately, these models may evolve to provide greater flexibility by perhaps transferring all heightened capital requirements from guarantor FCMs to customers through a greater premium margin. This would enable more FCMs to become essentially introducing brokers only, reduce capital requirements, and generate more revenue solely through the provision of expert outsourcing, risk management and other services. Time will tell. But in conjunction with the introduction of distributed ledger technology, the direct clearing membership model may be a harkening of major changes coming in the way customers trading exchange-traded derivatives are serviced going forward. Stay tuned!