At its January 11 meeting, the Commodity Futures Trading
Commission (CFTC) voted 4 to 1 to approve new protections for customer
collateral provided to a swaps dealer. Although it adopted the legally separate
but operationally commingled (LSOC) model, the CFTC also incorporated permitting
full physical segregation for swaps collateral as recommended by the Committee
on Investment of Employee Benefit Assets, or CIEBA, which represents more than
100 of the nation’s largest pension funds.
Many large pension plans use derivative investments, known
as interest rate swaps. CIEBA members use swaps to manage the risk of declines
in interest rates. Drops in interest rates increase the value of a plan’s
liabilities as well as increase the funding requirements imposed on the company
sponsoring the plan. If CIEBA members, who collectively manage $1.5 trillion of
defined benefit and defined contribution plan assets on behalf of 17 million
plan participants and beneficiaries, could not hedge against interest rate
risks, their pension liabilities would become much more volatile and their plan
costs would increase significantly.
In order to make swaps transactions more transparent, the
Dodd-Frank Act directed the CFTC to require most swaps to be cleared on an
exchange rather than traded on the over-the-counter (OTC) market. Last year the
CFTC’s proposed rule adopted the LSOC model, based on the current treatment of
customer collateral for cleared futures transactions, and it did not explicitly
permit physical segregation of customer collateral. In the OTC market, swaps
customers have the option of placing their collateral with a third party
custodian, usually a bank, and CIEBA members urged the CFTC to make these same
protections available to cleared swaps.
CIEBA advised the CFTC that, while the LSOC model was an
improvement over the current futures model, there were still significant risks
to pension plans. These risks include investment risk, misappropriation risk,
recordkeeping risk, lack of access to collateral, and lack of transparency. CIEBA
urged the CFTC to also allow collateral for cleared swaps to be held by
third-party custodians in individual physically segregated account in the
customer’s name.
The LSOC proposal
The recent MF Global bankruptcy made it clear that the LSOC
proposal would not provide customers, particularly pension plans, with adequate
protection of their assets and would expose them to greater risks than they
face today. The benefits of LSOC depend heavily on accurate recordkeeping by
the swaps dealer, especially during times of financial stress. Because customer
collateral would be comingled in an omnibus account on behalf of the dealer,
only the dealer would be able to determine what assets actually belonged to a
particular customer. It is precisely the recordkeeping that failed in the case
of MF Global. Although MF Global filed for bankruptcy almost three months ago,
the bankruptcy trustee reported January 12 that between $600 million and $1.2
billion in customer funds remain unaccounted for.
In light of the MF Global collapse, CIEBA again recommended
that the CFTC provide additional protection for customers’ collateral. CIEBA
urged the CFTC to delay mandatory clearing of swaps until a physical
segregation option was available to swaps customers. CIEBA also recommended
that the CFTC consider requiring swaps dealers to give customers the right to
elect physical segregation of their collateral.
Last week the CFTC made it clear that swap dealers could
voluntarily provide physical segregation of assets. Thus, pension plans’
collateral can continue to be held in third-party safekeeping accounts. This is
an important first step toward making the swaps market more transparent and
providing greater protection to pension plans’ assets.
In his opening remarks, Commissioner Bart Chilton noted that
“the lessons of MF Global teach us that we don’t have the luxury of time in
making additional progress to protect customers. We need to do more. And we
need to do it now.” At the meeting, Chairman Gary Gensler asked the CFTC staff
to “make recommendations on further safeguarding client collateral on an individual
basis,” and the CFTC’s lead staff attorney for the rule, Robert Wasserman,
stated that the CFTC will propose additional enhancements “with dispatch.”
Commissioner Jill Sommers voted against the rule because it
will apply only to swaps and not to futures or options. CIEBA is advising the
CFTC to make these protections available to futures and options as well as to
swaps.
CIEBA is also urging the CFTC to require swaps dealers to
offer their customers the option of full physical segregation of assets. Swaps customers,
particularly pension plans, need to be assured that their collateral is
protected. The new CFTC rules must increase protections for pension assets—not
put them at greater risk.
Learn more about CIEBA.