Individually segregated accounts at CCPs being sought by some hedge funds, says CME Group

Operational Risk
06 Feb, 2013

Some hedge funds are asking for individually segregated accounts at CCPs while there is nothing to stop managers pooling together their resources into a cooperative to become clearing members, CME Group has said.

Several managers have questioned whether LSOC (Legally Separate Operationally Co-mingled), which prevents CCPs from using client assets and collateral to meet a defaulting members’ clearing obligations, is sound following the MF Global and Peregrine Financial scandals.

“LSOC provides protection to client assets and collateral in the event of an FCM default caused by a customer default. We have enhanced our customer protections generally by requiring daily customer segregation reporting by all FCMs, surprise audits, and requiring electronic confirmation of segregated balances. However, we have heard of some hedge funds wanting individually segregated accounts,” said Mark Cox, executive director of clearing solutions at CME Group, speaking in Chicago.

Individually segregated accounts, whereby client collateral is held in individual accounts and is protected from clearing member defaults,  is not a new phenomenon. Eurex, the Frankfurt-based CCP owned by Deutsche Borse, announced it would offer clients individual segregation in March 2012 as it sought to reassure market participants left scarred by events surrounding MF Global.

“We have been engaging with the buy-side about the different models available to them. However, with increased protection comes increased costs, and individual segregation is more expensive,” he continued.  Others, including BlackRock, have warned individually segregated accounts could lead to significant operational complexities. Despite this, Cox said it was a broad spectrum of managers and not just the larger outfits, asking for individually segregated accounts.

In terms of buy-side membership of a CCP, numerous hedge funds view it as unlikely although the Chicago-based hedge fund Citadel was once a direct clearing member of CME. Most hedge funds and experts said direct membership of a CCP would be costly and an operational nightmare, a point reinforced by Cox. “Hedge funds tend to run very tight operations and becoming a clearing member would not be a straightforward process for the operational infrastructure that currently exists at most hedge funds” he said.

Furthermore, most managers concede investment banks, which have more opportunities to realise efficiencies of scale, are better placed to handle CCP requirements. However, some have asked whether hedge funds could become members of a CCP via an outsourced provider or utility which could handle all of the operational complexities clearing entails.

Another possibility is if hedge funds become members via a cooperative. “There is nothing to stop managers from doing this but it would be a significant challenge,” commented Cox.  This could also put those managers more at risk, particularly if one or more of the hedge funds inside that cooperative defaulted.

Mandatory OTC clearing comes into force in the US as of March 2013. Cox said the majority of managers appear to have a handle on the situation. “Most hedge funds have been preparing for this for a long time and have been engaged in conversation about mandatory clearing on a regular basis,” he said.