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The biggest story last week came not from a government regulator or a courtroom, but from a consortium of four self-regulators and industry organizations that released a study on the feasibility of adopting an insurance regime to protect customers trading futures through US futures commission merchants. The bottom line: only one model appears feasible on a cost/benefit basis, but even that model appears difficult to implement. Do FCMs really have the stomach to take on more fellow FCM risk – particularly where doing so might help a competitor?
This and the following matters are covered this week on Bridging the Week:
Video Overview:
Article Overview:
US Futures Industry Insurance Study Released
On Friday last week, a consortium of four self-regulators and industry organizations released a long anticipated report on the feasibility of adopting an insurance regime to protect customers trading futures through US futures commission merchants. The CME Group, the Futures Industry Association, the Institute for Financial Markets, and the National Futures Association commissioned this study in November 2012 following the collapses of MF Global and Peregrine Financial Group.
The study reviewed four scenarios for providing customer asset protection insurance resulting from the failure of FCMs and estimated the potential costs of the two most feasible models: one where FCMs voluntarily participate in a self-insurance scheme backed mostly by reinsurance and the other where insurance is provided to all customers of all FCMs under a program like that provided by the Securities Investor Protection Corporation for the securities industry. This proposal has been promoted in the past by at least one Commissioner of the Commodity Futures Trading Commission, Bart Chilton.
Under the captive insurance scheme, FCMs voluntarily would participate with a specially created company (FCM Captive). The FCM Captive initially would cover up to US $300 Million of claims by the participating FCMs, with the first US $50 Million of losses paid by the FCMs themselves, and the next US $250 Million being paid by a group of insurance companies. Payouts would be limited to US $50 Million per FCM and, according to a group of eight insurance companies contacted for the study, would cost an estimated US $18 – 27 Million annually, subject to further refinement and negotiation.
These costs might be passed on by FCMs to their customers based on their assets on deposit. Participating FCMs would be subject to minimum standards regarding their risk-management and internal controls, as well as other matters. That being said, each FCM involved with the FCM Captive effectively would be underwriting the risk of other FCMs in the consortium in connection with its own obligation to fund a portion the first level of potential losses. According to the study:
"Participating FCMs thus would be required to rely on the customer risk-management processes of other owner-participants of the FCM Captive that are sources of the risks that they do not directly observe or monitor. FCMs with more advanced customer risk management systems and customers with lower amounts of capital at risk thus may become concerned that they are cross-subsidizing less-sophisticated FCMs with higher-risk customers (especially when focusing on the scenario in which fellow-customer risk is the insurance trigger). On the other hand, because the FCMs would experience losses in the retained risk layer on a mutualized basis, the FCM Captive would have a strong incentive to encourage participating FCMs to adopt responsible risk-management and customer surveillance processes and to deny entry into the FCM Captive to FCMs that fail to do so."
Under the SIPIC-type plan, called the "Futures Insurance and Customer Protection Plan," customers at FCMs would be protected up to US $250,000 against the failure of an FCM. This program would be funded by an assessment of .5% of each FCM's gross revenues up to a US $2.5 Billion target funding level. Using these assumptions, it would take 54 years to achieve the target funding level, according to the study. As a result, to work, the FICPP would likely require government involvement at least on an interim basis potentially to fund any gap in need vs. resources in case of an FCM failure. It is unclear what the appetite of Congress would be to authorize this in the current environment in Washington, DC.
Two other options were considered by the study: one where customers would purchase insurance on a voluntary basis, and the other where FCMs would purchase insurance on a voluntary basis for their customers. Both options were considered prohibitively expensive, however.
Compass Lexecon, a consulting firm that bills itself as specializing in applying economics to legal, regulatory and policy issues, undertook the study.
The Commodity Futures Trading Commission recently finalized rules aimed to enhance protection of customers and their funds at FCMs. (see http://www.garydewaalandassociates.com/?p=1286) . This followed the earlier adoption of separate rules by the Chicago Mercantile Exchange and the National Futures Association, as well as voluntary initiatives proposed by the Futures Industry Association.
(Disclosure: Gary DeWaal is Co-Vice Chairman and a member of the Board of Trustees of IFM, one of the underwriters of the study.)
CFTC Adopts Final Rules to Ensure Systemically Important Designated Clearing Houses Can Qualify as QCCPs
Last week the US Commodity Futures Trading Commission adopted final rules aimed at ensuring that systemically important derivatives clearing houses (SIDCOs) under its jurisdiction continue to meet international standards so that international banks clearing derivatives trades through them are subject to lower capital charges. These rules address governance, risk management, credit risk, margin, liquidity risk, money settlements, segregation and portability, and operational risk, among other matters.
During August 2013, the CFTC adopted final rules to conform with international requirements (so-called "Principles for Financial Market Infrastructures" (PFMI) published by CPSS-IOSCO during April 2012), that among other things, required SIDCOs (1) that are involved with a more complex risk profile or that are systemically important in multiple jurisdictions to maintain sufficient resources to meet their financial obligations to their clearing members despite the default of two clearing members creating the largest combined financial exposure; (2) to assess their available financial resources available to meet their financial obligations in such a scenario without using their assessment powers; and (3) to maintain business continuity plans that enable them to recover their operations and resume daily processing, clearing and settlement within two hours of any disruption. The current new final rules endeavor to plug holes in PFMI requirements that the CFTC says were not addressed in its August 2013-adopted rules.
In connection with its originally proposed rules (also in August 2013), the CFTC had suggested that general obligations of a sovereign government, such as US Treasury securities, held by a SIDCO to meet its liquidity resource requirements must be subject to pre-arranged and highly reliable funding resources. The Chicago Mercantile Exchange had argued that if adopted, this requirement would mandate it to limit the amount of US Treasury Securities a clearing member could use to meet initial margin and guaranty fund obligations. However, the CFTC adopted its proposed rules with only slight modifications.
The CFTC's new rules are mandatorily applicable only to the CME and ICE Clear Credit. Other DCOs may voluntarily agree to comply with the new rules, however. The CFTC claims adherence to these rules will enable a designated clearing organization qualify as a so-called "Qualified CCP" under Basel CCP Capital Requirements. According to the CFTC, the consequences to a DCO that does not qualify as a QCCP can be horrific.
"As one market participant noted, the ‘ramifications for failure to achieve QCCP status are onerous for banks' CCP exposures and can result in capital charges on trades exposures that are 10-20 times larger than capital charges for QCCP trade exposures'."
And briefly:
For more information, see:
Canadian OTC Trade Reporting Requirements (Ontario only):
http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_20131114_91-506_91-507_derivatives.htm:
http://www.dfsa.ae/WhatsNew/DispForm.aspx?ID=269
ESMA EMIR Q&As:
http://www.esma.europa.eu/system/files/2013-1633_qa_iv_on_emir_implementation.pdf?utm_source=FIA+Weekly+Briefing+-+11%2F15%2F13+&utm_campaign=FIA+WeeklyBriefing_1115&utm_medium=email
US Consortium Futures Insurance Study:
http://www.futuresindustry.org/downloads/Customer_Asset_Protection_Insurance_Study.pdf
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of November 17, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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September 17, 2014
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Gary DeWaal
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Gary DeWaal's Bridging the Week: November 11 to 15 and 18, 2013 (US Futures Customer Insurance? Safer US Clearing Houses? ...and more)
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