The derivatives world is full of acronyms. CDS, IRS, CCP, CVA. The list goes on. ISDA itself is an acronym, and a relatively popular one at that.
Well, we can now add another acronym to the mix: LSOC. If you haven’t heard it yet, you are likely to, in the cleared swap world of the future in the United States. LSOC stands for “legally segregated, operationally commingled.” Under rules adopted by the CFTC (acronym alert!) last week, it is the basis for the complete legal segregation model, which determines how margin for cleared swaps will be held for the benefit of customers of a futures commission merchant (or, to cite another acronym, an FCM).
ISDA has been supportive of the LSOC approach since the very early days of the CFTC’s deliberations on customer margin for cleared trades. It is an approach to margin that bears similarities to the way that collateral has traditionally been held in the OTC derivatives business. The legal rights to collateral in OTC trades are clear under the widely-used ISDA credit support annexes backed by the legal opinions obtained by ISDA. Operationally, collateral provided for OTC trades may be commingled or even in some cases rehypothecated, but the legal rights of the provider of credit support are protected by the terms of the documentation.
The process followed by the CFTC in reaching its final rule last week is an example of effective dialogue among the CFTC and various interested parties. Soon after the Dodd-Frank Act (we’ll spare you the acronym) was passed, several market participants raised concerns with the CFTC that they could potentially find themselves less protected in margin arrangements for cleared swaps than for non-cleared OTC swaps, where they had negotiated third-party custodial arrangements. They wanted to take advantage of the risk reduction offered by clearing their trades, but they did not want to forego the degree of protection for margin that they had so carefully negotiated for the collateral in their OTC trades.
Through an advanced notice of proposed rule making, proposed rules, roundtables and an ongoing dialogue with ISDA and other market participants, the CFTC worked this issue extensively. Swap clearing is a pillar of national and international approaches to regulatory reform, and margin and its treatment is a linchpin of clearing. It was important to get this right so that customers would not have to be concerned about the protection of their margin as they moved to the cleared swap world.
LSOC seeks to strike a balance by recognizing that while full legal segregation of collateral can provide the highest degree of protection, it can also create operational challenges where a third-party custodian is involved. Complete segregation through a third-party custodian also comes at a cost and some customers may take the view that the extra protection is not justified by that cost. Clear, robust legal rights are essential. If those are in place, greater flexibility on the operational side is acceptable. Maintaining legal segregation while allowing for commingling of margin for operational reasons—the LSOC approach in a nutshell—was the best result.
The CFTC will continue to consider the approach to margin in both the cleared swaps and futures worlds as the market builds experience with LSOC and more details are discovered regarding what happened at MF Global. ISDA and the industry will also assess its experience with LSOC and the other rules adopted by the CFTC last week. The dialogue that has been established through the CFTC’s consideration of LSOC will serve the CFTC and the industry well for the future.
The long and short of it is that LSOC is a good step in the right direction.