Vanguard is a registered investment adviser based in Valley Forge, Pennsylvania, with more than $1.8 trillion in assets under management. Vanguard has been a vocal supporter of many of the proposed derivatives market reforms including enhanced regulatory oversight and requiring the central clearing of standardized swaps.
William Thum is a principal in Vanguard's legal department and is responsible for derivatives legal support including coverage of fixed income and equities trading, negotiation of derivatives trading agreements, and legal analysis of derivatives regulatory reform. He is also heavily involved with industry initiatives to establish new market architecture and standard clearing documentation. Before joining Vanguard in 2010, he was a partner at the law firm of Fried Frank and head of derivatives documentation, Americas, at Morgan Stanley.
In this interview, Thum discusses several issues related to the protection of customer funds. He offers his views on the "LSOC" model approved earlier this year by the Commodity Futures Trading Commission to safeguard margin for cleared swaps. He also comments on several regulatory initiatives to strengthen customer fund protections, including the amendments to Rule 1.25 that the Commodity Futures Trading Commission adopted in December and the recommendations that the Futures Industry Association's MF Global task force issued in March.
He cautions, however, that customers cannot rely entirely on regulations to protect their funds. Regular due diligence is also essential, and he suggests several questions that institutional investors should ask their futures commission merchants.
FI: You have been very involved in the rule-making process at the Commodity Futures Trading Commission, especially with respect to the rules around the clearing of swaps. Let's start by talking about the kinds of risks that you see in these rules.
THUM: Swaps clearing presents two main benefits. First of all, it substantially mitigates credit risk related to your dealer, or the possibility your dealer will default and fail to perform under the swap. As the principal to the trade is the clearinghouse, you can derive significant comfort from the risk mutualization across all of the clearinghouse's members. Secondly, it facilitates the easy transfer, or porting, of live positions from a failing clearing member to a strong clearing member. This is a significant benefit compared to the over-the-counter world where positions are terminated upon a dealer's default and you have to enter into new trades with a new dealer.
Given the importance of the ability to port and thereby maintain open positions, we have been very attentive to any risk that might impact our ability to move trades to a relatively strong clearing member.
Other risks presented by individual clearing members are certainly important, but hopefully they are of lesser consequence. The first is fellow customer risk, or the possibility that your clearing member fails due to its inability to meet the margin obligations of one of its other customers. The second is investment risk, where the investments made by your clearing member decline and it cannot replenish the margin pool. Finally, there is operational or fraud risk, where your clearing member fails to properly segregate your margin from its assets.
In thinking about the CFTC's rules and how they address clearing member risks, I put them into three categories. There are the risks that are fully addressed by the regulatory structure surrounding cleared swaps. Then there are the risks that are only partially addressed by the regulatory structure. And finally there are the risks that need to be mitigated by your own due diligence. In other words, not all clearing members are created equal, and if you perform a regular due diligence review of your clearing member, you can largely mitigate some of these risks.
FI: What risk mitigation techniques have you been using up to now in the OTC bilateral world?
THUM: Well, Vanguard has a suite of SEC-registered mutual funds, some of which enter into over-the-counter derivatives trades, and in accordance with the '40 Act, mutual fund assets must be held by a custodian. Our derivatives are backed by full bilateral collateral arrangements where collateral is pledged either by the fund or by its dealer to secure obligations arising under the derivatives transactions. Consistent with the '40 Act mandate, those pledged assets are held by the fund's custodian in a segregated control account. So if the pledgor defaults, the secured party has access to the pledged assets securing the obligation. We have also negotiated what I'll call "pledgor access provisions" whereby if the secured party defaults, the pledgor can easily recover the pledged assets from the custodian.
The use of a custodian to hold the pledged assets protects a fund from a whole host of risks that the dealer presents. The assets are not held by the dealer, they're not commingled with other customers' funds, they're not invested by the dealer, and there's no risk of fraud because the dealer has no access to these assets in the ordinary course of trading.
While the custodial structure eliminates risks otherwise presented if the dealer held the collateral, there are, of course, other risks. For example, there remains credit risk to the dealer with respect to market gains or losses that arise between the time that collateral is last posted to you and the time you're able to liquidate the collateral and apply the proceeds. Conceivably you could be under-secured depending on the extent to which the market has moved in the interim and the market value exceeds the pledged assets. In addition, while having a custodian hold assets on your behalf insulates you from risk to your dealer, you are presented with a degree of risk related to the custodian itself in the event the custodian commits fraud or becomes insolvent.
FI: In a custodial arrangement, the margin can't be invested by the dealer and therefore you have a degree of protection against what you have described as investment risk. But if the dealer can't invest those funds on your behalf, doesn't that create an opportunity cost for the customer?
THUM: That's right. When the collateral is held outside of the dealer by a custodian, that impacts the pricing of deals. It becomes more expensive to do the trades in that the dealer cannot benefit from holding the collateral and using it in its business. In addition, there are expenses related to setting up and maintaining the custodial relationship. But remember, I'm speaking about SEC-registered mutual funds, where the fund's pledged assets must be held by a third-party custodian. Other market participants, such as hedge funds, typically do transfer their collateral directly to the dealer and that collateral is held and invested by the dealer raising the prospect of dealer risk related to any collateral in excess of the market value of the derivatives.
The main point is that there are a number of risk mitigation techniques that have been developed in the over-the-counter derivatives world. Those techniques are, for the most part, set up for each account and involve negotiation of bespoke documentation. There's no market standard documentation for the custodial relationships. There are costs associated with holding the collateral this way. And while many of the risks presented in the over-the-counter world are addressed through these practices, they don't eliminate all risks. In fact, some new risks are introduced when you have a custodial third party involved.
FI: Let's talk about LSOC. This is a new type of clearing model that the CFTC has mandated for cleared swaps starting this fall. What are the key details of the LSOC rules?
THUM: There are a couple that stand out. Of course, the main rule, 22.15, clarifies that one customer's margin can't be used to cover a fellow customer's default. This is a significant point of departure from the futures model where the clearinghouse has access to the entire pool of customer margin in the event one customer fails and the clearing member also fails in its obligation to make up any margin shortfall. That's the most critical point in the LSOC rules. There's also a related rule, 22.13(c)(2), which says that when a customer posts additional margin to the clearing member above and beyond the clearinghouse minimum requirement, that margin also receives full protection and may not be used by the clearinghouse to meet any other customer's default. So you not only have your core margin protected, you also have any excess margin protected from fellow customer risk.
Another area of the rule making addresses margin that is posted to the clearinghouse by a clearing member, either specifically with respect to an individual customer or overall as a cushion to address margin transfers on a daily basis. Rule 22.2(e) clarifies the extent to which LSOC treatment, or full protection from fellow customer risk, is also provided to this excess margin posted by the clearing member.
FI: What are the pros and cons of LSOC from your perspective?
THUM: Well, LSOC is effective in largely insulating each individual customer from the risk presented by fellow customers of a common clearing member. The margin transferred by each customer to the clearing member, while held in a commingled, omnibus account, is fully segregated from the margin posted by any of the clearing member's other customers. In the event another customer fails to meet a margin call, neither the clearing member, nor indeed the clearinghouse can use the margin posted by the other solvent customers to satisfy the margin shortfall.
Getting back to one of the primary objectives mentioned at the outset, a critical benefit, of course, is that all of that margin is then available for the solvent customers to help facilitate the prompt transfer of their positions to a new solvent clearing member. If the clearinghouse had access to all customer margin to meet the needs of a failed customer, less margin would be available for porting which could either be delayed or derailed as the clearinghouse needed to collect additional margin prior to arranging the transfer of solvent customer's positions. Given that portability, and not trade termination, is a major benefit of the central clearing, a system that effectively preserves the margin value for each customer and makes it available to support trades that are ported to a new clearing member is a significant improvement.
FI: There are some other requirements that address record keeping and disclosure. Can you talk about those and the value that those provide to you as a customer of this industry?
THUM: That's where it's important that we don't just think about the LSOC rule as simply mitigating fellow customer risk. There is also important language in the LSOC rule that serves to mitigate the risk that a clearing member is not maintaining adequate segregation or is somehow making use of margin in an inappropriate manner. That language is in rules 22.11(c) and 22.11(e).
First of all, the clearing member must provide the clearinghouse with daily records of its customers, their positions, and their margin. And then the clearinghouse is tasked with confirming that such reports are accurate, complete, and timely. So this is effectively a full disclosure by the clearing member to the clearinghouse of who the customers are, what their positions are, and how much the margin has been posted with respect to each customer and their positions.
Mandating this window into the clearing member's business will undoubtedly enhance the discipline of the clearing member in maintaining full segregation and robust record keeping. It also will provide the clearinghouse with accurate, complete and timely information so that if something goes wrong with a customer, or even with the clearing member, the clearinghouse will know who the clients are, what their trades are, and what margin has been posted for those trades. Armed with this information, the ability to efficiently port trades to a new clearing member without the need to post additional margin is significantly enhanced.
FI: So the clearinghouse would have position-level information for each customer?
THUM: That's right. In addition, under LSOC, the clearinghouse collects margin on a gross basis related to the risk presented by each individual customer rather than on a net basis across the risk presented by all of a clearing member's customers. Gross margin requirements also help to ensure the clearinghouse will hold adequate margin for the porting of customer positions in the event of the failure of a clearing member.
FI: Has your firm had any experience with LSOC?
THUM: Well, we certainly have been in conversation with clearing members and each of the different clearinghouses as we assess the appropriate selection to be used by the Vanguard funds. In so doing, we have considered the various models for holding margin and protecting margin for cleared swaps. What has always seemed to us to be the system that makes the most sense is where a clearinghouse has a regular window into the trades that are put on by individual customers and the risks presented by those specific trades, and collects margin on a gross basis from each customer. In other words, a system where each customer "pays its own freight" in terms of the relative risk that it and its trades present to the system. So that helped to guide our own thought process in our support for the LSOC model over time.
The futures model has always appeared to us to be less desirable. That model looks at exposure on a net basis across all customers, with the apparent expectation that there could be access to the margin of non-defaulting customers to satisfy defaults by a defaulting customer. In effect, we came to perceive that those customers with conservative trading strategies and approaches and robust credit parameters are subsidizing the customers with lower credit qualities and more aggressive trading strategies.
FI: How do you address the argument that the futures model has, in fact, worked? Even if you are right that futures customers are exposed to fellow customer risk, in practice the clearinghouses have never tapped one customer's assets to cover a default by another customer.
THUM: We certainly have not had the fellow customer risk issue tested, to a large extent, in the futures world. One could argue, though, that the type of trading in the futures world presents less risk to the system than trading in the cleared swaps world. In the cleared swaps world, we see a much broader range of trade types, with each type traded at a much lower level of frequency. This lower liquidity also raises the possibility of greater volatility, so the risks that an individual customer can present to the overall model could be significantly greater in the cleared swaps world.
So it is particularly important in the cleared swaps world that each individual customer pays its own freight with respect to its relative risk, as I said before. We also see that, going forward, it's compelling for the futures model to be reconsidered and ideally have the LSOC approach apply to the futures world. The benefit, of course, is not only will every customer be paying its own freight, but also, when you have a harmonization of the models used between futures and cleared swaps, you then open the door to the possibility for portfolio margining and greater margin efficiency across your futures and your cleared swaps trading.
FI: You have made some comments at industry conferences about the need for clarification on certain issues covered by the LSOC rules. Can you give us some examples?
THUM: It seems to us that, while the LSOC rules make it very clear how a customer's initial margin is protected, how the rule relates to variation margin could benefit from further clarification. Our understanding is that the largest three clearinghouses may have different interpretations of what is required under LSOC with respect to the level of protection to be applied to variation margin. So we feel that this area would benefit from clarification from the CFTC.
Another issue relates to this idea of excess margin posted by clearing members at the clearinghouse. It's clear that excess margin posted by customers receives full protection from fellow customer risk under the LSOC rules. The question is, what about excess margin posted by a clearing member to either supplement an individual customer's margin or as an overall buffer for all customers of that clearing member? That's another area where it appears there may be some divergent views among the clearinghouses and, again, we think that there should be an effort made to see if clarification of the rule would help to minimize any unintended ambiguity on this topic.
FI: As you know, the CFTC has made some amendments to Rule 1.25, which sets limits on how FCMs invest customer funds. What is your view of those amendments?
THUM: This relates to the investment risk that I talked about at the outset. The question is, to what extent are customers exposed to the investments of customer margin made by a clearing member? In other words, the risk that the clearing member makes poor investments, there are significant losses, and the clearing member fails and is unable to supplement the margin account to address those losses. In amending Rule 1.25, the CFTC narrowed the range of investment options that a clearing member is permitted to make. We see this as a significant step forward in terms of mitigating investment risk overall. So those who question the extent to which investment risk has been addressed by the LSOC rules should gain some comfort from the recent changes to Rule 1.25.
Certainly we could eliminate all investment risk by having the margin held in a third-party account or certain other more novel approaches that have been suggested. The critical question is what is the incremental level of risk? How can that incremental level of risk be most efficiently mitigated? Is the best approach to develop a cumbersome and expensive system to fully eliminate that incremental risk? We think that, through a combination of related rule-making and a customer's own due diligence, the relatively small level of incremental risk can largely be mitigated.
FI: There have been some proposals put out by the FIA and other organizations about how to improve customer protections. What do you see as the most critical elements of those recommendations?
THUM: I think the FIA has done a great job in crafting a set of best practices that really can go a long way to filling any perceived gaps in addressing the kind of incremental risk not addressed by the LSOC rule. Requiring daily reporting of clearing member segregation calculations to the self-regulatory organization is a key best practice that should be implemented on a uniform basis. The twice monthly reporting of clearing member compliance with the Rule 1.25 investment limitation is also very important, as is an annual clearing member certification that there are no material weaknesses in a clearing member's controls relating to capital computations and protection of customer funds. These are all critical ways that some of that incremental risk can be addressed.
There's also an added discipline that is the natural byproduct of greater transparency into clearing member practices. These best practices really create an environment where the clearing members—not just individual clearing members but across all clearing members—consistently apply much more robust practices.
FI: The Federal Home Loan Banks filed a comment letter with the CFTC suggesting that some of this information should be made public. What is your take on that?
THUM: I think it's a great idea. The main thrust of that comment letter is that as soon as the regulatory organization gets the report from the clearing member, the results of the report should be made available immediately on the appropriate web site so that customers have a regular window into the health and best practices of their clearing members. Having more transparency can only enhance the level of discipline of each clearing member, and it will better enable individual customers to assess clearing members against its own risk tolerance levels as it contemplates whether to maintain its trading portfolio with a particular clearing member. And if the risks exceed those tolerance levels, it allows the customers time to make the decision to move to a clearing member that is acting within their tolerance thresholds.
FI: The CFTC currently publishes some FCM financial data on its web site on a monthly basis. Is that information helpful to you?
THUM: I think it's helpful, but I think a lot can happen within the course of a month. The recommendations in the FHLB letter that resonate the most with us are, first, that the daily clearing member reporting of segregation calculations should be published immediately on the web site; second, if there's a notice of a breach of segregation by a clearing member, that should immediately be made available on the web site; and third, that the results of any stress test should be published on the web site.
The more information that is available, the more it will enhance the practices of the clearing members and provide the customers with information to be able to assess their clearing members against their risk tolerance expectations and decide if they need to best protect their customer assets by moving them to a new clearing member.
FI: Should there be any kind of lag or delay of these reports in order to prevent them from having some kind of market impact?
THUM: No, I think at the end of the day you have to consider who bears the risk of an inadequate flow of information. The funds which we manage represent the investments of a broad range of the public that are focusing on retirement, children's education, and meeting their future hopes and dreams. When you limit the flow of information with respect to a failure to meet regulatory obligations, especially rules meant to protect customer assets, the customers are the ones that are bearing that risk. Not having that information in a timely way effectively serves to compromise the credibility of the system for the customers to make their investment choices.
FI: One of the themes that you brought up several times is the need for customers to do due diligence on the FCMs that they are planning to use for their cleared swaps. What kinds of things should customers be looking at as they do their due diligence on FCMs?
THUM: This gets back to the point I made early on, that not all clearing members are created equally. While they may offer similar services, the way they handle the risk inherent in their operating model can be very different. Customers have the right to ask their clearing members how they are performing against a customer's risk tolerance levels. For example, what is the clearing member's capitalization level? Is it capitalized at the CFTC minimum level or at some multiple thereof? When you talk to different clearing members, you will find there is a fair divergence in capitalization.
In terms of investment risk, there are some clearing members that limit investments to only the most liquid and less volatile range of investments within the overall pool that they're permitted to make. So if you were to ask them what investments they make and have that dialogue on a consistent basis, you may find that some clearing members are more conservative in their investments, whereas others, perhaps to achieve a greater return, invest across the whole spectrum allowed under Rule 1.25.
And, of course, there's the history of their compliance with asset segregation rules. Have they consistently met their requirements under the segregation rules or have there been gaps from time to time?
The last area would be how clearing members delegate their responsibilities to clearers in other jurisdictions. You could ask your clearing member for the list of clearers that it uses in specific jurisdictions and perform due diligence on the clearers on that list. Then make sure that you're comfortable with those firms, or limit the range of instruments that you are trading so that there is no need to rely on unacceptable delegated clearers.
The idea here is that each customer needs to bear some level of responsibility for performing regular due diligence on its clearing members, in coming up with its risk tolerance levels, and then deciding on whether or not a particular clearing member should continue to serve in that role or, indeed, if positions should move to a new clearing member.
FI: One last question. What happens if a customer doesn't have tens of billions or hundreds of billions of dollars in assets under management? Do you think that the relatively smaller funds or organizations will have the same ability to conduct that due diligence and to obtain that kind of information from FCMs as the large organizations such as yours?
THUM: I think that's where the FIA's proposal comes in. While a large fund family can make these sorts of due diligence inquiries as an inherent part of its own audit process, all market participants would benefit greatly from requirements for clearing members to make a more robust disclosure to the regulators and for the regulators to promptly make that information available to the market.