Managed Funds Association (MFA) and the Alternative Investment Management Association (AIMA) have jointly submitted a letter to the Commodity Futures Trading Commission’s (CFTC) requesting the repeal of the rule on the treatment of funds deposited in safekeeping for futures and options transactions.
Essentially, the repeal of the Amendment of Interpretation to the Financial and Segregation Interpretation No. 10 by the CFTC’s Division of Clearing and Risk as well as the Division of Swap Dealer and Intermediary Oversight would be intended to allow the use of tri-party arrangements in connection with cleared swaps. In the letter, the MFA and AIMA said that their member firms were concerned by the recent MF Global and Peregrine insolvencies and the related misuse and misappropriation of customer assets. In addition, MFA and AIMA explained the typical control arrangements related to third-party custodial accounts used in the over-the-counter derivatives market in response to the CFTC’s concern about FCMs having immediate and unfettered access to customer collateral.
In Segregation Interpretation 10-1, CFTC stated that, with limited exception, third-party custodial accounts were no longer permitted or appropriate, and that FCMs would not be “in compliance with the requirements of Section 4d(a)(2) if they deposit, hold or maintain margin funds for customer accounts in third-party custodial accounts”.
The associations said: “We believe that, in light of the MF Global (MF Global) and Peregrine Financial Group, Inc. (“Peregrine”) failures, it is the appropriate time for the Divisions to consider the commenter’s request, and we respectfully request that the Divisions repeal Segregation Interpretation 10-1 for Futures. Our members are customers to FCMs and are fiduciaries to their investors. Thus, we were very troubled by the MF Global and Peregrine insolvencies, which resulted in Futures customers experiencing a delay in the return of their segregated Futures assets or incurring material losses of their Futures funds. Therefore, we believe that repealing Segregation Interpretation 10-1 to permit third-party custodial accounts for Futures is an important step towards safeguarding investors’ assets.
“Third-party custodial accounts would provide increased protection for Futures customers from a number of risks, including “fellow customer risk”. “Fellow customer risk” is the risk that a derivatives clearing organization (“DCO”) uses assets of an FCM’s non-defaulting customers to satisfy losses of that FCM’s defaulting customer in the event that those losses exceed the margin assets of the defaulting customer and the FCM.”
Steven Lofchie, co-Chairman of the Financial Services Department at financial services law firm Cadwalder said: “This letter indirectly illustrates one of the most significant ways in which Dodd-Frank increased the risks to derivatives customers. That is, pre-Dodd-Frank, customers could negotiate to hold swaps collateral in tri-party arrangements with banks. Under Dodd-Frank, collateral for “futurized” swaps must be held with FCMs. However, in light of the failures of MF Global and Peregine, as noted in the joint letter, customers have less confidence in the FCM segregation scheme than they have in bank custody arrangements.”