Professor Urges CFTC to Replace Futures Model with LSOC Model
Commentary by Steven Lofchie
In a paper titled Collateral Damage: Adopting the LSOC Model and Insurance in the U.S. Futures Markets, Zayed University Professor Christian Chamorro-Courtland argues that for the protection of cleared swaps customers, the Legal Segregation and Operationally Commingled (LSOC) model of segregation of margin deposits should replace the futures model in order to eliminate fellow customer risk for futures customers.
Professor Chamorro-Courtland asserts that advantages of the LSOC Model would include:
- Central Counterparties (CCPs) would be prohibited from using the margin of non-defaulting customers;
- CCPs would have an added incentive to closely monitor the clearing members, as fellow customer risk would be shifted from customers to the CCP;
- customers would be able to transfer their open futures and cleared swaps positions to a solvent Futures Commission Merchant (FCM) without having to close out all their open contractual positions upon the insolvency of their FCM;
- there would be no additional capital requirements on banks that post customer margin in a manner that is bankruptcy remote from the CCP pursuant to the Basel III Accord; and
- insurance would protect futures customers and cleared swaps customers from an FCM insolvency that results from other operational risks (e.g., fraud, terrorism, and human error) that would provide U.S. derivatives customers the same protections afforded to U.S. securities markets customers and derivatives customers.
Professor Chamorro-Courtland concluded by recommending the following steps to implement the LSOC Model: (i) a CFTC press release to confirm that the LSOC Model will replace the Futures Model in the futures industry; (ii) amendments to CFTC Regulations to clarify that FCMs must provide a daily report of individual futures customer margin deposits in the Customer Segregated Account to the CCP to enable CCP identification of individual customer margin deposits; and (iii) legislation that creates a Futures Investor and Customer Protection Corporation to provide insurance to futures and cleared swaps customers.
Commentary
While there are certainly benefits to the LSOC model that could make it worthwhile, the Professor does not fully acknowledge the much greater costs and higher margining requirements that the actual implementation of this model would require. Further, he likely overestimates the benefits of an insurance system for this particular market. Most institutional investors, who constitute most of the participants in the futures markets, are generally indifferent to insurance because the amount insured is relatively little compared to their actual exposure. Accordingly, imposing an insurance system on the market is likely imposing a cost (and related administration) that most market participants would not want to bear. In sum, it may be that in this case, there are some risks that are not worth the cost of eliminating.