Clearing/Cleared Swaps/MF Global Bankruptcy

Transcription

1 Clearing/Cleared Swaps/MF Global Bankruptcy Chair: Ronald H. Filler, New York Law School, Allen & Overy Panelists: Alessandro Cocco, JP Morgan Geoffrey Goldman, Shearman & Sterling Susan Milligan, LCH Clearnet Anada Radhakrishnan (Invited), CFTC Elizabeth L. Ritter, CFTC Kathryn Trkla, Foley & Lardner Table of Contents 1. Selected US and EU Legal Requirements for Swap Clearing, Geoffrey B. Goldman Shearman & Sterling LLP 2. Derivatives Clearing Regulatory Developments, Kathryn M. Trkla, Partner, Foley & Lardner LLP 3. Consumer Protection: How U.K. Client Money Rules Differ From U.S. Customer Segregated Rules When a Custodian Firm Fails to Treat Customer Property Properly, Ronald H. Filler 4. Are Customer Segregated/Secured Amount Funds Properly Protected After Lehman?, Ronald H. Filler 5. Ask The Professor: OMG! What Did MF Global Do?, Ronald H. Filler 6. Panelist Biographies 2012 Derivatives & Futures Law Committee Meeting - 1 -

2 American Bar Association Business Law Section Derivatives and Futures Law Committee 2012 Winter Meeting Swap Clearing Panel December 19, 2011 Selected US and EU Legal Requirements for Swap Clearing Geoffrey B. Goldman Shearman & Sterling LLP * I. Introduction The requirement that certain derivatives be centrally cleared is a key component of the Dodd- Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or the Act ). In connection with this requirement, the Dodd-Frank Act adopts a comprehensive framework for the registration and regulation of clearing intermediaries and clearing organizations for derivatives. In the United States, jurisdiction over clearing (as with derivatives products generally) is divided between the Commodity Futures Trading Commission ( CFTC ) and Securities and Exchange Commission ( SEC ), based on the particular product. Broadly similar, but not identical, clearing requirements, are expected to be imposed in the European Union under the proposed European Market Infrastructure Regulation ( EMIR ). Both US and EU rules may have extraterritorial effect in certain cases, raising the possibility that market participants could be subject to inconsistent or conflicting clearing obligations in multiple jurisdictions. Key details of these new clearing requirements are left to implementing rules and regulations yet to be adopted (or in some cases, proposed) as of the date hereof. The degree of harmonization between the requirements of the Dodd-Frank Act and EMIR, and between those of the SEC and the CFTC within the US market, will have a significant impact on market participants as clearing mandates are implemented. II. Summary of Key Clearing Requirements Under Dodd-Frank Act A. CFTC/SEC Jurisdiction Jurisdiction over clearing is split between the CFTC and the SEC. * These materials were prepared for instructional purposes and do not represent the official position of Shearman & Sterling LLP or any of its partners, counsel, associates or employees, including the presenter, nor do they constitute legal advice applicable to any specific matter.

3 Page 2 The CFTC has jurisdiction over clearing of swaps. o Swaps include interest rate, currency, commodity and broad-based security index swaps (including equity index swaps and index CDS). The SEC has jurisdiction over clearing of security-based swaps. o Security-based swaps Include swaps on an individual security or loan or a narrowbased security index (including single equity swaps and single-name CDS). Treatment of clearing of mixed swaps (i.e., swaps referencing both a security and nonsecurity) under clearing requirements has not yet been addressed by regulations. B. Swap Clearing Requirements The CFTC is authorized to determine that any particular swap (or class or category of swaps) is required to be cleared with a registered DCO (or a clearing organization exempt from such registration). (CEA Sec. 2(h)) o The CFTC has adopted rules establishing a process for review of swaps for the mandatory clearing determination. (76 Fed. Reg (July 26, 2011)) o CFTC may make this determination upon the request of a clearing organization or on its own motion. o Clearing organizations are required to submit to the CFTC for consideration each swap or class or category of swaps that they intend to accept for clearing. o Submissions are to be published for public comment. o The CFTC may impose terms and conditions on the requirement to clear a swap or category of swaps. The Dodd-Frank Act and existing proposed and final regulations give limited guidance as to what swaps are expected to be subject to mandatory clearing, although discussion has centered around more standardized products. Under the Dodd-Frank Act and CFTC regulations, factors relevant for making the determination as to whether mandatory clearing applies include the following: o Existence of significant outstanding notionals, trading liquidity and adequate pricing data. o Availability of rule frameworks, capacity, expertise and credit support infrastructure to clear the contract. o Effect of clearing on the mitigation of systemic risk, taking into account the relevant market and resources of the clearing organization. o Effect on competition. o Existence of reasonable legal certainty in the event of the insolvency of the clearing organization or one or more clearing members. The CFTC cannot require a clearing organization to list a particular swap if clearing that swap would threaten the financial integrity of the clearing organization. Timeframe for clearing requirement

4 Page 3 o The CFTC has indicated that several rulemakings need to be finalized before mandatory clearing could be implemented. These include the product definitions, the end-user exception and the cleared swap margin segregation requirements. o The CFTC has proposed adopting a phased implementation approach once a mandatory clearing determination is made. (76 Fed. Reg (Sept. 20, 2011)) Phase 1: 90 days after mandatory clearing determination: Trades between swap dealers, major swap participants and active funds (private funds that are not third party subaccounts and execute 20 or more trades per month on average over the 12 months preceding the clearing determination). Phase 2: 180 days after mandatory clearing determination: Trades with commodity pools, private funds (other than active funds), employee benefit plans and certain other financial entities (other than third party subaccounts). Phase 3: 270 days after mandatory clearing termination: Trades with all other market participants. Earlier compliance would be permitted. o Swaps entered into before the application of the clearing requirement do not have to be cleared, so long as they are reported to a swap data repository (or to the CFTC if there is no such repository). C. Security-Based Swap Clearing Requirements The Dodd-Frank Act contains broadly parallel provisions allowing the SEC to determine that a particular security-based swap (or class or category of security-based swaps) is required to be cleared with a securities clearing agency registered with the SEC (or a clearing organization exempt from registration). (1934 Act Sec. 3C) o The Act envisions a similar procedure for making determinations as to whether a security-based swap is required to be cleared. o The SEC has proposed rules with respect to procedures for reviewing securitybased swaps for a mandatory clearing determination. (75 Fed. Reg (Dec. 30, 2010)) o The SEC has not yet given formal guidance as to the expected timing for such determinations. D. Exceptions to Clearing Requirement The Act provides a limited end-user exception from both the CFTC and SEC clearing requirements. (CEA Sec. 2(h)(7); 1934 Act Sec. 3C(g)) o The clearing requirement does not apply if one of the counterparties to a swap: Is not a financial entity, Is using swaps to hedge or mitigate commercial risk, and

5 Page 4 Notifies the CFTC or SEC, as applicable, how it generally meets its financial obligations under non-cleared swaps. o What is a financial entity? Swap dealers and security-based swap dealers Major swap participants and major security-based swap participants Commodity pools (which include collective investment vehicles that trade in swaps as well as futures) Private funds (e.g., 3(c)(7)-exempt vehicles) Employee benefit plans Persons engaged in the business of banking or activities that are financial in nature as defined in section 4(k) of the Bank Holding Company Act. In effect, the definition limits the end-user clearing exemption to corporate end-users engaging in hedging activities. Hedge funds and similar investment vehicles will generally not qualify and will have to clear swaps that are subject to the mandatory clearing requirement. Certain financing subsidiaries of corporate entities are also eligible for the exemption: An entity whose primary business is providing financing and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90% or more of which arise from financing that facilitates the purchase or lease of products, 90% or more of which are manufactured by the parent company or another subsidiary of the parent company. The exemption also covers affiliates entering into commercial hedges on behalf of the non-financial entity, provided that the affiliate is not itself a swap dealer or security-based swap dealer, major swap participant or major security-based swap participant, commodity pool, exempt fund under Section 3(c)(1) or 3(c)(7), or bank holding company with $50 billion in assets. An end-user that is a public company (i.e., a 1934-Act reporting company) must obtain the approval of an appropriate committee of its board of directors to enter into non-cleared swaps under the end-user exemption. o What is hedging or mitigating commercial risk? The CFTC has proposed that this prong will be satisfied where the swap is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise where the risks arise from potential changes in the values of relevant assets or liabilities or services, as well as relevant FX and interest rate movements. The swap must not be used for the purpose of speculation, investing or trading or to hedge or

6 Page 5 mitigate the risk of another swap (unless that other swap is itself used to hedge or mitigate commercial risk). (75 Fed. Reg (Dec. 23, 2010)) The SEC has proposed a generally similar definition. (75 Fed. Reg (Dec. 21, 2010)) o What type of notification will the CFTC and SEC require? The CFTC and SEC have proposed a set of information that must be provided to a swap data repository or security-based swap data repository where a party is relying on the end-user exception. An end-user eligible for the exemption from clearing is nonetheless entitled to require that the transaction be cleared (and to determine the clearing organization at which it is to be cleared). E. Registration/Regulation CFTC: A clearing organization for swaps is required to register as a DCO with the CFTC or obtain an exemption from registration. (CEA Sec. 5b) o The CFTC may grant an exemption, with or without conditions, from the DCO registration requirement if it determines that the clearing organization is subject to comparable, comprehensive supervision by the SEC as a securities clearing agency or by a regulator in its home country. o The Act expands the set of core principles applicable to registered DCOs. o The CFTC has adopted a comprehensive set of Part 39 regulations implementing the new core principles. (76 Fed. Reg (Nov. 8, 2011)) SEC: A clearing organization for security-based swaps is required to register with the SEC as a securities clearing agency or obtain an exemption. (1934 Act Sec. 17A(g)) o The SEC may grant an exemption, with or without conditions, from the registration requirement if it determines that the clearing organization is subject to comparable, comprehensive supervision by the CFTC or by a regulator in its home country. (1934 Act. Sec. 17A(k)) o In contrast to the core principles approach provided for DCOs under the CEA, the SEC has broad discretion to adopt rules for the regulation of securities clearing agencies involved in security-based swaps. (1934 Act Sec. 17A(i)) o The SEC has proposed a new set of clearing agency standards for operations and governance applicable to security-based swap clearing. 76 Fed. Reg (Mar. 16, 2011)) F. Open Access/Fungibility Issues The Act contains requirements for open access to clearing organizations and contract fungibility.

7 Page 6 o A clearing organization s rules must provide that all swaps submitted to it for clearing with the same terms and conditions are economically equivalent and may be offset with each other within the clearing organization.(cea Sec. 2(h)(1)(B); 1934 Act Sec. 3C(a)(2)) o A clearing organization must provide for non-discriminatory clearing of swaps executed bilaterally or on an unaffiliated exchange or execution facility. These requirements do not apply to futures contracts. o A clearing organization cannot, however, be required to accept the credit risk of another clearing organization. o Accordingly, while a clearing organization cannot discriminate against trades from different execution venues, it is not required to enter into clearing links or cross-margining and similar arrangements that would permit full fungibility across clearinghouses. G. Clearing Intermediary and Segregation Requirements The Act imposes additional requirements on entities that act as a clearing member for customer (i.e., non-member) positions o An intermediary that clears swaps on behalf of a customer (and accepts margin in connection therewith) must be registered with the CFTC as an FCM. (CEA Sec. 4d(f)(1)) o A person that clears security-based swaps on behalf of a customer (and accepts margin in connection therewith) must be registered with the SEC as a brokerdealer or security-based swap dealer. (1934 Act Sec. 3E(a)) It is expected that much clearing activity will be conducted through joint broker-dealer-fcms, which would be permitted to clear both swaps and security-based swaps. o These requirements do not apply to entities that self-clear (i.e., are not clearing on behalf of a customer). Segregation o The Act imposes a margin segregation requirement generally similar to the futures segregation model for FCMs under CEA Sec. 4d. o Parallel segregation regimes are created for swaps (under CFTC jurisdiction) (CEA Sec. 4d(f)) and security-based swaps (under SEC jurisdiction) (1934 Act Sec. 3E(b). o Regulations will need to address key aspects of both segregation regimes: Permissible investments (e.g., CFTC Rule 1.25/collateral transformation. Acceptable custodians Financing of margin requirements. Use of margin assets by clearing organizations/mutualization.

8 Page 7 The possibility of holding swaps and security-based swaps in the same account (to facilitate portfolio margining and insolvency treatment). o The CFTC has proposed rules implementing a legally segregated, operationally commingled structure for swap customer margin intended to reduce risk of loss to a customer from default by another customer. (76 Fed. Reg (June 9, 2011)) H. Systemically Important Clearing Organizations III. Title VIII of the Dodd-Frank Act imposes additional requirements on clearing organizations that are designated by the Financial Stability Oversight Council (the Council ) as systemically important ( Designated Clearing Entities ). (Act Sec. 804) The CFTC and SEC, in consultation with the Financial Stability Oversight Council and Federal Reserve Board, may adopt additional risk management standards for Designated Clearing Entities. (Act Sec. 805) These standards may address: o Risk management policies o Margin requirements o Default policies and procedures o Timely completion of settlement responsibilities o Financial resources The Federal Reserve Board may determine that the standards adopted by the CFTC or SEC applicable to a Designated Clearing Entity are insufficient to prevent or mitigate significant systemic risks to the financial markets or financial stability. If the Council agrees, it may require the CFTC or SEC to adopt additional standards. o These standards do not apply to the determination of whether a swap or securitybased swap is eligible for clearing or required to be cleared, which is left to the CFTC or SEC. Title VIII authorizes the Federal Reserve to provide emergency assistance to a Designated Clearing Entity under limited circumstances. (Act Sec. 806(b)) Title VIII also provides enhanced supervision of rules and rule changes for Designated Clearing Entities. (Act Sec. 806(e)) Summary of Proposed EU Requirements Under EMIR, a mandatory clearing obligation would apply to designated categories of derivatives that are between two financial counterparties or, subject to certain exceptions, between a financial and a non-financial counterparty or between two non-financial counterparties. o The clearing obligation would apply to a trade between an EU-domiciled institution and a third country institution.

9 Page 8 IV. o Trades between third country institutions could be subject to the EMIR clearing obligation where the contract has a direct, substantial and foreseeable effect within the EU or where necessary to avoid evasion of clearing requirements. Exceptions to clearing obligation would exist for: o Intra-group transactions (i.e., affiliate transactions). o Short minimum maturity (to be defined) on date clearing obligation applies. o Proposed time-limited exception for pension schemes arrangements (Art. 71). o Transactions with non-financial counterparties Low volumes, below clearing threshold (to be defined) Commercial hedges: transactions objectively measurable as reducing risks directly related to commercial activity/treasury financing activity. As a result, transactions between financial counterparties (including investment firms, banks, insurers, UCITS funds, pension funds) would generally be subject to the clearing obligation. Transactions with non-financial counterparties would not be subject to the clearing obligation if below a threshold. o This may result in a broader exemption for transactions with non-financial endusers than under US law. Applicability of clearing obligation will be determined by the European Securities and Markets Authority ( ESMA ) o Member states must notify ESMA of cleared contracts. o ESMA determination is expected to be based on: Degree of standardization Volume and liquidity Availability of fair, reliable and generally accepted pricing information. o Date obligation comes into force for particular class of OTC derivative to be based on: Volumes Whether already cleared Ability of CCPs to handle volumes and risks Type and number of active counterparties Time needed to set up clearing arrangements Risk management, legal and operational capacity of participants. Extraterritorial Questions. Dodd-Frank by its terms should not apply to activities outside the United States unless they have a direct and significant connection with activities in, or effect on, commerce of the United States (or contravene rules designed to prevent evasion). Similarly, EMIR may apply to transactions between third country entities that would be subject to regulation if established in the EU, provided the swap has a direct, substantial

10 Page 9 and foreseeable effect within the EU (or where regulation is necessary or appropriate to prevent evasion). One or both regimes may therefore apply in a cross-border context. The possible cross-border application of US and/or EU clearing requirements (or those of other jurisdictions) creates potential for inconsistent or conflicting standards, or the potential for market fragmentation to avoid inconsistent or conflicting requirements. Particular questions may arise in the context of cross-border clearing. o Where does a transaction have to be cleared? What if a transaction is potentially subject to mandatory clearing in two jurisdictions (e.g., a transaction between a US bank and an EU bank). Will registration of CCPs in multiple jurisdictions be required, or will exemptions be provided based on home country regulation? Dodd-Frank and EMIR contemplate the possibility of exemptions or cross-border recognition for CCPs. Will clearing brokers/intermediaries be subject to regulation in multiple jurisdictions? Dodd-Frank does not specifically provide for exemptions for intermediaries in cross-border context. Dodd-Frank imposes FCM requirement for customer clearing for US customers. How will customers access CCPs in different jurisdictions? US customers wanting to clear in an EU CCP? EU customers wanting to clear in a US CCP?

11 ABA WINTER MEETING JANUARY 2012 Committee on Derivatives & Futures Law of the Business Law Section Panel On Clearing Issues Derivatives Clearing Regulatory Developments Kathryn M. Trkla, Partner Foley & Lardner LLP (December 18, 2011) INTRODUCTION This outline provides an overview of the Dodd-Frank Act 1 amendments to the Commodity Exchange Act ( CEA ) and the Securities Exchange Act of 1934 ( Exchange Act ) that impact derivatives clearing along with a summary of the rulemaking initiatives of the Commodity Futures Trading Commission ( CFTC ) and Securities and Exchange Commission ( SEC ) to implement those amendments (excluding rulemaking proposals regarding governance fitness standards, conflicts of interest and composition of governing bodies). OUTLINE I. Dodd-Frank Amendments To the CEA and Exchange Act Impacting Derivatives Clearing A. Mandatory Clearing for Swaps and Security-Based Swaps 1. CEA (a) The Clearing Requirement. New CEA 2(h) [7 USC 2(h)] sets out the requirement mandating clearing of transactions in types of swaps that are subject to a mandatory clearing determination by the CFTC. The provision includes the end-user exception. (b) Procedural Requirements. CEA 2(h) also sets out the procedural and substantive standards, subject to further rulemaking by the CFTC, that the CFTC must follow to make a mandatory clearing determination or to stay such a determination. 1 The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Public Law , 124 Stat (2010). Title VII, The Wall Street Transparency and Accountability Act of 2010, made significant amendments to the CEA and Exchange Act (and amendments to other federal securities laws) to establish a comprehensive framework for regulation of OTC derivatives. Other titles of Dodd-Frank also impact regulation of derivatives, specifically, Section 619 of Title VI, which sets out the so-called Volker Rule limitations on proprietary trading by banks and bank affiliates, and provisions of Title VIII providing for enhanced oversight by the Federal Reserve Board, CFTC and SEC of clearing and settlement systems that are designated as systemically important

12 (c) Substantive Requirements. CEA 2(h) also sets out five factors the CFTC is required to consider in deciding whether to mandate clearing for any type of swap, specifically: 2. Exchange Act (1) Whether there are significant outstanding notional exposures; (2) Whether there is an available rules framework, capacity, operational expertise and resources, along with credit support infrastructure, to clear the contract on terms that are consistent with the materials terms and trading conventions on which the contract is then traded; (3) The effect that clearing will have on mitigation of systemic risk, taking into account the size of the market for the contract and the resources of the applicable clearinghouse to clear the contract; (4) The effect that clearing will have on competition, including appropriate fees and charges applied to clearing; and (5) Whether there is reasonable legal certainty in the event of the insolvency of the clearinghouse or one or more of its clearing members or participants with respect to the treatment of customer and counterparty positions, funds and property. (a) The Clearing Requirement. New Exchange Act 3C [15 USC 78c- 3] sets out the requirement mandating clearing of transactions in types of security-based swaps that are subject to a mandatory clearing determination by the SEC. The provision includes the end-user exception. (b) (c) Procedural Requirements. Exchange Act 3C also sets out the procedural and substantive standards, subject to further rulemaking by the SEC, that the SEC must follow to make a mandatory clearing determination or to stay such a determination. Substantive Requirements. Exchange Act 3C also sets out as factors that the SEC must consider when deciding whether to mandate clearing for any type of security-based swap the same five factors described above that the CFTC must consider

13 B. Registration Requirements for Clearinghouses 1. CEA (a) Swaps. Under new CEA 2(h) [7 U.S.C. 2(h)] and amended CEA 5b [7 USC 7a-1], to clear swaps, a person is required to register with the CFTC as a derivatives clearing organization ( DCO ) or receive an exemption from the CFTC from such registration. The CFTC may grant an exemption only if it determines that the clearinghouse is subject to comparable, comprehensive supervision and regulation by the SEC or by its regulator in its home jurisdiction. (b) Futures and Options on Futures. To operate a clearinghouse for exchange-listed futures and options on futures ( futures ), a person is required to register as a DCO pursuant to CEA 5b [7 USC 7a-1]. (This requirement pre-dates Dodd-Frank and was added to the CEA in 2000.) (c) DCO Defined. The term derivatives clearing organization is defined in CEA 1a(15) [7 USC 1a(15)] as: a clearinghouse, clearing association, clearing corporation or similar entity, facility, system, or organization that, with respect to an agreement, contract, or transaction (i) enables each party to the agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the derivatives clearing organization for the credit of the parties; (ii) arranges or provides, on a multilateral basis, for the settlement or netting of obligations resulting from such agreements, contracts, or transactions executed by participants in the derivatives clearing organization; or (iii) otherwise provides clearing services or arrangements that mutualized or transfer among participants in the derivatives clearing organization the credit risk arising from such agreements, contracts, or transactions executed by the participants

14 2. Exchange Act (a) (b) (c) Security-Based Swaps. Under new Exchange Act 3C(a) [15 USC 78c-3(a)] and 17A(k) [15 USC 78q-1(k)], to clear security-based swaps, a person is required to register with the SEC as a clearing agency or receive an exemption from the SEC from such registration. The SEC may grant an exemption only if it determines that the clearinghouse is subject to comparable, comprehensive supervision and regulation by the CFTC or by its regulator in its home jurisdiction. Securities Generally. Exchange Act 17A(b) [15 USC 78q-1(b)] requires a person to register as a clearing agency or receive an exemption from such registration to operate as a clearing agency for securities. This provision also applies to clearing of securitybased swaps (and of options on securities and securities indexes), because such derivatives are securities under the Exchange Act (and other federal securities laws). Clearing Agency Defined. The term clearing agency is defined in Exchange Act 3(a)(23)(A) [15 USC 78c(a)(23)(A)] as any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities. Such term also means any person, such as a securities depository, who (i) acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry without physical delivery of securities certifications, or (ii) otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates. Note, the breadth of this definition covers and has been interpreted by the SEC to cover persons engaged in any of a range of activities short of acting as a central counterparty,

15 such as securities depositories and securities matching services. 3. Repeal of Provisions for Multilateral Clearing Organizations. Effective July 16, 2011, the Dodd-Frank Act repealed Section 409 of the Federal Deposit Insurance Corporation Improvement Act, which allowed a clearinghouse for OTC derivatives to operate as a multilateral clearing organization pursuant to (a) regulation as a bank under U.S. federal or state law; (b) registration as a DCO with the CFTC; (c) registration as a clearing agency with the SEC; or (d) supervision by a foreign financial regulator, if one of the U.S. federal banking regulators, the CFTC or the SEC determined that such supervision met appropriate standards. 4. Clearinghouses Deemed Registered Effective July 16, 2011 (a) (b) As a DCO for Swaps. Under CEA 5b(g) [7 U.S.C. 7a-1(g)], a depository institution or SEC-registered clearing agency that cleared swaps prior to enactment of Dodd-Frank was deemed registered as a DCO with respect to swaps effective July 16, As a Clearing Agency for Security-Based Swap. Under Exchange Act 17A(l) [15 U.S.C. 78q-1(l)], (1) a depository institution that cleared swaps prior to enactment of Dodd-Frank or (2) a CFTCregistered DCO that cleared swaps prior to enactment of Dodd- Frank pursuant to an exemption from clearing agency registration, was deemed registered as a clearing agency with respect to security-based swaps effective July 16, C. Substantive Regulation of DCOs and Clearing Agencies 1. CEA (a) (b) DCO Core Principles. Dodd-Frank revised and expanded the core principles applicable to a DCO, which are set out in new CEA 5b [7 USC 7a-1]. The core principles and related-cftc rulemaking are covered below in Section II.B. and the attached table. Access To Clearing (1) Access and Cross-Market Fungibility for Cleared Swaps (A) Open Access. Under new CEA 2(h)(1)(B) [7 USC 2(h)(1)(B)], a DCO is required to provide for nondiscriminatory clearing of OTC swaps and swaps executed on or through the rules of an unaffiliated

16 swap execution facility or designated contract market (i.e., a futures exchange). (B) Cross-Market Offset. Under CEA 2(h)(1)(B) [7 USC 2(h)(1)(B)], a DCO is also required to treat swaps submitted to it that have the same terms and conditions as economically equivalent and subject to offset against one another within the DCO. (C) Limitations on Interoperability. CEA 5b(f) [7 USC 7a-1(f)] prohibits the CFTC from compelling a DCO to accept the counterparty credit risk of another clearinghouse. This limitation could impede the development of cross-market fungibility for cleared swaps. 2. Exchange Act (2) Futures: No Open Access or Cross-Market Fungibility. In contrast, there are no comparable open access or crossmarket fungibility requirements for futures. The listing exchange dictates the DCO that must be used. (a) (b) General Standards. Security-based swaps are a type of security; accordingly, a clearing agency for such instruments is subject to the general clearing agency standards set out in 17A of the Exchange Act, in particular 17A(b)(3)(A)-(I). In addition, Dodd- Frank added 17A(i) to the Exchange Act, which authorizes (but does not require) the SEC to adopt rules to establish standards specific to a clearing agency for security-based swaps. Access To Clearing (1) Open Access and Cross-Market Fungibility for Security- Based Swaps (A) Open Access. Under new Exchange Act 3C(a)(2) [15 USC 78c-3(a)(2)], a clearing agency is required to provide for non-discriminatory clearing of OTC security-based swaps and security-based swaps executed on or through the rules of an unaffiliated security-based swap execution facility or national securities exchange

17 (B) Cross-Market Offset. Under Exchange Act 3C(a)(2) [15 USC 78c-3(a)(2)], a clearing agency is required to treat security-based swaps submitted to it that have the same terms and conditions as economically equivalent and subject to offset against one another within the clearing agency. (C) Interoperability. Exchange Act 17A(a)(3)(B) [15 USC 78q-1(a)(3)(B)], which pre-dates Dodd-Frank, provides that the SEC may not register a clearing agency unless it makes certain prescribed determinations, including that the clearing agency has rules providing for other registered clearing agencies to become a participant of the clearing agency. Traditionally, linkages between clearing agencies are established through that means. See Regulation of Clearing Agencies, 45 Fed. Reg (June 17, 1980). This statutory provision stands in sharp contrast to the Dodd-Frank provision added to the CEA, noted above, that prohibits the CFTC from requiring a DCO to accept another clearinghouse s counterparty credit risk. (2) Securities Generally. The foregoing provisions with respect to security-based swaps reflect long-standing federal policies under the Exchange Act. Exchange Act 17A(a)(2)(A) [15 USC 78q-1(a)(2)(A)] establishes as federal policies that the SEC should facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities and facilitate the establishment of linked or coordinated facilities for clearing and settlement of transactions in securities. D. Segregation Requirements: Treatment of Customer Funds by Clearing Intermediaries and Clearinghouses. The CEA and Exchange Act provisions with respect to protection of customer funds held by clearing intermediaries for futures, i.e., by futures commission merchants ( FCMs ), and by clearing intermediaries for securities, i.e., by broker-dealers, which pre-date Dodd-Frank, are still in place. In addition, Dodd-Frank added provisions to the CEA and Exchange Act that prescribe specific, virtually identical, segregation requirements with respect to customer funds for cleared swaps and securitybased swaps. The Exchange Act requirements also apply to security-based swap

18 dealers, which are permitted to act as clearing intermediaries for customers with respect to security-based swaps. 1. CEA (a) Futures. The basic segregation requirements with respect to futures customer funds are set out in CEA 4d(a) and (b) [7 USC 6d(a)-(b)]. For more discussion, see Section II.C. below. (b) Swaps. Dodd-Frank added CEA 4d(f) and (g) [7 USC 6d(f)-(g)], which prescribe the customer funds segregation requirements for cleared swaps. Although the statutory language is almost identical to the segregation requirements for futures, there are slight differences which the CFTC considers significant and cites in support of proposing segregation rules that differ in significant respects from the existing segregation rules for futures. See the discussion below in Section II.C. 2. Exchange Act E. Portfolio Margining (a) Securities Generally. Exchange Act 15(c)(3)(A) [15 USC 78o(c)(3)] sets out the SEC s authority to adopt rules applicable to broker-dealers regarding custody and use of customer securities and carrying and use of customer deposits or credit balances, including customer reserve requirements. (b) Security-Based Swaps. Dodd-Frank added segregation requirements for cleared security-based swaps to the Exchange Act in 3E [15 USC 78c-5], which parallel the provisions for cleared swaps added to the CEA. If the SEC interprets 3E to require some form of legal segregation by customer, as the CFTC has proposed for cleared swaps (discussed below), the requirements may be incompatible the reserve requirements for customer deposits and credit balances under Exchange Act 15(c)(3) [15 USC 78o(c)(3)] and SEC Rule 15c Futures and Securities. Dodd-Frank added provisions to the CEA and Exchange Act, as well as to the Securities Investor Protection Act of 1970 ( SIPA ), to facilitate customer portfolio margining of futures and securities

19 (a) Securities in a Futures Account (1) Authorization. New Exchange Act 15(c)(3)(C) [15 USC 78(o)(3)] provides that the SEC may grant an exemption pursuant to Exchange Act 36 to allow a dually-registered FCM and broker-dealer to hold securities and associated funds in a portfolio margining account carried as a futures account subject to CEA 4d, pursuant to a CFTC-approved portfolio margining program. It also requires the SEC to consult with the CFTC to ensure that such transactions and accounts are subject to comparable requirements to the extent practical for similar products. (2) Bankruptcy Treatment. New CEA 20(c) [7 USC 24(c)], which sets out the CFTC s authority to adopt rules governing a commodity broker (DCO or FCM) bankruptcy liquidation under Subchapter IV of Chapter 7 of the Bankruptcy Code, directs the CFTC to exercise its authority to ensure that securities held in a portfolio margining account carried as a futures account are customer property and the owners of those accounts are customers for the purposes of those Bankruptcy Code provisions. (b) Futures in a Securities Account (1) Authorization. New CEA 4d(h) [7 USC 6d(h)] provides that the CFTC may grant an exemption pursuant to CEA 4(c) to allow a dually-registered FCM and broker-dealer to hold futures and associated funds in a portfolio margining account carried as a securities account subject to Exchange Act 15(c)(3), pursuant to an SEC-approved portfolio margining program. It also requires the CFTC to consult with the SEC to ensure that such transactions and accounts are subject to comparable requirements to the extent practical for similar products. (2) Bankruptcy Treatment. Dodd-Frank also amended the definitions in SIPA 16 [15 USC 78lll] to expand (1) the definition of customer to include a person with a claim against a debtor broker-dealer for cash, securities or futures in a portfolio margining account carried as a securities account under an SEC-approved portfolio margining program and (2) the definition of customer property to include futures in a portfolio margining

20 account carried as a securities account under an SECapproved portfolio margining program. 2. Swaps and Security-Based Swaps. Dodd-Frank does not expressly address portfolio margining of swaps and security-based swaps. It is open to agency interpretation whether the amendments discussed above with respect to portfolio margining of futures and securities could be read to cover swaps and security-based swaps. Regardless, nothing in Dodd-Frank, the CEA or Exchange Act prohibits portfolio margining of swaps and security-based swaps. To the contrary, the amendments to encourage and facilitate portfolio margining of futures and securities indicates general Congressional support for portfolio margining and the efficiencies and benefits that can be achieved through a portfolio margining program. 3. Futures and Swaps. Dodd-Frank raises the issue of portfolio margining of futures and swaps by adding separate segregation provisions for cleared swaps under CEA 4d(f) and (g), discussed above. II. CFTC and SEC Rulemaking A. Mandatory Clearing for Swaps and Security-Based Swaps 1. CFTC Final Rule. The CFTC adopted its procedural rule, Rule 39.5, last July, which sets out the procedures pursuant to which it will review swaps for a mandatory clearing determination, along with the stay procedures for reconsidering a prior determination. Process for Review of Swaps for Mandatory Clearing, 76 Fed. Reg (July 26, 2011). Rule 39.5 took effective on September 26, (a) DCO Submissions. A DCO is required to make a submission for a mandatory clearing determination for each type of swap that it plans to accept for clearing. (A DCO is presumed to be eligible to accept a swap for clearing if it is within a type it already clears, subject to the CFTC s right to review the presumption. For other swaps, a DCO must submit a request for an eligibility determination to the CFTC.) A DCO is required to provide prescribed information for each type or group of swap covered by its submission, including (1) information to assist the CFTC in making the statutorily-required quantitative and qualitative assessments described above; (2) information on the DCO s product specifications and standardized legal documentation; (3) pricing sources, models and procedures; and (4) risk management procedures, such as margin methodology

21 (b) Review Process. Following the statutory standard, Rule 39.5 provides that a DCO submission is subject to a 30-day public comment process, and that the CFTC will finish its review within 90 days of receiving a completed application, unless the DCO agrees to an extension. The 30-day review process is triggered by the CFTC s posting of the submission on its website. (c) CFTC-Initiated Review. Rule 39.5 also provides that the CFTC may, at any time, and on an ongoing basis, review swaps that are not accepted for clearing by any DCO to determine whether clearing of such swaps should be required, and will provide notice of any such determination on its website for a 30-day comment period. (d) CFTC Investigation of Unavailability of Clearing. The rule also provides that if no DCO clears a type of swap that the CFTC determines should be subject to mandatory clearing, the CFTC will investigate the relevant facts and circumstances and issue a public report of the results of the investigation within 30 days of completing the investigation. To address this situation, the rule also provides that the CFTC may take such actions as the Commission determines to be necessary and in the public interest, which may include requiring the retaining of adequate margin or capital by parties to the swap, group, category, type, or class of swaps. (Emphasis added). 2. SEC Proposed Rules. The SEC issued proposed rules and rule amendments last December. Process for Submissions for Review of Security-Based Swaps for Mandatory Clearing and Notice Filing Requirements for Clearing Agencies; Technical Amendments to Rule 19b-4 and Form 19b-4 Applicable to All Self-Regulatory Organizations, 75 Fed. Reg (Dec. 30, 2010). (a) Clearing Agency Submissions. As proposed, a clearing agency is required to make a submission for a mandatory clearing determination for each type or group of security-based swap that it plans to accept for clearing. The clearing agency would be required to provide prescribed information for each type or group of security-based swap covered by its submission, including (1) information to assist the SEC in making the statutorily-required quantitative and qualitative assessments described above; (2) an explanation of how the submission is consistent with the clearing agency standards set out in Exchange Act 17A, including requirements to have rules to promote prompt and accurate

22 clearance and settlement of securities transactions, safeguard securities and funds in the clearing agency s custody or control, and remove impediments to, and perfect, the mechanism for, a national system for clearing and settling securities transactions; and (3) an explanation of how the clearing agency s rules comply with open and non-discriminatory access requirements. (b) Review Process. Following the statutory standards, the SEC proposes publishing a submission on its website, and also in the Federal Register, for a 30-day public comment period. It would complete its review within 90 days of receiving a submission that is complete and complies with SEC requirements, unless the clearing agency agrees to an extension. (c) (d) SEC-Initiated Review. The proposed rules do not cover this. Gradual Migration to Mandatory Clearing. The SEC s proposal reflects a cautious approach that focuses on facilitating nonmandatory clearing of security-based swaps before moving towards mandatory clearing. The SEC states that a premature determination that a product is subject to mandatory clearing may, in certain circumstance, limit the ability of certain market participants to utilize that product... which in turn could ultimately result in less clearing and more limited use of the product than might otherwise have been the case if it had been permitted to trade without being subject to a mandatory clearing requirement for a longer period of time. 75 Fed. Reg (e) Complying with Mandatory Clearing. The proposal includes proposed Rule 3Ca-2, which provides that a security-based swap that is subject to mandatory clearing must be submitted to a clearing agency that functions as a central counterparty. Given the broad clearing agency definition (discussed above), the SEC determined that such a rule is necessary to prevent evasion of the Congressional intention underlying the mandatory clearing provisions of Dodd-Frank. B. Registration and Substantive Regulation 1. CFTC Final Rules. In November, the CFTC adopted final rules implementing many of the DCO core principles, as expanded and revised by Dodd-Frank (the DCO Rules ). Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg (Nov. 8, 2011)

23 (a) General Provisions in Subpart A, Including Definitions. The DCO Rules include general provisions in Subpart A covering, e.g., scope, procedures for registration and enforceability. Rule 39.2 in Subpart A includes definitions for the terms back test, customer, customer account or customer origin, house account or house origin, key personnel, stress test, and systemically important derivatives clearing organization. (b) Amendments to Existing Rule 1.3 Definitions. The CFTC also adopted amendments to its Rule 1.3 definitions, separate from the definitions in DCO Rule 39.2, to conform to the Dodd-Frank amendments to the CEA. Specifically, the CFTC modified the definitions for clearing member, clearing organization (expanded to add derivatives clearing organization as a defined term also covered by that definition) and added definitions for clearing initial margin, customer initial margin, initial margin, margin call, spread margin and variation margin. In addition, the CFTC modified the definition of customer, but moved the definition to Rule (c) DCO Rules Implementing DCO Core Principles. Subpart B sets forth the regulatory standards for the DCO core principles governing substantive aspects of a DCO s operations, including financial and operational resources; clearing participant and product eligibility; risk management; settlement procedures; treatment of funds; default rules and procedures; rule enforcement; system safeguards; and legal risk. The rules do not cover DCO core principles relating to governance fitness standards, conflicts of interest or composition of governing boards, which are the subject of separate CFTC rulemaking. The attached table provides a summary of the DCO Rules in Subpart B. (d) (e) Registration. In this same release, the CFTC also adopted Form DCO, which is the application form for registration as a DCO. Form DCO also contains a detailed list of documents to be included as exhibits to the application. Positioning for Regulation of Systemically Important DCOs. Title VIII of the Dodd-Frank Act is intended to mitigate systemic risk in the financial system and promote financial stability. See Dodd- Frank Act 802(b). The Financial Stability Oversight Council ( Council ) is authorized under Dodd-Frank 804 to designate those entities involved in clearing that are systemically important

24 The CFTC is authorized under Dodd-Frank 805(a) to prescribe special rules for those DCOs for which the Council makes such a designation. The CFTC added the definition for systemically important derivatives clearing organization ( SIDCO ) to Rule 39.2 in connection with those Dodd-Frank provisions. The definition covers a CFTC-registered DCO that is designated as systemically important by the Counsel and for which the CFTC is the Supervisory Agency pursuant to Dodd-Frank 803(8). The CFTC had proposed, but did not adopt as part of the DCO Rules, heightened requirements with respect to financial resources and system safeguards for business continuity and disaster recovery for a SIDCO. In the adopting release for the DCO Rules, the CFTC explains its reasons for deferring adoption of such rules, noting that the Council has not yet designated any SIDCO; that it may be some time before that occurs; and that it would be prudent for the CFTC reconsider its regulation of SIDCOs in light of ongoing international developments in the regulation of central counterparties. 76 Fed. Reg (f) Effective Date and Compliance Deadlines. The DCO Rules and amendments to Rule 1.3 take effect on January 9, 2011, but the dates by which a DCO must comply with the rules is staggered. The attached table also covers the compliance dates for the DCO Subpart B Rules. 2. SEC Proposed Rules. The SEC has published several notices of rulemaking under Dodd-Frank that will impact regulation of clearing agencies. Clearing Agency Standards for Operation and Governance, 76 Fed. Reg (March 16, 2011) is the primary SEC proposal that addresses clearing agency standards. The proposal contains only one rule specific to a security-based swap clearing agency, acting as a central counterparty. Specifically, proposed Rule 17Aj 1 would require a clearing agency to publicly disseminate end-of-day settlement prices, other prices established to calculate mark-to-market margin requirements and any other pricing or valuation information with respect to security-based swaps that the clearing agency distributes to its clearing participants, all on fair and reasonable terms that are not unreasonably discriminatory

25 C. Segregation Requirements: Treatment of Customer Funds by Clearing Intermediaries and Clearinghouses 1. CFTC Rules and Proposed Rules (a) Existing Rules for Futures. The CFTC has long standing rules implementing the futures segregation requirements set out in CEA 4d(a) and (b) [7 USC 6d(a)-(b)]. The rules impose a number of fundamental requirements, including the following, among others. (1) An FCM must segregate cash and securities sufficient to meet its obligations to its customers, and may not use the cash or securities of one customer to meet the obligations of another. See CFTC Rules 1.22, 1.23 and This effectively means that the FCM must exclude customer accounts with negative balances from its calculation of the amount of funds it is required to hold on a segregated basis. Although not expressly set out in any CFTC rule, an FCM is expected to deposit its own funds into segregation to cover customer trading losses resulting in debit account balances; in practical terms, that is required to stay in segregation compliance. (2) Cash and securities held in segregation are property of the FCM s customers, and customer funds may not be used by the FCM for its own purposes. See CFTC Rule (3) An FCM or DCO, though, may invest customer cash and securities and retain the earnings, subject to strict CFTC requirements including, among others, that it must hold the investments as customer segregated property and may only withdraw earnings to the extent it is holding segregated funds in excess of the amount it is required to hold in segregation. CFTC Rule 1.25 and On December 5, 2011, the Commissioners approved amendments to CFTC Rule 1.25, in the wake of the MF Global Inc. ( MFGI ) bankruptcy filing on October 31, 2011 and press reports of substantial losses of segregated funds of MFGI s futures customers. Investment of Customer Funds and Funds held in an Account for Foreign Futures and Foreign Options Transactions, available at uments/file/federalregister120511a.pdf. (As of the

26 December 18, 2011 date of this outline, the rules were not published yet in the Federal Register.) Among other changes, the amendments: (A) (B) Impose limits on investing in debt issued by Fannie Mae or Freddie Mac; and Eliminate as permitted investments of segregated funds by an FCM or DCO: (1) corporate debt obligations that are not fully guaranteed as to principal and interest by the U.S.; (2) foreign debt (while noting that the CFTC will consider petitions for exemption from an FCM or DCO); (3) in-house transactions by a dually-registered FCM and broker-dealer of a type that is economically equivalent to a repo or reverse repo transactions; and (4) repo or reverse repo transactions with an affiliate of the FCM or DCO. (4) An FCM or DCO may hold margin funds of multiple futures customers on a commingled basis, i.e., on an omnibus basis. See CFTC Rule In the event of a clearing FCM default triggered by a customer default, this creates the so-called fellow customer risk that funds of the FCM s non-defaulting customers could be used by the DCO to meet the financial obligations of the defaulting customer. (5) An FCM is not permitted to commingle its cash or securities with those of its customers, except that it may contribute its own cash or securities into segregation. CFTC Rules 1.20 and FCMs typically deposit their own funds into segregation to provide a cushion to cover potential customer losses and remain in segregation compliance. (6) An FCM must obtain from each third party, including another FCM, with which it deposits customer segregated funds a written acknowledgement from such party that the funds in the account are the property of the FCM s futures customers, being held in accordance with the provisions of the CEA. CFTC Rules 1.20(a) and 1.26(a). However, in lieu of a written acknowledgement from a DCO, a clearing FCM may rely upon DCO rules setting out the DCO s segregation obligations

27 (7) An FCM is required to have immediate, unfettered access to customer funds held in segregation at a third party custodian to meet on a timely basis its margin and settlement obligations to a clearing FCM or DCO with respect to customer positions. See CFTC Segregation Interpretation 10, as amended, 70 FR (May 11, 2005). (b) Proposed Rules for Cleared Swaps. The CFTC has proposed segregation rules for cleared swaps that differ significantly from the futures segregation rules, which it refers to as the Complete Legal Segregation Model. Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 76 Fed. Reg (June 9, 2011). As proposed: (1) An FCM or DCO may hold swap customer funds on a comingled basis at a depository bank or trust company, but with legal separation within the FCM s or DCO s internal account records. (Legal segregation at the FCM level exists in the futures context, through requirements to maintain separate account records for each direct customer.) At the DCO level, the DCO would essentially have to treat each underlying swaps customer as a separate account in the event of a clearing FCM s default to isolate the losses of the defaulting customer that has triggered the FCM s default. (2) As an ongoing matter, though, in the absence of a default, the proposal stops short of requiring a DCO to maintain separate internal bookkeeping accounts or subaccounts for each underlying swaps customer that records the actual cash or other collateral deposited by each customer with the FCM and re-deposited with the DCO in respect of the customer s cleared swaps positions. Instead, a clearing FCM would have to provide the DCO on a daily basis with information on each customer s portfolio of rights and obligations. The proposed rules do not define what that term means. (3) A clearing FCM clearing customer trades for another FCM would have to obtain similar information from the nonclearing FCM with respect to its underlying swaps

28 customers, with the view that such information would be passed on to the DCO. (4) To protect non-defaulting customers of an FCM from the fellow customer risk described above, in the event that a clearing FCM defaults to a DCO due to a swaps customer default, the DCO could not use the funds of the defaulting FCM s other, non-defaulting swaps customers to cover the amount owed. The CFTC, though, also described a modified approach under consideration under which the DCO could have recourse against the combined funds of the defaulting FCM s underlying swaps customers, but only after applying other financial resources in the DCO waterfall available to cover the defaulting clearing FCM s losses, such as the DCO s own capital and clearing member contributions to a guaranty fund. 2. SEC Rules and Proposed Rules (a) (b) Existing Rule 15c3-3. SEC Rule 15c3-3 requires a broker-dealer to (1) maintain physical possession and control of all fully-paid securities and excess margin securities that it carries for the account of customers; and (2) segregate funds in a special reserve account for the exclusive benefit of the broker-dealer s customers in an amount determined pursuant to the reserve formula set out in the rule. Under the reserve formula, the broker-dealer must add various credit items, including customer account cash balances and funds obtained through the use of customer securities, and debit line items including money owed by customers (e.g., for margin lending), securities borrowed by the broker-dealer to effect customer short sales, and required margin posted with a clearing agency with respect to customer securities transactions. A broker-dealer with deposit requirements of $1M or more must compute its reserve requirement on a weekly basis as of the close of the last business day of the week. No Proposed SEC Rules for Cleared Security-Based Swaps. As of the December 18, 2011 date of this outline, the SEC has not issued any rulemaking proposal to implement the segregation requirements for cleared security-based swaps added by Dodd- Frank in new Exchange Act 3E [15 USC 78c-5]

29 D. Portfolio Margining 1. Futures and Securities (a) CFTC. The DCO Rules include Rule 39.4(e), which provides a procedural framework for a DCO to submit rules to the CFTC to implement a portfolio margining program under which securities would be held in a futures account, and requires the DCO concurrently to petition the CFTC for an order under CEA 4d. (b) SEC. The SEC has not proposed any procedural rules for portfolio margining of futures and securities. 2. Swaps and Security-Based Swaps. Neither agency has proposed any procedural (or other) rules with respect to portfolio margining of swaps and security-based swaps, whether carried in a segregated cleared swaps account subject to CEA 4d(f) or in a securities account subject to Exchange Act 15(c)(3). ICE Clear Credit LLC has submitted petitions to the CFTC and SEC, respectively, seeking various exemptions to permit it to provide portfolio margining for CDS swaps and CDS security-based swaps where positions would be held in segregated accounts subject to CEA 4d(f). Other clearinghouses have indicated that they plan to offer portfolio margining for such products, including notably the CME Clearing House. 3. Futures and Swaps. DCO Rule 39.15(b)(2) provides a procedural framework for a DCO to submit rules to permit the DCO and its clearing members to commingle customer funds for futures and cleared swaps in a single account, carried either as a segregated swaps account subject to CEA 4d(f) or as a futures account subject to CEA 4d(a). The rule also sets out the information that the DCO must provide in the submission, including identification of and product specifications for the covered futures and swaps; analysis of the risk characteristics of those products; and whether the swaps would be executed bi-laterally, on a designated contract market (i.e., a futures exchange) and/or on a swap execution facility

30 Table Summarizing the CFTC DCO Rules set out in Part 39, Subpart B, as adopted in Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg (Nov. 8, 2011). * Rule & Core Principle Summary of Rule Compliance Date 39.9 Scope Specifies that the Subpart B rules apply to any clearinghouse that is required to register as a DCO or that voluntarily registers. NA & Core Principle A: Compliance with core principles & Core Principle B: Financial resources The rule restates the core principle in paragraphs (a) and (b), requiring a DCO to comply with the core principles and related CFTC requirements and providing that the DCO has reasonable discretion in establishing how it will comply with core principles. Paragraph (c) sets out the requirement that a DCO must have a chief compliance officer ( CCO ); prescribes the CCO s duties; requires the CCO to prepare and submit to the CFTC an annual compliance report; and imposes recordkeeping requirements with respect to compliance policies and procedures, materials provided to the DCO s board or senior officer in connection with the review of the annual report, and the annual report and related work papers and documents. The rule imposes general requirements on a DCO to maintain sufficient liquid resources both to: 1. Cover its financial obligations to clearing members notwithstanding the default of the clearing member creating the largest financial exposure in extreme but plausible market conditions; and 2. Enable the DCO to cover operational costs for a minimum one year period, calculated on a rolling basis. The rule requires the DCO to compute financial resources on a monthly basis, including monthly stress testing to reasonably calculate the amounts needed to cover the default of its largest exposure clearing member. A DCO is also required at least monthly to compute the current market value of its financial resources available to cover those obligations, including January 9, 2012, with the exception of 39.10(c), for which the compliance date is November 8, May 7, 2012 * The table does not summarize the Subpart A Rules, Rules 39.1 through 39.8, which set out general provisions applicable to a DCO. For an overview of those rules, please refer to the discussion in the outline to which this table is attached. It should be noted that when it adopted the DCO Rules, the CFTC reserved Rules through 39.26, which are the subject of separate rulemaking proposals addressing Core Principle O on governance fitness standards, Core Principle P on conflicts of interest and Core Principle Q on composition of governing boards. Section 5b(b) [7 USC 7a-1(b)] permits a person to register voluntarily to clear transactions that are not required to be cleared under the CEA, such as forward contracts excluded from regulation under the CEA

31 Rule & Core Principle Summary of Rule Compliance Date limitations on the value to attribute to a DCO s authority to levy assessments against clearing members. The DCO is required to submit reports on its financial resources to the CFTC each fiscal quarter and upon request & Core Principle C: Participant and product eligibility & Core Principle D: Risk management Participant Eligibility. The rule sets out requirements with respect to a DCO s admission and continuing eligibility requirements for clearing members. Among other requirements, the rule provides that a DCO: 1. Must provide for fair and open participation; 2. May not limit clearing membership to swap dealers; and 3. May not, with respect to swaps clearing, impose a minimum capital requirement on a clearing member of more than $50M. Product Eligibility. The rule requires a DCO to establish appropriate requirements for determining the products it will clear, including the factors it should consider. Among other requirements, the rule also requires a DCO to: 1. Provide for offset of economically equivalent swaps; 2. Provide for non-discriminatory clearing of swaps that are executed bi-laterally or on an unaffiliated swap execution facility or designated contract market; and 3. Have rules that provide that when a swap is accepted for clearing, the original transaction is extinguished and replaced by an equivalent and opposite swap between the DCO and each clearing member, where the clearing member acts (a) as principal on a house trade (which would include trades cleared for affiliates or other parties considered to be proprietary accounts of the clearing member) and (b) as agent for a customer trade. The rule imposes various risk management requirements on a DCO including, among others, requirements to: 1. Have a chief risk officer; 2. Measure credit exposures and mark open positions to market for each clearing member at least daily; 3. Use a risk-based model and parameters to set initial margin to establish margin requirements at a confidence level of at least 99%, covering potential future adverse price moves using assumptions that it will take (a) a minimum of one day to liquidate futures and options or to liquidate swaps on May 7, 2012 May 7, 2012, with the exception of 39.13(g)(8)(i) setting out gross customer margin requirements, for which the compliance date is November 8,

32 Rule & Core Principle Summary of Rule Compliance Date agricultural commodities, energy commodities and metals and (b) a minimum of five days to liquidate all other swaps; 4. Collect initial margin on a gross basis from a clearing member with respect to its customer account(s), as if each customer were a clearing member; this is set out in paragraph (g)(8)(i); 5. Make portfolio compression exercises available to its clearing members with respect to cleared swaps, if such services have been developed by a third party; 6. Require its clearing members to maintain written risk management policies and procedures addressing the risks that they may pose to the DCO; and 7. Have the authority to take additional actions, based on the application of objective and prudent risk management standards, such as to impose enhanced capital or margin requirements; impose position limits or prohibit an increase in positions or require reduction of positions; liquidate or transfer positions; or suspend or revoke clearing membership & Core Principle E: Settlement procedures & Core Principle F: Treatment of funds The rule requires a DCO, among other things, to: 1. Effect daily settlements and have the authority and capacity to effect intra-day settlement; 2. Have arrangements to eliminate or strictly limit its exposure to settlement banks; 3. Provide for settlement finality; and 4. For physical-delivery contracts, (a) have rules stating what obligations the DCO has assumed and whether it indemnifies clearing members for losses they may incur in the delivery process and (b) identify and manage the risks of each obligation its assumes. The rule requires a DCO, among other things, to: 1. Comply with applicable segregation requirements under CEA 4d and CFTC rules; 2. Hold customer funds in a manner that minimizes risk of loss or delay in the DCO s access to funds and assets belonging to its clearing members and their customers; 3. Have rules providing for prompt transfer of all or a portion of a customer s portfolio of positions, at the customer s instructions, from its carrying clearing member to another clearing member, without requiring positions to be closed out and re-booked, subject to certain conditions; and May 7, 2012 January 9,

33 Rule & Core Principle Summary of Rule Compliance Date 4. Comply with general standards in the rule and the requirements of CFTC Rule 1.25 with respect to the DCO s investment of customer segregated funds. The rule also sets out procedural requirements for a DCO to permit commingling of futures and swaps positions and funds & Core Principle G: Default rules and procedures Rule & Core Principle H: Rule enforcement & Core Principle I: System safeguards & Core Principle J: Reporting The rule requires a DCO, among other things, to: 1. Have a current default management plan; 2. Have default procedures permitting the DCO to take timely action in the event of a clearing member s default to contain losses and liquidity pressures and to continue meeting its obligations; 3. Have rules requiring a clearing member to provide prompt notice if it becomes the subject of a bankruptcy petition, receivership proceeding or the equivalent; and 4. Take appropriate action, in its discretion, with respect to a clearing member that has provided the foregoing notice or the house or customer position of such clearing member, such as liquidation or transfer of positions or suspension or revocation of clearing membership. The rule provides that a DCO must have adequate resources and arrangements to monitor and enforce compliance with its rules effectively and to resolve disputes. It also permits a DCO to delegate such responsibility to a risk management committee, except those responsibilities required of the CCO under the CEA or Part 39 Rules. The rule imposes various system safeguards on a DCO, including but not limited to the requirement to have a program of risk analysis and oversight of its operations and automated systems. The rule imposes requirements on a DCO to submit various reports and information to the CFTC, including but not limited to: 1. Daily reports, for each clearing member by house and customer origin (account), of initial margin requirements and deposits; daily variation margin and market-to-market amounts paid or collected; daily cash flows relating to options premiums and swaps-related payments such as coupon amounts; and end-of day positions; 2. Audited year-end financial statements; and 3. Reporting of certain specified events, such as a decrease of 25% in the DCO s financial resources available to cover its financial obligations to clearing January 9, 2012 January 9, 2012 November 8, 2012 November 8,

34 Rule & Core Principle Summary of Rule Compliance Date members in the event of the default of its clearing member creating the largest financial exposure in extreme but plausible market conditions & Core Principle K: Recordkeeping & Core Principle L: Public information & Core Principle M: Information sharing & Core Principle N: Antitrust considerations & Core Principle R: Legal risk considerations The rule requires a DCO to maintain records of all activities related to its business as a DCO, and to maintain such records in accordance with CFTC Rule 1.31 for a period of at least 5 years or, in the case of swap data, in accordance with the CFTC s Part 45 Rules. The rule requires a DCO to provide sufficient information to market participants to enable them to identify and evaluate accurately the risks and costs associated with using the services of the DCO, including clear and comprehensive rules and procedures. It also requires a DCO to disclose various information publicly and to the CFTC, including its margin-setting methodology, and to post such information along with its rules and a current list of its clearing members on its website. The rule requires a DCO to enter into appropriate domestic and international information sharing agreements, and to use the information it obtains under such agreements to carry out its risk management program. The rule prohibits a DCO from adopting a rule or taking any action that results in an unreasonable restraint of trade or imposes a material anticompetitive burden, unless necessary or appropriate to achieve the purposes of the CEA. The rule requires a DCO to operate pursuant to a wellfounded, transparent, and enforceable legal framework that addresses each aspect of its activities. That framework has to provide for: 1. The DCO to act as a counterparty and novation; 2. Netting arrangements; 3. The DCO s interest in collateral; 4. The steps the DCO would take to address a clearing member default, including but not limited to the unimpeded ability to liquidate collateral and close out or transfer positions in a timely manner; 5. Finality of settlements and funds transfers, which must be irrevocable and unconditional when they are effected (no later than when DCO accounts are credited and debited); and 6. Other significant aspects of the DCO s operations, risk management and related requirements. November 8, 2012 January 9, 2012 January 9, 2012 January 9, 2012 January 9,

35 Consumer Protection: How U.K. Client Money Rules Differ From U.S. Customer Segregated Rules When a Custodian Firm Fails to Treat Customer Property Properly Following the collapse of Lehman Brothers in September 2008, there were major differences in the U.S. and the U.K. as to how customer assets were protected and returned. This article addresses the regulatory structures in place in each country regarding this essential customer protection feature, how those regulations vary, and what changes are still needed to ensure that customer assets held at a financial firm that collapses are timely returned. The article also analyzes how the current U.K. laws have proved to be ineffective in resolving this issue, the current status of U.K. judicial proceedings, and proposed new legislation pending in the U.K. that may resolve future financial insolvencies in that jurisdiction. RONALD H. FILLER Section 1 4d of the Commodity Exchange Act and Commodity Futures Trading Commission (CFTC) Regulation require a futures commission merchant (FCM) to maintain and hold customer property that is deposited in a futures account in a customer segregated account. The FCM, in essence, acts as a trustee over such customer 1 7 U.S.C.A. 6d C.F.R Ronald H. Filler is a Professor of Law and Director of the Center on Financial Services Law at New York Law School (NYLS). He is also Program Director of the LLM in Financial Services Law Graduate Program at NYLS, which offers more than 40 courses involving various aspects of the global financial services industry, including several courses on derivatives law and products. (To learn more about this program, visit Before joining the NYLS faculty in 2008, Prof. Filler was a Managing Director in the Capital Markets Prime Services Division at Lehman Brothers Inc. in its New York headquarters. He also acts as a Senior Consultant for Allen & Overy, a major international law firm. He may be contacted by at ronald.filler@nyls.edu Civic Research Institute and Ronald H. Filler. property and must maintain it in accordance with applicable laws and regulations. CFTC Regulation 1.20 states, in essence, that [a]ll customer funds must be separately accounted for, and shall not be commingled with the money, securities or property of the FCM or of any other person. 3 Similarly, in the U.K., pursuant to the Financial Services Authority (FSA) Client Asset Sourcebook (CASS), 4 client property referred to there as client money also must be segregated and be subject to a similar trust law concept. The purpose of both approaches is to establish procedures to ensure that customer property is protected, via these customer segregated or client money accounts, from the claims of third-party creditors in the event the customer s financial institution files for bankruptcy. On September 15, 2008, Lehman Brothers Holdings Inc., the parent company of all Lehman Brothers entities and the NYSE listed public company (NYSE 3 See id. at 1.20(c). 4 See Financial Services and Markets Act, 2000, pt. X, c. 1, 139 (Eng.). The U.K. client money rules are reflected in Chapter 7 of CASS, and are thus commonly referred to as CASS7. May/June 2011 Vol 24 / No 5 CONSUMER PROTECTION 25 TFI-2405-s3-Filler-FINAL.indd 25 4/18/2011 5:03:19 PM

36 Symbol: LEH), filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. On the same day, Lehman Brothers International (Europe) (LBIE), its principal U.K. subsidiary and the Lehman entity registered with the FSA, filed for bankruptcy under the U.K. Insolvency Act of In the U.S., Lehman Brothers Inc. (LBI) which was registered as a broker-dealer with the Securities and Exchange Commission (SEC) and as an FCM with the CFTC did not file for bankruptcy that day. In fact, LBI, having the requisite net capital to continue its business activities, continued to operate throughout the week of September 15 19, 2008, which gave its securities and futures customers the In the U.S., Lehman customers were made whole with respect to futures positions and other assets held in customer segregation; but the outcome was dramatically different for customers of Lehman s U.K. subsidiary. opportunity to transfer their respective open positions and collateral to other well capitalized brokerage firms or to liquidate their open positions during the entire week. By continuing to operate for these five additional days, LBI, as an FCM, did not incur any significant customer property issues as a consequence of its parent and affiliates bankruptcies. 5 LBI s customers were made whole with respect to their futures positions and other assets held in customer segregation. However, events were dramatically different at LBIE which, as noted above, filed for U.K. bankruptcy on September 15, On that day, PricewaterhouseCoopers was appointed as Administrator over the LBIE estate, a role similar to that of a trustee in U.S. bankruptcy proceedings. U.S. REGULATIONS GOVERNING FUTURES ACCOUNTS Substantial financial safeguards and customer protections exist within the U.S. futures industry that, as noted above, are designed to protect customer funds in the event of the FCM s bankruptcy. Customer assets held by the FCM on behalf of its futures customers (e.g., the margin amounts paid by the futures customers to fund their obligations to purchase or sell their underlying futures positions) are required to be maintained in at least one of two different types of customer accounts, namely a customer segregated account for all customer assets used to margin futures positions traded on a U.S. futures exchange (technically known as a designated contract market ) 6 or a secured amount account for all customer assets used to margin non-u.s. futures positions. 7 Types of Customer Fund Accounts. The two main types of customer fund accounts used by an FCM are segregated funds and secured amount funds. A third type of customer account permitted under applicable laws and regulations but, due to recent FCM failures, not typically used today is known as a non-regulated fund account. Each of the buckets described below contains funds used by customers to margin the relevant futures products; they differ as to whether the futures products are traded on U.S. or non-u.s. futures markets and, for non-us markets only, whether the customer is a U.S. or a non-u.s. entity. Segregated Funds. A segregated fund account, established pursuant to Section 4d(a)(2) of the Commodity Exchange Act (CEA) 8 and CFTC Rule 1.20, 9 is referred to as the customer segregated funds account. It holds the assets of all customers (U.S. and non-u.s.) deposited in conjunction with transactions on all U.S. futures markets. All customer assets are required to be held only in accounts maintained at custodial banks and other permitted financial institutions, including other FCMs and clearing houses that are registered with the CFTC as derivatives clearing organizations (DCOs). All customer segregated accounts are required to be clearly identified as segregated pursuant to CFTC Rule These segregated funds are not permitted to be commingled with the FCM s proprietary funds or used to finance its futures or broker-dealer businesses. The amounts held in the segregated funds accounts are calculated daily as required by CFTC Rule 1.32, and the FCM must take immediate action in the unlikely event that there is ever a shortfall in its segregated funds accounts. This daily calculation must be completed by each FCM by not later than noon on the next business day. However, the required segregated amount needs to be in a good control location 10 the night before. Otherwise, the FCM is deemed to be under segregated, and, if 6 17 C.F.R See CFTC Part 30, 17 C.F.R. pt. 30; 17 C.F.R U.S.C. 6d(a)(2) C.F.R See Ronald Filler, Are Customer Segregated/Secured Amount Funds Protected After Lehman?, 28 Futures & Derivatives L. Rep. 1 (Nov. 2008). 10 Good control location is mainly a term used by brokerdealers pursuant to SEC regulations but its meaning here implies an account established in accordance with CFTC regulations. 26 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS May/June 2011 Vol 24 / No 5 TFI-2405-s3-Filler-FINAL.indd 26 4/18/2011 5:03:19 PM

37 the FCM is under-segregated, this must be reported promptly to the CFTC and its respective Designated Self-Regulatory Organization (DSRO). 11 Given this same-day deposit requirement, most large FCMs will deposit a large amount of their own capital in the customer segregated account to ensure that such accounts are never under-segregated. This capital infusion can amount to several hundred million dollars, depending on the total amount held in the segregation pool. Secured Amount Funds. The second type of account, governed by CFTC Rule 30.7, is known as the customer secured amount account and holds the assets of U.S. residents deposited in conjunction with their transactions on non-u.s. futures markets. These funds are also required to be held in accounts at banks and other permitted financial institutions, including non-u.s. clearing houses and members of non- U.S. exchanges, provided such non-u.s. clearing houses and non-u.s. member firms are deemed to be a good secured location. Like segregated funds, secured amount funds are not permitted to be commingled with the FCM s proprietary assets and are calculated daily and represent 100 percent of that day s customer requirements. 12 FCMs are permitted to secure more than the minimum requirement stated above and can elect to deposit all funds used to trade on non-u.s. markets by all of its clients, including foreign domiciled clients. Like the segregated funds noted above, the calculation for the secured amount requirements must be completed by the following morning but the secured amount requirement must be deposited in a good secured location the night before or the FCM will be deemed to be in default. 13 As noted above with customer segregated accounts, most large FCMs will also 11 See the Interpretative Statement issued by the CFTC on September 26, 2008, regarding funds related to cleared-only contracts. Interpretative Statement Regarding Funds Related to Cleared-Only Contracts Determined to Be Included in a Customer s Net Equity, Fed. Reg. 65,514, 17 C.F.R. 190 (Nov. 4, 2008). 12 For those jurisdictions (e.g., Germany, Hong Kong, Korea) that do not provide the standard customer asset protection that requires the separation of a firm s proprietary assets from its customer assets, the FCM may deposit a corresponding amount of its own capital in a good control location, typically in the accounts at its respective custodial bank, to reflect the amounts as determined in its CFTC Rule 30.7 daily secured amount calculation (based on the amount for that trade date), in its U.K. FSA segregation daily calculation (based on the amount as determined on the trade date plus one day) and in its weekly SEC Rule 15c3-3 weekly calculation. This form of double segregation provides significant protections to an FCM s futures customers. 13 Note that, pursuant to applicable CFTC regulations, an FCM is required to deposit all customer cash and securities in a customer segregated fund account but, in reality, is not required to place customer assets in a secured amount account. The FCM can elect to use its own capital to meet the minimum secured amount requirements. deposit their own capital in a secured amount account to prevent any under-funding from occurring. Non-Regulated Funds. The third type of account, normally referred to as the non-reg account, contains the assets (cash and open trade equity) of non-u.s. customers deposited in conjunction with transactions on non-u.s. futures markets if such amounts are not included in the secured amount account as noted above. 14 An FCM, also registered as a broker-dealer, may use this third account type, In connection with its custodial arrangement, the FCM must obtain a seg. waiver letter acknowledging and agreeing that all assets deposited in this segregated account are for the sole benefit of the FCM s futures customers and are not subject to the claims of any of the FCM s creditors. which is governed by SEC Rule 15c The amounts held in this account reflect the total of the credit balances calculated for each individual account owed by the FCM to its non-u.s. customers for transactions on non-u.s. futures markets less any deposits of cash or securities held with a clearing organization or correspondent clearing. 16 Any 14 If the FCM is also registered as a broker-dealer, then these non-regulated accounts are maintained in accordance with SEC Rule 15c3-3. The Customer Reserve Formula calculation required by SEC Rule 15c3-3 is performed weekly, typically on each Monday, reflecting the amounts as of the previous Friday s close of business. The assets held in this account can not be commingled with the FCM s proprietary funds and are maintained in a designated Special Custody Account for the Exclusive Benefit of Customers (EBOC Account) at a designated custodial bank CFR c A broker-dealer ( BD ) must maintain its securities customer assets in compliance with the SEC s customer protection rule (Rule 15c3-3), including maintaining cash in a special reserve account and maintaining fully paid and excess margin securities in a segregated account. See 17 C.F.R c3-3. In general, the securities accounts maintained at a BD will receive the benefit of expedited administration and the right to recover up to US$100,000 in cash or US$500,000 in securities if its broker-dealer were to become insolvent. Under such a scenario, customer assets held in a securities account would be administered pursuant to a proceeding brought by the Securities Investor Protection Corporation ( SIPC ) pursuant to the Securities Investor Protection Act ( SIPA ). See 15 U.S.C. 78aaa et seq. If the BD were also registered as an FCM, futures customers should understand, however, that SIPA rules specifically exclude futures customer accounts and their assets from its provisions. Most BDs have purchased a surety bond that provides protection in excess of the amounts provided under SIPC. However, this surety bond would, like SIPA, be limited to only the broker-dealer securities accounts and would not apply to the futures customer assets held by a joint BD-FCM. May/June 2011 Vol 24 / No 5 CONSUMER PROTECTION 27 TFI-2405-s3-Filler-FINAL.indd 27 4/18/2011 5:03:19 PM

38 amounts held in a non-regulated account are not covered by the provisions of the Securities Investor Protection Act (SIPA). Further Restrictions on Placement of Client Funds. In addition to the segregation and secured amount requirements, CFTC regulations restrict where client funds may be placed. CFTC Rule 1.20 requires the FCM to maintain customer segregated funds, whether in the form of cash or collateral, either with a clearinghouse of a U.S. futures exchange registered with the CFTC as a designated clearing organization (DCO), in a customer segregated account with a bank, or with another FCM. In connection with its custodial arrangement, the FCM must obtain what is known as a segregation acknowledgement letter, commonly known as a seg. waiver letter, in which the respective custodial bank or FCM acknowledges and agrees that all assets deposited in this segregated account are for the sole benefit of the FCM s futures customers and are not subject to the claims of any of the FCM s creditors, including that bank or FCM, The FCM must report to the appropriate regulators within 24 hours if its net capital falls below the early warning level, and must promptly add additional capital to bring its net capital above this level. respectively. Similar letters must also be obtained for the Rule 30.7 secured amount account and the Rule 15c3-3 non-regulated account at the respective custodial bank. All customer assets are therefore held at all times in these accounts at the respective custodial bank or FCM, in accounts at the various clearing houses, or with other clearing brokers that act as clearing brokers on the various exchanges around the globe on behalf of the FCM. Required Accounting and Reporting. An FCM is also required by CFTC regulations to properly account for and calculate, on a daily basis, both the amount required to be held in segregation and the amount that actually is in its customer segregated accounts. 17 Any deficiencies in the amounts required must be remedied 17 See CFTC Regulation 1.20 which states: All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers. Such customer funds when deposited with any bank, trust company, clearing organization or another futures commission merchant shall be deposited under an account name which clearly identifies them as such and reported immediately to the appropriate regulators. Most large FCMs deposit a substantial amount of their own capital in the customer segregated account to provide excess funds in the event a futures customer does not timely meet its margin requirements. This capital infusion may also be used to satisfy customer claims in the event of the FCM s insolvency. Similarly, to provide additional protections to its customers, the FCM must report, in accordance with applicable CFTC regulations, to the appropriate regulators within 24 hours if its net capital falls below the early warning level and must promptly add additional capital to bring its net capital above this level. 18 IMPACT OF FCM S BANKRUPTCY ON CUSTOMERS ASSETS In the event of the FCM s bankruptcy, 19 futures customer assets are normally protected except as described below. First, assuming no material futures customer-related default exists or was the cause of the FCM s bankruptcy (e.g., the insolvency was the direct result of a non-futures customer or transaction), a bankruptcy filing should have no material impact on customers assets held in the three aforementioned types of accounts. Under such circumstances, each account should contain 100 percent of the required amounts and should be transferred back to customers in an orderly fashion. An FCM bankruptcy would be administered under Chapter 7 of the U.S. Bankruptcy Code, which contains specific provisions for the protection of customers in the event of an FCM s insolvency. Under Part 190 of the CFTC s rules, the bankruptcy trustee would have the responsibility of returning the custodied assets back to each futures customer. Creditors of the FCM s bankrupt estate would have no claim to any of the assets held in the customer accounts. The assets would be held solely for the benefit of the FCM s futures customers. If, on the other hand, the FCM s bankruptcy resulted from a futures customer s failure to deliver the required margin for its futures trading positions, and the default was greater than all of the shareholder equity of the and shows that they are segregated as required by the Act and this part. 17 C.F.R 1.20(a). CFTC Regulation 30.7 contains similar language regarding the treatment of foreign futures and options secured amount accounts. See 17 C.F.R See 17 C.F.R For a more detailed explanation of applicable laws and regulations affecting the bankruptcy of an FCM, see Subchapter IV of Chapter 7 of the U.S. Bankruptcy Code and Part 190 of the CFTC Regulations. 11 U.S.C ; 17 C.F.R. pt JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS May/June 2011 Vol 24 / No 5 TFI-2405-s3-Filler-FINAL.indd 28 4/18/2011 5:03:19 PM

39 FCM, then each of the customer accounts noted above held at the custodian bank (or an FCM) would be treated independently of each other. Customers assets held in one of these accounts may not be used to satisfy any shortfalls in another account (e.g., the entity may not use the amounts held in the segregated account at the respective custodial bank or at a DCO to cover a shortfall held in the non-regulated account). However, as noted in greater detail below, a clearinghouse, including a DCO, may apply a clearing member firm s customer assets that are on deposit with that respective clearing house to satisfy margin amounts owed to the clearinghouse by that clearing member firm (and that clearing member firm only) for its customer accounts. In other words, customer assets held by a clearinghouse may not be used to cover a shortfall in the FCM s house account, nor may assets held at one clearinghouse be applied to cover a shortfall at another clearinghouse, unless a cross-margining arrangement exists with respect to the two clearinghouses. The assets of an FCM s futures customers, which trade on the U.S. futures markets, are normally wired directly by those customers into the customer segregated account at the respective custodial bank. The custodian bank would typically maintain different segregated accounts to hold cash and any non-cash collateral, such as U.S. Treasury bills, respectively. This firewall between the bank and the FCM provides important protections to the FCM s futures customers. As noted above, the assets held in these accounts at the bank do not fall within the bankrupt estate and are reserved for payment to customers if the FCM files for bankruptcy. If the bank mishandles futures customers assets held with the FCM, its full shareholder capital should stand behind the accounts. 20 If the FCM is required by an exchange to send cash or collateral to a DCO to meet its customers initial or variation margin requirements, the required amounts are typically sent via wire transfer from the customer segregated account at the respective custodial bank or FCM to another customer segregated account held in the name of the DCO for the benefit of the FCM s futures customers. Therefore, at all times, assets of the FCM s futures customers who trade on U.S. futures markets are held in a customer segregated account 20 See also Brief of Amicus Curiae, filed by the CFTC on Mar. 28, 2011, in connection with the case of Frederick J. Grede, as Liquidation Trustee of the Sentinel Liquidation Trust v. Bank of New York Mellon Corp. and Bank of New York, on appeal before the U.S. Court of Appeals for the Seventh Circuit (Consolidated Appeal Nos , , and ), in which the CFTC argued that Bank of New York, as the custodian bank for Sentinel Management Group Inc. ( Sentinel ), a bankrupt FCM, violated 6d(b) of the Commodity Exchange Act, 7 U.S.C. 6d, in its handling of certain commodity customer segregated accounts established by Sentinel. at the FCM s or the DCO s custodial bank. Similarly, assets that need to be transferred to clearing brokers or clearinghouses outside the U.S. are also sent directly from CFTC Rule 30.7 Secured Amount Account at the bank to the required good secured location. SPECIAL SHORTFALL ISSUES INVOLVING A DEFAULT AT A CLEARINGHOUSE When an FCM, also acting as a Clearing Member Firm (CMF) at a futures clearinghouse, technically known as a DCO, incurs a shortfall in its customer segregated account held on the books of the DCO, and amounts are due from the defaulting CMF, the DCO, depending Customer assets held by a clearinghouse may not be used to cover a shortfall in the FCM s house account, nor may assets held at one clearinghouse be applied to cover a shortfall at another clearinghouse, unless a cross-margining arrangement exists with respect to the two clearinghouses. on its rules, may apply assets of non-defaulting customers of the defaulting CMF to satisfy the amounts owed by that CMF. In futures, all trading gains and losses are marked-to-market each trading day, with the total amount of the gains equaling the losses on any given trading day. This is commonly known as a zero sum game. Therefore, if a customer of a defaulting CMF loses such a large amount trading futures on a single trading day, and the CMF does not have the necessary capital to meet its financial obligation to the DCO, as required by the DCO s rules, then a shortfall occurs. The defaulting CMF thus owes this shortfall to the DCO which, in turn, will pay this amount to other customers who made the trading profit that day. And the DCO may apply the non-defaulting customer assets also held in the defaulting CMF s customer account to satisfy these financial obligations. While there has not been such a shortfall, these rules still exist and could one day be applied. Following the recent passage of new financial regulatory reforms, known as the Dodd-Frank Act, 21 the CFTC has issued an Advanced Notice of Proposed Rulemaking which sought comments on three different methods of applying non-defaulting customer assets in the event of a CMF s default that leaves a shortfall with respect 21 Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L , 124 Stat (2010). May/June 2011 Vol 24 / No 5 CONSUMER PROTECTION 29 TFI-2405-s3-Filler-FINAL.indd 29 4/18/2011 5:03:19 PM

40 to OTC derivatives cleared by that CMF. Each of these three methods raises important issues, all involving different public policy concerns. The final CFTC rule may significantly change the futures model noted above. LEHMAN S BANKRUPTCY AND ITS AFTERMATH U.S. Events Following the Bankruptcy. LBI had opened a Customer Omnibus Account on the books of LBIE to permit LBI futures customers to trade on the various European exchanges. LBIE was either directly a general clearing member firm (GCM) on the clearinghouses in Europe, such as LCH Clearnet SA and EUREX Clearing AG, or had established its own customer omnibus accounts on the books of a thirdparty clearing firm on other European exchanges. LBI was the clearing member firm on the U.S. futures exchanges and had opened a futures customer omnibus account with other Lehman Brothers affiliates or Through the tremendous efforts of many governmental agencies, SROs, firms, exchanges, clearinghouses, and clients, the goal of transferring the open futures positions was effectively achieved within five days of the Lehman Brothers bankruptcy. third-party clearing firms in Canada and Asia. LBIE had opened a customer omnibus account on the books of LBI to allow its futures customers to trade on the U.S., Canadian, and Asian markets. All futures customer accounts were opened with either LBI or LBIE. 22 Note that LBIE had many direct futures accounts opened on its books, including some accounts, especially hedge fund accounts, that involved a prime brokerage and cross margin netting arrangement. LBI had similar arrangements with hedge funds on its books but also had a large number of futures-only accounts that were managed by large investment advisory firms. As noted above, the concept of segregated funds is designed to protect the cash and collateral deposited by futures customers to margin their futures positions. These regulations do not directly address the actual 22 Over this same weekend, Merrill Lynch was acquired by the Bank of America and American International Group ( AIG ) received a $85 billion loan from the U.S. Treasury. All of these events, and other similar concerns, created huge volatility in the global markets all at once. During this same period, many banks refused to issue credit to other financial institutions, including other banks. Over the weekend of September 19 21, 2008, the U.S. Treasury announced its $700 billion bailout which received Congressional approval on October 3, futures positions themselves. Given the uncertainty of the situation and the volatility in the marketplace, senior Lehman futures officials worked closely with their futures clients and governmental and exchange officials to transfer the client futures positions to other clearing firms in order to provide these customers with a new home that was properly capitalized. This process started immediately after LB Holdings filed its petition for bankruptcy in the U.S. but not so outside the U.S. PricewaterhouseCoopers, as the newly-appointed Administrator, did not permit the transfer of the open futures positions until late in the day on Wednesday, September 17, 2008, with the vast majority of the futures positions being transferred on Thursday, September 18, or Friday, September 19. Most of the futures positions held by Lehman s customers, whether they were held on the books of LBI or LBIE, were either moved to other clearing member firms per the instructions of such customers by the close of business on Friday, September 19, or these remaining Lehman futures customers became futures customers of Barclays Capital Inc. (BCI), the U.S. affiliate of Barclays Bank PLC. BCI acquired all of the remaining futures customer accounts on the books of LBI after the close of business on September 19, Therefore, the system worked for the most part although, as noted above, quicker action was needed. Through the tremendous efforts of many governmental agencies, SROs, firms, exchanges, clearinghouses, and clients, the goal of transferring the open futures positions was effectively achieved within five days. This reflects the strong working relationships that exist within the global futures community. No other product area or industry can make a similar claim. U.K. Background and Cases Involving Lehman. Following the bankruptcy filing by LBIE, as noted above, PricewaterhouseCoopers was named as the Administrator for the LBIE estate. Ever since then, customers of LBIE have been pursuing actions with the Administrator to collect back their assets held by LBIE. These claims have fallen within different groups, each having a common interest. One group, or tier, of customers involves assets held in compliance with the CASS7 rules, as noted above. A second group involves assets held outside the CASS7 rules, but which customers claim should have been held in accordance with those rules. As noted above, U.K. firms are required to maintain client property in a client money account. The issue is what protections, if any, do customers receive in the event their U.K. brokerage firm does not properly hold their property in compliance with CASS7. In the Global Trader case, which arose in the same 30 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS May/June 2011 Vol 24 / No 5 TFI-2405-s3-Filler-FINAL.indd 30 4/18/2011 5:03:19 PM

41 time frame as the Lehman bankruptcies, the U.K. High Court held that customers are completely at risk if their financial firm, Global Trader in this case, failed to comply with the CASS7 rules, and would thus become unsecured creditors of the bankrupt estate. 23 If, as appeared to be the case, LBIE did not hold all of its customer property in accordance with CASS7 rules, the affected customers would be reduced to unsecured creditor claims. Conversely, those LBIE customers whose funds were held in accordance with CASS7 rules would be made whole; their assets would be unaffected by the claims of other customers whose funds were held, without their knowledge, outside the CASS7 rules. In other words, the question before the U.K. courts was whether to give preferential treatment to those customers whose assets were held in compliance with the CASS7 rules or to treat all LBIE customers including those whose assets were not held in a client money account but which should have been equally under trust law, effectively saving the latter customers at the cost of the former. In two judgments handed down on December 15, 2009, and on January 10, 2010, Judge Briggs held that LBIE customers with client property not segregated in accordance with CASS7 at the time of administration (e.g., on September 15, 2008), had no claim against the client money pool (CMP) of properly segregated funds and thus would be treated as unsecured creditors. These decisions were appealed. On August 2, 2010, the U.K. Court of Appeals reversed the High Court decisions and held that client money property should be treated equitably, whether the client monies were held in accordance with CASS7 or not. The Administrator, GLG Investments Plc Sub- Fund: European Equity Fund (GLG), and LBI sought permission to appeal directly from the U.K. Supreme Court to appeal the Court of Appeals decision. Issues Raised by the Court of Appeals Decision. The U.K. Court of Appeals, in essence, held as follows: 1. The statutory trust over client money takes effect immediately upon receipt of the client monies. 2. CASS7 requires client money pooling of all identifiable customer property wherever it may be found, and not just the amount of client money actually held in the segregated accounts. 3. All clients have a contractual right to participate in distributions from the CMP, not just those whose property happened to be properly segregated. 23 Re Global Trader Europe Limited (in liquidation) (2009), EWHC 602 (Ch). In determining that all identifiable clients are entitled to a distribution from the CMP, including clients of Lehman affiliates whose assets were not held in a segregated account, the U.K. Court of Appeals appeared to focus on the method used by a financial firm, such as LBIE, to place client property in the CMP. Thus, if a firm accepts the client assets initially in a firm account and then transfers the client property to the CMP, those clients whose funds had not been transferred to the CMP as of September 12, 2008, should be treated as if their funds were transferred to the CMP. In the U.S., pursuant to CEA Section 4d and CFTC Rule 1.20, customer property at all times must be held in a customer segregated account. The U.S. FCM is not permitted to allow a I n contrast to the U.S. rule, the U.K. Court of Appeals appears to have approved the receipt of funds outside the client money account (i.e., a direct deposit in the house account) and treated these funds as if they were held in the client money pool. customer to send its property to a bank account in the name of the FCM but must send the wire transfer funds directly into the customer segregated account at the respective custodian bank. When such funds are then transferred to the clearinghouse to margin the underlying open futures contracts, the customer funds are transferred from the FCM s customer segregated account to another customer segregated account held by the clearinghouse on behalf of its clearing member firm, the FCM in this case. Funds are returned back the same way. In contrast to the U.S. rule, the U.K. Court of Appeals appears to have approved the receipt of funds outside the client money account (i.e., a direct deposit in the house account) and treated these funds as if they were held in the CMP. Under prior precedents, only those client funds held in the CMP received the statutory protection. The U.K. Court of Appeals has thus decided to protect those customers whose client property was not placed, for whatever reason, in the CMP, thus supporting the argument that customers of a U.K. firm, who have no control over or knowledge as to how the financial firm handles their funds, should be protected. In its opinion, the U.K. Court of Appeals also established two rights. One is a contractual right, that is, all clients with monies held in the CMP have a contractual right to distributions from the CMP. However, it goes further and seems to establish a May/June 2011 Vol 24 / No 5 CONSUMER PROTECTION 31 TFI-2405-s3-Filler-FINAL.indd 31 4/18/2011 5:03:19 PM

42 property right, that is, that all clients have a right to the property in the CMP even if their respective assets, through no fault of their own, were not placed in the segregated account. Finally, this decision places a significant burden on the Administrator. The Administrator must now determine which customer property that was not held in the segregated account should be identified as belonging to the trust assets for distribution. This is not an easy task. Appeal of the U.K. Court of Appeals Order. In September 2010, the Administrator, GLG and Lehman Brothers Inc. sought permission to appeal directly from the Supreme Court. The applications for permission to appeal have been considered by the Supreme Court, and an order has been made by the Appeals Panel. The Appeals Panel has granted GLG permission to appeal but refused LBI s application because it did not raise an arguable point of law of general public importance. GLG is representing those clients for whom LBIE did segregate client money in accordance with the CASS7 rules. As of this writing, no decision has been made regarding the appeal made by the Administrator. NEW U.K. ADMINISTRATION REGIME On February 8, 2011, a Special Administration Regime (SAR) came into force in the U.K. regarding U.S. investment banks. The U.K. government, led by its Treasury and given the lessons learned from LBIE, created the SAR to give Administrators the ability to return client property held in trust as promptly as possible. 24 This SAR will apply to all U.K. investment banks regardless of their size and has three major objectives: 1. To ensure the return of client assets (including client money) as soon as reasonably practicable; 2. To ensure timely engagement with major infrastructure bodies and the Bank of England, the Treasury, and the FSA; and 24 See the Investment Bank Special Administration Regulations, 2011, SI 2011/245, for an Explanatory Memorandum on the new SAR and the Investment Bank (Amendment of Definition) Order, 2011, SI 2011/239, both issued on February 8, To rescue the bank as a going concern or to wind it up in the best interests of creditors. 25 Obviously, the first objective addresses one of the biggest concerns following LBIE s insolvency, namely, the return of client money. It appears, from the SAR, that the HM Treasury has decided that it is in the best interests to return all client assets as promptly as possible and there should be no distinction made between segregated and non-segregated assets. However, the SAR goes further and gives the Administrator the right to return client assets in the order that the Administrator deems to be the best approach and enables the Administrator to allocate any shortfall held in the client money account on a pro rata basis. CONCLUSION Time will tell whether the U.K. Court of Appeals decision will be the final outcome or whether the High Court decisions in Global Trader and LBIE will be reinstated. Going forward, however, another solution is to simply require by regulatory fiat that all client assets be held 100 percent of the time in the CMP and, as noted by the recently issued SAR, to take immediate steps to return client assets as soon as is reasonably practicable. 26 Another issue which needs to be addressed and which depends on future CFTC rulemaking involves how customer assets held by a defaulting FCM that is also a clearing member firm of a central clearinghouse (CCP) should or should not be fully protected if such a default results in a shortfall in the customer segregated account held at the CCP on behalf of the defaulting FCM. This article is in the works. 25 See Special Administration for Investment Banks (Allen & Overy, E-Bulletin, Feb. 24, 2011), available at overy.com/getfile.aspx?itemtype=bulletin&id=a53a8e80-4a a-164f4b39d01a. 26 For more information on the LBIE matter, go to the website established by the U.K. Administrator, featuring updates on issues affecting LBIE claims. Lehmans Client Money, PWC UK, html (last visited Mar. 12, 2011). 32 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS May/June 2011 Vol 24 / No 5 TFI-2405-s3-Filler-FINAL.indd 32 4/18/2011 5:03:19 PM

43 REPORT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives Law November 2008 n Volume 28 n Issue 10 Are Customer Segregated/Secured Amount Funds Properly Protected After Lehman? By: Ronald H. Filler Ronald H. Filler is a Professor of Law and the Director of the Center for Financial Services Law at New York Law School. He was formerly a Managing Director in the Capital Markets Prime Services Division at Lehman Brothers Inc., has served on several DCO, governmental, exchange and industry boards and advisory committees, and is a member of the Board of Editors of the FDLR. The short answer is yes for the most part with respect to customer assets held in a customer segregated account in the United States but major changes to the procedures and policies now in place are needed to provide greater customer protection safeguards, especially in connection with assets held outside the United States in CFTC Regulation secured amount accounts, regarding trading on non-u.s. futures exchanges. Most mystery authors normally wait until the last few pages of the last chapter to provide the final clues and solve the mystery. This is, however, a different mystery story even if it s filled with suspense, exciting themes and horror. And for those who do not believe that the role that segregated and secured amount funds play in today s global futures markets is not mysterious and challenging, then they must have slept through the period of the last two weeks in September and most of October. What we all believed were the rules to be applied in the event of an FCM s bankruptcy were all interpreted differently by the various global exchanges and clearing houses. Some clearing houses, like EUREX Clearing AG, LCH Clearnet SA, the CME Clearing House, ICE Clear US and The Clearing Corporation, acted admirably and professionally while others acted in a manner that was not necessarily in the best interests of futures customers. 2 This article will explain what many of us in the futures industry understand to be the role of customer segregated and secured amount accounts, then explain what occurred after Lehman Brothers Holdings Inc., the parent company of Lehman Brothers Inc. ( LBI ), filed for Chapter 11 protection and then provide several recommendations of best practices that this global industry should now consider. Since the brokerage firms today are truly global in their customer and product base, any future solution must be a global approach. CONTINUED ON PAGE 3 Article REPRINT Reprinted from the Futures & Derivatives Law Report. Copyright 2008 Thomson Reuters/West. For more information about this publication please visit thomson.com REPRINT ARTICLE

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