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BlackRock Battles CME Over Rule Segregating Swaps Collateral

CFTC Swaps-Collateral Regulation
CME Group, the world largest futures exchange, has opposed the segregation model since the CFTC first requested comments last year. Photo: Tim Boyle/Bloomberg

A U.S. regulatory proposal to protect individual swaps traders is gaining support from Wall Street dealers, buyers such as BlackRock Inc. and LCH.Clearnet Group Ltd., owner of the world’s largest clearinghouse for interest-rate swaps.

The proposal, issued by the Commodity Futures Trading Commission and required under the Dodd-Frank Act, governs collateral in trades guaranteed by clearinghouses that stand between buyers and sellers of derivatives. Under the plan, clearinghouses would be prohibited from drawing on the collateral of a non-defaulting client when another client’s downfall results in their broker’s default.

Support is coalescing behind the proposal after more than a year of debate, two daylong CFTC roundtables, 40 meetings between industry and agency officials and at least 50 letters commenting on how to protect collateral in the $601 trillion swaps market.

“There is not unified opposition to it on the dealer or sell side or the clearinghouse side such that there is going to be such strong pushback that we don’t end up there,” Joel S. Telpner, a New York-based partner at Jones Day who represents clients supporting the proposal, said in an interview.

Dodd-Frank seeks to reduce risk and boost transparency by having most swaps guaranteed by clearinghouses and traded on exchanges or other platforms. The parties in such trades are clearinghouses, brokers that are members of and capitalize clearinghouses, and the brokers’ trading clients.

Citigroup Inc. analysts estimated in July that 60 percent of the global bilateral derivatives market will eventually be eligible to be processed by clearinghouses.


The financial-overhaul law was enacted by President Barack Obama last year after largely unregulated trades helped fuel the 2008 credit crisis. After the default of Lehman Brothers Holdings Inc. that September, hedge funds and asset managers that were clients of the securities firm lost billions of dollars because their collateral wasn’t segregated.

Last November, the CFTC asked buyers, sellers and clearinghouses to respond to four proposals for protecting collateral. In April, the CFTC proposed adopting a system, known as “complete legal segregation,” which it described as a compromise between requiring entirely separate collateral accounts and pooling all collateral.

The proposal would require clearinghouses and brokers to keep records tracking each client’s collateral while allowing it to be managed in a single account. If a broker defaults, the clearinghouse couldn’t tap the collateral of a broker’s non-defaulting client in an effort to guarantee the trades.

‘Most Appropriate Choice’

The proposal is “the most appropriate choice” and “an important first step in arranging appropriate customer protections,” Robert Pickel, executive vice chairman at the International Swaps and Derivatives Association Inc., said in an Aug. 8 letter to the CFTC. The association represents the world’s largest swap dealers, including JPMorgan Chase & Co., Deutsche Bank AG and Morgan Stanley.

A clearinghouse should “never rely” on a non-defaulting client’s collateral to cover broker positions, said Ian Axe, chief executive officer of LCH.Clearnet. It is “possible if not highly probable” that a non-defaulting client would have already sought to move its collateral out of the clearinghouse by the time a broker defaults, Axe said in a letter to the CFTC. LCH.Clearnet, which is majority-owned by banks, is the largest clearinghouse in the $364 trillion global interest-rate swaps market.

BlackRock, Fidelity

The plan also found support among large trading clients and swap-buyers, such as BlackRock, Fidelity Investments, Freddie Mac, and two trade groups -- the Investment Company Institute, which represents mutual funds, and the Managed Funds Association, which represents hedge funds.

The CFTC plan “would protect customer collateral from fellow customer and other risk without imposing undue costs on market participants,” BlackRock’s Joanne Medero, head of government relations, said in an Aug. 8 letter. The letter was also signed by Richard Prager, managing director and head of global trading, and Supurna VedBrat, managing director and co-head of electronic trading and market structure.

The CFTC may still revise the rule, and could even decide to allow more than one collateral system for clearinghouses. The agency is aiming to complete most Dodd-Frank rules by the end of the year; no meeting has yet been set to finalize the rule.

Not all brokers and clearinghouses support the CFTC proposal, according to letters filed with the CFTC before the official comment period closed this week.

Futures Method

CME Group Inc., the world’s largest futures exchange, has opposed the segregation model since the CFTC first requested comments last year, arguing that the agency should base its regulation on the method it currently uses to clear futures trades.

Futures are derivatives that are exchange-traded and cleared and have been regulated by the CFTC for decades. Before Dodd-Frank, swaps were largely exempt from CFTC rules and traded directly between buyers and sellers often in non-cleared transactions.

Under the futures model, a client’s collateral is tracked by clearinghouses and kept in a single account. If a clearing broker defaults, however, the clearinghouse can tap collateral from all of the broker’s clients to continue to guarantee trades.

To add more protection for clients, CME has proposed CFTC adopt a futures model with an “opt out” option.

‘Opt Out’

A system that “allows those swaps customers that are most concerned to secure such protections to ‘opt out’” is the “only approach” that will guard against fellow-customer risks without imposing high costs on clearinghouses, Craig S. Donohue, CME Group chief executive officer, said in the letter.

Newedge USA LLC, the largest futures broker by customer funds, $21.6 billion as of June 30, and DRW Trading Group, a Chicago-based proprietary trading firm, also opposed the CFTC’s proposal, citing an increase in costs for clients.

“To the extent clearinghouses will not be able to rely on the pool of non-defaulting customer collateral in the event of a clearing member default, they will look to make up that shortfall elsewhere,” Gary DeWaal, Newedge’s senior managing director and general counsel, and Donald Wilson, DRW’s president and chief executive officer, said in the letter.

The debate over costs may lead the CFTC to provide the industry with some flexibility to choose among different systems, said Ed Tracy, a principal at Deloitte Consulting LLP and co-head of the derivatives team.

“There may be a middle position going from legal segregation to futures,” Tracy said in a phone interview.

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