Whither Futures Market? (Part 4)

Terry Flanagan

In the final part of our four-part series about the futures market in the wake of the MF Global collapse, potential remedies are parsed.

Additional costs that increase investors’ futures-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.”

Most representatives of FCMs and futures exchanges at the roundtable were skeptical of changes that significantly altered the current futures-market paradigm 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 co-mingle customer collateral parked in segregated accounts with house funds.

John Brynjolfsson of Armored Wolf likened FCMs’ investing of co-mingled 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.

Brynjolfsson’s emphasis on protecting customer accounts echoes that of 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 final 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 realms 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 reach a conclusion regarding 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 for effectuating that fraud,” Brynjolfsson said.

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