Swaps Industry Debates Bankruptcy Code Fix to Protect Customers

Derivatives industry executives and a U.S. regulator differed over whether to change the bankruptcy code to protect customers from sharing in losses from a brokerage failure.

CME Group Inc. has backed a plan to allow pension funds and other big asset managers to deal directly with a clearinghouse rather than with a bank brokerage to avoid customers being caught in bankruptcy proceedings that can result in clients losing money, said Tim Doar, a managing director at the world’s biggest futures exchange. A simpler solution to this problem would be to change the U.S. bankruptcy laws, said Dan Maguire, head of U.S. operations for LCH.Clearnet Ltd’s Swap Clear service.

“Why don’t we actually look at the code if that’s what we want to do?” Maguire said today in a discussion at the Futures Industry Association annual conference in Boca Raton, Florida. “I know it’s a very big topic -- act of God, Act of Congress.”

The last change to the bankruptcy laws for derivatives markets took seven years, said Robert Wasserman, chief counsel in the division of clearing and risk at the Commodity Futures Trading Commission.

“We’re talking about the next 35 to 40 years; we shouldn’t be afraid” of a few years’ worth of work, Maguire replied.

Cutting Counterparty Risk

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 $1.6 billion of customer money that is still unaccounted for after MF Global Holdings Ltd. filed the eighth-biggest bankruptcy in U.S. history on Oct. 31. has added to customer calls for stronger protection.

The CME Group, based in Chicago, has worked with the Committee on Investment of Employee Benefit Assets, a representative of more than 100 pension funds that manages more than $1.4 trillion in benefits, to offer swaps customers a way to avoid sharing losses tied to a bankruptcy. The futures broker, known as an FCM, would still back the pension funds’ commitments to the clearinghouse under the plan, though the broker wouldn’t have control of the collateral posted as margin for trades, Doar said.

“It kind of turns on its head the traditional relationship a client has with its FCM,” he said. “We don’t anticipate this would be a cheap arrangement.”

Departure for Customers

Wasserman said he expects the plan will remove customers from sharing losses in a bankruptcy, unlike in the model where a client passes trades through its broker on to the clearinghouse. The CIEBA plan would be a big departure with how customers use brokerages to trade derivatives, said Seth Grosshandler, a partner at Cleary Gottlieb Steen & Hamilton LLP.

“We’re talking about radically changing the FCM model” where the brokerages become like insurance companies, he said.

The question of “when is a relationship a client or not” is rooted in legal theory and won’t be easy to untangle, Doar said. “It’s a very valid concern FCMs have raised about this.”

Exchanges, clearinghouses, bank brokerages and customers such as BlackRock Inc., the world’s largest asset manager, have been meeting for weeks to discuss changes to the swaps market, what’s known as the “segregation working group,” said Michael Dawley, co-head of futures and derivatives clearing services at Goldman Sachs and chairman of the Futures Industry Association. Dawley, who leads the segregation group, moderated the panel discussion today.

The CIEBA plan “is quite controversial,” and too much change in the industry could threaten how futures brokerages do business, he said. “One thing we don’t want to see next year at Boca on the screen is ‘The Demise of the FCM.’”

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