From the November 01, 2012 issue of Futures Magazine • Subscribe!

Spotting broker red flags

Due diligence

The first step should be a visit to the National Futures Association’s (NFA) BASIC web page. BASIC stands for Background Affiliation Status Information Center. BASIC is free and available to the public without needing to register or having a password. Searching by firm name or individual name, you can view Commodity Futures Trading Commission (CFTC) registration and NFA membership information and futures-related regulatory and non-regulatory actions contributed by various regulatory agencies and futures exchanges. Without giving you the name of one particular FCM searched, I found 11 separate regulatory actions and 167 CFTC reparations cases, including a $75,000 fine for recordkeeping practices. Smoke does not mean fire, but you cannot have fire without smoke. 

At the very least, BASIC will let you know if your brokerage firm, commodity trading advisor (CTA) or commodity pool operator (CPO) is registered with the NFA. We read weekly about criminal charges brought by the CFTC against unregistered, unlicensed CTAs, CPOs and retail forex dealers. If someone solicits your account for trading futures or currencies, in any manner of investment vehicle, and the broker and his or her firm is not found on BASIC (or FINRA’s Broker Check), it is best not to proceed

There are many excellent, well-regulated and well-run investment pools, funds and partnerships, but not all of them are above reproach. In addition to the usual questions you should ask regarding performance, drawdowns and trading strategy, be sure to ask the name of the brokerage firm where the investment is housed and which will be clearing the trades. The first red flag would be when the investment manager refuses to provide the information. The second red flag could be when the investment manager gives you a name of a broker or auditor or anyone else you can call to confirm a legitimate account. Instead, call the brokerage firm directly (you can find contact info on BASIC). If the manager offers individually managed accounts, it is up to you to choose a broker. While he may provide a list of approved FCMs, he should not be steering you to a specific broker, particularly if its commissions are non-competitive. 

Multiple levels of checks are better, so it is best to perform due diligence on a broker and manger separately. If you are getting information from only one source on an IB, FCM and manager, you are not doing effective due diligence. 

Publicly traded companies like MF Global have numerous reports they must file with the Securities and Exchange Commission (SEC), and, as a registered FCM, MF Global had to submit monthly segregated account reports to the CFTC. These reports can reveal a lot of information, though many of them, especially SEC filings, can be dense and hard to interpret if you don’t know what to look for. Find someone who does.

The CFTC numbers are more straightforward. They list the amount of customer segregated funds the FCM holds as well as adjusted net capital, net capital requirement and excess capital. Large swings in any of these numbers, particularly customer funds, as MF Global experienced, are one red flag. A more serious flag is a shortfall in the excess net capital. MF Global’s July 2011 report showed it negative $150 million after being forced to adjust this number by regulators. The total seg funds reported by MF Global in July was $8.8 billion; that dropped to $7.3 billion in August (a volatile month that would have required higher margins) so someone was paying attention. 

A red flag that has come up in several cases is inadequate auditing. A large futures broker or investment firm should have, if not one of the big four, an institutional level auditor. The Sam Israel Bayou Hedge Fund, Bernie Madoff and PFG scandals all used sole proprietor or inadequate auditors. While the big guys have messed up as well, a large firm managing hundreds of millions of dollars shouldn’t be hiring someone working out of his (or her) garage. If they do, it is a blazing red flag. 

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