Using central clearinghouses to process swap transactions will be a lot safer than the current process of two parties negotiating a contract between themselves, right?

After all, the central counterparty assures that each counterparty can fulfill its end of the deal.

But what happens to a fund manager if its clearing agent goes bust through no fault of its own?

This could occur if the agent takes the hit for the financial distress of another institution or a fund manager whose financial health it has vouched for-and whose end of a transaction it has covered.

The answer to the question has pitted fund managers against broker-dealers as evidenced by responses to alternatives proposed by the Commodity Futures Trading Commission on how it wants to segregate the collateral of fund managers. Responses to the CFTC's request for comments were due by Aug. 8.

Central clearing of swaps is part of the Dodd-Frank Wall Street Reform Act, with the CFTC and Securities and Exchange Commission overseeing a new $600 trillion market where standardized swap contracts must go through a central clearinghouse which purportedly, does not allow a transaction to occur unless it can verify that each side can fulfill its side of the deal.

Two of the collateral segregation modes proposed by the CFTC-the physical segregation model and futures model-are polar opposites. The middle ground is a version of a model called the legal segregation model. One of those is called the complete legal segregation model and the other is called the legal segregation with recourse model.

Here is how each model works:

Physical segregation: Each clearing agent and derivatives clearing organization would segregate or separate on its books and records the cleared swaps of each individual customer and the relevant collateral. Each clearing agent and each clearinghouse would maintain separate individual accounts per customer.

Futures: Customer margin held by the futures commission merchant or FCM is segregated from the FCM's creditors but commingled in an omnibus account with other fund managers. The collateral can be used by the clearinghouse if the FCM doesn't have enough collateral to meet the requirements of a defaulting customer. This is used in the futures industry.

Legal segregation: The clearing agent and clearinghouse would separate the cleared swaps of each individual customer and the collateral from the clearing agent and other fund managers using the same clearing agent. However, from an operational perspective each clearing agent and clearinghouse would be permitted to combine or commingle the relevant collateral of multiple fund managers in one account.

The Investment Company Institute, Asset Managers Forum and LCH.Clearnet, the London- and Paris-based clearinghouse, have sided with fund giants such as BlackRock and Vanguard in favoring the complete legal segregation model. Clearing agents for futures trades, such as Newedge, advocate the futures model.

In his letter to the CFTC, Gary DeWaal, senior managing director for Newedge, a New York and Chicago based broker-dealer and FCM warned that if clearinghouses could not rely on the pool of "non-defaulting" customer collateral in the event of a clearing member's default, the clearinghouses would either increase the margin which the fund manager must post or the FCM's obligations to the clearinghouse's default fund. FCMs and clearinghouses would also have additional operating costs to implement the complete legal segregation model.

But as Andrew Cross, a partner with the law firm of Reed Smith in Pittsburgh, noted, the buy-side remains steadfast in its opposition to the futures model. There will be larger amounts of collateral tied up for longer periods of time for swaps than futures contracts, he explained.

"The buy-side wants the CFTC to adopt a business model closer to what the mutual fund industry and many pension plans have implemented in connection with trading over-the-counter derivatives," Cross said. A third-party custodian bank holds collateral posted by each fund in a separate custody account. So what would then happen under the legal segregation model if the clearing agent and one or more of its fund manager or broker-dealer clients went bust simultaneously?

Under the complete legal segregation model, the clearinghouse could use the collateral of the defaulted customer but it could not use the collateral of the non-defaulted customer-aka the fund manager who did nothing wrong. Under the legal segregation with recourse model, the clearinghouse could as a last resort use the collateral of the fund manager who didn't default and wasn't to blame.

However, the clearinghouse must first use the collateral of the clearing agent and then the collateral of the defaulting fund manager and then tap into the contributions of a guarantee fund before it uses the collateral of the blameless fund manager.

Joanne Medero, managing director of BlackRock, called the complete segregation model a "more elegant" solution than the physical segregation model.

"Following a default, it leads to the same result as the physical segregation model but with less disruption and lower start-up and maintenance costs as the current operational flows existing for futures collateral and margin management can be leveraged," she explained in her Aug. 8 letter to the CFTC.

According to Medero, the complete legal segregation model would allow the blameless fund manager to move its collateral and positions to another clearing member far more quickly quicker than in the legal segregation with recourse model.

"We have been using the legally separated but operationally commingled (LSOC) model in Europe since 1999 but can only use the futures model in the U.S.," said Daniel Maguire, executive director at LCH.Clearnet in charge of its Swapswire service. That is LCH.Clearnet's version of the complete legal segregation model.

Maguire said the operational costs to implement the complete legal segregation model are minimal relative to the futures model and fund managers don't have to worry about losing their initial collateral due to a default of another client of their client member.

He warned that clearinghouses should never rely on the availability of collateral posted by one fund manager to cover either the default of another fund manager or its clearing agent.

Why? "It is possible, if not probable that a customer will move its margins and positions to another FCM either in advance of the default of its FCM, or in advance of the default of another customer of its FCM," said Maguire.

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