Until the Lehman collapse, customers thought that having a segregated account meant that if the firm went under, only the firm’s money would be at risk, and customers would promptly get back their money. The Lehman collapse proved this perception wrong when administrators froze large pools of collateral. In response to this and the MF Global problems, both U.S. and European regulators are taking steps to restructure how futures commodity merchants (FCMs) and derivative clearing organizations (DCOs) segregate client funds.

Each model has its pros and cons.

The U.S. adopted a new segregation model for cleared swaps, the legal segregation with operational commingling (LSOC) model. The LSOC model allows FCMs and DCOs to operationally commingle funds, but requires firms to maintain legally segregated customer accounts. Further, it prohibits firms from using a non-defaulting customer’s collateral to cover the losses caused by a defaulting customer of the firm.

The LSOC model has risks and limitations:

  • No Effect on Futures. It only applies to cleared swaps and not futures. Even if the LSOC model had been in place at the time, it would not have protected the futures customers of MF Global and it still doesn’t.
  • No Additional Restrictions to Limit Operational, Fraud, or Investment Risk. The LSOC model doesn’t address these fundamental issues that underlie the MF Global situation. The FCM can still experience investment risk. Fellow customer risk, although greatly reduced, still persists. Should a default occur, due to netting practices, there will be some exposure to non-defaulting customer collateral.
  • No Optional Segregated or Third-Party Custodial Accounts at DCOs. The final LSOC rule does not provide customers with the option of individually segregated collateral accounts to hold customer collateral that is passed to the DCO.

The LSOC model is a one-size-fits-all approach that fails to fit all customers’ needs and may call for greater complexity and cost than circumstances would otherwise require. More complexity in today’s environment probably means greater regulatory oversight and involvement. As the regulators ramp up to enforce these new regulations, FCMs and DCOs can only wait to see how these regulations will play out for their operations.

In contrast, the European Union (EU) is implementing the European Market Infrastructure Regulation (EMIR) to regulate derivatives, central counterparties and trade repositories. The regulation will require anyone who has entered into a derivatives contract to report and risk-manage their derivative positions. EMIR applies to any entity established in the EU that has entered into (or is a legal counterparty to) a derivatives contract, and it applies indirectly to non-EU counterparties trading with EU parties. The relevant technical standards came into force on March 15, 2013.

EMIR imposes three new requirements on those who trade derivatives:

  • Clearing. To clear OTC derivatives that have been declared subject to the clearing obligation through an EMIR-authorized or recognized central counterparty
  • Risk Management. To put in place certain risk management procedures for OTC derivatives transactions that are not cleared.
  • Reporting. To report derivatives to a trade repository.

EMIR provides more flexibility than LSOC. It is not so narrow or limited. EMIR requires customers to be given a choice between omnibus client segregation and individual segregation. Individual segregation allows for both transparency and protection. Further, EMIR also allows the collateral model to be either pledge or title transfer, whereas LSOC is limited to pledge only. Clearly, EMIR’s flexibility is an advantage for customers who don’t fit the LSOC model. It’s also an advantage to firms that want to offer more choices than LSOC will allow. In closing, the EMIR model may prove to be the better approach.