The Commodity Futures Trading Commission (CFTC) Wednesday approved a final rule that would protect the funds of cleared swaps customers of futures commission merchants (FCM) as the agency continues to look for $600 million in missing customer securities from New York-based MF Global Inc., which filed for bankruptcy protection last fall (see Daily GPI, Nov. 14, 2011).

By a vote of 4-1, the Commission also voted out the proposed “Volcker Rule,” which bars federally insured depository institutions, bank holding companies and their subsidiaries or affiliates from engaging in short-term proprietary trading of any security, derivative and certain other financial instruments. Moreover, it prohibits banking entities from owning, sponsoring or having certain relationships with a hedge fund or a private equity fund.

The Volcker Rule, which was originally proposed by economist and former Federal Reserve Chairman Paul Volcker, prohibits a bank or institution that owns a bank from engaging in proprietary trading that isn’t at the behest of its clients, and from owning or investing in a hedge fund or private equity fund. It also limits the liabilities that the largest banks can hold (see Daily GPI, July 22, 2010).

Under the rule protecting cleared swaps customers, which cleared the CFTC by 4-1, the Commission adopted a model known as “Complete Legal Segregation Model,” or the LSOC model. It allows the collateral of all of an FCM’s cleared swaps customers to be kept together (commingled) pre-bankruptcy and requires information about the FCM’s cleared swaps customers’ portfolios to be sent to the applicable clearing organizations at least once a day.

But in the event of a default by both a clearing member FCM and one or more of the clearing member’s cleared swaps customers, a derivatives clearing organization (DCO) would not have recourse to the collateral posted by nondefaulting cleared swaps customers, the agency said. The DCO would only have recourse against the collateral of the defaulting cleared swaps customers of that clearing member (as well as the resources of the clearing member itself).

This “increases the protection [of customers] under our rules and the bankruptcy code,” said CFTC Chairman Gary Gensler.

The “segregation rule is an important step forward in protecting customers and reducing the risk of swaps trading. Segregation of customer funds is the core foundation of customer protection in the commodity futures and swaps markets…It prohibits clearing organizations from using the collateral of nondefaulting, innocent customers to protect themselves and their clearing members,” he said.

“The LSOC model substantially reduces fellow customer risk…but no regulation — indeed, no segregation model in itself — will in every case prevent the willful misappropriation of customer funds. That is why I have asked the staff to consider whether additional or other collateral protections could further reduce risks to customer collateral,” Commissioner Mark Wetjen said.

Commissioner Scott O’Malia said the rulemaking would not have prevented another MF Global, and only would have offered a “misleading sense of comfort” to the market. “The rulemaking is entitled, in part, Protection of Cleared Swaps Customers Contracts and Collateral. Therefore, it benefits cleared swaps customers, and not futures customers (who are bearing the brunt of MF Global).”

The CFTC’s proposed Volcker Rule “is basically a mirror” of the joint rule proposed by the Board of Governors of the Federal Reserve system, the Office of Comptroller of the Currency, Treasury, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission (see Daily GPI, Oct. 13, 2011). The CFTC is a “supporting member,” while the banks are playing a “lead role,” Gensler said The agency has put the proposal out for comment for 60 days.

“As we vote on the Volcker Rule proposal…I can’t help but question the timing of this vote and why the Commission did not join the other agencies in their proposal back in October,” said Commissioner Jill Sommers.

“Unfortunately we are proposing rules that are virtually identical to the other agencies’ proposed rules well after they have been widely criticized and after many have called for those agencies to start over, including Paul Volcker. What will we do if they repropose their rules? Will we be prepared to withdraw our proposal and join a reproposed Volcker Rule with the other agencies?” she asked.

The FTC also voted out two other final rules — one implementing the Dodd-Frank Act’s business conduct requirements for swap dealers (SD) and major swap participants (MSP) in their deadlings with counterparties, including “special entities;” and a second establishing a process for the registration of SDs and MSPs. Concurrent with the adoption of the latter rule, the CFTC delegated to the National Futures Association the authority to perform the full range of registration functions with respect to SDs and MSPs.

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