The collapse of MF Global Holdings made the protection of customer funds a hot topic for the futures industry. Dan Maguire, head of SwapClear U.S., participated in the “New Models for Protection of Customer Funds” panel at the 37th International Futures Industry Conference. SmartBrief caught up with Maguire after that panel to discuss customer protection and other market trends.
What were some of the lessons SwapClear learned from the bankruptcies of Lehman Brothers Holdings and MF Global?
The first thing is they’re very different. On the Lehman side — I can talk from personal experience because I traded a lot of the book there — we were very pleased with how we handled the Lehman default. If the central-counterparty model had not worked so well for resolving Lehman’s default, then I’m not sure we’d be talking about clearing being the right thing for swaps.
So the key thing we learned with Lehman is you’ve got to know your risk. You need to have tried and tested processes. We saw warning signs coming up to Lehman’s default, and we took measures along the way. In fact, we called additional margin from Lehman at 4 p.m. U.K. time Friday, Sept. 12, 2008, because we were doing real-time risk management. Lehman proceeded to default on the morning of Monday, Sept. 15, but we knew what our position was and were able to swiftly move into our default-management process. I think the key thing learned from our experience was: Always know what your risk is at all given points to all given counterparties.
That lesson is something we’ve translated into our client clearing method. We are prepared for a double-default scenario, where the only way we’ll inherit a client portfolio that we’ll have to trade and risk manage in the market is if the client takes the clearing member down. That could happen. So we want to be able to see at all times the risk profile and the valuation, etc., of every client account. We’ve built a platform that does that in real time with every client, down to subfunds. So this concept of waiting a day for the futures commission merchant to report client positions up to us before we call for additional margin the next day is not something we would be happy to subscribe to.
MF Global was different. It had a lot of customer accounts in the MF Global U.K. entity that we closed out. We transferred 300 clients’ positions to the clearing members of their choice. And, secondly, all of the collateral associated with them was passed back to the administrator, KPMG. This default-management process complies with U.K. bankruptcy code. The other aspect of it was house positions. MF Global had eurozone cash bond and repo positions that we needed to close out. And they’re different. For the over-the-counter client positions we didn’t hedge or close out, we transferred them. However, for the house positions, we traded hedges in the market and ultimately packaged them up and sold them to nondefaulting client members.
The big headline for us on MF Global was, again, we knew what our real-time risk was and we knew what our clients’ collateral position was all the way through. So we weren’t unscrambling the eggs; we were moving straight into the default-management process. Always know where you are in a default so can start hedging your portfolio immediately.
Should rules on protection of customer funds and LSOC — legally segregated, operationally commingled — be the same for futures and cleared swaps?
There’s a lot of discussion now after MF Global, and I’ve tried to remind people to go back to the beginning and remember the reason we did this, the reason we went down this route of segregation 18 months ago. We wanted to remove fellow customer risk. We wanted to ensure we have the highest probability of portability pre- and post-default. We actually wanted to come up with something we can design that’s practical and is not going be too costly. We didn’t set out to prevent any kind of malfeasance or any issues around that. We didn’t set out to define the ultimate end game for segregation across everything. And, very specifically, we didn’t set out to apply this to futures. It was very much a swaps play. The world has shifted.
For the futures world, whether LSOC is right for it is an open question. For futures, you’re really going to have to deconstruct a lot of operational, technological and legal infrastructure and then reconstruct it. The conceptual perspective is relatively similar, but I think the actual practical limitations are much more significant for futures. Compared with futures, clearing swaps for the buy side is rather like a green field. We’ve been clearing half of the world’s swaps for a long time, but for the buy side, it’s new. So we’re not using old pipes. We’re building new ones, and that makes LSOC easier to implement.
Are there some jurisdictions that handle these issues better than others?
There’s a lot of dialogue about moving beyond LSOC. There’s growing talk about full physical segregation of sorts. All of that is really driven by clients trying to avoid ratable distribution in the bankruptcy code. And it’s very hard to say what will happen. Even in Europe, you’ve got so many different jurisdictions and underlying bankruptcy codes there, it’s difficult to determine which is best. What I think we are going to end up doing is tailoring client-asset protection to each different region, to each underlying different bankruptcy code.
As Bob Wassermann, chief counsel of the Commodity Futures Trading Commission Division of Clearing and Risk, said during the panel discussion, you’ve got the standards that the regulatory committees can agree on, but in terms of the actual implementation, I don’t think you’re going to get cookie-cutter solutions that you can lift and drop into multiple jurisdictions. There’s going be quite a bit of customization required. But if that’s what clients want, then that’s what we are going to do.
You recently announced a move to collaborate with New York Portfolio Clearing, Depository Trust & Clearing and NYSE Euronext to expand the combined “one-pot” cross-margining arrangement to include interest-rate swaps cleared by LCH.Clearnet Group. What is the background on that arrangement, and why those partners?
We are tremendously excited to be working on this collaboration with them. They obviously have a lot of provenance — they pioneered the one pot first across fixed-income cash, repo trades and futures contracts.
There’s a big dialogue in the market about capital efficiency and the need for more of it. This collaboration fully acknowledges that and seemed like an obvious partnership. In December, we signed nondisclosure agreements. From there, we worked through a lot of risk, default, operations, collateral, legal and regulatory issues to arrive at the announcement. We’ve executed a memorandum of understanding that is pretty detailed and began the process of receiving regulatory approval before making the release.
Our aim is to build what we refer to as a best-in-class clearing solution across the broadest spectrum of interest-rate products. So it’s the U.S.-traded interest-rate futures contracts. It’s the fixed-income cash and repo trades cleared by Fixed Income Clearing, plus our huge liquidity on the swaps market as well. It’s really a capital-efficiency play, ultimately, to deliver that to clearing members and clients. That’s the background. Those guys have gone down this route before — they pioneered this — and we think it’s going to be a strong partnership. LCH.Clearnet is the third leg that really completes the whole concept.
What other potential products do you hear clients or potential clients talking about in the marketplace?
If you look at what we actually do, we clear 17 currencies in most flavors and versions of swaps that you can get. Our coverage of the linear space is so broad that the biggest noise we hear is asking us to get into the nonlinear space — mainly swaptions. So this is where we’re looking to go, and we’ve been looking at it for quite some time because we think it takes our risk to a very different place — when solving for the black-swan event. Volatility in swaptions is somewhat high. Liquidity is somewhat low, especially in a default environment. So we think the risk and the default aspects on swaptions are very challenging. We’ve spent more than 18 months completing research and feasibility studies and will continue to do so until we are happy we have the risk-management aspects of nonlinear nailed.