On July 13, 2009, an ad hoc group comprised of both buy-side and sell-side market participants in credit default swap (“CDS”) transactions prepared and distributed a report to the supervisors of the major over-the-counter (“OTC”) derivatives dealers entitled, Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals of Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin (the “Report”).
The Report is part of the ongoing industry initiative described, in part, in a letter delivered by certain market participants to the Federal Reserve Bank of New York on June 2, 2009, intended to “achieve buy-side access to CDS clearing (through either direct [central clearing CDS counterparty (“CCP”)] membership or customer clearing) with customer initial margin segregation and portability of customer transactions no later than December 15, 2009.” The Report essentially discusses the protections afforded to market participants (“customers”) in connection with CCP-cleared CDS positions and related margin upon a default or insolvency of a clearing member (each, a “Member”). In particular, the Report analyzes customer protections as they relate to the “segregation” of initial margin (i.e., the manner in which such margin is provided and held and, more specifically, the extent to which it is segregated from the assets of the relevant Member and recoverable by the customer) and the “portability” of transactions and initial margin (i.e., the effectiveness of CCP procedures for the transfer of a customer’s positions and related margin) upon the default or insolvency of a Member. In preparing the Report, the ad hoc group solicited responses from two U.S.-based and four European-based CCPs on relevant matters.
With respect to segregation, the Report explores several factors that could have an effect on, among other things, a customer’s ability to identify and recover the initial margin it posted, including: (i) the manner by which a customer posts margin (e.g., by granting a security interest or through a title transfer); (ii) whether CCPs may collect margin from Members on a net basis (i.e., a level of margin reflecting the aggregate risk to the CCP of such Member’s customer positions) or gross basis (i.e., all CCP-imposed margin amounts posted by such Member’s customers); (iii) whether cash or securities are posted as margin; (iv) whether margin is held by the Member directly, by the CCP directly or by a third-party custodian; (v) whether margin is commingled with assets of other customers; (vi) the relationship between the CCP, the Member, any custodians and the customer; (vii) whether margin is subject to any liens or set-off rights and (viii) whether margin is subject to rehypothecation.
With respect to portability, the Report notes that the ability to transfer CDS positions and related margin decreases the risk of close-outs (and their related transaction costs) and mitigates the systemic risk that goes along with the insolvency of a financial institution. The Report points out certain factors that strengthen the segregation analysis (such as margin being held away from the Member and not being commingled with the property of other customers) enhance the ability of customers to transfer CDS positions and related margin from a distressed Member to other market participants.
In conclusion, the Report recommends certain legislative and regulatory reforms that would both help to protect customer margin and increase the likelihood that this margin would be transferred (along with a customer’s CDS positions) or returned to a customer upon a Member default or insolvency. These recommendations include the implementation of rules to clarify the treatment of CDS margin upon a Member insolvency and to strengthen the ability of CCPs to transfer a Member’s customer positions and related margin upon a Member default or insolvency.