1. What IM is and why it must be segregated

• VM vs IM: Variation Margin is settlement of daily mark-to-market. It is rehypothecable. Initial Margin is a buffer for potential future exposure over the Margin Period of Risk - 5 to 10 days. It covers replacement cost if counterparty defaults.
• Core Principle: VM = transfer of title / exposure extinguishment. IM = collateral to be returned. Therefore IM must not be available to the secured party's creditors.
• Regulatory Mandate: BCBS-IOSCO 2013 framework Key Principle 4: IM must be segregated from proprietary assets and not rehypothecated.

Without segregation, the posting party becomes an unsecured creditor.

2. Two Parallel Regimes

A. Cleared Derivatives - US and EU

US CFTC:

• CFTC Reg 39.15 and 22.2-22.5: FCM must hold customer cleared swap collateral in account segregated from its own property.
• LSOC - Legally Segregated Operationally Commingled: For cleared swaps, each customer's IM is legally segregated, but operationally held together at the DCO. FCM cannot use one customer's IM to cover another's loss - prohibited fellow customer risk.
• Customer collateral must be held at DCO, not available for FCM's own use except in very limited circumstances.

EU EMIR Article 39: CCP must offer Omnibus Client Segregation and Individual Client Segregation. Individual segregation offers highest protection but higher cost.

B. Uncleared Derivatives - UMR

This is where "segregation" is now most litigated.

US: Dodd-Frank Section 724(c) and CFTC Rules 23.702 and 23.703

Pursuant to the Dodd-Frank Wall Street Reform and Commodity Futures Trading Commission Rules 23.702 and 23.703 thereunder, swap dealers are required to notify their counterparties that they have the right to require segregation with a third-party custodian of any initial margin posted.

Key features:

1. Notification Obligation: Dealer must annually notify buy-side of right to segregate.
2. Custodian: Must be independent third party, not affiliate of either party.
3. Account Control Agreement - ACA: Tri-party agreement among Pledgor, Secured Party and Custodian. Must allow transfer without other party's consent upon submission of written statement under oath/penalty of perjury that party is entitled to control.
4. Eligible Collateral & Investment: Limited to CFTC Reg 1.25 - highly liquid - government securities, etc. Prohibition on rehypothecation.

Prudential Regulators Rule - OCC, Fed, FDIC: For Covered Swap Entities: Required IM must be held by one or more custodians that are not affiliates.

EU: EMIR Article 11(3) and Commission Delegated Regulation 2016/2251

FCs must have risk-management procedures in place requiring the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts

• Two-way gross: Both parties must post and collect.
• Segregation requirement: Articles 19 and 20 of RTS: IM must be segregated in bankruptcy-remote arrangements, such as tri-party or third-party models.
• Must be held in a way that is bankruptcy remote from both collector and custodian, and immediately available in default.

3. Operational Models of Segregation

1. Title Transfer - English CSA: Not permitted for Regulatory IM. Violates segregation because ownership transfers.
2. Security Interest - NY CSA / English CSD / ISDA 2016 Credit Support Deed for IM: Creates security interest. Requires:
   • Third-Party Custodian Model: Assets held in segregated account designated for and on behalf of end-user.
   • Tri-Party Agent: BNY Mellon, JP Morgan, Euroclear, Clearstream. They enforce eligibility, haircuts, substitution.
3. ISDA Account Control Agreement Template 2019: Standardizes control.

4. Case Laws that Shaped Segregation

Case 1: Lehman Brothers International (Europe) v CRC Credit Fund UKSC 6 - The Client Money Case[2012]

Facts: LBIE used FSA CASS 7 "alternative approach" - client money paid into house account then segregated later. At administration, billions were in house accounts.

Holding - Supreme Court of England:

1. Protection arises upon receipt of client money. Not dependent on actual segregation.
2. Pool available for distribution should be all funds readily identifiable as client money. It is not necessary that funds are placed in an account segregated from firm's own funds.
3. Entitlement to pool does not depend on whether funds were actually segregated.

Impact for IM: Led directly to CASS 7A reform and to EMIR RTS requirement that IM must be legally effective, not just operationally segregated. "Readily identifiable" test is now codified in EU custody rules. The decision created a "substantially reduced percentage payout" because pool was shared with un-segregated clients.

Case 2: In re MF Global Inc., 11-2790 (S.D.N.Y.) and MF Global UK - Special Administration

Facts 2011: MF Global Inc misappropriated $1.6bn of customer segregated funds to meet proprietary margin calls. IM posted by energy trading firms was commingled with firm funds.

Legal findings:

• Violation of CEA Section 4d(a)(2) and CFTC Reg 1.20-1.30 - customer funds must be separately accounted for.
• US Bankruptcy Court held that clients whose funds were not properly ring-fenced when MF Global went into administration could still claim on pool per Lehman precedent, but recovery was delayed years.
• CFTC v. Corzine et al. settled for $5m penalty and industry-wide imposition of LSOC and mandatory third-party custodian for uncleared IM.

This case is why UMR prohibits re-use and requires daily segregation reporting.

Case 3: In re Lehman Brothers Inc., 791 F.3d 277 (2d Cir. 2015) - Prime Brokerage IM

US SIPA liquidation. Hedge funds argued their excess IM posted as independent amount under ISDA CSA should be treated as customer property.

Court held: If IM was posted under Title Transfer CSA, title passed - claimant is general unsecured creditor. If posted under New York law Security Interest CSA with segregation, it remained customer property.

Lesson: Choice of English CSA vs NY CSD determines segregation outcome in US insolvency. Post-Dodd Frank, Reg IM must be security interest, not title transfer.

Case 4: LCH.Clearnet Ltd's handling of Lehman - 2010 House of Lords Evidence

Not litigation but regulatory precedent cited by courts:

LCH stated losses caused by failure of Lehman Brothers were covered by 35% of Lehman's initial margin. No mutualized default fund was touched. Used by courts to uphold CCP IM segregation as effective and enforceable. Also used in Sentinel Management Group case.

Case 5: CFTC's interpretation of Segregation - Effective Collateral Protection (Casetext analysis)

Commentary notes: "Initial margin, an amount of liquid collateral protecting Lehman against adverse price movements... was usually commingled with Lehman's own funds and rehypothecated. No regulator was to blame; swaps were largely unregulated." Congress passed Dodd-Frank to fix this. This analysis is cited in support of CFTC No-Action Letter 17-11 that prohibits netting of IM across accounts even if operationally commingled.

5. Consequences of Failed Segregation

• Legal: If not segregated, IM loses protection under 11 U.S.C. § 766(h) safe harbor. It becomes part of estate.
• Regulatory: For dealers, breach of 23.157, EMIR Art 11(3) - fine up to 10% turnover under EMIR 3.0.
• Cost: Segregation prevents reuse - "Segregation is also expensive because it largely prevents the initial margin being used for investment and funding purposes".

Practical Checklist for Compliance

1. Use ISDA 2018/2019 IM CSD + ACA, not legacy CSA.
2. Elect segregation annually in writing under 23.702/703.
3. Appoint independent custodian, obtain control.
4. Ensure no rehypothecation clause.
5. Daily reconciliation and prohibition on commingling with proprietary assets.