FM: Some of you have said the regulation has been overdone but also that some of the regulatory response on MF Global was appropriate. Give examples of the good and bad.
GC: First, the story continues to unfold as the CFTC [Commodity Futures Trading Commission] just recently released a new proposed rulemaking that is 438 pages, which the industry is digesting and trying to absorb. A lot of good things have happened, and we share those with customers all the time to represent the things that have changed to improve the safeguarding of their assets. Shortly after MF Global failed, the CFTC passed the revision to rule 1.25 on how FCMs can invest customer assets. MF Global was widely reported to have invested in sovereign debt that in some part related to the failure of the company; the revised rules don’t allow those types of investment. It pushed to investment spectrum way to the short side, the very safest investment an FCM could invest customer funds in, so that right off the bat was very important.
TK: Did that affect you? The change in 1.25?
TK: It didn’t affect us.
GC: No, because we invested our funds along those lines.
GC: It restored customers’ confidence that when we speak about only investing in the safest instruments and they ask ‘well, how do we know that?’ they know because it is the regulation and we have to file our portfolio twice a month with the regulator. So I agree with you, it didn’t change the behavior of conservative firms like ours, but it did restore [customer] confidence and them knowing for certain that their assets are invested at the FCM in safe products.
TK: I use that to point out that rule had no effect on us. We were very conservative before so it had no effect on us. We don’t believe in taking principal risk with customer assets. I do agree that transparency and disclosing our portfolio [are] good things.
SS: At least [for] everyone around this table, it had no impact. The reality is we didn’t take customer funds and invest them in sovereign debt. I think all of us here would view that as irresponsible.
SG: People around this table neither did what MF Global did nor what PFG, did but the industry is suffering because of [their actions].
PJ: [We invest using] very conservative guidelines, short-duration type investments. The one restriction that did impact us was the ability to do internal repos, which a lot of big banks did. But it wasn’t a huge impact and something that we were easily able to adapt to.
SG: Some of the things that have been put into effect would have prevented either what MF Global did or what PFG did, and that is a positive. There [are] both good and bad there.
PJ: The main point there is the electronic verification.
GC: I do participate in the working group with the NFA and the CME, and we hope to have the daily verification of bank accounts by early December.
SS: The regulators have put in place third-party verification that I thought quite frankly was in place before but it was circumvented because it was not belts and suspenders. So now should you confirm stuff directly with the banks? Of course. Should you make sure that assets are reinvested in conservative instruments? Of course. What happened at PFG and or MF Global could not happen today or should be caught by what was put in place.
JG: I don’t think the industry did a good enough job highlighting that PFG came to light because of the post-MF Global procedures put in place to verify bank balances. It was that procedure that outed the PFG problem. It wasn’t random that that came up.
There are also unintended consequences from what I would call regulatory overreach. For example, in the repo market where you have delivery vs. payment, if I wanted to do a repo transaction I might want to do $500 million of repo and I could have done that up until the new rules; now I can only do 25% of my repo with any counterparty. So when we called some of the big firms and said ‘we want to do a repo with you, we can only do this much per day,’ some of the big Wall Street firms said ‘pound sand.’ They are just saying that is too small.
Another example of unintended consequences is the rule that requires you to not reduce your excess seg by more than 25% in any day without having to notify your DSRO plus the CFTC and NFA. Historically what many FCMs did is they would leave as much cash as they had in the pool. If a firm had $20 million of excess cash they would leave that excess on top of the customer segregated money, giving that customer seg the maximum protection that firm had. On the seventh business day of every month, we have a CME collect for the exchange fees, we have a $5 million bill every month, so if I have $20 million in excess sitting there and the seventh the CME collects my $5 million I will drawdown by 25% and have to notify everyone. The unintended consequence of this new CFTC rule is I have to leave not as much money as I can in excess seg.
SS: I hear what you are saying and I know it is a tough world out there but I get a little concerned when we as industry leaders say that regulators are overreaching at a time when quite frankly some pretty horrible stuff happened — that we as an industry failed the customer. From my perspective, no regulation is perfect — but on balance it is my opinion regulators reacted with measures that are appropriate given what happened. The things they put in place go a long way in giving comfort to clients that there are systems and procedures in place that would prevent what happened. Retail customers are looking for us to lead.
PJ: Two other unintended consequences that I would point to are a narrowing of the competitive field in the FCM space; it will be more pronounced in the OTC clearing space given the capital requirement, but it also will have an impact on futures-only FCMs. Clients are going to have less choice when dealing with our markets. The other unintended consequence is on the back of some of the client protections that are being put in place, which are good things, but people need to realize that the interest income revenue stream — FCMs make their money in three ways: Execution, clearing commissions and interest income — has accounted for upwards of 50% of the overall revenue stream for many years. Zero interest rates for the past couple of years haven’t helped but [added] restrictions [regarding] 1.25 [and] LSOC (legal segregation with operational commingling) are going to add [more] constraints to FCMs in terms of being able to earn what had been significant revenue streams. You hear estimates of an 80% drop over the past two or three years in that revenue stream. That creates a pretty significant pricing model issue for the industry.