Lehman’s bankruptcy was a nightmare for those who had deposited margins with Lehman (particularly Lehman Brothers International Europe in London) for their derivative trades. Many of them ended up as unsecured creditors of Lehman and will have to wait for years to get back a few cents in the dollar. Margins deposited with Lehman US were protected by segregation rules which cannot be overridden by contract, but apparently many hedge funds chose to use LBIE in London to get higher leverage and signed away many of their rights.
Lehman risk is a significant risk for derivative exchanges because even when the risk containment processes of the exchanges work perfectly, the ultimate customer ends up with little or no protection at all. This is an important issue, but even after fruitful discussions with some UK lawyers on this matter, my understanding of the legal issues has been rather poor.
Now however we have access to a 158 page report submitted by derivative dealers to the New York Fed that is based on work by 13 lawyers from six countries on all the legal complexities involved in providing protection to ultimate customers. The report focuses on Central Counter Parties (CCPs) clearing CDS contracts but the principles are of broader application.
The key takeaways from the report are:
- In the event of a CM [Clearing Member] default, the two essential elements of the customer protection analysis are (i) the manner in which margin is provided and held, and particularly, the extent to which margin is segregated from the CM’s assets and recoverable by the customers (the “Segregation Analysis”) and (ii) the effectiveness of the CCP’s procedures for the transfer or novation of customer positions and related margin (the “Portability Analysis”).
- Collection by CCPs of the Gross Amount (rather than just the Net Amount) may enhance both the Segregation Analysis and the Portability Analysis.
- It is better for customers to grant a security interest in the securities provided as margin than to transfer the securities outright to the CM. By doing this they ensure that the margin would remain property of the customers. Proprietary claimants may have the ability (subject to tracing or other requirements) to recover their property ahead of unsecured creditors, on the ground that the property they deposited with the insolvent entity did not form part of the insolvency estate, but was merely held in a safekeeping or custodial capacity.
- For certain entity types of CMs, the posting of securities is preferable to cash from a customer protection standpoint.
- Holding margin away from an insolvent CM may be helpful to customers for several reasons.
- Where margin is held at the CCP or a third-party custodian, it is generally the case that, the more direct the contractual relationship between customers and the CCP or third-party custodian, the stronger the corresponding Segregation Analysis becomes. For instance, the notion that ownership of customer margin does not pass to the CM would be buttressed to the extent the CM were acting as agent vis-á-vis the CCP on behalf of customers (rather than as principal).
- Portability of positions and related margin is highly desirable, as it reduces the need for position close-outs and resulting transaction costs. Any transfer or novation of positions and related margin requires a willing transferee CM, but it is important to be able to effect the transfer legally without the consent of the insolvent transferor CM.
Finally, the report states upfront that “This Report does not address the risk of fraud, and assumes that the relevant CM has complied with its segregation and other obligations in respect of customer margin.”
Indian derivative exchanges use gross margins and enforce some degree of segregation of client assets, but I think that a lot can and needs to be done to improve customer protection against Lehman risk. I particularly like the idea of replacing cash margins with security interest in low risk securities.