05.01.2012
By Terry Flanagan

Whither Futures Market?

With six months passed since MF Global’s collapse and as much as $1.2 billion in client money still missing, market participants are questioning the once-vaunted segregated accounts they relied on and proposing solutions to bolster the market’s integrity.

“I for one am scarred in terms of my confidence in the integrity of the operational controls supervised by the Chicago Mercantile Exchange, the Commodity Futures Trading Commission, and the banking community,” said John Brynjolfsson, managing director at Armored Wolf, a registered investment advisor that manages a commodities investment sub-advisory assignment for Eaton Vance and an offshore macro hedge fund.

I for one am scarred in terms of my confidence in the integrity of the operational controls. John Brynjolfsson, managing director at Armored Wolf

Prior to founding Armored Wolf in 2009, Brynjolfsson worked at Pacific Investment Management Co. (Pimco) for 19 years, where he managed several of its largest funds. The alternative-investment veteran’s reaction to MF Global’s implosion and the rash of unanswered questions since then is shared by many other futures market participants.
“The fact that customers at a minimum have been extremely delayed in recovering those funds, and there’s a good chance they lost substantial funds that were in a (Futures Commission Merchant) collateral account — it’s a big black mark on the industry,” Brynjolfsson told Markets Media.

Attempted remedies to prevent a similar meltdown have so far been restricted to technical fixes by CME Group, which runs the biggest U.S. futures exchange and the self-regulatory organization that oversees most FCMs. Most of those fixes are pending.

Since MF Global’s October 31, 2011 bankruptcy, numerous government bodies and private groups representing different corners of the futures market have weighed in on how to bolster the integrity of the market and especially segregated accounts. Previously, futures players had touted segregating customer funds from FCMs’ own collateral as, safer, more effective and a less cumbersome approach in bankruptcy proceedings than the security market’s insurance coverage of $500,000 per account provided by the Securities Investor Protection Corp., but the MF Global saga has introduced cracks in that façade.

Reassessment Needed
“If segregated accounts worked like they should have, customers would have their money back already,” said CFTC Commissioner Bart Chilton, who was confirmed by the U.S. Senate in 2007 and previously headed government relations at the National Farmers Union and was deputy chief of staff to former U.S. Secretary of Agriculture Dan Glickman. “Do I think we need to reassess how segregated accounts are treated? Yes I do. This was a cold slap in the face and a wake-up call for regulators.”

Chilton has found mixed support for his three recommendations. The one garnering the least overt interest so far, he said, is a proposal to allow investors to choose whether FCMs can invest the funds in their segregated accounts. FCMs typically commingle customer funds from segregated accounts with their own funds and invest in ultra-safe instruments such as overnight repurchase agreements; MF Global went off-course on that count with a large bet on distressed European sovereign debt that appears to have involved customer funds. Even the shortest-term investments perceived as safest may be held in custody at different clearing and settlement houses, potentially entangling customer funds when precarious situations arise.

“It’s your money and margin, and you should have the choice whether an FCM uses it,” said Chilton, who has also recommended instituting a SIPC-like insurance fund, insuring customers up to perhaps $1 million. “I’ve talked with members of Congress in the House and Senate, and I don’t see any bills up there yet, but I hope it catches on,” he said.

Chilton’s third recommendation is for regulators to implement ‘deep data dives’. These would be assisted by the CME’s new requirement, going into effect May 1, for FCM clearing members to file daily segregated, secured and sequestered statements signed off on by a designated top executive. FCMs are already required to generate most of that data in-house, but reporting it would be new.

Chilton said the daily reporting should be accompanied by frequent spot checks by regulators to make sure customer funds are where FCMs say they are. The CFTC pursued 70 such checks in the weeks after MF Global’s collapse, but Chilton said they must be more systematic and less reactive. “There’s no reason in this age of electronics that banks can’t report to us or an SRO what’s in customer accounts at certain times throughout the day,” he told Markets Media.

CME on April 2 said it would begin performing spot checks of customers’ segregated, secured and sequestered statements in addition to regular risk-based examinations. The Chicago-based futures exchange also plans at some point to require FCMs’ management to pre-approve in writing any disbursements in excess of 25% of a customer’s funds in a segregated account that are not made for the benefit of the customer. And starting July 1, clearing members will be required to file bi-monthly reports that detail how customers’ segregated funds are invested and where the assets are held in custody.

Investors and traders with skin in the futures market welcome increased FCM disclosure.
“Consider how grateful MF Global’s customers would have been if MF Global had been required to provide the clearinghouse with daily records on customer positions… and if the clearinghouse took appropriate steps to confirm such information and present it accurately and completely and provide it on a timely basis,” said William Thum, principal and senior derivatives counsel at Vanguard, at a March 29 roundtable sponsored by CFTC that involved almost 50 futures-industry executives and regulatory officials.

Thum spoke at a roundtable discussion that focused on applying to exchange-traded futures the Legally Segregated Operationally Comingled (LSOC) model the CFTC finalized in January for OTC swaps. The LSOC model, hailed by Thum for its robust disclosure requirements, mandates separation of customer and broker funds while instituting strict requirements to permit commingling of margin for operational purposes.

CME is bolstering its rules in conjunction with recommendations put out earlier in the year by other groups, such as the National Futures Association, an SRO overseeing smaller FCMs, and the Futures Industry Association. Many of the industry’s recommendations overlap. Additionally, the U.S. Senate Ag Committee has held discussions with market participants and will consider policies to help customers recover money and protect collateral.

If segregated accounts worked like they should have, customers would have their money back already. CFTC Commissioner Bart Chilton

More Proposals
If that is not a sufficient number of initiatives, the Customer Commodity Coalition, formed by former MF Global customers, has proposed six changes to regulation, policies and bankruptcy law to bolster account protections. These include bringing financial oversight of all brokers under CME; establishing commodity customers as first in line for recovered segregated funds in a bankrupt FCM’s estate; and encouraging CME and other exchanges to increase industry-supported protection funds.

FCMs have also weighed in, at times drawing the distinction between pure FCMs that provide brokerage services only in the futures market, and others including MF Global and big Wall Street firms that are active in other financial markets and are regulated by the U.S. Securities and Exchange Commission.

R.J. O’Brien, one of the largest pure, privately owned FCMs, felt reverberations from MF Global. RJO Chief Executive Gerry Corcoran noted in December testimony before the House Committee on Agriculture that his firm received 20,000 MF Global accounts in light of the collapse. That was the good news – the bad news was that clients were requesting financial data at previously unseen rates and withdrawing cash “because there is a lack of confidence in the system as a whole.”

Corcoran suggested FCMs engaging in proprietary trading use other FCMs, or create a separately capitalized, special-purpose FCM for that activity. His other suggestions included requiring accounts exceeding certain margin thresholds on an intra-day basis to fund via direct wire transfers, ensuring margin calls are met, and requiring a certain portion of an FCM’s capital be placed in a customer-segregated account.

While the MF Global debacle has fueled legislative and populist anger and sparked calls for immediate action, market participants say it will take time to sort out and craft the right response.

“All of the proposed solutions put forward appear to enhance customer protection, but they will likely result in unexpected costs advantaging some participants over others,” said John Hiatt, chief administrative officer at Chicago-based proprietary trader Ronin Capital, and former chief executive at Board of Trade Clearing Corp.
Applying fixes without knowing what happened to MF Global’s customer funds would essentially unleash solutions in search of a problem, Hiatt said.

The CFTC roundtable covered topics relevant to safeguarding customer funds, including alternative models for the custody of customer assets, and issues related to dually registered FCMs and broker-dealers. In terms of LOSC requirements, which many FCMs are already implementing for their over-the-counter activities, panelists generally agreed that more disclosures would increase margin requirements for investors.

Kenneth Ackerman, counsel at Olsson, Frank, Weeda, Terman, Matz, noted little has been published about the costs or benefits of LSOC rules for the cleared OTC swaps market, and by extension, if similar disclosures can be applied to the futures market. Ackerman participated in the investigation of the collapse of Volume Investors Corp. in 1985, the only other publicized instance where FCM customers lost money, in that case approximately $3 million.

“If you look at the Volume Investors case and MF Global, and the big void in between them, that’s a very small risk that can be measured and contained,” Ackerman said.

Institutional View
Additional costs that increase investors’ margin requirements would be acceptable for at least some on the buy side.

“We need more security in the market and we’re willing to pay extra margin if we have that security,” said Andrew Karsh, commodities portfolio manager at the California Public Employees Retirement System (CalPRS).

Gary DeWaal, group general counsel at Newedge, a large FCM and broker-dealer, said at the roundtable that most of the proposals currently being bandied about were considered in the NFA’s two-year study of Volume Investors’ collapse. “All these ideas were eventually rejected because they thought they would increase risk — certainly the risk of moral hazard,” DeWaal said.

DeWaal said the Volume Investors incident ultimately prompted regulators to encourage FCMs to enhance internal controls, and the industry must return to making sure the current clearing model works. DeWaal acknowledged that “over time, firms haven’t been as diligent in that area as they could have been.”

Most representatives of FCMs and futures exchanges at the roundtable were skeptical of changes proffered that would significantly alter the current futures market structure and FCMs’ use of customer collateral, prompting some participants to voice frustration.

“What I’ve heard from some of the FCMs and exchanges is why we can’t do something, rather than what we can do to protect (customer) assets,” said John Torell, chief financial officer at hedge fund Tudor Investment Corp.
A major lesson of the 2008-2009 financial crisis is that regulation tends to loosen over time, especially amid bull markets. That history has prompted some market participants to call for more extreme measures, such as insurance for customer funds, that would likely require Congressional action.

More market-altering measures may ultimately be necessary if the futures market’s prized segregated accounts are to retain their allure. Most FCMs loathe the notion of rule changes that would reduce or eliminate their ability to commingle customer collateral parked in segregated accounts with house funds.

Brynjolfsson likened FCMs’ investing of commingled funds as “picking up pennies in front of a steamroller,” adding that customers need to know where their collateral is and that it is 100% risk free — perhaps left in Treasury bills or deposited at the Federal Reserve. Reaching for marginal yields with that capital, he said, “is either putting risk on retail customers without their full understanding or approval, or it’s creating systemic risk where either the government or futures industry must bail out any resulting failures.”

Brynjolfsson views the benefit of regulation to be generally overstated and markets to be largely self-regulating. “But one area where I certainly take the other side of the coin is retail customer protection,” he said.
Institutional investors can mostly take care of themselves, Brynjolfsson said, but retail customers’ collateral should be placed in accounts that must invest in all-but-riskless securities such as U.S. Treasuries. A less attractive option would be an industry guarantee for those accounts.

“If there was an insurance fund, presumably it would have strong authority and incentives to regulate the FCMs to make sure they didn’t take risks with the collateral, and properly segregated it. If that were the case, it could be workable,” he said.

2011 Average Daily Futures Volume on CME

Brynjolfsson’s emphasis on protecting customer accounts echoes Chilton, who said in early April that the CFTC is analyzing a panoply of proposals, and clarity about the agency’s next steps will likely emerge in May or June.
The direction will likely depend on the regulator’s explanation for the disappearance of MF Global’s customer funds. It may be that MF Global executives knowingly misappropriated segregated customers funds for corporate use.

Another possibility, according to an expert in the realm of clearing and settlement, is that MF Global’s proprietary trading stretched customer funds between the futures market, where customer and house collateral are segregated, and the securities markets, where that collateral is netted at clearing houses. When the firm’s giant bets on European sovereign debt went awry, the clearinghouses issued margin calls and MF Global customers began withdrawing funds in a panic. Positions no longer netted, leaving clearinghouses with insufficient funds if the broker failed to meet its margin calls and prompting them to retain collateral.

“The root of the problem is really that the clearinghouses don’t have the systems or the processes to segregate the customer collateral,” said the clearing and settlement source, who spoke on condition of anonymity. “Their whole side of the world was built on the idea that the broker-dealer gets to net positions.”

Such a scenario suggests no laws may have been broken, but rather mixing the futures and securities regulatory and insolvency paradigms resulted in customer funds ending up in different hands when the music stopped.

Whatever the outcome, Brynjolfsson said, it is taking the powers-that-be too long to sort out MF Global; self-interest should have already persuaded the major players — especially the SROs, CME and CFTC — to acknowledge their part in the collapse, and acknowledge responsibility for customer losses.
“They should have made customers whole within 24 hours, and there should be consequences for the people who are directly responsible,” Brynjolfsson said.

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