A POST-MF GLOBAL PROPOSAL
The full facts remain elusive but, according to the MF Global bankruptcy trustee, some $1.2 billion may be missing from MF Global’s segregated customer account. For generations, the U.S. Commodity Exchange Act has required a strict separation of a broker’s customer funds from its own operating resources. Under no circumstances may customer funds be used to pay the broker’s own bills. Violations are crimes. And, for generations, that creed was honored. If it is concluded that this is the exception, especially considering the size of the shortfall, there will be calls for corrective measures. The challenge, in that case, will be to find a remedy that does more good than harm.
The “good” is to reassure market users that this is one-of-a-kind event and has been addressed effectively. The harm would be devising a response that chases traders out of the market because of cost. This article identifies the dangers (and opportunities) that two solutions under active consideration could yield.
Insurance. One proposal would seek to emulate a program that has been in place for many years in the securities industry, namely, an insurance system administered by the Securities Investor Protection Corporation (SIPC) that (within limits) compensates securities customers if they suffer losses from their broker’s bankruptcy. Such a plan for the futures community was considered once but rejected because the customer funds segregation regime (until now?) worked remarkably well.
But SIPC has a fundamental difference from what is now being proposed for futures, namely, in almost all cases the deficiency in securities accounts occurred lawfully because stockbrokers are not subject to the same “seg” restrictions as the futures world. Within limits, a securities broker may use customer funds for other purposes, so shortfalls at bankruptcy typically are the result of lawful broker conduct. An insurance program, as a result, restores the customers within the existing legal framework, not as a result of broker criminality.
But the losses to futures customers from a broker bankruptcy can occur only if a violation of law has occurred. Otherwise, all customer funds would be safe and sound, readily transferable in full by the trustee to other brokerage firms. It is less common to insure against criminal behavior. Thus, a futures insurance plan would be based on different facts and circumstances and, presumably, a different risk profile.
Policymakers also need to consider the “moral hazard” feature of an insurance plan that pays for the criminal actions of others. Might such a program encourage the ethically challenged to follow their instincts more quickly than if they would face crippling personal liability by proceeding?
Then there is cost. The Commodity Futures Trading Commission (CFTC) would need to dictate an insurance program by rulemaking. It already is being sued over other rules for allegedly failing to give proper attention to the costs inflicted on regulated entities by its directives. If the cost of an insurance program were to prove substantial, it may be attacked as well.
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.
Other potential beneficiaries might be the existing clearinghouses. After all, the back office of a repository would include many functions similar to those now performed by clearinghouse managers. Is there an affiliate in their future?
But wait! This may be the first time in eons that a serious customer funds shortfall has occurred. Are we over-reacting? True, the recent events are nearly unprecedented. But suppose that there were dozens of similar incidents, with aggregate potential losses of over $1 billion affecting an aggregate 35,000 customers. That question would not be asked. The magnitude and impact are immense. Once is enough (remember, we only die once, too).
1) Based on the concept that each customer will maintain two (2) accounts, one with the futures commission merchant (FCM) for trading purposes and one with a CFTC-regulated central customer funds repository (Repository) where all customer funds are held, received, dispersed and refunded. It is also contemplated that amounts payable to or receivable from the clearinghouse for cleared customer positions will be coordinated by the Repository with the clearinghouse.
2) FCMs will continue to handle all proprietary trading using their own resources. The broker-customer relationship remains largely intact, except that funds flows now occur directly between the customers and the Repository.
3) The Repository will need complete details on customer activity, including margin calls, account closures, new trades and liquidations, and other funding matters.
4) Because the Repository will invest customer funds in permitted ways, the FCMs will no longer earn income from this activity. It is proposed that a substantial part of the Repository’s gains from these investments be remitted to the FCMs as compensation for providing extensive customer activity information to the Repository (see note 3).