LSOC – A Solution to Avoid 'Fellow Customer Risk'

Abstract

Counter-party risk is the risk that a counter-party may not be able to make payments due under a contract. To mitigate this risk, parties may often require the posting of collateral to cover some or all of the potential losses in the event of a default.The current method of using collateral to mitigate counter-party risk in the over-the-counter (OTC) derivatives market is accomplished through thenegotiation of bilateral credit support arrangements.The Dodd-Frank Act promotes central clearing as the primary method for managing counter-party risk. In central clearing, a central counter-party steps in between the parties to a derivatives contract and becomes the buyer to every seller and the seller to every buyer. There are presently two models with regard to protecting customer collateral:1. The Futures Model, which currently governs futures transactions.2. The Legally Segregated Operationally Commingled (or “LSOC”) Model, which the Commodity Futures Trading Commission (CFTC) has required for cleared OTC swaps.The LSOC Model offers customers greater protection than the Futures Model against fellow customer risk because, in LSOC model a non-defaulting customer's margin cannot be used to cover the losses stemming from another customer's default. However, under both models, a customer may still share pro rata in losses due to operational mismanagement or investment risks.