CME to Offer Swaps Users Cash Protection That Beats CFTC Rule

CME Group Inc. plans to allow swaps traders to keep collateral with a third party, offering stronger protections than U.S. regulators required after MF Global Holdings Ltd. failed to safeguard $1.6 billion in customer cash.

CME Group, the futures exchange that’s expanding into clearing interest-rate and credit-default swaps, will give customers the option of holding their money at a neutral bank, said Kim Taylor, president of the Chicago-based company’s clearinghouse. The unaccounted-for customer funds at MF Global were within the brokerage’s control, not secured at either a clearinghouse or a third-party bank.

A Commodity Futures Trading Commission rule passed in January didn’t require collateral to be held by third parties and didn’t address misuse or loss of funds held by brokers. BlueMountain Capital Management LLC, Paulson & Co., Fidelity Investments and Och-Ziff Capital Management Group have pushed for greater safeguards on the collateral they must provide to back positions, according to letters filed with the CFTC.

“Some of the larger customers in this market in the bi-lateral arena already have these third-party arrangements in place,” Taylor said in a telephone interview, referring to private trades done in the over-the-counter market between two parties, typically a bank and an investment firm. “They’d like to be equally well-protected as they move to the cleared OTC environment.”

Adapting to Changes

Banks, hedge funds and asset managers active in the $708 trillion over-the-counter derivatives market are adapting to changes mandated by the Dodd-Frank Act passed by Congress in 2010, including a requirement to process most swaps with a clearinghouse to cut counterparty risk. The demands for greater collateral protection were underscored by the $1.6 billion of customer cash that went missing after MF Global filed the eighth-biggest bankruptcy in U.S. history on Oct. 31.

A group of more than 100 swaps users and service providers has been meeting to understand the collateral rules passed by the CFTC and to determine if a better system should be available, according to three members of the group who asked not to be named because the discussions are private.

The so-called “segregation working group,” which began meeting in January, includes representatives from Goldman Sachs Group Inc., JPMorgan Chase & Co., BlackRock Inc., Newedge Group SA, Moore Capital Management LP, Fidelity Investments, Vanguard Group Inc., and CME Group, among others, according to six people familiar with the firms’s involvement.

Representatives of the companies declined to comment.

‘Full Physical Segregation’

As many as 70 from the group met in person for the first time last week at the Manhattan office of law firm Cleary Gottlieb Steen & Hamilton LLP, before a CFTC discussion the same week on protecting customer money, four of the people said.

Michael Dawley, co-head of futures and derivatives clearing services at Goldman Sachs and chairman of the Futures Industry Association, runs the group, four of the people said. Its next meeting is scheduled for March 9, two members said.

CME’s optional plan, known as “full physical segregation,” would put the clearinghouse, rather than the broker, in control of collateral, Taylor said. Only the clearinghouse, the custody bank or the customer would have the power to move funds. The broker would only be able to access the funds if the customer defaulted on its obligations, Taylor said.

The segregation discussions are still preliminary, and no decisions have been made about recommendations to protecting client money, the group members said.

Bankruptcy Exemptions

For the CME plan to work, it must exempt customer cash from bankruptcy proceedings of brokerages to prevent that money from being pro-rated in the event of a loss, two of the group members said. In the MF Global case, the bankruptcy trustee overseeing the liquidation of the broker has returned about 72 cents for every dollar of customer money, according to a report last month.

The protections passed by the CFTC leave swaps users with the risk they won’t recover all their money in a broker bankruptcy because they continue to allow brokerages to hold customer assets. If there is a shortfall in those assets following a broker failure, the U.S. bankruptcy code provides that customers share the losses.

Any plan to move customer cash to a third party would also eliminate a brokerage’s ability to invest that money to generate interest income, a staple of brokerage earnings, four of the people said.

The cost of CME Group’s plan is “difficult to see” as of now, Taylor said. “That’s why we think it’s important to have it be optional rather than required.”

Transfers Balloon

MF Global often moved money between its own accounts and those of customers in amounts of less than $50 million a day, replacing the cash by day’s end, according to the trustee report.

The sizes of those transfers ballooned in the last week of October, the report shows, when credit-rating downgrades, a record quarterly loss and revelations about its $6.3 billion European debt trade unnerved investors and increased cash demands on the futures broker. Starting Oct. 26, “funds did not return as anticipated,” the trustee said.

Congress, the CFTC, Securities and Exchange Commission and the Justice Department are investigating the disappearance of the customer funds and other events surrounding MF Global’s collapse.

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