Collateral damage: the legal and regulatory protections for customer margin in the U.S. derivatives markets

This Article provides a detailed analysis of the laws and regulations that apply to margin posted by customers entering into futures and cleared swaps contracts in the United States. It describes the types of margin accounts used by Futures Commission Merchants (“FCM”) and Central Counterparties (“CCPs”). It analyzes the rights of customers upon the insolvency of their FCM. First, this Article explains why futures customers currently receive a lower level of protection under the Commodity Exchange Act than that received by cleared swaps customers under the Dodd-Frank Act. On the one hand, futures customers currently share risk as co-owners for margin that they post (the “Futures Model”), which exposes them to “fellow customer risk.” On the other hand, the Dodd-Frank Act protects cleared swaps customers from fellow customer risk by prohibiting CCPs from using the margin of non-defaulting customers of an insolvent FCM (the Legal Segregation and Operationally Commingled Model, or the “LSOC Model”). This Article argues that the different level of protection received by futures customers and cleared swaps customers is unjustified because the statutory language suggests that they should receive the same treatment in an insolvency situation. There are also many benefits to adopting the LSOC Model in the futures markets; therefore, the LSOC Model should replace the Futures Model in the futures industry in order to eliminate fellow customer risk for futures customers. It also considers the ramifications of this change and recommends how to implement this new approach. Second, it recommends that mandatory insurance should be used to protect futures and cleared swaps customers against losses resulting from fraud and other operational risks. This would increase the level of customer protection and confidence in the U.S. derivatives markets. These changes should enhance legal certainty during the next financial crisis and allow regulators and the courts to speedily allocate losses and transfer or return margin to customers. Finally, it compares the U.S. approach for protecting customer margin with the approach in the U.S. securities markets and other jurisdictions that have large derivatives markets.