Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Lehman Risk, Segregation, Net Margins and Cash Margins

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

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
  • 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
  • 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
  • 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.


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