Former CFTC head offers MF Global solution

Equally important, a high-cost insurance plan almost surely would result in a “trickle down” of that expense to market users. For honest brokers, this could cause a flight of customers into non-market venues using, among other things, swaps to meet their needs. The Dodd-Frank Act grants broad exemptions from exchange trading for a wide swathe of existing or potential customers (e.g., commercial hedgers) that may exit the markets for lower transaction costs available elsewhere.

Perhaps most importantly, an insurance plan would perpetuate the underlying risk. If a road is dangerous because of a sharp curve, which is the better solution: Provide accident insurance, or straighten the road?

A Central Customer Funds Repository. This plan eliminates the risk. All customer funds would move solely and directly between the trader and the repository. Each customer would maintain a trading account with the broker and a funds account with the repository. Account documents would be executed between the trader and the broker; all orders would be placed there; a relationship with a favored associated person (“AP”) of the broker would be established; trading confirmations, monthly statements and margin calls would continue to be generated by the broker; and the dynamic (and economics) between broker and trader would remain largely as before. But customers would send their initial and maintenance margins directly to the repository for deposit in their separate accounts there, and all return payments would flow directly from the repository to the customer.

The repository would be authorized to invest customer funds in CFTC-approved securities, as the broker is permitted to do at the present time. And, because brokers earn substantial income from such investments today, the repository would be expected to minimize that loss of brokers’ revenue by sharing its investment results with them.

This approach would require new regulations. First, a licensure requirement for repositories would be appropriate, including an absolute bar against misappropriation of customer funds (less of a danger because the repository, unlike brokers, would exist solely to safeguard customer money). Second, those within the brokers who are responsible for keeping the repository apprised of developments in customer accounts would be registered and subject to severe personal penalties if misinformation is provided to the repository.

Setting up one or more central customer funds repositories would represent an initial cost but, through modest fees charged to brokers that may be passed on to customers, should be manageable. The question is whether this solution would impose less of a financial burden than an insurance program. The numbers would have to be crunched but my hunch is that it would.

What is in it for the brokers? For one, keeping customers rather than watching them flee to swaps or other alternatives to avoid the burden of an insurance fund. For another, having the ultimate come-back: “Oh, that. Don’t worry. We have eliminated that risk.” And commissions, fees and distribution of investment gains from customer deposits at the repository largely should be unaffected.

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