Washington, 5 November 2010

The U.S. futures regulator could dramatically inflate the costs for clearing swaps and unintentionally increase risks to the financial system if it decides to require segregation of margins posted by individual companies, Commissioner Scott O'Malia said on Thursday.

The Commodity Futures Trading Commission has not yet unveiled its proposal for segregating client funds for cleared swaps, one of dozens of regulations it is crafting to implement the Dodd-Frank financial reform law by July. The agency is weighing how to require futures commission merchants to keep collateral posted by clients separate and protected during times of financial crisis -- a step favored by money managers like BlackRock, Vanguard, and large funds.

But O'Malia, a Republican commissioner, said he is concerned the potential ramifications of the rule are going unnoticed because of its complexity.

"What impact does it have on the cost of clearing, and what impact does it have on our systemic risk management?" said O'Malia in an interview. "Obviously, it will have an impact on who clears and under what conditions," he said.

O'Malia sent letters this week to raise awareness and seek comments from business groups including the Chamber of Commerce, National Association of Manufacturers, and trade groups representing energy, power and agricultural producers.

He said he hopes to have their opinions by Nov. 19, when the CFTC is slated to unveil its proposed regulation. The five commissioners will vote at the meeting on whether to release the detailed proposal for public and industry comment for at least 30 days. O'Malia said he is reserving his decision for the hearing.

After the comment period, the commissioners at the CFTC will have a final vote on whether it becomes regulation. The new Dodd-Frank law requires most over-the-counter derivatives to pass through clearinghouses, which will mean many players will have to post margin. Businesses using swaps to hedge risks associated with manufacturing or resource production will be exempt from mandatory clearing, but are worried large banks and others dealing swaps will pass on their new costs, O'Malia said.

"Even if they are eligible for an end-user exemption, some of their counterparties might have substantially increased margin and capital standards to their clearinghouse or their FCM, so how that would be passed through?" he said.

COULD CREATE "MORAL HAZARD"

At a CFTC public meeting on the segregation issue last month, staffers said they were drafting a rule that would prevent clearinghouse members from tapping client funds to cover losses caused by defaulting members. Instead, the clearinghouse would be responsible.

That's different from the futures market, where currently, if a futures commission merchant goes bankrupt, a clearinghouse can tap that FCM's pool of customer funds to meet its obligations. Major clearinghouses owned by CME Group and IntercontinentalExchange said the plan could increase margin costs by 50 to 100 percent, as well as the size of default cushions that clearing members are required to fund.

The clearinghouses said the rule could push some clearing members out of the market, concentrating risk among those who remain.

The proposal could create a "moral hazard" for FCMs by reducing the incentive for managing risk, O'Malia said. "The FCM, which has a significant risk management role today, really (would) not have any necessity to keep a larger reserve fund, take prudent measures, get a diversified client base," O'Malia said.

Having different regimes for futures and swaps also could affect prospects for creating efficiencies through portfolio margining, O'Malia said. And a more costly regime for swaps would discourage end users from voluntarily clearing those trades, he said.

"We want to make this as easy, cost-effective and as standard as possible for end-users to encourage them to clear, and not create further disincentives for them to avoid clearing," he said.

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